Government stabilization policies in macroeconomic theory and practice

Macroeconomic Analysis

Economically, recession is described as a significant drop in economic activity over a short period of time usually a few months (bbc news, 2008). Gross Domestic Product (GDP), household income and other macro-economic indicators drop while others such as unemployment and bankruptcy rises. Recession can be caused by many factors e.g an external trade shock or the burst of an economic bubble such as the United States housing bubble. Most governments deal with recession by applying expansionary macroeconomic policies like reducing interest rates and increasing government spending. By lowering interest rates, governments hope to entice business into expanding.

Fiscal policy refers to the use of the government taxation (revenue collection) and expenditure (spending) to influence the economy of a country. The changes in the two key pillars, revenue collection and expenditure influence macro-economic variables such as aggregate demand, resource allocation pattern within the government and the distribution of income.

Monetary policy refers to the regulation of supply of money and interest rates in a country by a central governing authority such as the Federal Reserve Board in the U.S. (Marc L., 2013). By controlling the key two pillars, supply of money and interest rates, they help stabilize the price of commodities and keep unemployment low. Two policies are generally used in the controlling the supply of money, expansionary and contractionary policy. In expansionary, the total supply of money is increased rapidly than usual and is used controlling unemployment during a recession. Interest rates are reduced in the hope that easy credit will encourage businesses to expand. In Contractionary policy, the money supply is expanded slowly than normal even in some cases it is shrunk. The goal here is to slow inflation and to control the value of a currency.

The great recession of 2008 hit the U.S. economy in December 2007 and lasted until June 2009. The Federal Reserve initiated "Operation Twist" whereby it sold and purchased short-term and long-term bonds. The program's main goal was to reduce the interest rate making borrowing cheaper for consumers and businesses. It involves selling short-term bonds and taking the cash to buy long-term bonds. This action saw a small improvement in the labor market as unemployment reduced.

Another policy adopted the Federal Reserve was quantitative easing. It involved the purchase of significant amount of mortgages (Bernanke, 2009). The action target was to reduce long-term interest and to stimulate spending. This measure was undertaken in the hope of restarting the faltering economy and firing up the stock market. As the economy worsened during 2008 and 2009, the Federal Reserve provided lines of credit to financial institutions. President Bush signed a $700 billion bailout for banks. This was to inject funds for consumer loans and to stimulate spending. It also gave the government the chance to buy non-liquid assets from banks. The Federal Reserve also funded the government in the acquisition of American Investment Group (AIG) which is one of the largest global insurance firms.

In early 2008, as the global financial crisis spread, foreign banks that needed U.S. dollars to transact business found it very difficult accessing loans from money markets. The result effect was distorting the market for inter-bank loans (Hilsenrath, 2012). The Federal Reserve provided money to some foreign countries' central banks so that loans could be made their local banks with liquidity problems. The banks included the bank of England, the European Central bank and the Swiss National bank. The money would also be used in lending to consumers and businesses to stimulate growth in their respective countries.

The Federal Reserve actions in dealing with the recession of 2008 bore fruits as the U.S. economy recovered in June 2009. They bailed out key financial and lending institutions which in turn made it easy for consumers and business to access loans. With the economy recovering and recession contained, macro-economic indicators such as unemployment posted a positive sign as it dropped to 9%.