Economic recession is a serious challenges faced by all of the world economy players. The major causes that leads to recession was falling prices in the property market, rising unemployment, increasing bankruptcy situations among the individuals as well as corporate organizations, down ward trend in the stock prices and decreasing public confidence in the economy etc. The governments and policy makers have great role in helping the economies to overcoming the challenging situation. Recession is mainly characterised by scarcity of financial resources in the economy.
The intervention of government in the economy is essential for reducing and overcoming the financial challenges resulting from recession. The governments in different countries are adopting the interest rate reduction as a tool for enhancing the flow of money in the economy and thus creating an artificial inflation in the economy. The interest rate reduction tool seems to be effective to make up the recession on certain extend only. The interest rate cuttings are mainly aimed to boost aggregate demand in the market by giving the individuals more disposable income by ensuring the cheaper borrowing and investment options.
The attitude of the government of the USA towards its great depression in the 1930s seems to be inappropriate and ineffective for overcoming the depression. The reason is that Government have a great role in ensuring the safety and liquidity of the financial investments in the country as it is the measure of economic stability of a country. In order to ensure the safety and liquidity of the funds invested in the banks and other financial institutions, government have to play active role. It is essential for keeping the confidence of the investors which is the base of all types of investment. In order to analyse the effectiveness of the interest rate reduction policy of governments to boost the economies, its aspects on different sections of the economy have to be deeply analysed.
Impact of interest rate cut on the stock market
The relationship between interest rates and the stock market movement is of indirect in nature. With the reduction of the interest rates in the economy the stock market can be positively influenced. Through the reduction in the interest rates, people who wish to borrow money can be supported with interest arte cut. But it negatively affects the lenders of the money and the investors in the bonds through reducing the return from the lending process through reduced interest rates. In case of rational investor, the decreasing interest rate will force them to follow equity market investment rather than bond market. This will facilitate the stock listed businesses through availability of funds from the investors. This will improve their future earning potential and thus booming trend in the stock prices can be seen. Thus the lower interest rate will improve the financial position of the business firms through availability of relatively cheap financial resources. “Overall, the unifying effect of an interest rate cut is the psychological effect it has on investors and consumers; they see it as a benefit to personal and corporate borrowing, which in turn leads to greater profits and an expanding economy.” (Investment question: What does a cut in interest rates mean for the stock market? 2009).
Interest rate adjustments of the government will result in increasing the liquidity in the economy as well as in investment market. But it suffers from limitations regarding extends of the interest rate cuts without employing the devaluation of currency on large scale. Reduction in the interest rate cut will support the exporters from the country but badly affect the importers. As a result of this, the import costs will be increased. In order to attract the investors, higher interest rates is essential. Thus the reduction in the interest rates will badly affect the investment in the financial markets. The rising protectionism among various countries leads to rejection of free trade and thus the export opportunities are greatly reduced. As a result of the decreased export opportunities in the economy national income also reduced greatly. It leads to contraction of the GDP together with currency devaluation. (Rees 2009).
By providing support to the exporters with lower interest rate, the foreign exchange earnings can be improved.
Impact of interest rate cut on the home sale market
While looking into the causes of financial crisis it is seen that crisis started in real estate market. The real estate bubble was developed due to the high demand of financial securities and this real estate bubble led to financial crisis. The major cause that leads to recession in the economy is uncontrolled real estate transactions and resulting asset price inflation. In the home sale market availability of cheap fiancé will leads to enhanced investment from the part of the investors. Thus a boom condition will be created in the sectors which influence the economy positively.
Impact of interest rate cut on the banking and financial markets
The causes of economic recession are mainly related to the financial weaknesses of the banking and financial companies in the USA. Financial market instability in the economy is the result of defaulted free market system and the capitalism. It causes booms and bust conditions in the global economy. The defaults in the operations of banking and monetary system are another root cause of the crisis situation. When considering the possible causes for this economic situation, fundamental defect of the free market system is the prominent reason for the crisis.
In the US economy, the defective economic policy of the government leads to spending of banks and financial institutions more than they can afford. This leads to domination of speculative activities in the economy. Speculators are only interesting in short term gain from the economy. Thus the long term yield on assets is not properly ensured. The zero interest rate policy of central banks will assure cheap financial resource in the market for the borrowers. Due to the lower interest rate, investors will be interested in equity investment and thus in stock market a boom condition will be aroused. The cutting down policies of governments relating to the interest rates should be effective for ensuring the financial flow in the economy. It will result in overcoming the financial recession on a certain extend.
The interest rate reduction will cause new challenges to the financial institutions. “There have been concerns that possible further reductions in short-term rates could impair money market mutual funds and bank profits, thereby altering the flow of finance from households to firms.”
Effectiveness of interest rate reduction on overcoming credit crunch
The credit crunch: Alan Greenspan, ex- Federal Reserve chairman described the present financial crisis as a credit tsunami. Credit crunch is a situation in which the economy faces a sudden shortage of funds and the corresponding down-turn of availability of lending loans. It occurs due to the following reasons:
A Credit Crunch can occur for various reasons:
- Sudden increase in interest rates (e.g. in 1992, UK government increased rates to 15)
- Direct money controls by the government (rarely used by Western Government’s these days)
- A Drying up of funds in the capital markets.
The current credit crunch was due to the rise in the sub prime mortgages which resulted in the shortage of funds. It is expecting that the credit crunch will be long lasting as down fall in the house price is continuing and it reduces the value of mortgage loans. Through the interest rate reduction, the availability of cheap fiancé in the economy will be ensured and thus the credit crunch can be successfully overcome by the economy.
Effectiveness of interest rate cut for overcoming the recession
Keynesian Theory: Keynesian theory is developed during the period of great depression. John Maynard Keynes, during great depression, explained that in a normal economy characterised by high level of employment the cash low in the economy is in circular nature. In reverse market conditions such as stock market crash, declining asset price, the consumer confidence will be affected and thus the cash flow will be restricted. To overcome the financial crisis resulted from stuck in the cash flow circle, government have to spend more amount of money in the economy to maintain the consumer confidence. Thus the circular flow of money in the economy would be re-established.
As per the Keynesian Theory, if the increase in money supply is faster than the rate of growth of national income; it will lead to inflation in the national economy. If the money supplies increases corresponding to the inflation, the inflation will be disappeared.
The cost of money in the economy is reduced through cutting down of the interest rate in the banking transactions. It leads to increasing the volume of money in circulation in the economy and inflation will be created in the economy. It will boost the market economy with easy availability of borrowed finance to the business firms and the home owners. This will support the economy to prevent the deflation. But it will result in further bad debt creation in the economy as the repayment of debt becomes restricted with decreased employment opportunity, downward movement of the economy as well as the stock market.
When considering the causes of the economic recession, the interest rate reduction seems to be in-effective for overcoming the recession situation. The major cause of recession is excess liquidity in the market resulted from Unsound methods of debt financing adopted by major central banks. Through their irresponsible actions in the economy, increased debt financing without proper guarantee for return has highly increased. The resulted sudden cash flow in the economy created a more risky environment. Due to the financial recession, the return to financial institutions is restricted and thus bad debts rate is highly increased. It affected their financial position badly. (Karam 2008).
Sustainable economic growth has to be ensured by the government along with assuring price stability. In case of interest rate reduction, the interest income available to the banks should be reduced.
The general concept relating to the interest rate reduction is that it will lead to irrational boom conditions in the property market. The GDP growth rate of most of the countries is reduced through diminished economic activities especially diminished foreign exchange transactions. Companies are reluctant to offer bonuses and the investment in the stock market is greatly reduced. In the present conditions of the economy slow down, downward movement of the stock market and greater loss of job opportunity, only interest rate reduction is not enough to overcome the situation by creating boom conditions. The creation of baseless liquidity in the economy through interest rate cuts will lead to increased bad debt in the economy.