Monetary Expansion & Monetary Contraction

In the aftermath of the great depression, Mr Hoover wrote a letter to the president elect, Franklin D Roosevelt. In the letter Hoover informed Roosevelt that "it would steady the country greatly if there could be prompt assurance that there will be no tampering or inflation of the currency; that the budget will be unquestionably balanced even if further taxation is necessary; that the government credit will be maintained by refusal to exhaust it in issue of securities"

This policy of Hoover was essentially a rejection of the tools of fiscal and monetary policy that were at his disposal. These tools could of limited and reduced the effects of the Wall Street Crash. As a consequence America sled into a very significant deflationary spiral between 1930-1933.

Ben Bernake, the present chairman of the federal reserve has studied the Great Depression with great depth. One of the main conclusions of his studies, is that this deflationary spiral could of been avoided if the Federal Reserve had not caused a contraction of the money supply. Such a contraction is known as monetary contraction

However, there are some very real dangers of implementing a policy of monetary expansion, the opposite of monetary contraction.

If monetary expansion is two aggressive, this will result in significant inflation. Very strong inflation will destroy people's saving and pension funds, place upward pressure on prices and result in social upheaval. Yet, very strong will inflation would have the positive effect of eroding the real value of debt and liberating the borrower from his repayments. Though such inflation could be seen as a reward for reckless borrowing and raises some questions in relation to moral hazard.

Therefore, a policy of expansionary expansion is as dangerous as a policy of monetary contraction as it can destabilize an economy even further, damage consumer sentiment delay any upturn. Thus, an equilibrium must be found between each policy.

Part 3--The Collapse Of The Housing Bubble

06/05/2005 - -------------------- 24/03/2007 -------------------------------04/10/2008

The above actions of the Federal Reserve in the aftermath of dot com bubble and the 9/11 terrorist attacks allowed the US economy to avoid a severe economic slowdown

However, once the housing market bubble imploded the Federal reserve was unable to find another medium that would allow the economy to operate at its full potential because consumer and business confidence was so low, the levels of debt they were carrying are so great, and personal saving rates were minimal.

Today, consumers and business are more concerned with paying off debt instead of buying Channel hand bags and new equipment. Employment thus falls as does the use of existing capital stock.

As we continue to pay back the debt, the values of our houses collapse, our pension funds crumple, unemployment soars and the economy may become deflationary. This will result in debt becoming relatively greater and becoming even harder to repay resulting in even greater levels of savings.

Part 2--The Beginning Of The Housing Bubble

24/03/2001                                  21/04/2001                               30/03/2002

Following the collapse of the dot com bubble , the American and world economy experienced a significant slow down. For example, $10 trillion was wiped off global share values from 2000 to 2001, the net worth of American households fell in 2000 for the first time since records began 55 years ago and America's corporate sector suffered its deepest recession since the 1930s

Moreover, the Japanese economy, the second biggest economy in the world at time was on the verge of re-entering a recessionary and deflationary period.

This economic situation was destabilized further by the September 11th terrorist attacks.

In order to avoid a deep recession and to stimulate economic growth in light of these events, Alan Greenspan, chairman of the federal reserve cut interest rates from 6.5 % in November 2000 to 1.75% in July 2002.

These reductions allowed credit to become cheap and easy to obtain. For example, in 2003, there was wide spread promotion of mortgages with low introductionary rates. All this cheap money filtered into other sectors of the American economy and allowed consumers to go shopping once more.

Perhaps, the economist magazine put it best when it wrote of these interest rates reductions " as one bubble burst, another started to inflate. "

Part 1--Economic Bubbles:Boom and Bust

On the 10th of March 2000, the NASDAQ index reached 5132.52. This was its peak value and was more then double the value of index from the previous year.

This represented the end of one of greatest bull markets of our modern time. From then, the market began a steady decline downwards. Even today, the NASDAQ has never returned to those heady heights.

The reason for the metamorphosis of market sentiment is unknown. It could of been related to the negative findings of the United States V Microsoft case which was being heard in the Federal Court. Or the reduction in spending by companies on information communication technology following the passing of the Y2K switchover deadline.

The conclusion of the unrelentless upward advance of the New York Stock Exchange in October 1929 is equally unknown. It could of been caused by the refusal of the Massachusetts Department of Public Utilities to allow Boston Edison to split its stock into four highlighting in its decision that "due to the action of speculators" stock levels had reached a level" where no one in our judgement... on the basis of earnings, would find it to his advantage to buy". Or by some negative comments by economists in the press at the time.

These bubbles were created by rising share prices commonly in new emerging markets such as internet or radio companies. These rising prices encouraged more people to invest in the hope that the share price would rise further. These investments were not based on economic fundamentals such as price earnings ratios but on stupid speculation. This caused further rises and resulted in the creation of massive economic bubble.

When these bubbles finally collapsed, significant social and economic costs developed. These included large unemployment, wealth destruction, the collapse of consumer confidence and the start of a deflationary spiral as was the case during the great depression.