PeakTrader.com

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PeakTrader said...

The cause of the recession was the combination of restrictive monetary policy and contractionary fiscal policy.

The chart shows the money supply was low from 2003 until the recession (or below 6% growth), while budget deficits shrunk to $162 billion in 2007.

Also, I may add, in the equation MV = PT, if M and P are constant, then V = T, i.e. V, the velocity of money, or the number of times money is exchanged, equals T, the number of transactions, or the quantity of goods exchanged. T can be represented by real GDP.

The goal of monetary policy should be to keep actual GDP close to potential GDP, which smooths-out the business cycle creating optimal growth (since there's neither strain nor slack in the economy).

The fact that there are monetary tightening and easing cycles, to close output gaps, are attempts to smooth-out T in the short-run. V and T fluctuate in the short-run, which require adjustments in M to stabilize P and smooth-out T.

For example, if people decide to hoard money, then V and T will fall (in the short-run). So, M needs to rise (higher than a constant growth rate).

A problem of monetary policy are the lags in the adjustment process. So, the Fed has to work in the future economy.

If the Fed began the easing cycle several months earlier, that would've made a significant difference, e.g. between a mild recession and a moderate recession.

However, the Bush tax cut in early '08 gave the Fed time to catch-up. The country was on a path to a mild recession, until Lehman failed in Sep '08.

It's more accurate to say in the mid-2000s, monetary policy was accommodative, became neutral, and then restrictive rather than the money supply was too low.

Also, up to $800 billion a year trade deficits drained money out of the private sector, because dollars were shifted to export-led economies, and then flowed into the government, i.e. U.S. Treasury bonds.