By increasing the money supply, the Federal Reserve can lower interest rates. Th

Question

By increasing the money supply, the Federal Reserve can lower interest rates. This has a broad impact on the economy as mortgages, business loans, etc. can be obtained less expensively. Some economists believe that the money supply increases contributed to a housing bubble and the subsequent housing market crisis of 2008-09. They suggest that this event is an example of how the Fed can create recessions by artificially encouraging bad investment decisions, and that the same pattern can be seen in the tech stock bubble of the late 1990s and other recessions even as far back as the Great Depression.

Evaluate this view of the cause of recessions. Do you agree or disagree? Why?

Though your answer needs to be correct in terms of economic theory (be sure to read the assigned chapters), creativity and diverse opinions are strongly encouraged.

Explanation / Answer

Yes, one of the factors which drove down the interest rates prior to the crisis was Fed increasing the monetary base. But there are other factors too which contribute to the lower interest rates. A sudden increase in savings was also one of the other major factors to have driven down the interest rate.

But most of the increase in monetary base went into the portion of currency held abroad and an annual growth rate of money supply was actually lower in 2006. It was around 10% in 2001, which fell down to 5% growth in 2006.

Thus, increase in money supply by Fed cannot be held responsible for the housing bubble.

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