Financial Institutions and Markets Essay Example | Topics and Well Written Essays - 2000 words

Financial Institutions and Markets - Essay Example A monetary policy employed by a country can either be an expansionary monetary policy or ‘contractionary’ monetary policy. Expansionary monetary policy helps in increasing the money supply in the economy of a country at a faster rate than normal and in case of ‘contractionary’ monetary policy, the money supply increases at slower rate or even fall behind in the economy. Expansionary monetary policy is often employed to prevent unemployment during recession. It happens because of interest rates going lower which therefore attracts credit facility to be available easily for the business concerns to help themselves expand. In the United States, expansionary monetary policy is implemented through the combination of three things. They are: a) Using Open Market Operations, by purchasing securities in the open market. b) Federal Discount Rate is lowered. c) Reserve Requirements are also lowered. Now, all these three steps have a direct impact on the interest rates, including mortgage rates. This leads to increase in borrowing of mortgage loans, as well as increase in rates of capital investments by business concerns. Most countries follow an expansionary monetary policy to ensure higher economic growth and go on decreasing the interest rates. It helps in growth of employment opportunities but at the same time has its limitations too. This can only have a short term effect on the economy. In the long run, it will lead to higher inflation rate and would also affect the economy in an adverse way (Mishkin, 2007, p.39). Thus, effect on long term mortgage rates are less predictable and the effect is on a lower proportion as compared to the extent of expansionary economic measures taken by a country. This happens mainly due to two reasons. Firstly, real factors like market demand influences the long term mortgage interest rates more than the monetary factors. Secondly, the effect or impact of monetary factors operates mainly on the expected future l ong term mortgage rates (Gwartney, et. al. 2008, p.301). Although the expansionary economic measures reduce the short term mortgage interest rates, it may lead to a rise in interest rates in long term. This unpredictability problem creates a surmounting problem in creating a balance between the mortgage rates and expansionary economic measures followed by a country. Expansionary Monetary Policy Expansionary monetary policies are used by countries to help stimulate the economic growth of the country. It leads to increase in supply of money in the country. It usually leads to lowering of interest rates in the country. This in turn reduces the borrowing cost and also reduces the return on savings. This helps in increasing the aggregate demand of goods and services in the economy. People are more attracted towards investing in housing by taking loans at lower interest rates. These types of expansionary monetary policies are often employed in countries to counter the recessionary gap. It helps in reducing or preventing unemployment