Evaluate These Two Comments On The Merit Of Their Arguments

Evaluate Thesetwocomments On The Merit Of Their Arguments See If You

Evaluate these TWO comments on the merit of their arguments. See if you agree or disagree with what they say and explain why. The comments refer to this topic - "It is argued that expansionary monetary policy of US Fed and other central banks and the resulting near zero interest rates have caused bubbles and bursts. The logic behind this argument is that near zero interest rate encourages borrowing by risk loving investors who use cheap funds to finance excessively risky projects. But once the economy gets back to normal condition, interest rates start rising and these risky investments increase systematic risk. Many financial institutions who take exposure to these projects during low rate regimes have concentrated risk that could lead to systemic risk"

Paper For Above instruction

Expansionary monetary policies implemented by the US Federal Reserve and other global central banks have been pivotal in shaping financial market behaviors in recent decades. These policies, characterized by near-zero interest rates and large-scale asset purchases, are often aimed at stimulating economic growth during downturns. However, evidence suggests that such policies also contribute significantly to the formation of financial bubbles and subsequent market crashes, raising questions about their broader systemic implications.

The core argument posits that near-zero interest rates lower the cost of borrowing, thereby incentivizing risk-loving investors to seek high returns through increasingly risky projects. These investors, motivated by the cheap financing available, may undertake speculative investments in sectors such as real estate, technology stocks, and emerging markets. For example, during the prolonged low-interest rate environment following the 2008 financial crisis, there was a marked increase in mortgage-backed securities and real estate investments that eventually contributed to the 2008 housing bubble burst. This pattern aligns with the liquidity effect theory, which suggests that excess liquidity drives up asset prices beyond their intrinsic value (Mishkin, 2007).

Furthermore, the argument highlights that once the economy begins to recover and interest rates start rising, these previously financed risky projects become more vulnerable to cost increases. The increase in interest rates can precipitate a rapid decrease in asset prices, leading to widespread losses across financial institutions exposed to these risky investments. Since many institutions often hold concentrated positions in these assets, their sudden devaluations can pose systemic risks, potentially triggering financial crises. The collapse of Lehman Brothers in 2008 exemplifies how excessive risk concentration can lead to systemic failure (Brunnermeier, 2009).

Critics of expansionary monetary policy argue that continuous low-interest rates distort market signals, leading to misallocation of resources. They suggest that artificially suppressed interest rates incentivize speculative behavior rather than productive investment, ultimately creating bubble formations. Moreover, these policies can impair the financial market’s ability to accurately price risk, since normal risk premiums are suppressed, leading investors to underestimate the likelihood of losses (Bernanke, 2015).

On the other hand, some scholars contend that low interest rates are necessary during economic downturns to prevent deflationary spirals and promote employment. They argue that bubbles are an unintended side effect that can eventually be managed through regulatory frameworks rather than monetary policy restrictions. Nonetheless, empirical evidence indicates that bubbles often form during prolonged periods of low rates, and their bursts can have systemic repercussions, emphasizing the importance of cautious policy calibration (Kindleberger & Aliber, 2011).

In conclusion, the assertion that expansionary monetary policy and near-zero interest rates contribute to financial bubbles and systemic risk is compelling. Historical and empirical data support the view that prolonged low-interest environments incentivize risky investments that may defend against economic downturns but pose long-term risks to market stability. Policymakers must, therefore, balance the short-term benefits of monetary easing with the potential for creating financial vulnerabilities, possibly through enhanced macroprudential regulation and improved risk assessment mechanisms (Adrian & Shin, 2010).

References

• Adrian, T., & Shin, H. S. (2010). The Changing Nature of Financial Intermediation and the Financial Crisis of 2007-09. FRBNY Economic Policy Review, 16(1), 11-28.
• Bernanke, B. S. (2015). The Courage to Act: A Memoir of a Crisis and Its Aftermath. W. W. Norton & Company.
• Brunnermeier, M. K. (2009). Deciphering the Liquidity and Credit Crunch 2007-2008. Journal of Economic Perspectives, 23(1), 77-100.
• Kindleberger, C. P., & Aliber, R. Z. (2011). Manias, Panics, and Crashes: A History of Financial Crises. John Wiley & Sons.
• Mishkin, F. S. (2007). The Economics of Money, Banking, and Financial Markets. Pearson Education.