Did America Choose Recession?

An economist from the Massachusetts Institute of Technology, Rudi Dornbusch said:

None of the post-war expansions died of old age. They were all murdered by the Fed. with
the exception of the one in 2001.
The Federal Reserve seems to act more gentile this days, as they have cut its discount
rate on August 17th, which left the investors and the banks the impression that the FED is
trying to maintain stability in the markets and to insure some liquidity, but that they are not
panicking about the situation. They admitted for the fist time that the economy would suffer if
the loans were expensive and difficult to obtain. This represents the exact opposite strategy,
where they choose to increase the interest rates to handle the inflation.
There were rumors among the economists about the magnitude of the disaster that the
falling house prizes and the subprime mortgages will create, and everyone is asking if the FED
should prevent it or not.
A generally accepted belief is that the FED should not cut interest rates in order to help
the lenders and investors, because this will encourage greater risk-taking and misleading
situations. However, in critical situations it will be a good option for the bankers to be guided
by the Taylors rule, which suggests appropriate adjustment to the interest rate according to the
inflation and employment rate. If inflation or employment rate are higher than desired, interest
rate should be increased and vice-versa.
Some economists claim that central bank should not always try to avoid recession. This
statement is strengthen by the idea that people would be mislead to the conception that the
central bank can handle everything. This will encourage more borrowing, less savings and
bigger risk-taking. During the last 25 years, U.S has been in recession only 5% of the time,
while 25 years before that, it has been in recession 22% of the time. Good reasons for this
situation are the major structural changes that have made the economy more stable. However,
another reason could be the repeated wake-up calls when the economy seemed to be falling
asleep.
A lot of people claim that the current financial crisis occurred due to the softness of the
2001 dot-com recession. Even though there were hard times for the Internet stock market,
the U.S wasnt in technical financial crisis, which represents a fall of the GDP in two

consecutive quarters. This outcome gave to the government and to the FED a better grip on the
entire economy, they were left with the idea of overall stability. Now was the moment when
the FED took the risk. The FED slashed the interest rate (by more than the Taylor rule
prescribed) encouraging a house price boom, as the conditions for a loan were more attractive
and not so well regulated. By this series of tax cuts and interest rates cuts, the FED managed to
increase the demand, which is not something that you wish for when the economy is strong.
A lot of economists hope that the FED will not repeat the trick. Cutting interest rate
will encourage borrowing and spending. But after this long time of sharp and unreal expansion,
wouldnt a wake-up call be necessary? Contrary to peoples belief, it is not central banks job
to prevent recession at any cost. Its responsibilities are to keep inflation down, to protect the
financial system, and to prevent a recession turning into a disaster.

2. State the connection between the increase of inflation and the central banks need to
raise interest rate.
I answered this question in the resume above, where I mentioned Taylors rule, but now
I will go a bit deeper into this situation.
There are two general theories explaining inflation. One is the demand-pull theory and
the other is cost-push theory. The first says that if a lot of people are after the same good or
service and there is not enough for everyone, the prices will increase so demand meets supply.
The latter states that the companies will increase prices to cover higher supply prices and
maintain profit margins.
Inflation is a powerful tool, and it needs to be controlled. When not treated well, it can
lead to disasters. As an example, we have the hyperinflation in Germany in 1920s which
breakdown the entire monetary system. Prices rose 2500% in one month. So, to avoid this kind
of situations, the central bank should intervene in the early stages.
If there is an increase in inflation, central banks have 3 options to reduce it to the
normal range. There they are:

Direct the FOMC to sell U.S. Treasuries on the open market

Raise the reserve requirements
Raise the discount rate

If the Federal Open Market Committee offers securities to sell, it bids up interest rate in
order to entice investors, who take money out of their bank accounts to buy Treasuries. These
leaves less money in the banking system, which means banks have less money to lend. With
less money to lend, the price (which is the interest rate) on the remaining loanable funds will
increase. This slows down demand and lowers the prices across the economy.
If the bank increases the reserve requirements (which leaves less of a banks deposits
available for lending) or increases the discount rate (which makes it more expensive for the
banks to borrow money from the Federal Reserve, thus making it less lucrative to borrow
money to lend to the customers), it compounds the slow-down effects.

3. How would affect the cut of the discount rate both the lenders and investors?
In the latter paragraph I have explained how an increase of the discount rate will affect
the economy. In this situation, obviously, the exact opposite will happen. If the central bank
cuts the discount rate, the banks will borrow money much cheaper, thus making it more
affordable to lend money with a lower interest rate. Lending money much cheaper will
encourage investors to borrow for future investments or for personal usage. This will have a
speed-up effect in the economy.
4. How can a central bank try to avoid recession?
The central bank has 3 options to avoid recession.

Direct the FOMC to buy U.S Treasuries on the open market

Lower the reserve requirements

Lower the discount rate

If the Federal Open Market Committee buys U.S Treasuries on the open market, the
investors will move the money from the transaction into the bank account. Thus making more
money in the banking systems. More money into the banking system, means more loanable
fund, which means that there is in the interest of the banks to try to lend as much as possible;
as a consequence they will reduce the interest rate. With a low interest rate, the investors will
be more tempting to borrow money to extend their business and also will tempt the normal
people to make a loan for personal usage such as mortgages and car loans.
If the central bank lowers the reserve requirements (which means that there will be
more money into the banks deposits, which means more loanable funds), the banks will lower
their interest rate and the same think will happen if the central bank lowers the discount rate
(this means that it will be cheaper for the banks to borrow money, in order to lend them).

5. State the connection between recession and moral hazard

Investment banks have more knowledge and information about the economy. In a time
of recession, usually these banks will provide misleading information about its assets,
liabilities or credit capacity in a desperate attempt to make some profit. This is how they
choose to act to recover the economy.

6. When do consumers, firms, investors, borrowers take bigger risks? In recession or

expansion?
Usually investors will take bigger risk in recession, because central bank will lower the
interest rate so they are more appealing to bet on higher return form the same risky structured
products.
Investors will probably buy again structural leverage investments such as collateralized
debt obligation.

7. State the connection between interest rates, equity, mortgages, demand.

Obviously, there is a direct connection between the interest rate and the mortgage.
According the fluctuation of the interest rate people are more appealing or not to buy a house.
So if the interest rates are low, people will be more tempting to get into a loan.
Also, demand has a strong connection with interest rate. The same thing happens as in
the first place. If the interest rates are high, people are not willing to take a loan, which means
that there will be less money on the market, which means that there are fewer money running
after the same product, which means that the demand will decrease. The revers thing will
happen if the interest rate is low.
Well, if we are talking about equity, there is not that direct relationship as in the
previous cases. Changes of the interest rate affect the behavior of the consumers and
businesses.
One method to valuate the attractiveness of an investment opportunity represents the
Discounted Cash Flow Method, which takes in consideration all the expected future cash

flows. To calculate a stocks price, take the DCF and divide it by the number of shares
available. Well, if a company cuts its spendings (because of high interest rate) or shows less
profit (because of the consumers), the price of the stock will fall. If this happens for more
companies, the overall market or the market indexes (which is also attribute as the market)
will fall.

8. Whose job is to prevent recession?

It is central banks job to handle inflation and unemployment, which means that its
central banks job to prevent recession; but, opposite to the received wisdom, central bank
should not avoid recession at any cost. FEDs job is to maintain a stable inflation percentage,
to protect the financial system and to keep the damages as low as possible in recession.

9. Whose to benefit from recession? What about from expansion? State the economic
impact of both?
Usually, big and well-structured firms benefit from recession, because they can find
bargains on the market. Everyone is selling so the prices are extremely low, if you have a deep
pocket, you can make some great deals during recession.
Taking it as a business, firms selling inferior goods will have a great time in recession
(demand rises as income falls) take it as example second hand stores.

10.Whats the dotcom bubble burst business and how did this affect the American
economy?
The dotcom bubble represents the massive investment in the informational and tech
companies during 1995-2000. Although, there was a rapidly growing demand after 1997, so
some would say the bubble was between 1997-2000; anyway, it all started back in early 1990s.
According to the IDC, there was a major growth of Internet users in 1995, the number
reached as high as 16 millions users. As a result, a lot of Internet start-ups were born and they
were referred as dot-coms. Everybody started to invest in these companies, even though

there were nothing more than an idea.

The classical criteria that you have to consider when you invest were usually ignored,
and here Im not talking about time value of money, net present value, simple rate of return or
mutually exclusive investment, no; Im talking about the very basic question, that even a 4
years old would ask. Is this business going to turn profit?
Everyone was so obsessed with this new economy that they were afraid or they
wouldnt want to miss out the next big thing. They would invest in companies without a
strong, clear business plan or execution plan.
There was the dot-com theory which says that for an internet company to grow and
succeed, there should be a sharp expansion of its customer base; in most of the cases this will
happen with a long period of losses, a very good example is Google and Amazon which are
great companies right now but it took a very long time to turn profit.
So, everybody was pumping huge amounts of money into these companies, especially
in IPOs. In 1999, an outrageous thing happened and I have two regrets about that. First, Im
extremely angry that the society runs in such manner, and second, Im extremely angry that I
wasnt born in the 70s so I could profit about what happened.
In 1999, in the U.S, there were 457 IPOs, most of them Internet based and technology
companies. Out of this huge number, 117 of them doubled their value within the first day of
trading! How about that? Another reason to consolidate the fact that market runs in some cases,
strictly on emotion.
Of course, everything where the know-how lacks should have an end and it had. On
March 10th 2000 the bubble burst. On this day NASDAQ peaked at 5046.86, which was
double the value that it had a year before. This happened because of the antitrust case agains
Microsoft which was declared a monopoly in April. Somehow the market anticipated this
outcome and the price felt down 10% in the next 10 days. However, the market showed a little
bounce back, but it wasnt a recovery it was the last breath. Later that year, investors realised
that the companies they invested in, were actually loss-making companies and they stopped
pumping money. After two and a half years, on 9th October 2002, NASDAQ hit a low of
1114.11 points.

1.What would be the economic advantage of induced recession?

The major advantage of induced recession is the peoples belief about the state of the
economy. If there will be long periods of expansion and the FED appears to handle anything,
people will take bigger risk, spending more money than they should and saving less.
Obviously, this is not healthy.
Also, another advantage represents the casualties that the recession will produce. If you
kill it early in its process, it will produce less wounds. If you let it expand, under uncontrolled
conditions, when it will fall, it will create irreversible damage.

11. What would be the economic advanced of induced recession? What would be the
consequences of induced recession?
I have put a lot of thought in those questions because Im not sure I understand them.
As I didnt find an exact definition for this term (induced recession) I fell free to analyze the
syntagma and make a guess. When I hear the term induced recession I think of someone who
caused the recession. Well my mind goes to the FED who changed the monetary policy in
order to slow-down the expansion, but I dont know if Im right or not. Following this
hypothesis I will try to answer this questions.
I would start by explaining, in my opinion, why the FED would want do this. I will
assume that the FED has more information about the state of the economy of that moment. If
the board comes to the conclusion that there is a bubble in the economy and cant get rid of it,
they would try to stop the expansion in early ages in order to reduce the damage. So if they
apply one of the measures that Ive presented above, or all of them they will slow down the
investments and the loans.
If the companies wont borrow money to extend their businesses, there would be less
people employed, so less people with money and less people fired when it comes to case. Also,
If there are less people with money, it means that there will be less people with mortgages or
loans which means that there will be less people affected by the burst.
In other words, the government might prefer a slower, but safer expansion rather than a
sharp and unsafe one; and I totally agree with this because psychological effects are major in

this conditions. Humans tend to be more affected when they lose something rather than
winning something;
So the advantage would be that less people would be affected and the pre-mature,
unstable and bad businesses would go off the market. Also, the FED is again in the position to
handle the economy, to direct it on the right path, to be more cautious about the decisions that
it makes.
As a consequence, people would get fired, wont be in to position to take a loan to
follow their dreams, or it will be harder; the government would face a huge wave of early
retirements and medical insurance that they have to provide.

Task 1
How do aggregate demand and output fluctuate when a national government chooses to
borrow abroad and spend the money on necessities?
If the government decides to borrow money, they will be forced to increase the interest
rate in order to cover debt. As a result they will crowed out a consistent part of the private
sector spendings; so if there is a decrease in private investment spending, a slow-down of the
deficit spending will happen as a result.
In other words, on the graph with prices on the y-axis and output on the x-axis, the
aggregate demand curve will move to the right. Which means that for the same price of a good,
the quantity demanded would increase.
Task 2
Can a government choose to start up different public works during recessions?
The answer is yes. The government should start up different public works. This is the
first sign of punching back. This is how the government responds during hard times.
If the economy goes into recession, many workers will lose their jobs, which means that
there will be less income tax collected. Moreover, if there is high unemployment, there will be
more people using government social programs. Besides that, the government could be forced
to create new social programs in order to help people through hard times. An example of that is

the establishment of New Deal after the Great Depression in 1930s.

Also, if there is a lack of cash flow into the economy, it means that the businesses will
suffer, so less profit or none, which affects the budget, as there as less money collected.
In this situation, the government should make long-term investments into the
infrastructure and other public works, which will drive economic growth in the future.
Another benefit of these investments, which represents the immediate effect, is the creation of
jobs. There will be less unemployment.
An example to consolidate my statement is that after the Great Depression, U.S.A built
highways and bridges to encourage commerce, dams and power plants to produce energy.
These investments still deliver nowadays. The Americans are still taking profits from those
projects.

Task 3
What phase of the business cycle is in your country right now? What is the current fiscal
policy? What tax and expenditure policies seem appropriate?
Romania puts itself in a position of expansion. However, according to other states from
EU, the current fiscal policy could be changed.
The current period, Romania presents a income tax of 16% and the VAT of 24%. The
VAT has some other values for 2 or 3 goods.
The percentage of the fiscal taxes into the GDP is with 10 % lower than the average of
the EU. Some economists say that there can be an increase in this area, if this will happen we
will report consistent economic growth.
Future priorities about the fiscal policy could be:

A general reduction of the contribution

Broadening the tax base
Simplifying the taxing system
Rising the income tax for the budgetary sector
Reducing the tax evasion