The Federal Reserve monetary policy was largely responsible for the Financial Crisis of 2008

#1) the crisis does not resemble a monetary phenomena Milton Friedman did extensive research on depressions in the US economy. He concluded that long depressions were a result of a contraction of the money supply[1]. As the graph shows below, a contraction of the money supply resulted in a decrease in GDP. Of course, this does not mean that one can simply expand the money supply infinitely, and expect the economy to grow indefinitely as well. A problem associated with that is that demand-pull inflation would occur, which simply means that the increase in demand associated with increasing the money supply causes the economy to be at full potential and full employment (called the natural rate of unemployment) Another problem is that a policy of continuously expanding the money supply will cause inflation in the long run. However, recessions and depressions are a short-run phenomena. #2) The Federal Reserve can only target short-term interest, and cannot set long-term interest rates. The Federal Reserve on their website admits that the Federal Reserve cannot influence the real long term interest rate[2]. Instead, the Federal Reserve influences the nominal interest rate. Nominal interest rate = real interest rate + inflation If a business owner expects inflation in the future, he/she will accept a higher interest rate in the future, knowing that inflation could pay it off. This is turn will increase demand for loanable funds, and based on basic supply and demand, increase the long-term interest rate. Every person with a degree in business, economics or engineering understands how to find the value of an investment based on inflation and the interest rate. What the Federal Reserve does is target the short-run interest rate. The Federal Reserve cannot set the interest rate, because the interest rate is determined based on the supply and demand of money. The Federal Reserve increases the money supply to lower interest rates, or decreases the money supply to increase interest rates. However, the Federal Reserve recognizes that increasing the money supply by too much indefinitely would cause long-term inflation and rising interest rates[2]. #3) Monetary policy effects both the interest rate and inflation rate Increasing the money supply must be accompanied through lowering the short-term interest rate and vice versa. Thus one cannot say that the Federal Reserve should expand the money supply, but keep interest rates high as well, since an expansion of the money supply causes interest rates to be low. #4) Inflation is not inherently bad Inflation is not inherently bad, so long as it is predictable. Most people recognize that inflation occurs over time and take it into consideration when making decisions. It is only if inflation or deflation becomes unpredictable, for example sudden deflation or inflation that it is bad. If for example, sudden deflation occurs, then this means that business investments that would have been originally been profitable would all of a sudden become unprofitable. This would cause many bankruptcies and foreclosures to occur. This in turn would cause banks to become insolvent. The converse, sudden inflation would cause people to lose their value on their cash or cash equivalents. While sudden inflation is bad, sudden deflation is even worse because it disrupts business activity. However, the best policy is to have a predictable inflation rate. Why the Federal Reserve monetary policies cannot be blamed a) It followed its main purpose of keeping prices stables. As this chart shows, that after the 1980s, the Federal Reserve kept prices relatively stable. Compared to when before the Federal Reserve was created and monetarist and Keynesian theory was not developed, there were spikes in deflation and inflation. In some instances inflation would spike to over 20% to 30% in one year, and then spike below 10% the next year. The constant fluctuation in the inflation rate makes it difficult to make business calculations and increased risk unnecessarily. Instead the inflation rate has flat-lined around 3-5%. b) It has not done any actions that have led to monetary problems in the past The Federal Reserve has not contracted the money supply like it has in the past, which led to the Great Depression. Stagflation in the 70s and 80s was a result of the Federal Reserve believing that inflation would lower unemployment based on the Philips Curve. Milton Friedman, who discovered the link between money supply and the Great Depression, predicted that stagflation would occur as a result of rational expectations. It is not recognized that the Philips Curve does not hold true in the long-run. c) Recessions and Depressions occurred before the Federal Reserve existed Recessions and depressions occurred before the Federal Reserve existed and were much worse than currently[3]. Even during the Great Recession, unemployment has not reached below 10%, and GDP only declined by 5%. In contrast, the Long Depression of 1873 lasted over 5 years, and business activity declined by -33.6%. The Great Recession is not as bad as the Great Depression, before modern monetarism and Keynesian economics existed. During the Great Depression, unemployment peaked at 24.9% and GDP delinked by −26.7%. Other causes of the Great Recession The Great Recession can be explained based on non-monetary explanation. The Great Recession was caused due to the housing bubble. Financial bubbles can be explained due to non-monetary reasons. Some explanations are: a) Animal spirits – During good economic times, people invest their money believing that economic prosperity will continue. During bad economic times, people do not invest their money underestimating the value of stocks. People also think in herd mentalities, following the trends of the crowd and follow their investment advice, even though such decisions might not be wise. b) The greater-fool-theory – Investors could agree that an investment has no fundamental value. However, as long as an investor can ride the bubble, he or she can make a great profit, and sell the asset off to a greater fool. Wall street traders are especially motivated to follow this reasoning because they have to make a profit and fast if they want to remain employed. Investments that have sound fundamental analysis could prove not worthwhile If it will take many years for the investment to pay off and the stock remains undervalued. The wall Street investor needs a profit now. c) Financial complexity – The 21st century saw rise to many financial innovations, many of which the unintended consequences were unknown. Since risk cannot be accessed exactly, but only estimated, this gives leeway for systematic errors in assessing risk. Due to the interconnectivity of the financial system, the housing bust caused problems to spread over through the entire financial industry and be more problematic than expected. Behavioral economics and experiments have demonstrated how economic bubbles can occur. One experiment involved a simulated stock trading game, in which real money could be earned. Each person was given a fictitious financial asset. They were told that the financial asset would decrease in value over time, eventually becoming worthless. However, they could trade the financial asset at any price. The result was that instead of the financial asset decreasing in value, the asset values actually increased in price, even though there fundamental value was decreasing. This represents a classical bubble[4]. The prices eventually collapsed in the final trading period. Thus this demonstrated that a financial bubble can occur even without the FED. http://www.federalreserve.gov...[1] http://www.frbsf.org...[2]http://en.wikipedia.org...;[3] http://www.pbs.org...[4]