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a blog from young economists at Nova SBE

Housing bubble effects in the US economy

In beginnings 2004, the United States faced a great inflation housing bubble, an increase in housing princes powered an increase in demand in the event of limited supply which takes a long time to adjust, the speculators enter the market convinced that they can make short run profits through quick buying and selling. With the purpose of reducing the impact of this event, the Federal Reserve desired to increase mortgage rates. But instead of the increasing the federal funds rate, i.e., an increase in short-term rates, it did not raise the long-term rates, as expected.

The yield on long-term bonds can be explained by three different variables: expected inflation, average short-term rates and a term premium.  The relation between them can lead to different results. According to Ben Bernanke chairman of United States Federal Reserve, the biggest contributor for the lower long-term rates is the decline in the term premium, which is nearly zero and sometimes even negative.

The central bank purchases of government debt are one of the motives that generate a very low term premium. Since the government debt is commonly used in transactions between financial banks as collateral, its demand continues firm regardless the low or below zero real return.

Bernanke, also stated that the inflows from the Global savings glut countries, that is when the desired savings by these countries exceed the desired investment, are an important explanation for a small long-term interest rates In the United States last years. Bernanke expressed concern about the significant rise in global supply of savings, whose implications in monetary policy can be adverse.  This occurrence also has an effect in rising global imbalances with respect to international current account balances.

Foreign governments and central banks with positive current accounts hold approximately half of the total amount of the treasury debt outstanding as international reserves. The recently financial crisis has increased the demand of treasury securities lowering treasury yields, which consequently implies a low or negative term premium.

The problem behind foreign governments wanting to purchase American government debt is related to the fact that it decreases the competitiveness of America by diminishing its exports due to the increase in relative price of the dollar.

United States Federal Reserve could through its available tools implement different fiscal policy in order to stop the reckless lending. For example, moderate inflation may be a useful device to increase long-term rates.

The American monetary policy may boost the exposure of foreign countries if they continue to accumulate reserves which become a weakening force to the American economy. A greater accumulation of reserves by the foreign governments will lead to higher dependency on domestic demand to the US economy. If the American government creates more treasuries that is highly demanded by the rest of the world, it would be able to borrow massively and consequently be able to invest in several areas such as infrastructure, education, research and development, health, defense, etc… If the Federal Reserve boosts interest rates by a small percentage it would make investments in treasuries more appealing besides that investors also consider the fact that dollars could appreciate in a few years.

If we consider the hypothesis of an increase in the interest rate the United States would sell more treasuries at the same time investing on debt from other countries. It would increase the number of Treasuries available on the market therefore it would demand the markets to deal with these new supply and would increase the long term rates which would help the economy to recover. Buying foreign debts would be good for these foreign economies which would decrease the value of the dollar and boost American exports helping to stabilize the financial system at a global level.

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References:

http://www.federalreserve.gov/newsevents/speech/bernanke20130301a.htm

http://www.investopedia.com/terms/h/housing_bubble.asp

http://www.telegraph.co.uk/finance/economics/10578491/Ben-Bernanke-Fed-should-give-the-US-economy-what-it-needs.html

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Author: studentnovasbe

Master student in Nova Sbe

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