The U.S government acts as the regulator in the stock markets and other specific industries. In ensuring high maintenance of the U.S economy, the government controls inflation and employment at lower levels. To achieve this, the government employs two mechanisms: the monetary policy and the fiscal policy. The monetary policy manages the money in the system. It checks to detect influx of money in the system (inflation) or depression and maintains a balance between the two. The fiscal policy determines the appropriate levels of taxes imposed by the government and the spendings. The fiscal policy as argued out by an English economist Keynes is concerned with the government spending and the imposition of takes. Reforms in financial policies were undertaken by the government to improve the economy during the depressions that affected it in the 1930s. According to Keynes, the way forward in stopping the emanating decline in economy was to lower tax and spend more. Whichever the method adopted it would generally increase money in the system and people would be able to spend.
In controlling economy, fiscal policies are required. There are two main tools used in regulating the fiscal policies, these are expansionary policy and the contractionary policy. The expansionary policy is used when the government is combating unemployment. This is normally in cases where the economy is facing a downturn. The government lowers the interest to encourage people to borrow more money from financial institutions. The contractionary policy is applied when the government is responding to the inflation. The government imposes high interest rate to discourage the individual from borrowing. It may also decide to sell to the public government Bonds among other securities. Stock market is a public market that deals with the trading of shares from listed companies and delivatives at a negotiable price determined by the buyer and the seller. The purpose of the stock market is to provide for physical market in buying and selling of securities. The information on the stock exchange is real-time which helps price discovery of the securities.
Stock market is effective due to the availability of real-time information available on the traded securities. This is facilitated by the (EMH) the efficient market hypothesis. The hypothesis states that the financial markets are “informationally efficient”. This implies that traders of security cannot consistently get the same returns from the sale of securities but keeps on fluctuating depending on the available information in the market. The main versions used for EMH hypotheses are: weak hypothesis; which proposes that the public information is reflected by the traded stock prices. The second is the semi-strong EMH; which proposes that prices are a reflection of latest information based on the shift of the prices and available figures. The results from EMH are said to convey even the most concealed information. This information is available to the brokers who conduct the business on behalf of the customers.
The interest rate
Interest rate refers to the amount borrower pays to the lender for the use of money he has borrowed. The Federal Reserve applies the rate of interest for the United State’s investors; these are charged on borrowings made by the banks. Federal Reserve is responsible for controlling the inflation. Increase of money in the system / supply is referred to as inflation. It is characterised by greater demand than the economy is able to supply. This creates competition for the scarce goods leading to increase in its value. The Fed controls inflation by controlling the amount of money in circulation. Increasing the Federal fund rate is an attempt by the Fed to discourage borrowing and a strategy by the Fed to reduce the money already in the supply.
Variation of interest rate has much effect on the economy and all business at large. Inflation rate is lowered with the increased interest and vice versa; this controls money circulation in the market thereby leading to lowered rate of inflation. Borrowing from federal reserves also becomes expensive; this affects the way customers and business spend their money, and may compel the firms to pay more and thereby get reduced returns. Eventually it discourages the investors to invest they money in stock market. The nominal value of shares also tends to go down to entice the investors to buy the stock.
This element of economy is used to stabilize the fiscal industry; it also regulates the circulation of cash in the market. When the cash in the reserve rises, the amount in circulation is reduced and the converse is true. In America, the Federal Reserve has set a reserve ratio, which is expressed as a percentage (Fama 427-465).The ratio compels the banks to set 10% of their deposit, this amount should not be subject to loans advanced to the borrowers, and ensures that the banks have available money to cater for unexpected demands. Its also gives the customers confidence of getting some of their deposits in case the bank is declared insolvent.
Although reserve ratio does not have a direct impact on the stock exchange, they indirectly contribute to the buying trends of stocks. When the reserve ratio is reduced, banks are able to lend to the institution and individual freely. This can stimulate the need to invest some money in buying the stock as one way of investing. In contrast increasing the reserve ratio means the financial institution are limited to the amount they can loan to the borrowers. This reduces the affinity for individual and institution to invest in stocks.
The amount of cash in circulation in any given time is referred as Money supply. Increased circulation in the market pushes the wages and prices up and the general spending of individuals also increases. Increased amount of money in the market may lead to inflation and subsequently affect the buying pattern of stocks negatively. Money supply is much dependent on the interest rate charged; this can be observed in the way interest is raised or lowered. When there is a lot of money circulating in the market, reserve increases its ratio which impacts on the government compelling them to increase interest rates, this has lasting effects on the circulation of money in the market since very few people access loan. When the amount circulating is low, the reserve reduces its ratio, implying lower deposits for the banks, and hence interest lowered and the process continues.
The IS/LM model
Another element used in determination of connections between outputs, cash in circulation and interest rates is the IS/LM. The model is presented in Cartesian plane as a graph. The horizontal or Y axis in representation reflects the GDP (Hicks 147-159). The Graph also gives a representation of the rate of nominal interest in the x or vertical axis. These two representations intersect and the point of interconnection is referred to as the monetary or the real sectors. The IS schedule; the (I) stands for investment and S for saving equilibrium. The GDP and rate of interest can also be used to represent IS schedule; this is done when a curve is formed of the functions. Lower interest rate encourages high fixed investment. Saving are directly proportional to the amount earned, this means that the more the income the higher the possibility of increased savings which would be at the given arte of interest.
A blend of income and rate of interest can give equilibrium state of the market and this is shown by the LM schedule. Such curve that slopes upward conveys the money circulation and fiscal records of the market. To get the point of equilibrium, LM is observed and this gives a representation of the detailed circulation moments of money in the market. These may include fiscal demand and supply in the market. Demand for money in the fiscal market can also be referred to as liquidity preference. According to Keynes, the labour market is slightly different from other markets. The demand of labour is not directly related to the level of wages. During economic recession, the aggregate demand may be insufficient to require all production factors. This is an abnormal case where the economy can still be in equilibrium with persisting unemployment. In such cases, the government may stimulate the economy with macroeconomic policies and keep the inflation level constant.
The GDP components
The C (consumption) is the largest GDP component in the economy. It includes the private house-hold final consumption expenditure in the economy. Spending that is for individual use is usually classified in the category of durable if they are and non-durable if they are perishable goods. (Sullivan 2). The other component of the gross domestic product is the investment (I) this includes business investment but excludes the exchanges in the existing assets. Investment may include the company purchasing new piece of land to expand the business or spending by household on new house. The other component is the Government spending (G). It refers to all the expenses incurred by the government on goods and services. This includes any expense incurred by the government either in acquisition of new items or remuneration to the civil servants. These expenditures are exclusive of transfer costs which may include benefits for the unemployed. The other component is the (X) export. The GDP captures the amount of a country’s produces. It excludes any imports of goods received outside government territory.
From the components of the GDP, the equation C + I + G + NX = Yad can be explained as the summation of the total consumption within the country, the investment companies and individual excluding government investment, the government expenditure and the net imports. Net import can be arrived at after subtracting the gross import and the gross export. To come up with GDP, all the fiscal or economic outputs of the country are summed. This can be done in the following three methods. The first one is the product approach (Sanjoy 663-682). This sums all the enterprises output and gives the final figures. The other one is the expenditure approach, which assumes that products will eventually be bought by somebody. The implication is that the total individual expenses must equal the cost of all the products. Another approach that is considered is the income; in this method, all the income of the entire productive factors is summed and ought to equal product value.
Briefing the US economy between the year 1950-2009 and predict 2010 and beyond to next economic cycle
The American economy has shown a consistent relationship between the interest rate and the expected inflation. Decrease in the interest rate in 1955 was characterized by decrease in inflation. At this time, the government had increased its spending especially on the military perspective and relaxed on taxes. During the 1950s the economy was relative stale because it was uneventful period. In the 1960s America experienced high inflation which was as a result of effects of ww2. The other cause of inflation in this period was the onset of the Korean War. This pushed the cost of living very high, especially after the removal of the price control after the ww2. Between 1960 and 1965 the economy was recovering. This was attributed by the government cutting down on taxes to business men. Kennedy recommended that the dealing required tax aid which should be offered by liberalizing the depreciation allowances on new equipment and plant. In the 1970s the inflation was terribly high. This was as a result of American resisting vying for chairmanship of Federal Reserve office. This meant that there was no one regulating the economy and the prices continued sky rocketing. It became the climax of inflation and the interest rate was charged at a very high rate. Another reason for poor economic results was a result of high unemployment. This trend continued up to the early 1980 when the inflation reached its climax. Increased government spending and reduction in taxes saw a decline in the inflation. The Federal Reserve also relaxed on the interest rate charged to the business men. This period was characterized by economic growth and stable prices for commodities. Between 2005 and 2008, there was an upsurge of inflation again. This was characterized by the effect of Afghanistan and Iraq war. American had used a substantial amount of money in funding for the war which reduced the government spending internally. Oil prices were another reason why there was an increase in inflation. Iraq being one of the major oil producers, its invasion by the American fuelled the oil prices to increase. This period also experienced economic recession which was felt world wide. There was a major industrial shake up with some great companies like AG facing insolvency. American economy is expected to improve tremendously after saving most of its big companies from falling. Withdraw ofAmerican Troops in Iraq and Afghanistan is expected to be a major boast in the American economy. The economy is also predicted to grow in the coming year after the reforms which were proposed by the democrats, passed by the senates. Of the major reform expected to give the economy a big boast if the health care reforms.
The stock market has registered tremendous growth over the other sectors of economy in the US. This has resulted due to the availability of real-time information that affects the trading of the stocks. The Fed policies of increasing the government spending and cutting down the taxes have improved the individual and institutional investment. This has in overall improved the GDP and reduced unemployment rate in the country.
Fama, Eugene. The Cross-Section of Expected Stock Returns. Journal of Finance, 3.7(1985): 427-465.
Hicks, John. And Keynes. The Classics – A Suggested Interpretation. Econometrics 5(1937): 147-159.
Sanjoy, Basu. Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A test of the Efficient Markets Hypothesis. Journal of Finance 32(1977): 663-682.
Sullivan, Arthur and Steven, Sheffrin. Economics: Principles in action. Upper Saddle River, New Jersey: Kogan Page, 1996. Print.