1. Boston College
Four Challenges at the Core of the American Economy
Investigating the Federal Balance Sheet, Low Interest Rates, Housing
Market and Government Debt
Ana Grisanti
Matthew Mikrut
Tyler Shelepak
2. In the wake of the 2008 recession, The Federal Reserve—the central bank of the United
States—instituted some unorthodox monetary policy in order to maintain stable prices and high
employment. Interest rates were lowered to an all-time low, and they have not risen since.
Specifically, the asset-purchasing program of Quantitative Asset, and increased regulatory role
of the Fed has been relatively successful, and many European countries are now instituting. The
United States has experienced a slow, yet noticeable, recovery since the financial crisis of 2008;
however, many problems still persist. In our report, we will focus on four particular issues: the
Federal Reserve’s large balance sheet, historically low interest rates, a lethargic housing market,
and the federal debt. Quantitative easing may have ended, but the size of the balance sheet still
remains an issue. The choice to sell or hold these assets would then affect nominal interest rates.
Regarding the housing market, we will analyze reasons why it is lagging and the effect of
possibly higher interest rates. Lastly, the Fed must decide what it can do to help ease the burden
of the federal debt. We will show the ramifications of these through various economic models
and reasoning. The Federal Reserve must use all of the tools at its disposal in order to solve these
issues and promote high employment, stable prices, and moderate long-term interest rates. First,
we will delve into how to address the size of the Fed balance sheet.
The Balance Sheet and Interest Rates
After stopping quantitative easing, the Fed has two choices regarding the size of its
balance sheet: either maintain the current size, or sell its acquired assets. What would be the
aftermath of each case? We will represent this aftermath in terms of the IS-LM and AS-AD
models. The IS-LM model represents the interaction of the goods market (IS curve) and the
financial market (LM curve), to form the full impact of aggregate demand (AD curve), which
later interacts with aggregate supply (AS curve) in the full AS-AD model. The IS-LM model is
3. represented with graphs that show the effect of output (Y) on interest rates (i), and the AS-AD
model is plotted on graphs that show the effect of output on price (P). As the Fed has been
buying bonds and securities on the market, nominal money (M), and real money stock (M/P)
have increased. This has shifted the LM curve (M/P= L(i,Y)) to the right, as seen in Graph 1 in
the Appendix, which has decreased interest rates and increased output. This also leads to a
rightward shift of the AD curve (Y= Yd (M/P, G, T, Z)), increased output, and higher prices
(Graph 2). Now that the Fed has stopped quantitative easing, the curves will stop shifting while
the Fed remains inactive, so the current conditions will remain in the short run.
Low interest rates should stimulate investment, even in the medium run, which in the
long run would increase capital and thus the level of output per worker. This long run effect is
run through expectations of a higher future output, which would make the public optimistic and
shift the AD curve even further right in the short run, thus increasing output further and lowering
prices. Since the U.S. has been slow to recover from the recession of 2008, keeping interest rates
low might be beneficial as it stimulates the economy. However, there is some doubt of this
because investment has not been as responsive to the low interest rates as expected. This can be
seen in the table at the end of the appendix from a database of Harver Analytics. Gross domestic
investment as a percentage of GDP has been growing slowly since its 2009 level of 18%. At the
end of 2013, it was still only at 19% of GDP, which is much lower than the 23% of 2006.
Nevertheless, there has been some recovery in the economy and thus the AD curve has
shifted right even if slightly, increasing prices. If the Fed decides to keep its large balance sheet
and low interest rates in the medium run, prices in the next 3 to 5 years would increase further as
price expectations adjust, and the AS curve (P=Pe (1+m) F(1- Y/L, z)) would shift left (Graph 3).
Output would thus go back down towards the original level of output – where it ends up exactly
4. depends on how much the AS curve shifts. The possible locations of the AS curve are
represented in Graph 3 of the appendix. Prices increase considerably in either possibility, so this
course of action could potentially bring a high rate of inflation, something that the Fed should try
to avoid. Although the Fed reported on its website that “inflation has continued to run below the
Committee's longer-run objective” (Press Release) in recent times, the daunting possibility of
high inflation still lingers in our horizon with these low interest rates, as shown in the theory
explained above. Although in the long run these policies would bring output growth by
increasing investment and thus capital, the Fed might want to be more orthodox in its decisions.
To avoid this potentially high inflation, the Fed could decide to start selling bonds after
its next meeting, thus increasing nominal interest rates. Selling an amount of bonds equivalent to
a more than 1% increase in interest rates would decrease real money stock, and in the short run,
the LM curve would shift left – lowering output as well (Graph 4). The AD curve would also
shift left from a decrease in real money stock, lowering both prices and output (Graph 5).
Expectations of a lower future output from decreases in investment would also shift the AD
curve left even further, thus again lowering output. Selling bonds would thus cause some
unemployment in the short run as output decreases. Some may say, that considering
unemployment is at a current low rate of 5.7%, fighting inflation has precedence over lowering
it. However, this number might be an understatement of the hardships in the economy, as it is
influenced by a fall in the labor force participation rate “to a three-decade low of 62.7%” in
September of 2014 (Wall Street Journal). The Fed must take this into consideration when
deciding whether or not this is the right time to raise interest rates and combat inflation.
Nevertheless, in the medium run of 3 to 5 years price expectations would adjust down
from their level above real prices. This would shift the AS curve to the right over time, allowing
5. output to slowly increase towards its original pre-policy level, while lowering prices even further
(Graph 6). Thus in the medium run, output and unemployment would not be affected, and the
risk of high inflation would be mitigated. The Fed should consider raising interest rates in the
next meeting because the effects of this policy, in the medium run, would be quite beneficial.
The Housing Market
Considering the low interest rates, one would expect the housing market in the United
States to be much stronger than it currently is. Under the IS model, home purchases fall under
the investment in the equation Y = C(Y-T)+I(Y,r)+G – which itself is a function of output and
the real interest rate. Given the current monetary policy, one would expect inflation to be higher
because of the lower interest rate, higher output, and higher prices; however, it has not risen to
the expected level due to less lending by banks. This problem may be outside the scope of
monetary policy; rather, the onus is on banks to begin lending more money in order to stimulate
investment. Also, one reason for the current low unemployment is the large number of
discouraged workers dropping out of the work force. Based on the Phillips curve relationship, [π-
πt-1
=-α(U-Un)] if the unemployment rate cannot be reliably measured, the Phillips curve cannot
be used to reliably measure the change in inflation.
In order to exemplify this, imagine an economy in medium run equilibrium with a natural
unemployment rate of 5%, a previous inflation rate of 3%, and Phillips curve coefficient of 1. In
the United States, the unemployment rate in this economy is currently 5.8%. Using the Phillips
curve equation, the inflation rate is calculated to be 2.2% (2.2% - 3% = -(5.8% - 5%)). If we
account for the discouraged workers, the unemployment rises to 7.5%. Using this number, the
inflation rate is calculated to be .5% (.5% - 3% = -(7.5% - 5%)). The later scenario produces
higher real interest rates because you are subtracting a smaller number from an exogenous
6. nominal interest rate. If this is a more reliable representation of unemployment, then the real
interest rate should be higher than what it actually is. Assuming that the United States is
currently above the natural rate of unemployment, the higher actual value of the real interest rate
could be what is deterring investment.
It is unclear how raising interest rates in the future would affect the housing market.
Interest rates have been at historically low rates, and though the Fed has not explicitly stated as
such, one could expect the Fed to raise interest rates in the future (see shifts in Graph 5).
Considering the Lucas critique, the public can expect these higher interest rates if the central
bank is credible. As stated above, housing investment depends on the real interest rate, but there
is generally a direct correlation between nominal interest rates and real interest rates. In the short
run, both nominal and real interest rates will rise given contractionary monetary policy; however,
in the medium run, contractionary monetary policy has no effect on real interest rates because
nominal interest rates change one-to-one with inflation due to the Fisher effect. Depending on
how consumers adjust their expectations from the short to medium run, housing investment
could increase or decrease. This shows that increasing nominal interest rates will have an
unknown effect of the housing market.
The Government Debt/Deficit
Another issue beleaguering United States is facing right now is the Federal Budget. The
United States is currently, according to the St. Louis Fed, 17.6 trillion dollars in debt, and it has
been running a trade deficit since the Clinton Administration. The Congressional Budget Office
projects debt held by the public– “representing the amount that the federal government has
7. borrowed in financial markets”– would be equal to 74% of our GDP by the end of 2014 (The
Long Term 9).
In the case interest rates remain where they are, it will be easier for the United States to
repay their debts since the interest rates are nearly zero. The currently low interest rates
incentivize the government to pay back their debt while they incur less interest on it. In terms of
fiscal policy, according to the CBO the deficit will increase, ceteris paribus, in upcoming years
as we have an aging population because social security costs will increase. As the CBO correctly
states, increased borrowing from the federal government will actually crowd out private
investment in the long run as “the portion of people’s savings used to buy government securities
is not available to finance private investment.” Therefore, there would be a lower rate of savings,
which would result in a smaller capital stock, which will decrease output (The Long Term 72).
Thus, in the long run, lower interest rates would be inimical to output growth if there were a
deficit.
If the interest rate were to increase now, it would be much more difficult for the United
States to pay back its loans. To put it into perspective, if annual interest rates were to go up just
by 1% and we are 17.6 trillion dollars in debt, this will add a whole 176 billion dollars to the
deficit. This could be mitigated by increased government revenues—which have increased from
$3.3 trillion to almost $4 trillion in 2012—but they are unlikely to reach a level to completely
augment the additional debt given higher interest rates (OECD Statistics). This repayment of
debt would not increase government spending as it is financing money the government funded
previously. Thus, an increase in the interest rate would have a very adverse effect on the
economy. The increased interest rate would also, as described in previous parts of the report,
decrease output and employment in the short run.
8. However, the deficit has been gradually decreasing in the last couple years. In 2011 the
deficit was 1.3 trillion dollars, 2012 at 1.1 trillion dollars, and in 2013 at 680 billion dollars
(Sahadi). Therefore, this gradual decreasing in the deficit could boost up expectations for the
future. People and companies would spend more, believing this trend would continue and that
the government will not crowd out their investment, which would keep the savings rate constant.
So, if this example shows anything, the onus is on the government to change the deficit. If the
deficit is reduced, the people and investors will think optimistically about the future, which
would reduce the adverse effect of increasing the interest rate.
Therefore, changes to the national debt and deficit are better rooted in fiscal policy.
However, if the Fed were to increase interest rates now, it would increase debt payments greatly
in the short run. But if Fiscal Policy were changed, paying back debts would be less of a concern.
If no changes were made to Fiscal Policy in the long run, budget deficits could continue to
increase which would decrease the savings rate, and consequently decrease the capital stock and
output.
Keeping Interest Rates Low
After analyzing the current state of the economy and the implications of different
policies, the Fed may not yet want raise interest rates for three reasons. Firstly, although the
economy has been slowly recovering, studies suggest that it is nowhere near reaching its pre-
crisis growth state. The data about investment as a percent of GDP published by Harver
Analytics clearly supports this. Next, a slow growth rate in wages suggests that in the near future
the economy is not in danger of high inflation. Average hourly earnings “have risen 2% over the
past year” (Job Growth Rebounds), which only matches the Core CPI inflation rate of 1.8% of
9. 2014, published by Barclays Capital. The wage-price spiral concept suggests that we are thus not
yet at risk of ever accelerating inflation. Lastly, the current low unemployment rate might make
it seem like the economy has recovered, but as explained above, this number is skewed by a
decrease in labor participation, not an increase in employment.
Increasing Interest Rates
The best course of future United States monetary policy would be the steady rising of
interest rates by selling off our current assets. With unemployment on a steady decline and
output growing (the Real GDP has increased by $1.8 billion between the first quarter of 2009
and the second quarter of 2014) (Real Gross), it would seem that conditions are favorable for a
shift towards more traditional monetary policy. In order to combat the expected inflation that
could arise from overly expansionary monetary policy, the Fed needs to raise interest rates. By
selling bonds, the central bank decreases the nominal money supply, which increases interest
rates and decreases output. This decrease in output should not be too severe because we are
merely increasing interest rates – at a steady rate – away from the current extreme policies. A
rightward shift of the expectations-augmented IS curve, due to high expected future output based
on current trends, will mitigate any decrease in output. Unfortunately, both shifts of the IS and
LM curves lead to higher interest rates, which could lead to less investment and capital
accumulation in the medium and long run. Nevertheless, it is ultimately in the best interest of the
United States to engage in contractionary monetary policy in order to sell off their assets, and
steadily increase interest rates to a more typical level
10. Conclusion
Economic conditions have certainly improved since 2008, so we believe that the central
bank should begin selling off its assets in order to increase interest rates. Although the
unemployment rate may be skewed lower due to a drop in the participation rate, but this is
expected with an aging population. Overall, the climate is much more favorable for workers.
Selling off assets shifts the LM curve to the left, which increases interest rates and decreases
output. However, given the improving conditions, one could expect future output to increase
which shifts the expectations-augmented IS curve to the right—making up for any lost output.
These policies could lead to inflation in the future; however, implementing an increase in interest
rates gradually should mitigate this effect.
