Impacts of US Financial Markets on Economy
US financial markets affect the economy, businesses, and individuals in many ways. Financial instruments such as stocks and bonds influence the flow of savings and investments in the entire economy. This in turn allows for the accumulation of capital and increased national output. Therefore, weak financial markets are unable to enhance savings and investments within the economy. Consequently, the economy experiences a reduction in investments leading to poor performance in terms of Gross Domestic Product (GDP). According to Valdez (2011), GDP influences the rate of economic development and growth. As such, US financial markets influence the rate of economic growth in many ways.
Further, the speculative nature of stock markets dictates the level of investment in an economy. Prior to the global financial crises of 2007-2008, US financial markets were able to predict investment behavior in the economy. However, the same financial markets suffered from systemic effects of the financial crises because of reduced investor confidence and subsequent low stock prices. It is important to mention that financial markets also influence government borrowing particularly from the public (Meltzer, 2009). The rationale is that weak financial markets are unable to generate enough money for the government from treasury bonds. Consequently, the government faces difficulties in funding its recurrent budget leading to poor economic performance.
The Role of the Federal Reserve
Federal Reserve was created in 1913 after the passage of the Federal Reserve Act by congress (Meltzer, 2009). Its role in the US economy has changed over time. Nonetheless, it serves as the US central bank and plays regulatory roles in the US financial markets. These roles include management of the country’s monetary policy (regulating interest rates), regulation of banking institutions as well as management of systemic risk that US financial institutions face (Meltzer, 2009). It is worth mentioning that the global financial crisis of 2008 led to the increased role of the Federal Reserve in the national economy. After the passage of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, Fed Reserve now bears the responsibility of breaking up large multinationals and other companies that might threaten the economy (Meltzer, 2009). As such, the roles of the Fed Reserve have changed over time.
Currently, Ben Bernanke heads Federal Reserve and is the head of the institution. Alongside the other six members of the Board of Governors, he facilitates the achievement of goals and objectives set out by the institution. It is worth noting that the Federal Reserve has come under immense scrutiny following the global financial crises of 2008. According to Valdez (2011), Fed Reserve was partially responsible for the ineffectiveness of US financial markets during the crises. The reason is that Fed Reserve kept interest rates at a very low level for a prolonged period prior to the crises.
Impacts of Interest Rate
Interest rates have many impacts on the US economy. Fed Reserve regulates interest rates and base lending rates of US financial and banking institutions. At the outset, a low-interest rate stimulates economic growth. The reason is that individuals incur reduced interest costs leading to an increased level of disposable income. This in turn increases the level of consumption, investment, and savings for households (Valdez, 2011). Additionally, manufacturers and farmers benefit from low interest since it allows them to access capital easily. As such, they are able to produce more goods and services to cater to the increased demand of the households. This way, a low rate of interest boosts the US economy in terms of increased GDP, aggregate savings, and investments.
On the other hand, a high rate of interest slows the US economy. Nonetheless, it has different outcomes for individuals. The rationale is that people tend to save more in periods of high-interest rates due to the incentive of high returns. As the level of savings increases, Pilbeam (2010) says that savers feel richer and consequently increase their consumption. For companies and manufacturers, a high rate of interest diminishes their ability to access capital. This in turn leads to reduced investments and inefficient production of goods and services (Pilbeam, 2010). As such, the Fed Reserve needs to monitor the rate of interest in order to accelerate economic growth in the US.
Exchange Rate and Interest Rate
Interest rates affect the foreign exchange rates in a number of ways. For instance, if the interest rates in the US are higher than the interest rates of other countries in the world, the foreign direct investment will increase because of the incentive of high returns (Pilbeam, 2010). To that, a high rate of interest in the US pushes the value of the dollar upwards. On the contrary, a low rate of interest has the tendency of pushing the value of the dollar downwards (Pilbeam, 2010). The reason is that many foreign investors do not in the US economy. Consequently, the demand for the dollar reduces substantially leading to losses among the exporters. It is important to highlight that the US Fed Reserve kept the rate of interest at a low level from the fiscal year 2000 to 2006. Consequently, reduced investments from foreign firms exacerbated the effects of the global financial crises of 2007-2008.
Meltzer, H. (2009). A History of the Federal Reserve. New York: Greenwood Press.
Pilbeam, K. (2010). Finance and Financial Markets. London: Palgrave Publishers.
Valdez, S. (2011). An Introduction to Global Financial Markets. Washington DC: Macmillan Press Ltd.