This response was intended to stimulate the economy. In 2001, the rate decreases were also intended to stimulate the economy, but they mainly stimulated one sector. The Fed's goal with the most recent round of drastic rate cuts is to stimulate lending. The rate cuts came when the scope of the crisis was just becoming apparent. The rapid reaction this time was met with skepticism from markets. Where before there was at least one strong sector in which to invest excess capital, this time there were none. Worse, the mistakes of the past few years had put banks in a position where they could not reasonably lend out their money. Many bank executives simply did not trust their lenders and tightened restrictions severely. The result of this was a credit crunch, as the liquidity the Fed was trying to inject into the banking system was either being used to cover losses on subprime loans and collateralized debt obligations or was simply not lent.
The Money Supply and Savings Rates
The money supply typically refers to the total amount of money in the economy at a point in time. The money supply (M2) consists of money that is readily available for spending (M1) plus money in savings deposits, time deposits and individual money market accounts. The objective of the Fed's interest rate decreases was to ensure sufficient money supply in the economy. For the most part, that strategy worked. While money supply growth was slow, it only receded once, during August 2008 (Federal Reserve, 2009). Yet, growth in the money supply did not equate to growth in the economy.
One of the contributors to M2 of course are savings accounts. In April 2008, the savings rate was zero. Americans, buoyed by a surging stock market, still with high real estate values, and not yet fully aware of the impending financial crisis, were spending as much as they made. Low savings rates were also reflected in high rates of consumer spending. With the onset of the crisis, this changed.
Investors, once confident about the future, had that confidence shaken by the realization that not only was the housing market bust but that the stock markets were set to tank, and quickly. Consumers began to save. As the subprime crisis blossomed into the global financial crisis, savings rates only increased, such that by May 2009, just one year after the savings rate hit zero, it was at 6.9% (Miller & Sider, 2009). While this is likely good for the overall economy, particularly in China's savings rates come down, it is bad for businesses that rely on consumer spending.
Consumer Spending
Consumer spending is the largest component of the Gross Domestic Product. Although some dispute the inclusion of certain components such as health care programs that should be included as government spending, consumer spending is considered to be roughly 70% of the GDP (Mandel, 2009). Even without government health care funding, consumer spending is the largest portion of the GDP. It also provides 60% of total employment in the U.S. economy (Toossi, 2002).
During the real estate bubble and stock market increase, savings rates dropped while consumer spending increased. This increase fueled substantial profits, which fueled strong stock markets. Consumer spending, however, has gone into a tailspin as a result of the lingering effects of the subprime crisis. In addition to the aforementioned increase in the savings rate, consumer spending has been hampered by the lack of credit. Despite the Fed's efforts and the efforts of Congress to inject liquidity into the banking system, consumer spending remains suppressed.
The intensity of the subprime crisis is ultimately dependent on consumer spending. With the category accounting for 60% of domestic employment, job losses were inevitable as consumer spending fell. However, as unemployment increases, consumer spending should fall further. This cycle perpetuates recession. With savings rates still increasing and consumer spending still suppressed, it is expected that unemployment will remain high for the foreseeable future as well.
Stimulus
With consumer spending suppressed, the federal government took the view...
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