The Financial Crisis And The Lender Of Last Resort. What Is The Role Essay

The Financial Crisis And The Lender Of Last Resort. What Is The Role Of The State And Central Banks - Essay Example The state every time after undergoing a crisis had to interfere in the monetary policies adopted by central banks and frame suitable policies for recovery. This has continued to be a regular phenomenon. Even for the current scenario the state as well as central banks have very carefully made certain changes in existing laws and imposed certain new legal restrictions to deal with the economic conditions post crisis. Appropriate monetary and fiscal policies have become a necessity right from the emergence of crisis. They are framed as per the needs of the respective countries. Governmental policies play an active part in setting up an effective regulatory framework that control all segments of financial services2. The concepts of economic Law and monetary law at the international levels have been merged together for establishing rules for regulating financial services globally. With this at the backdrop the paper intends to give a detailed description on the role of central banks and s tate during financial crisis and how reforms undertaken have brought about a change in the situations post crisis. World economy has suffered from a series of crisis dating back to the days of World War II which left the economy into a miserable state. The great depression of 1929 proceeding World War II deserves mention in the list of economic disasters. The financial crisis at the end of 1998 in the West hampered the normal functioning of many liberalized markets and private sectors3. The most recent has been the global financial meltdown in 2008-09 which led to vast unemployment and demand cuts. It was found that some features of monetary policies could be blamed for such a crisis. The defects of the prevailing macroeconomic framework had been realized immediately after the crisis. It needed a reconstruction for recovering from crisis. Monetary policies under pre crisis situation State had given central banks much freedom so as to frame monetary policies for the country. It was b elieved that the central banks should be allowed to frame monetary policies independently so as to maintain a stable price system in the economy and minimize the chances for high inflation. For giving this independence to the central banks modifications were made in the policies during 1990. But such a freedom proved costly to the state as it was utilized elsewhere like short term demand management. Besides the ‘flexible inflation targeting’ policy adopted by central banking system ignored the problem of instability in inflation. Established with the purpose of reducing output volatility, the inflation policy initiated instability by limiting information about inflation output gap. Errors were detected in gap measurements and this diverted the economy from the right track. The issue of liquidity and money were also ignored and this favored the climate for economic downturns. The inefficiency of the adopted theoretical models was revealed during crisis.4 The models did n ot have practical implications. While looking upon the stability of one period it did not consider important factors that also contributed towards stabilization. It neglected a wider picture of the assumed period. Fitting models only on the basis of empirical data could not be considered enough. It was equally necessary to look upon the causes of instability and capture those factors in the model5. The 2008-09 financial crises has taught a lesson to many risk loving investors who were lured by