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Chapter 26: Problem 2

If the Fed believes the economy is headed for a recession, what actions should it take? If the Fed believes the inflation rate is about to sharply increase, what actions should it take?

Short Answer

Expert verified
If the Fed believes the economy is headed for a recession, it should lower the fed funds rate and purchase government securities to stimulate growth and increase liquidity. If the Fed believes the inflation rate is about to sharply increase, it should raise the fed funds rate and sell government securities, with the aim to slow down the economy and prevent inflation from accelerating.

Step by step solution

01

Analyzing the first scenario: Recession

The main goal of the Fed during a recession is to stimulate economic growth. To do this, the Fed can use several tools, but the most commonly used are lowering the fed funds rate and buying government securities (quantitative easing). The Fed can lower the federal funds rate, which is the interest rate at which banks lend reserve balances to other banks on an overnight basis. Lower interest rates make borrowing cheaper, encouraging businesses and consumers to spend and invest more, hence stimulating economic growth. Quantitative easing involves buying government securities to inject money into the economy to promote increased lending and liquidity.
02

Analyzing the second scenario: Sharp increase in inflation

When there is a sharp increase in inflation, the Fed aims to slow down the economy to prevent overheating. In order to combat inflation, the Fed typically raises the federal funds rate making borrowing more expensive. This ultimately leads to less spending, which in turn can slow down inflation. The Fed could also sell government securities, effectively taking money out of the economy and reducing the amount of money available for lending.

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Most popular questions from this chapter

Recall that securitization is the process of turning a loan, such as a mortgage, into a bond that can be bought and sold in secondary markets. An article in the Economist noted: That securitization caused more subprime mortgages to be written is not in doubt. By offering access to a much deeper pool of capital, securitization helped to bring down the cost of mortgages and made home-ownership more affordable for borrowers with poor credit histories. What is a "subprime mortgage"? What is a "deeper pool of capital"? Why would securitization give mortgage borrowers access to a deeper pool of capital? Would a subprime borrower be likely to pay a higher or lower interest rate than a borrower with a better credit history? Under what circumstances might a lender prefer to loan money to a borrower with a poor credit history rather than to a borrower with a good credit history? Briefly explain.

Explain whether you agree with this argument: If the Fed actually ever carried out a contractionary monetary policy, the price level would fall. Because the price level has not fallen in the United States over an entire year since the 1930s, we can conclude that the Fed has not carried out a contractionary policy since the \(1930 \mathrm{~s}\)

What are the Fed's two new policy tools, and why does the Fed now need to rely on them to change the federal funds rate?

A column in the Wall Street journal referred to policy actions aimed at "fulfilling both sides of the Fed's dual mandate." a. Who gave the Fed a dual mandate? b. Does the Fed's dual mandate require it to attain a zero percent unemployment rate? Briefly explain. c. Does the Fed's dual mandate require it to attain a zero percent inflation rate? Briefly explain.

Suppose that the equilibrium real federal funds rate is 2 percent and the target rate of inflation is 2 percent. Use the following information and the Taylor rule to calculate the federal funds rate target: Current inflation rate \(=4\) percent Potential \(\mathrm{GDP}=17.0\) trillion Real GDP \(=17.17\) trillion
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