Why might the Federal Reserve choose not to respond to the decline in aggregate demand?

that was how former Federal Reserve Chairman Alan Greenspan once described Show more Irrational exuberance that was how former Federal Reserve Chairman Alan Greenspan once described the booming stock market of the late 1990s. He was right that the market was exuberant: Average stock prices increased about four-fold during this decade. And perhaps it was even irrational: In the first few years of the following decade the stock market took back some of these large gains as stock prices experienced a pronounced decline falling by about 40 percent from 2000 to 2003 and again by more than 45 percent from 2007 to 2008. Most recently in September-November of 2012 and in early 2015 the stock prices fluctuated (up and down) rather rapidly with an average daily rate of three-to-five percent. Regardless of how we view the booming market or the busting market it does raise an important question: How should the Federal Reserve respond to stock-market fluctuations? The Federal Reserve has no reason to care about stock prices in themselves but it does have the job of monitoring and responding to developments in the overall economy and the stock market is a piece of that puzzle. When the stock market booms households become wealthier and this increased wealth stimulates consumer spending. In addition a rise in stock prices makes it more attractive for firms to sell new shares of stock and this stimulates investment spending. For both reasons a booming stock market expands the aggregate demand for goods and services. One of the Federal Reserves goals is to stabilize aggregate demand because greater stability in aggregate demand means greater stability in output and the price level. To do this the Federal Reserve might respond to a stock-market boom by keeping the money supply lower and interest rates higher than it otherwise would. The contractionary effects of higher interest rates would offset the expansionary effects of higher stock prices. In fact this analysis does describe the behavior of the Federal Reserve: Real interest rates were kept higher by historical standards during the irrational exuberant stock-market boom of the late 1990s. The opposite occurs when the stock market falls. When spending on consumption and investment declines it depresses aggregate demand pushing the economy toward recession. To stabilize aggregate demand the Federal Reserve needs to increase the money supply and lower interest rates. Indeed that is what it typically does. For example on October 19 1987 the stock market fell by 22.6 percent one of its biggest one-day drops in history. The Federal Reserve responded to the market crash by increasing the money supply and lowering interest rates. The federal funds rate fell from 7.7 percent at the beginning of October to 6.6 percent at the end of the month. In part because of the Federal Reserves quick action the economy avoided a recession. Similarly the Federal Reserve reduced interest rates during the stock market declines of 2001 and 2002 although this time monetary policy was not quick enough to avert a recession. Again during the stock market declines of 2007 2008 and 2011 similar policy actions were undertaken by the Federal Reserve to stabilize the market and the economy but there didnt seem to be any effect on the declining stock market. While the Federal Reserve keeps an eye on the stock market stock-market participants also keep an eye on the Federal Reserve. Because the Federal Reserve can influence interest rates and economic activity it can alter the value of stocks. For example when the Federal Reserve raises interest rates by reducing the money supply it makes owning stocks less attractive for two reasons. First a high interest rate means that bonds the alternative to stocks are earning a higher return. Second the Federal Reserves tightening of monetary policy reduces the demand for goods and services which reduces profits. As a result stock prices often fall when the Federal Reserve raises interest rates. Questions: 1.Suppose that survey measures of consumer confidence indicate a wave of pessimism is sweeping the country due to the poor performance of the stock market. Why might the Federal Reserve choose not to respond to the decline in aggregate demand? What should the Federal Reserve do if it wants to stabilize aggregate demand? Answer: 2.Suppose that the Federal Reserve determine inflation to be the most significant problem in the economy and that the Federal Reserve implements each of its three policy instruments. Explain how the net export effect resulting from these monetary policy actions will reinforce their effects that operate through interest rate changes. Note that in answering this question you must first explain how the Federal Reserve uses the three monetary policy tools to control inflation and then discuss the net export effect resulting from these monetary policy actions. Answer: Show less

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