Question

In 2003, as the U.S. economy finally seemed poised to exit its ongoing recession, the Fed began to worry about a “soft patch” in the economy, in particular the possibility of a deflation. As a result, the Fed proactively lowered the federal funds rate from 1.75% in late 2002 to 1% by mid-2003, the lowest federal funds rate on record up to that point in time. In addition, the Fed committed to keeping the federal funds rate at this level for a considerable period of time. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary.

1. How might fears of a zero lower bound justify such a policy, even if the economy was not actually in a recession?
2. Show the impact of these policies on the MP curve and the AD/AS graph. Be sure to show the initial conditions in 2003 and the impact of the policy on the deflation threat.

Short answer

1. There is a risk of economic damage in the case of a deflationary spiral that is large enough to result in any significant inflation risk during the implementation of the policy. As a result, policymakers prefer to stand on the sidelines in order to avoid deflationary danger.
2. The diagram showing the impact of federal policy on the economic policy curve and AD-AS graph is as follows:

Step-by-step solution

Part (a) Step 1: Concept Introduction

The term "zero lower bound quotes" refers to when the actual interest rates drop to zero. Interest rates will be manipulated by central banks to either stimulate or calm a stagnant economy.

Part (a) Step 2: Explanation

In the minds of policymakers, there was a potential that, in the event of a shock, the financial system would be forced into a deflationary spiral, with the accelerated nominal policy rate being 0 or below a certain rate. In light of this, the schematic financial policy may appear to be ineffective. According to the policymakers, there is a risk of financial harm in the event of a deflationary spiral that is severe enough to result in any considerable inflation risk during policy implementation. As a result, policymakers want to be on the defensive in order to avoid deflationary risk.

Part (a) Step 3: Final answer

In the event of a deflationary spiral large enough to result in any major inflation risk during the implementation of the policy, there is a danger of economic damage. As a result, policymakers choose to remain neutral in order to prevent the risk of deflation.

Part (b) Step 1: Concept Introduction

The financial policy curve is the graph that depicts the relationship between the real interest rate and the inflation rate. The sum total of all needs for goods and services in the economy at a positive price level at any given point in time is known as the combination call. The total amount of output that all businesses in the economy are likely to provide at a given price level over a specific time period is known as the mixture supply.

Part (b) Step 2: Explanation

The diagram showing the impact of federal policy on the economic policy curve and AD-AS graph is as follows:

Where,

- MP is the monetary policy.

- LRAS is the long-run aggregate supply.

- AS is the short-run aggregate supply.

- AD is the aggregate demand.

A negative shock would send the economy into a manageable deflationary spiral. The MP curve would fall downwards in the short run as a result of autonomous easing policies. Because the zero nominal lower bound inflection point lies on the right of the long-run aggregate supply curve, the economy might be pushed to a stable long-run equilibrium via the self-correcting mechanism.