Question

1. Make a list of what the Federal Reserve (Fed) has done in response to the COVID-19 crisis using 31 March 2020 as the cut-off date. [Please do not include fiscal responses in your list]
2. Why, in your opinion, is the Fed’s actions you have listed in question 1 important to mitigate the economic effects of the COVID-19 outbreak? Explain in light of the roles of the financial system to the economy.
3. Analyse the effects of the Fed’s actions you have listed on the economy using the AD/AS Model. Start with the state of the economy before the COVID-19 crisis. Do you think the Fed’s actions can successfully stabilize the economy?

Answer 1

State of US economy before 31st March 2020 -

• US had a GDP growth rate of 2.1%(fair enough to provide sufficient employment but chances of inflation/asset bubble were there)
• Chances of real estate market crashing were there
• Value of dollar($) was stronger.Hence, exports were more expensive
• Retail trade, Finance & Insurance being the leading contributors in economic growth

Actions taken by US Federal Reserve after March 31,2020 to account for the COVID19 pandemic -

(Reasons why the actions seem valid listed in brackets[ ] )

• Interest rates were lowered to almost zero. [ Subsequently, borrowing costs were lowered on mortgages,loans,etc]
• Purchase/lending of long-term securities [ Helped in smooth functioning of the market preventing market crashes ,while keeping the credit market in check ]
• Encouraged banks to lend more [ To get lower interest rates from the Fed, which helps the banks. ]

Analysis by AS/AD model -

The uncertainties caused due to the pandemic affected the individuals and families with stable employments; causing them to limit their purchases. This lowered the Aggregate Demand(please see graph). In order to contain this phenomena, the Fed has decreased interest rates to almost zero(0) causing a shift in the Aggregate Demand.

The Crisis can cause an Aggregate Demand and Aggregate Supply shock. While the AS shock is not much in control of the Fed's actions, the AD shock is the pressing issue. Demand will drastically fall owing to social distancting and fear in the mind leading to big drops in consumption. The Fed can stimulate AD by decreasing interest rates and making credits more available.

Can the Federal Reserve's actions stable the economy in US ?

While lowering interest rates might be one of the solutions to this ongoing crisis, but this might not be enough to control the situation. Hence, the Fed has to be more proactive and procure more creative solutions to this problem.