Question

In 2007–2008, the U.S. real estate bubble deflated. As a result, the value of homes fell.

1. If the Fed tries to keep output constant, what type of monetary policy would it pursue? Would the Fed increase or decrease the federal funds rate? (Please use the aggregate expenditure (AE) curve to explain your answer. Start with a long-run equilibrium of the economy where ? = ? ∗ . Then, show the impact of the deflated real estate bubble on the AE curve. Lastly, show the impact of the Fed’s policy on to the economy on the AE curve.)
2. What phenomenon would prevent the Fed from achieving its goal? Clearly state the term economists use for this phenomenon and explain how it affects the effectiveness of the Fed’s monetary policy. Use the AE graph you draw in part a) to explain your answer.

Answer 1

Recession reduces the aggregate demand, output, and employment level in the economy. Thus, the Fed would go for the expansionary monetary policy. During the economic recession, the Fed reduced the federal Fund rate thereby tried to drive up the aggregate demand in the economy or AE was pushed upward.

Following is the diagram:

In the above diagram, the During the recession GDP fall from the Y1 to Y0, Fall in the GDP is caused by the fall in the AE in the economy. AE falls from AE0 to AE1, now equilibrium is established at the lower level.

the expansionary monetary policy would shift the Aggregate expenditure upward to level where full employment level exists.

But monetary policy is not effective always , the problem of liquidity trap makes the monetary policy quite ineffective in raising the level of output and expenditure. Liquidity trap makes it difficult to push economy towards the previous level of AE0.