In which of the following situations would the Fed have the most power to stimulate the...

In which of the following situations would the Fed have the most power to stimulate the economy?

- the federal funds rate is zero and the inflation rate is 0%

- the federal funds rate is zero and the inflation rate is 2%

Does the preceding question and answer describe why the Fed prefers inflation of 2% as opposed to inflation of 0%?

yes

Solutions

Expert Solution

a) When the Federal fund rate is Zero and inflation rate is 0%: In such a situation the Fed doesn't have any power to stimulate the economy. They can't put a negative interest rate and depreciate the value of Capital and savings in the economy. As per the scenario the economy is in recession putting negative rates will cause massive capital outflow. The only thing they can adopt here is using Helicopter money but that has not been used anytime before in any economy. Zero inflation and Zero interest rate is an extreme situation after which the FED doesn't have any tool left the stimulate the economy as the nation is in a liquidity trap.

b) The federal fund rates are zero and inflation rate is 2%: In such a scenario the Federal bank lot of room to increase the fund rates and decrease the money supply in the economy. Decreased money supply will reduce the money in the hand of the people and they will demand even less reducing the inflation in the economy. Here, in this case, the Fed is more powerful to stimulate the economy and the outcome.

"Yes, the preceding question and answer describe why the Fed prefers inflation of 2% as opposed to inflation of 0%."

Rahul Sunny answered 1 year ago

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