Question

The financial crisis of 2007-09 resulted in immediate action by the Fed to cut interest rates. Two or three months later some economic commentators complained that the Federal Reserve’s policies had obviously failed to turn the economy around because things were still getting worse. Was this a fair complaint against the Fed? Why or why not?

Answer 1

In the financial crisis of 2007-2009, the world economy was slowing down due to a lack of demand in the world economy and unemployment was going up. In that period, the Fed played an import role by implementing the expansionary monetary policy which included the reduction in the interest rate. There is one problem with this policy is that it has a time lag. It takes some time to be effective in the economy. The reduction in the interest rate increases the investment as investment becomes less costly for producers as interest rate decreases. The increment in the investment causes to increase the aggregate demand.

In this crisis, the Fed only reduces the interest rates to boost the economy and the interest rate became so lower which made the banks bankrupt. On the one side, the Fed wanted to increase the aggregate demand by increasing investment and on the other side, banks were getting bankrupts. After implementing this policy, the economy was not coming on track as the fiscal expansion was also required to boost consumption and government expenditure.

The Fed tries to boost the aggregate demand by the reduction in the interest rate but it could not have lowered it beyond a specific level. Thus, in the initial months, the economy failed to turn around. Hence, the economist complaint about this was fair.