Question

In his New York Times column of May 27, 2005, economist Paul Krugman stated: “After all, the Fed’s ability to manage the economy mainly comes from its ability to create booms and busts in the housing market.” What do you think he meant by that statement? Is it an accurate characterization of the Federal Reserve’s influence over the real economy?

Answer 1

This statement reflects the ability of the federal reserve Bank to influence the economic activity in the nation. By increasing the money supply the federal reserve Bank is able to reduce the rate of interest, which is helpful in increasing the investment spending in the short run. As a result there is a stimulus provided to the aggregate expenditure which creates demand for goods and services. although there is an increase in the real GDP in the short run there is also an increase in the rate of inflation. In unregulated markets this can result in booms where increasing price level increases the nominal value of wealth and creates an impression that real value is also increasing. This is what happened in housing market bubble of 2006.

Similarly the federal reserve Bank can bring down the inflationary gap by reducing the money supply and raising the rate of interest. This is not an accurate characterization of the federal reserve influence over the real economy because in the long run the federal reserve is not able to influence the economic activity on the real GDP. the long run equilibrium is sustainable because of the economy's resources being used fully and using the the latest available technology.