Question

In 2003, as the U.S. economy finally seemed poised to exit its ongoing recession, the Fed began to worry about a “soft patch” in the economy, in particular the possibility of a deflation. As a result, the Fed proactively lowered the federal funds rate from 1.75% in late 2002 to 1% by mid2003, the lowest federal funds rate on record up to that point in time. In addition, the Fed committed to keeping the federal funds rate at this level for a considerable period of time. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary.

a. How might fears of a zero lower bound justify such a policy, even if the economy was not actually in a recession?

b. Show the impact of these policies using the IS-LM graph and the AD/AS graph. Be sure to show the initial conditions in 2003 and the impact of the policy on the deflation threat.

Answer 1