15.5 Monetary Policy: Evaluation and Issues

What are the two key advantages of monetary policy over fiscal policy?

Speed and flexibility; isolation from political pressure.

Why is monetary policy faster than fiscal policy?

The FOMC can change policy daily, while Congress may take months to act.

Why is monetary policy more insulated from politics?

Fed governors serve 14-year terms, making them less vulnerable to lobbying or voter pressure.

Why is monetary policy more politically neutral than fiscal policy?

It works broadly and indirectly, unlike fiscal policy which targets specific spending or tax changes.

How did the Fed respond to the 2007–2009 mortgage default crisis?

Lowered discount rate, cut federal funds rate from 5.25% to 2%, and prevented failures of key firms

What was ZIRP and when did the Fed adopt it?

Zero Interest Rate Policy, adopted in December 2008 to keep short-term rates near zero.

What unusual step did the Fed take during the crisis?

Acted as a “buyer of last resort,” purchasing debt securities at pre-crisis prices.

What was the Fed’s solution after ZIRP hit the zero lower bound?

Keep short-term rates low with IORB and ON RRP, and launch QE to lower long-term rates.

What signaled the end of monetary stimulus by 2015?

Unemployment fell to 5%, allowing the Fed to end ZIRP and QE and raise rates gradually.

What was the state of the U.S. economy by early 2020?

Full employment (3.5% unemployment) and stable inflation (2.3%).

How did the Fed respond to the COVID recession in 2020?

Used forward guidance, cut federal funds target to 0–0.25%, lowered money-market rates, and purchased $3T in bonds (QE).

Why was the COVID recession the shortest on record?

Aggressive Fed actions restored output to potential by fall 2021 (18 months after lockdowns).

What lags affect monetary policy?

Recognition lag and operational lag, but not administrative lag.

Why was there no recognition lag during COVID?

Lockdowns made the recession immediately obvious.

What is the typical operational lag for monetary policy?

3–6 months for interest rate changes to affect investment, AD, GDP, and prices.

Which Fed tools can have immediate effects despite lags?

Forward guidance and acting as a lender of last resort.

What is cyclical asymmetry in monetary policy?

Monetary policy is more effective at slowing inflation than at pulling the economy out of recession.

What metaphor is used to describe cyclical asymmetry?

“Pushing on a string” — easy to pull demand left (restrictive), hard to push demand right (expansionary).

Why is restrictive monetary policy usually effective?

Higher interest rates make lending unattractive, reducing loans, investment, and aggregate demand.

Why is expansionary monetary policy less reliable?

Lower interest rates may not lead to more lending or borrowing, especially in a liquidity trap.

What is a liquidity trap?

A situation where lower interest rates and higher reserves fail to boost lending, investment, or demand.

Example of liquidity trap during the 2007–2009 crisis?

Fed cut rates near zero and boosted reserves from $44B to $1.1T, but bank lending fell 25%.

Why did banks reduce lending during the 2007–2009 crisis despite high liquidity?

Fear that loans wouldn’t be repaid, leading to weak investment and demand.

What is the Fed’s “ample reserves regime”?

Policy of maintaining very high bank reserves through QE and reverse-repo operations (over $3.8T in 2022).

What does the phrase “you can lead a horse to water, but you can’t make it drink” mean in monetary policy?

The Fed can lower rates, but cannot force banks to lend or households/businesses to borrow.

Why did Congress act forcefully with fiscal policy in 2009?

Monetary policy was maxed out in a liquidity trap, so fiscal stimulus was needed to shift AD rightward.

What fiscal measures were taken during the 2007–2009 crisis?

The American Recovery and Redevelopment Act authorized $787B in tax cuts and government spending.

What fiscal measures were taken during the COVID-19 crisis?

Programs like the Paycheck Protection Program and CARES Act gave cash directly to workers and businesses.

What was the result of aggressive fiscal stimulus during COVID?

It boosted demand but, combined with supply chain problems, drove inflation from 1.4% (2020) to 7% (2021).

Why did inflation spike after COVID fiscal stimulus?

AD shifted right from stimulus while AS shifted left from supply chain issues, creating the highest inflation since 1981

Speed, flexibility, and isolation from political pressure are main advantages of ______

Monetary policy

________ policy may be highly effective in slowing expansions and controlling inflation but less reliable in pushing the economy from a severe recession.

monetary

Monetary policy faces a recognition lag and an operational lag, but avoids the _______ lag that hinders fiscal policy

administrative

The time it takes for the Fed to realize that a fluctuation in economic activity is heading toward a genuine recession is called the _____

recognition gap

If pursued vigorously, a restrictive monetary policy could deplete commercial banking reserves to the point where banks would be forced to reduce the volume of ____

lending