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A liquidity trap is


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1. Why did the FOMC under Paul Volcker in the late 1970's to early 1980's shift from targeting the fed funds rate ( i ) to targeting the quantity of money (M)? What were the results?

When Paul Volcker became the chairman of the Fed, the rate of inflation was very high (over 13% per annum) and value of dollar was falling. This was creating concerns in the financial markets. At that time FOMC's main theme for monetary policy was to control the interest rate. In order to do that FOMC injected more and more money into the economy leading to high money supply rate. The idea behind pumping more money into the economy was that higher supply of money could keep the interest rates under check. However, more money in the economy without any changes in the supply of goods and services resulted in more money chasing the same quantity of products and services. Hence, we saw a period of high rate of inflation and falling value of dollar. In 1979 and 1980, Volcker changed the FOMC strategy towards monetary policy drastically and set the strict money supply growth targets. The idea behind restricting the money growth was to reduce the inflation and keep it under check. However, this sudden change in the monetary policy shocked the economy and resulting in sharp increase in interest rate. The prime lending rate reached at its peak in December 1980 at 21.5%. The economy contracted and entered into a recession (worst for last 40 years) ...

Solution Summary

A liquidity trap is defined.