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Monetary stimulus and the real estate bubble

1. Go to the St. Louis Fed's web site and look at the graph of target federal funds rates
over the last few years:
Notice that from January 2001 until June 2003, the Fed lowered the target federal
funds rate in steps from 6.5% all the way down to 1% and left it there for a year;
then between June 2004 and June 2006 they raised the rate back up to 5.25%; and
then finally from September 2007 until now, they lowered the target federal funds
rate again in steps down to almost zero.
WHY did the Fed do this? What is the intended effect of either lowering or raising the
federal funds rate?
2. Explain the mechanism: what does the Fed actually DO (beyond making public
pronouncements about their intentions) to lower or raise the federal funds rate from
wherever it is?
3. What are the side effects, in the short run and the longer run, when the Fed does
what you described in (2)?
4. We have recently had a major nationwide boom (a "bubble") in residential real estate
and in the financial markets in general, which has come to an abrupt and painful
end. Is there any connection between this bubble and its end, and Fed actions as
shown in the graph you looked at in (1)?

Solution Preview

From the graph on the web site, you can see economic recessions indicated by gray bands. These coincide with the lower targets on the federal funds rates, and offer a clue as to the reason. Lower interest rates serve to stimulate economic activity. They essentially lower the price of money and make loans easier to obtain. Businesses especially benefit from lower interest rates, since they often rely on loans. With lower interest rates, they can use the money to hire workers and upgrade their facilities, paying less in interest. Consumers benefit mainly through the housing market. Lower interest rates can make homes that were unaffordable within reach. When home buying increases, construction does as well. As it is one of the largest industries in the economy, construction is often seen as an indicator of overall economic health. The opposite is true of raising the federal funds rate: economic activity declines, bringing the economy back to a sustainable growth rate and reducing inflation.

The Fed lowers the federal funds rate through open market operations. The federal funds rate is the rate at which banks loan money to each other in the overnight lending market, which is used to meet reserve requirements. The Fed cannot change this directly, but it sets a target and works toward it by using open market operations. For example, if it lowers ...

Solution Summary

How the Fed's actions relate to the recent collapse of residential real estate and financial markets