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Thinking Critically: Two Questions Answered, Essay Example

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Essay

How would the effect of monetary policy on aggregate demand change if there were more adjustable-rate mortgages than fixed-rate mortgages?

The Federal Reserve’s current monetary policy would be more effective. That policy is supposed to get the economy moving again by expanding the housing market. That means lowering mortgage-lending rates so more people will refinance their properties. This will lower their monthly payments, leaving them with more discretionary income to spend, thus helping the economy. But only adjustable-rate mortgage holders can benefit from refinancing. The more there are, the greater the impact of the Fed’s “expansionist” policy. By contrast, holders of fixed-rate mortgages are beyond that kind of help.

Explain how the change in the federal funds rate between 2004 and 2009 corresponded to the bursting of the U.S. housing bubble in 2005 and what the change in the federal funds rate indicates about the monetary policy employed by the Fed beginning in 2004.

I disagree that the housing bubble burst in 2005. According to other analysts, it just started in 2005, gathered momentum in 2006 and 2007, but didn’t really burst until 2008. In any case, the chart shows that between 2004 and 2006, the Fed, seeing that the economy was finally recovering from the dot.com bubble of 2000, began raising interest rates to forestall inflation. That plateaued in 2006 as housing continued its slide. In 2007, the Fed began slashing interest rates in a desperate effort to provide the liquidity needed to reassure capital markets, and to stabilize housing prices through increased borrowing and buying. That latter policy has yet to be fully successful.

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