Article Summary
The financial crisis of 2008 had led the economy to the worse kind of recession ever observed. The Fed had taken up a number of policy programs to stabilize the financial system as the first step and then to provide support to the receding economy. The Fed had to take a number of bailing out programs for the falling financial institutions and industries as well. The decision on the rate of interest was a difficult one. At the initial stages when the bail-out programs were still going on or had just begun, the rate of interest was at 2 per cent level . The Fed decided to keep the rate at that level.
Within a few months it was observed that the situation has worsened. The economy was moving deeper into recession. To bring out the economy from the recession an easy money policy was needed. The Fed had decided upon monetary expansion with more flow of credit into the economy. But some aspect of the economy raised apprehensions about the possible effects of a rate cut. The commodity prices had risen. The consumer price index had shot up to 5.5 per cent in 2008.
As the economy was rapidly taking a downward course the Fed had to take bold decisions. So, finally the Fed rate was reduced to zero . The Fed also announced plans to buy securities that had actually led to the fall of several financial institutions. This had pumped in more money into the economy and reduced the losses of the financial institutions finally bringing the economy out of crisis.
The situation is depicted in the figure below. As the rate of interest falls the credit flow in the economy increases . This leads to an increase in the aggregate demand shown by an upward shift in the aggregate demand curve from AD0 to AD1. The result is a rise in the price level from P0 to P1 and increase in output or income from Y0 to Y1.
AD1
AD0
Y0 Y1 Y
Works Cited
Hilsenrath, Jon. "New View Into Fed's Response to Crisis." The Wall Street Journal 21 February 2014: 6. English.
Mankiw, G.N. Macroeconomics. Macmillan, 2013.
