A Resistant Strain of Weakness
Subject Consumer Spending
Topic Monetary Policy
Key Words Tax Cuts, Budget Deficit, Budget Surplus, Recession, Interest Rates
News Story

The Federal Reserve cut its benchmark federal funds interest rate from 3 percent to 2.5 percent, the lowest level in 39 years. It was the ninth time the Fed has cut interest rates this year, and the second half-point decrease since the terrorist attacks of September 11. In a statement explaining its decision, the Fed said, "The terrorist attacks have significantly heightened uncertainty in an economy that was already weak." Interest rate cuts are supposed to induce business and consumers to increase spending; however, since the interest rate cutting began, business borrowing has virtually ceased and consumer-credit growth has slowed sharply. This behavior raises the question of whether the current economic weakness is resistant to monetary policy changes, that is, could interest rates even approaching zero, turn things around?

The issue is whether individuals and business firms are sufficiently alarmed by the uncertainty resulting from the terrorist attacks, causing them simply refuse to spend. Questioning the effectiveness of monetary policy in stimulating additional spending is not novel; it has been raised with each economic downturn. Yet, in each downturn since World War II, lower interest rates have, sooner or later, revived the economy. But last month's terrorist attacks are without economic precedent. All of the weakness that the economy displayed prior to September 11 has been intensified both in the U.S. and abroad. The biggest challenge is eroding confidence which may be immune to interest rate cuts. Adding to the economic bad news is the unsettling example of Japan, which has been struggling since 1990 with weak demand and a deflating economy.

Most mainstream economists believe that the combination of lowered interest rates, tax cuts and billions of dollars in additional spending will turn the economy around in early 2002. It may very well be as Alan Greenspan, Fed Chairman, put it in Congressional testimony in July, "You essentially get very complex differences in the way monetary policy plays out, but at the end of the day, it does seem to be effective.".

(Updated November 1, 2001)

1. It was hoped that significant interest rate cuts would lower the dollar in comparison to other currencies and that this would provide stimulus to the economy. How would a weaker dollar stimulate the economy? Can you suggest some reasons why the dollar has not fallen?
2. Although short-term interest rates have fallen dramatically this year, long-term rates have only fallen slightly. Why have long-term rates been stable? How are long-term rates determined?
3. Many economists argue that falling stock prices have4 offset any benefits of lowered interest rates. Explain this statement. How would decreasing stock prices affect consumption? How would decreasing interest rates affect consumption? President Bush is considering recommending a permanent decrease in corporate income taxes. How would such a decrease stimulate the economy?
Source Greg Ip and Greg White, "Toward Zero," The Wall Street Journal, October 3, 2001.

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