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The Rebound Cometh?
Subject Stabilization Policy
Topic Monetary Policy
Key Words Recession, Inflation, Economic Growth, Interest Rates
News Story

The Federal Reserve has cut interest rates by a total of five and three-quarter points since the start of the year. The economy, however, has not responded to these rate cuts, causing concern in the Fed. Policy makers have always been aware that there is a lag between the implementation of a rate cut and a resulting improvement in economic performance. The length of the lag is uncertain, but many economists believed, based upon previous experience, that the economy should already be showing the first sings of a rebound. The absence of these sign has caused Fed officials to wonder if additional rate cuts are needed.

When the Fed cuts rates, a number of economic forces are set in motion. The value of the dollar typically falls as international investors find interest rates in other countries more attractive. The falling dollar increases exports and increases imports. The rate cuts implemented this year have not depreciated the dollar. Lower rates usually lead to higher stock prices as the rate of return from bond ownership falls relative to stocks. Increased stock prices via the wealth effect boost consumer spending. The current series of interest rate cuts have not resulted in higher stock prices.

One of the most significant areas of impacts is the effect on investment. Typically, decreases in short-term interest rates lead to reductions in long-term rates and increased investment follows. Long-term rates have fallen only slightly since January and investment has not responded as predicted.

The question for policy makers is whether the Fed's actions coupled with the federal income tax cut will be sufficient to keep the economy from slipping into a recession. Many analysts and investors expect the Fed to continue to lower rates and this has generated concern that if the economy rebounds soon, the impact of additional rate cuts might be to fuel inflation.

(Updated August 1, 2001)

Questions
1. One of the important channels of monetary policy is its impact on investment. Using appropriate diagrams, illustrate the impact of interest rate cuts on investment and using an aggregate supply/aggregate demand model, show the resulting change in the level of real GDP and prices.
2. What is the wealth effect? How does an increase in the value of an individual's portfolio affect consumer purchases? What is the impact of this change on GDP and prices?
3. Analysts believe that weakness in Asian and European economies have kept the dollar from falling. How would a falling dollar help stimulate the U.S. economy?
Source John M. Berry, "Fed Wonders: Where's the Rebound?" The Washington Post, June 21, 2001.

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