Wednesday, November 24, 2010

Analysis of Fed Monetary Policy and Criticisms

A good explanation of what the Fed is doing and the likely impacts.

It has a chance of improving the economy through two channels. It will keep long term interest rates low which might encourage business investment. It may also cause the dollar to depreciate relative to foreign currencies and stimulate US exports. The chances that this will work are not high. Interest rates are low today and business is not investing. Furthermore, our trading partners will take actions to fend off appreciation of their currencies relative to the dollar.

The primary benefit may come from warding off price deflation. Price deflation is dangerous for several reasons. If prices for goods fall, wages will fall even faster. Consumers will have less money to spend and they will have less money to pay down their debts which will not fall. Falling prices also make it more likely that businesses will sell their products for less than they paid for them. The Fed understands that price deflation is very bad for the economy and hard to correct once it gains momentum.

It is possible that the Fed's policy can lead to inflation if they don't take steps to control it after the economy strengthens. The Fed understands this and it is better at controlling inflation than it is in beating back price deflation.

The Fed would like Congress to supplement its monetary policy with fiscal stimulus but it understands that this is politically unlikely given that campaign 2012 has stared already.

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