Webpages useful for teachers of intermediate macroeconomics:

Why a Stimulus Package Might Be Desireable

2001-10-14

Powerpoint Version

Animated Version

The terror attack on the World Trade Center on September 11, 2001 reduced consumer confidence—thus lowering likely future purchases of durable goods by households—and reduced businesses’ willingness to spend money on investment projects, at least until the future becomes clearer. But nobody knows how large or how long-lasting these shocks to household and business behavior will be.

In response, the Federal Reserve has reduced interest rates by a full percentage point in an attempt to stimulate investment spending and offset the contractionary impact of the shock. But can the Federal Reserve do enough? Its ability to reduce interest rates is limited by the fact that the nominal short-term interest rates it controls—and that now stand at 2.5% per year—cannot go below zero. Moreover, the effect of interest rate reductions may be limited: to the extent that investment spending is limited not by the cost of finance but by the fact that businesses value keeping the option to delay decisions about the future until the uncertainty generated by the terror attack is resolved, the Federal Reserve’s tools may be weak.

The Central Bank May Not Be Able to Prevent a Deep Recession

If it does turn out to be the case that the fall in spending produced by the terror attack is large, and that the Federal Reserve’s tools to fight the resulting recession are weak, then there will be a strong argument for stimulative policies—like expanded government spending—that affect the position of the IS curve directly, and would shift it to the right.

Unfortunately, the decision about a stimulus package must be made now, before we understand the magnitude and persistence of the shock to consumer confidence and business willingness to invest.


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