Question

In the recession that followed the subprime crisis,

Group of answer choices

the Fed lowered the nominal federal funds rate below zero

All listed options are true

. the Fed tried to raise real interest rates

targeting the nominal federal funds rate didn't affect real rates as predicted

the default risk premium plummeted

Answer 1

Answer: 4th option

The Fed rate should be targeted in a way which should not hamper the real rate of interest. This is the Taylor rule and very effective in subprime crisis arises due to the break of housing bubble.

Once there is a subprime crisis, the confidence of investors should be restored. This can’t be done simply by lowering the rate below 0, since this may create a liquidity trap.

Real rates can’t be increased, since this reduces money supply and creates more loss of confidence of investors.

Default risk premium can’t be lowered, since this decreases risk-taking encouragement of investors.

Therefore, not-to-hamper the real rate is the best way. This gains confidence of investors, since they realize that their returns become intact but not lowered.