Question

In April​ 2020, as a result of the coronavirus​ -- along with the​ Governments’ “shuttering​ in” policies​ -- the United States experienced​ deflation, rising unemployment​ (from 4.4% to​ 14.7%) and falling GDP​(annualized at a negative​ 4.8%). As a​ result, the Fed lowered the Federal Funds rate to zero percent​(0%). The natural rate of unemployment in the United States is​ 4.5%. Assume that in​ May, 2020, the inflation rate increased to​ 1.2% (annualized) and the unemployment rate fell to​ 9.8% in the United States. As a​ result, the most likely policy for the Fed is to

A. increase the targeted federal funds rate consistent with the short run Phillips Curve

B. maintain the current targeted federal funds rate.

C. increase the targeted federal funds rate consistent with the long run Phillips Curve

D. lower the targeted federal funds rate to a negative​ 1% (-1%) to be consistent with the ECB

Answer 1

The answer is (b) maintain the current targeted federal funds rate.

Since the inflation is below the target of 2% and the economy is still very weak, with unemployment at a very high rate of 9.8%, the best move is to continue at the current rate of 0% as it will provide confidence to the economic agents that interest rates are not going to be increased in the future and they can continue to make decisions based on the current interest rate.

(a) and (c) are wrong as with such a weak economy, rising interest rates is going to hurt the economy even more. The only option is to lower rates further.

(d) is wrong as keeping negative interest rate is a contentious issue with ongoing research, There can be harmful effects of negative interest rates and unless proven otherwise, the zero lower bound is binding frot he US.