Should The Federal Reserve Intervene Every Time The Stock Market Takes A Plunge?

1. For the most part, the Federal Reserve's main concern is first and foremost inflation, and secondarily unemployment. Given these two goals, should the Federal Reserve intervene every time the stock market takes a plunge?

Let us first examine what happens when stock market takes a plunge and how the central banks can respond to that.

Injection of money:

As a result of stock market plunge and liquidity crisis the system may get jammed, credit will become scarcer, market interest rate will rise and consequentially the economy will get jammed too. So the central banks can keep the financial system working smoothly by ensuring that the banking system has enough liquidity.

On the other hand pumping in too much money can entail in moral hazard,; if banks think that central banks will bail them out come what may, they will be more inclined to lend recklessly, i.e., encouraging the root cause of reckless subprime lending.

Setting interest rates:

Central banks' second function is macroeconomic stabilization, setting interest rates in check without causing the economy to stop and start. Since a credit squeeze raises market interest rates it will slow the economy down.

On the other hand if a central bank cut the interest rate too drastically it may push up inflation or cause the expectation of future inflation to rise. The medium term goal of price stability might be put at risk.

In seeking to resolve these dilemmas it is important to keep these two tasks distinct since liquidity crisis is short term emergencies and macroeconomic stability is a medium term goal. But to maintain this distinction is also difficult as locked credit market soon has wider economic effects.

Against the central banks taking actions while the stock market goes for a plunge it can be said that it would result in undermining of the efficient pricing of risk by providing insurance after the event for risky behavior and that in turn encourages excessive risk taking and sows the seeds of a future financial crisis.

Hence it is not that every time the stock market plunges the central banks has to swing into action. In resonance with Mervyn King, Governor, Bank of England we can say that Liquidity should be provided only if withholding it would be so costly to the economy that the moral hazard could be ignored.

2. Most economists believe that a permanent increase in the money supply will generate inflation and make the prices of everyday goods and services higher than they are today. Is this scenario likely given the large reserve injections in the U.S. and world money markets? Why or why not?

Getting inflation under control was a truly great achievement of the central banks. Technology and financial innovation have played their role in this great moderation but central banks can also share in the credit for smoothing the cycle since they helped squeeze inflation out of the system. But these hard fought lessons in monetary policy can soon be forgotten in a slowing economy as in the present scenario. In the short run loosening policy too much after this summer's turmoil could send inflation expectation back up and once lost, credibility is hard to regain. So a permanent increase in the money supply would always have a risk of inviting inflation attached to it.

New Keynesian economists fully agree with New Classical economists that in the long run, changes in the money supply are neutral. That is, neither a permanent increase in the money supply, nor a permanent increase in the inflation rate, can move unemployment permanently away from its natural rate. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run.

Nonetheless, it is not advisable using expansive monetary policy just for short run gains in output and employment, because doing so would only raise inflationary expectations and thus store up problems for the future. Instead, using monetary policy for stabilization should be the objective. That is, suddenly increasing the money supply just to produce a temporary economic boom is a bad idea (because eliminating the increased inflationary expectations will be impossible without producing a recession). But when the economy is hit by some unexpected external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary