Suppose the Fed had a policy of responding to asset-price bubbles. Under this policy, it would have set higher interest rates than it actually did during the stock market boom of the late 1990s and the housing bubble of the 2000s.
a. For the period 1990-2007, draw a graph showing roughly what interest rates the Fed would have chosen under the antibubble policy. Compare this hypothetical interest-rate path to the actual path of rates (see Figure 15.2).
b. How would the antibubble policy have changed the behavior of output and inflation? Draw rough graphs comparing the likely paths of these variables to the paths they actually followed. In this part of the question, assume the antibubble policy was unsuccessful: stock and house prices rose rapidly despite higher interest rates.
c. Now suppose the hypothetical policy succeeded: it dampened the stock market and housing bubbles. How does this change the answer to part (b)?