The rise in housing prices in 2001–2006 was a key factor in setting the stage for the financial crisis of 2007–2009. Low interest rates is one possible cause for the rise in housing prices. Because most housing is financed with long-term mortgages, small increases in mortgage rates lead to large increases in the cost of purchasing a house.
a. Why might the Fed have kept interest rates too low for too long? Frame your answer in terms of policy lags and the uncertainty of modeling.
b. Illustrate your answer with the IS–MP model.