Which of the following prevented the Fed from reducing long-term real interest rates during the financial crisis of 2007-2009?
A) an increase in expected inflation
B) an increase in the risk premium
C) the collapse in the housing market
D) the failure of the federal funds rate to respond to monetary policy

Question

Quizplus · Accepted Answer

An increase in the risk premium prevented the Fed from reducing long-term real interest rates during the financial crisis of 2007-2009. As investors became more risk-averse, they demanded a higher compensation for holding risky assets, which caused an increase in the risk premium. This increase raised the cost of borrowing for households and firms, offsetting the effects of the Fed's monetary policy on long-term interest rates. The collapse in the housing market (C) and the failure of the federal funds rate to respond to monetary policy (D) also contributed to the Fed's inability to lower long-term interest rates, but an increase in the risk premium was the predominant factor. An increase in expected inflation (A) would have raised nominal interest rates but had little effect on real interest rates.

Which of the Following Prevented the Fed from Reducing Long-Term