Chapter 25, Problem 1Q

To determine

The implications about the government’s views of the health of the interest rate channel during the implementation of a “cash for clunkers” program and a “cash for appliances” program

Introduction:

Interest-rate channel shows the effect of a fall in interest rate on spending and aggregate demand curve. It has main emphasis on the real interest rate rather than the nominal interest rate. In addition, it is often the real long-term interest rate and not the real short-term interest rate.

Explanation of Solution

The necessity of the implementation of “cash for clunkers” and later a “cash for appliances” rebate program indicates that the health of the interest rate channel was poor at the time of the Global financial crisis in 2009.

Despite low interest rates, as a result of expansionary or easing of monetary policy, expenditures on consumer durables were less at this period of time and thus the expenditures or spending had to be increased by such incentives. This was because of the failure of the Banking system due to the bank run. The public lost confidence and was in fear of the solvency of the bank and the failure of the financial markets and firms due to the presence of the financial frictions in these financial markets. This gave rise to the problem of moral hazard and asymmetric information at that period of time.

As a result, the government had implemented such rebate programs in order to increase spending in these areas.