Central banks manage monetary policy and target the rate of inflation and are less concerned with avoiding asset price bubbles. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are matters of debate among economists.
Some market observers have been concerned that Federal Reserve actions could give rise to moral hazard. A contributing factor to the rise in house prices was the Federal Reserve's lowering of interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0% to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation while the rate of inflation was low. The Fed's interest rate policy during the early 2000s was misguided, because measured inflation in those years was below true inflation, which led to a monetary policy that contributed to the housing bubble.
So why did the fed lower the rates in 2005?
During 2005, the Federal Reserve increased interest rate in order to prevent an increase in inflation rates. An increase in interest rate would mean a higher saving, lower consumption and lower investment spending because interest rates determine the cost of investment. This would in turn lead to a lower aggregate spending and hence a lower equilibrium output. Then automatically the money demand would fall leading to a fall in the price levels. Hence the inflation rates would have fallen. The interest rates are related inversely to the investment spending representing in part the cost of investment. Only those investment projects in the economy are likely to yield a rate of return higher than the market rate of interest will be funded. If the capital investment is financed with borrowing, higher interest rates increase the cost directly. If capital investment is financed with internal funds by the firms, higher interest rates would increase the opportunity cost of the investment. At higher market interest rates, fewer projects are likely to be profitable and hence would call for a lower investment spending.
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