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On the Fed's Demand Bubble
By William A. Niskanen
Introduction
It should now be clear that the Federal Reserve caused, or at least accommodated, the bubble in aggregate nominal demand from early 1998 through early 2000. Moreover, the Federal Reserve chose to wring out this excess demand by late 2001, and by late 2002 total demand was significantly below trend (Figure 1). The primary open questions are whether the Federal Reserve should have caused or accommodated the bubble and what the Fed should have done once the bubble was in place.
At this point, it is important to distinguish between the bubble in aggregate nominal demand and the nearly synchronous and much larger bubble in equity prices. At the peak of the demand bubble, aggregate nominal demand was only about $320 billion above trend. The bubble in equity prices, in contrast, was about $7 trillion. The monetary stimulus that led to the demand bubble may have contributed to financing the equity bubble but was only a small part of that story. Another study would be necessary to estimate the magnitude and timing of the equity bubble if the Federal Reserve had maintained a trend rate of growth of aggregate demand throughout this period. Until such a study is completed, there is no basis for holding the Federal Reserve responsible for the equity bubble.
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