1. For the most part, the Federal Reserve's main concern is first and foremost inflation, and secondarily unemployment. Given these two goals, should the Federal Reserve intervene every time the stock market takes a plunge?
Let us first examine what happens when stock market takes a plunge and how the central banks can respond to that.
Injection of money:
As a result of stock market plunge and liquidity crisis the system may get jammed, credit will become scarcer, market interest rate will rise and consequentially the economy will get jammed too. So the central banks can keep the financial system working smoothly by ensuring that the banking system has enough liquidity.
On the other hand pumping in too much money can entail in moral hazard,; if banks think that central banks will bail them out come what may, they will be more inclined to lend recklessly, i.e., encouraging the root cause of reckless subprime lending.
Setting interest rates:
Central banks' second function is macroeconomic stabilization, setting interest rates in check without causing the economy to stop and start. Since a credit squeeze raises market interest rates it will slow the economy down.
On the other hand if a central bank cut the interest rate too drastically it may push up inflation or cause the expectation of future inflation to rise. The medium term goal of price stability might be put at risk.
In seeking to resolve these dilemmas it is important to keep these two tasks distinct since liquidity crisis is short term emergencies and macroeconomic stability is a medium term goal. But to maintain this distinction is also difficult as locked credit market soon has wider economic effects.
Against the cen ...