Question

1. Please indicate why pursuing both (1) stable prices and (2) maximum sustainable employment can be contradictory of each other? What possible actions could the Fed take that can be leading both of those measures in opposite directions.

Answer 1

Stable prices and maximum sustainable employment are considered as dual mandates of Fed's monetary policy. While both are prerequisites for an economy to run smoothly in the long run, short run is flawed by business cycles. Thus, it is unavoidable to adjust monetary policy in the short run especially during recession, to adjust these variables in the required path.

Both the goals can run into contradictions with each other. As a matter of illustration, suppose economy is facing recessionary pressures. To combat massive unemployment, Fed adopts expansionary monetary policy. But if the expansionary monetary policy is allowed to operate for too long it can lead to rising inflation. This will be more rapidly so if increase in the real output does not increase in proportion to the increase in the money supply.

Fed could ensure that both mandates are at tandem with each other by adopting 'inflation targeting' which helps in ensuring price stability. This rate of inflation is usually set at a bar which is low and stable, generally at 2%. The Fed could also effectively strike a balance in rightly choosing the 'key mandate' among the two goals as different times require different solutions. It is generally agreed that monetary policy and employment levels have a weaker relation than monetary policy and price stability.