Question

Suppose the annual inflation rate is at 7% and 3% of the labor force is unemployed. If you were on the Federal Reserve's Open Market Committee, what action would you prescribe and why? How would this affect the economy, the inflation rate, and the unemployment rate?

Answer 1

If I were on the Federal Reserve's Open Market Committee I would prescribe "Contractionary Monetary Policy."

When inflation is high, the federal reserve should pursue contractionary monetary policy to curb inflation. This involves open market sale of bonds, which absorbs liquidity from the banking system. Similarly, the discount rate can be increased, which makes banks less willing to borrow from the federal reserve.

The objective of these tools will be to reduce the liquidity in the banking system. As liquidity in the banking system declines, the federal fund rate increases and this translates into higher interest rates for businesses and consumers.

When interest rates trend higher in the economy, consumers are less willing to pursue consumption spending and business are less willing to pursue investment spending. This translates into the aggregate demand curve shifting to the left and it implies relatively slow economic growth and lower price levels.

It is important to note that the natural rate of unemployment in the United States is around 5%. Therefore, an unemployment level of 3% and an inflation of 7% indicates that the economy is in a inflationary gap. Therefore, tight monetary policies would help close the inflationary gap and the economy moves back to potential output. The unemployment increases on a relative basis, but inflation declines and GDP growth cools down on a relative basis.

If contractionary monetary policy is not pursued at inflation of 7%, there could be potentially higher inflation. It is also important to note that the federal reserve targets inflation of around 2%. Therefore, inflation at 7% is significantly higher than the target rate and inflation needs to be curbed through contractionary monetary policy.