Question

Growth Rate: 3.2%

Unemployment Rate: 3.8%

12 Month Core PCE Inflation: 2%

Funds Rate: 2.5%

Explain the relationship between these 4 variables given the initial conditions (the given rates). Are these rates collectively consistent with what we would expect from basic economic models such as Phillips curve, IS-LM, etc?

Answer 1

From the given variables, it is clear that the United States economy is experiencing strong growth with GDP growth rate at 3.2%. It is also important to note that the unemployment rate in the United States is below the natural rate of unemployment and this further underscores the fact that growth is robust in the economy. Therefore, the relation between GDP growth and unemployment holds true.

However, the above readings are not consistent with the Phillips curve. When GDP growth is robust and unemployment is potentially below the natural rate of unemployment, it implies that the economy is at or above potential output. However, the economy has struggled in terms of inflation with 12 month core PCE inflation remaining muted at 2%. With robust economy growth and low unemployment rate (tight labor markets), the Phillips Curve would have suggested higher level of inflation in the economy.

It is also important to note that the Federal Reserve has been tightening monetary policy since 2015 with the current Federal fund rate at 2.5%. With the IS-LM given the relation between real output and interest rates, the relation holds well in this scenario. As growth has trended higher, so has nominal interest rates in the economy.

The tightening of monetary policy is also consistent with the AS-AD model with the US economy at potential output as suggested by the level of unemployment. While inflation has remained subdued, policy tightening is to ensure that asset bubbles can be avoided.

Overall, the growth, inflation and interest rates are in sync with the AS-AD model and the IS-LM model. However, inflation data does not suggest that the Phillips Curve model holds true for now.