Question

2. Imagine that you are elected the Chairman of the Fed and your goal is to keep both unemployment and inflation under control. This means that unemployment should be at its natural rate (e.g. 5%) and inflation at/around 2%. Can you achieve the two goals simultaneously? Why or why not? Explain in detail.

Answer 1

The goal of unemployment at the natural rate of unemployment of 5% and inflation at 2% can be achieved simultaneously. This can be best explained with the help of an example.

The United States witnessed the worst financial crisis in decades in 2008-09. The unemployment rate was at 10% in the second half of 2009 and the economy briefly slipped into deflation.

The Fed pursued ultra expansionary monetary policies with fed fund rate declining to near zero levels. This triggered leveraged consumption and investment spending in the economy and coupled with expansionary fiscal policy, the economy clawed back. By December 2015, economic growth was stable and unemployment has declined. The federal reserve started pursuing contractionary monetary policy and even with contractionary policies, economic growth remained robust and unemployment has declined to 3.8%.

The key point to note is that by increasing the money supply and lowering the cost of money, the federal reserve can boost economic growth, increase consumer confidence and help in improving business sentiments. This reduces the unemployment rate while inflation increases.

However, when inflation is above 2%, the federal reserve can choose to pursue contractionary monetary policy. As money supply become tight, inflation is curbed. However, consumer confidence remains at elevated levels.

Therefore, through a right mix of policies, lower inflation and natural rate of unemployment can be achieved. The short-run Phillips curve elaborate on this point. As unemployment declines, inflation increases due to higher pressure on wages. However, tight monetary policy can curb spending demand on a relative basis and keep a check on inflation.