Question

To work Problems 28 to 30 , use the information that during 2012 the inflation rate increased but remained in the "comfort zone" and the unemployment rate remained high.Explain the dilemma that rising inflation and high unemployment poses for the Fed.

Short answer

The dilemma for the Fed is balancing the need to control inflation without exacerbating unemployment, and vice versa.

Step-by-step solution

Understanding the Context

In 2012, the inflation rate increased but stayed within a 'comfort zone,' meaning it did not rise to worrying levels. Meanwhile, the unemployment rate remained high, indicating economic distress for many individuals.

Defining the Dilemma

The dilemma for the Federal Reserve (Fed) lies in balancing the dual mandate: controlling inflation and promoting employment. Rising inflation generally requires tightening monetary policy, while high unemployment may require loosening it.

Assessing Inflation Control

If the Fed decides to control inflation by increasing interest rates, this can reduce spending and investment. However, higher interest rates can also slow down economic growth, potentially worsening unemployment.

Assessing Unemployment Reduction

Conversely, to reduce unemployment, the Fed might lower interest rates to stimulate the economy. This can encourage borrowing and spending, potentially leading to higher inflation if demand outpaces supply.

Balancing Act

The Fed needs to find a balance where inflation does not exceed acceptable levels ('comfort zone') and unemployment does not remain excessively high. This often involves moderate adjustments and careful monitoring of economic indicators.

Key concepts

Inflation Control

Inflation occurs when the general price level of goods and services in an economy rises. Central banks, like the Federal Reserve (Fed), aim to control inflation to maintain economic stability. When inflation is within a 'comfort zone,' it generally reflects a healthy economy. If inflation goes beyond this comfort zone, prices for everyday items can become too high, reducing the purchasing power of consumers.
To control inflation, the Fed might increase interest rates. Higher interest rates make borrowing more expensive, which reduces spending and investment.
While this measure can succeed in slowing inflation, it may also negatively impact economic growth by making it costlier for businesses to expand and for consumers to buy homes and cars.

Unemployment Reduction

High unemployment means many people are out of work and unable to find jobs. This is a major concern for an economy because it can lead to lower overall consumer spending and increased government spending on social services.
To reduce unemployment, the Fed might lower interest rates. Lower interest rates reduce the cost of borrowing, encouraging businesses to invest and hire more workers. Additionally, consumers are more likely to spend on big-ticket items like homes and vehicles, driving demand and creating more jobs.
However, increased demand can lead to higher prices if it outpaces supply, potentially causing inflation.

Monetary Policy

Monetary policy refers to actions undertaken by a central bank, like the Fed, to influence the availability and cost of money in an economy. These actions are designed to help achieve macroeconomic objectives such as controlling inflation, managing employment levels, and promoting economic growth.
The main tools the Fed uses include adjusting interest rates and changing the amount of money in circulation. For example, raising interest rates can help combat inflation but may slow down economic growth. Conversely, lowering interest rates can stimulate growth but may lead to inflation.
Each decision involves trade-offs, and the Fed must balance these to maintain economic stability. The goal is always to foster an environment where inflation is kept within the comfort zone and unemployment is minimized.