Question

Use the following news clip to work. Inflation targeting promotes well- anchored inflation expectations, which facilitate more effective stabilization of output and employment. Thus inflation targeting can deliver good results with respect to output and employment as well as inflation. Explain how inflation targeting as described by Ben Bernanke is consistent with the Fed's dual mandate.

Short answer

Inflation targeting helps the Fed by anchoring inflation expectations, which stabilizes output and employment, aligning with its dual mandate for maximum employment and price stability.

Step-by-step solution

Understanding Inflation Targeting

Inflation targeting is a monetary policy where a central bank sets a specific inflation rate as its goal. By aiming for a predetermined inflation rate, the central bank, such as the Federal Reserve (the Fed), tries to influence economic expectations and behaviors.

The Fed's Dual Mandate

The Federal Reserve has a dual mandate: to promote maximum employment and to ensure price stability. This means the Fed is responsible for both motivating job growth and controlling inflation.

Anchor Inflation Expectations

By targeting a specific inflation rate, the Fed can anchor inflation expectations. When businesses and consumers believe that inflation will stay stable and low, it reduces uncertainty and promotes long-term economic planning and investment. This can lead to more stable employment and output.

Stabilizing Output and Employment

With well-anchored inflation expectations, the Fed's efforts to stabilize economic output and employment become more effective. When inflation is predictable, businesses are more likely to invest and hire, which supports the Fed's mandate for maximum employment.

Consistent with Dual Mandate

Since inflation targeting helps to stabilize both inflation and economic output, it supports the Fed's dual mandate. Ensuring stable inflation indirectly promotes job growth and economic stability, leading to a balance between the two goals of the mandate.

Key concepts

Federal Reserve

The Federal Reserve, often referred to as the Fed, is the central banking system of the United States. It was created in 1913 to provide the nation with a safe, flexible, and stable monetary and financial system. The Fed's main responsibilities include managing the nation's money supply, setting interest rates, regulating and supervising banks, and providing financial services to depository institutions, the U.S. government, and foreign official institutions.

The Fed plays a crucial role in the economy by influencing monetary policy. One of the key ways it does this is by setting the federal funds rate, which is the interest rate at which banks lend to each other overnight. Changes to this rate can affect borrowing costs for consumers and businesses, ultimately influencing spending and investment behaviors across the economy.

Another important function of the Fed is its role as a lender of last resort. In times of financial crises, the Fed can provide emergency lending to banks or other institutions to maintain financial stability and prevent panic.

Dual Mandate

The Federal Reserve operates under what is known as a dual mandate. This means that it has two primary objectives: promoting maximum employment and ensuring price stability. These two goals are sometimes referred to as the 'twin pillars' of the Fed's mission.

Maximum employment means achieving the highest level of job creation possible without causing inflation. When more people are employed, it typically leads to greater economic growth and higher standards of living.

Price stability, on the other hand, refers to maintaining a stable level of prices for goods and services over time. When prices are stable, it means that inflation is low and predictable, which is essential for long-term economic planning and investment.

The dual mandate requires the Fed to balance these two objectives, as sometimes actions to promote one goal can conflict with the other. For example, lowering interest rates might boost employment but also increase inflation, so the Fed has to carefully manage its policies to achieve a healthy balance.

Price Stability

Price stability is a core objective of the Federal Reserve and a key component of its dual mandate. It refers to maintaining a stable general price level in an economy over time, preventing both excessive inflation and deflation.

Inflation is the rate at which the general level of prices for goods and services rises, leading to a decrease in purchasing power. Deflation, on the other hand, is the decrease in the general price level, which can lead to reduced consumer spending as people hold off on purchases in anticipation of lower prices in the future.

To achieve price stability, the Fed uses various tools, such as adjusting the federal funds rate, conducting open market operations, and changing reserve requirements for banks. By targeting a specific inflation rate, usually around 2%, the Fed aims to create an environment where businesses and consumers can make long-term financial plans with confidence, fostering economic stability and growth.

Maximum Employment

Maximum employment is the second pillar of the Federal Reserve's dual mandate. It means achieving the highest possible employment level where nearly all individuals willing and able to work can find jobs.

The Fed aims to promote conditions that lead to job growth by influencing economic activity through monetary policy. When the economy is growing, businesses expand their operations and hire more workers. Conversely, during economic downturns, the Fed may lower interest rates to make borrowing cheaper, thereby encouraging investment and spending to stimulate job creation.

However, the concept of maximum employment does not imply zero unemployment. There will always be some level of frictional unemployment, which includes people temporarily between jobs or those voluntarily leaving to search for better opportunities. The goal is to minimize cyclical unemployment, which is related to the business cycle, and structural unemployment, which results from mismatches between workers' skills and job requirements.