Question

A column in the Wall Street journal referred to policy actions aimed at "fulfilling both sides of the Fed's dual mandate." a. Who gave the Fed a dual mandate? b. Does the Fed's dual mandate require it to attain a zero percent unemployment rate? Briefly explain. c. Does the Fed's dual mandate require it to attain a zero percent inflation rate? Briefly explain.

Short answer

a. The U.S. Congress gave the Federal Reserve its dual mandate. b. No, the dual mandate only requires it to maintain low, not zero, unemployment. c. No, the dual mandate does not require the Fed to maintain a zero percent inflation rate, but rather a low and stable rate of inflation.

Step-by-step solution

Understanding the Fed's Dual Mandate

To answer the question, it’s essential to know what the Fed’s dual mandate is. The Federal Reserve was given a dual mandate by the U.S. Congress, which requires the Fed to strive for low unemployment and low inflation.

Is Zero Percent Unemployment Rate Required?

The dual mandate doesn’t specify that Fed has to maintain a zero percent unemployment rate, but rather low unemployment. Theoretically, a zero percent unemployment rate would not be desirable or feasible due to factors such as frictional unemployment, which is a normal part of economic dynamics.

Is Zero Percent Inflation Rate Required?

The Fed’s dual mandate also does not require it to attain a zero percent inflation rate. Instead, the Fed targets a low, stable rate of inflation. In practical terms, the Federal Reserve has specified it aims for a 2% inflation rate over the longer run. A zero percent inflation could risk deflation, which can be harmful to an economy.

Key concepts

Federal Reserve Objectives

The Federal Reserve, often referred to simply as the Fed, plays a pivotal role in the U.S. economy by managing monetary policy to foster economic conditions that achieve two key objectives: stable prices and maximum sustainable employment. These two goals comprise what is commonly known as the Fed's dual mandate. Established by Congress in the Federal Reserve Act, the dual mandate serves as a guiding north star for the Fed's policy decisions.

Stable prices refer to controlling inflation by maintaining a level that is neither too high nor too low. This ensures that the purchasing power of the currency doesn't deteriorate due to excessive inflation, nor does it lead to the adverse effects of deflation. Maximum sustainable employment is not synonymous with a zero unemployment rate; it is a level of employment that the economy can maintain while keeping inflation in check. It accounts for the natural rate of unemployment that arises from job transitions and other factors independent of the economic cycle.

Unemployment Rate

The unemployment rate is a critical measure of economic well-being, reflecting the percentage of the labor force that is jobless and actively seeking employment. The Fed's dual mandate does not call for a zero percent unemployment rate. Such a goal would be neither achievable nor ideal due to 'frictional unemployment,' which occurs when workers are between jobs, and 'structural unemployment,' where there's a mismatch between workers' skills and job requirements.

Instead, the Fed seeks to achieve what is known as the 'natural rate of unemployment.' This is a dynamic benchmark that can change with economic conditions, encompassing frictional and structural unemployment but not cyclical unemployment, which is linked to economic downturns. A certain level of unemployment is considered healthy for the economy, and it is the Federal Reserve's objective to minimize cyclical unemployment through its economic policies.

Inflation Targets

Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. The Fed does not aim for a zero percent inflation rate; such an approach could lead to deflation, potentially causing a reduction in consumer spending, a slowdown in economic growth, and an increase in the real value of debt. Instead, the Federal Reserve seeks a modest inflation rate, which it has defined as 2% over the longer run as measured by the annual change in the Personal Consumption Expenditures (PCE) price index.

The 2% target is deemed optimal for promoting stable prices and maximum sustainable employment. This level balances the need to avoid harmful deflation with the flexibility required to respond to changing economic conditions. By managing inflation expectations, the Fed helps ensure that the economy operates efficiently, making long-term planning easier for businesses and consumers.

Economic Policy

Economic policy encompasses the strategies and decisions that a government undertakes to influence its economy. In the case of the Fed, its economic policies are dictated by its dual mandate and involve using tools such as interest rate adjustments, open market operations, and changes to reserve requirements to guide the economy toward the desired state. An essential aspect of these policies is to balance trade-offs between controlling inflation and promoting employment.

By raising or lowering interest rates, the Fed can cool down or stimulate economic activity. Higher rates can reduce inflation but also might increase unemployment, while lower rates can boost employment but may increase inflation risk. The Fed carefully monitors economic indicators and adjusts its policies to keep the economy on a path of stable, sustainable growth, fulfilling its mandate while accounting for the ever-changing economic landscape.