Question

(Related to Solved Problem 28.4 on page 1011 ) Suppose the inflation rate has been 5 percent for the past four years. The unemployment rate is currently at the natural rate of unemployment of 4.5 percent. The Federal Reserve decides that it wants to permanently reduce the inflation rate to 3 percent. How can the Fed use monetary policy to achieve this objective? Be sure to use a Phillips curve graph in your answer.

Short answer

The Federal Reserve can use contractionary monetary policy to reduce the money supply in the economy by increasing interest rates or selling government bonds. This reduction in money supply can decrease demand, thus reducing prices and lowering inflation. Any increase in unemployment caused during this process can be normalized by going back to an expansionary policy once the inflation target is achieved.

Step-by-step solution

Understanding the Goal

Firstly, the aim of the exercise is to determine how the Federal Reserve can utilize monetary policy to decrease the inflation rate from 5% to 3% without affecting the natural rate of unemployment, which is currently at 4.5%.

The Phillips Curve Overview

The Philips curve is a model used in economics that shows the inverse relationship between unemployment and inflation rates in an economy. Typically, a lower unemployment rate correlates with a higher inflation rate and vice versa. It's vital to keep this relationship in mind when formulating the strategy for the Federal Reserve.

Leveraging Monetary Policy

The Federal Reserve could use contractionary monetary policy to affect the inflation rate by decreasing the money supply in the economy. This could be achieved by increasing interest rates, selling government bonds, or both. When the Federal Reserve takes these measures, it makes borrowing more expensive which leads to less money being in circulation. Less money in circulation can reduce demand, subsequently reducing prices and lowering inflation.

Understanding the Aftereffects

Although contractionary monetary policy can help achieve the desired decrease in inflation rate, it might increase unemployment temporarily above the natural rate due to a slowdown in economic activity. However, once the inflation target is achieved the Federal Reserve can go back to expanding the money supply which will lower interest rates, encourage borrowing and spending, and eventually, decrease unemployment back to its natural rate.

Key concepts

Monetary Policy

Monetary policy is a crucial economic strategy used by central banks to manage economic stability. It involves the regulation of money supply and interest rates. In the United States, the Federal Reserve is the institution responsible for this task. By adjusting the amount of money available and how expensive it is to borrow money (through interest rates), they can influence inflation and unemployment.

Contractionary monetary policy is one technique used when inflation is higher than desired. This involves decreasing the money supply, often by increasing interest rates. When borrowing becomes more costly, consumers and businesses tend to spend less, leading to reduced demand.

• Less spending limits the growth of prices, helping to lower inflation.
• The Federal Reserve may also sell government bonds to pull extra money out of the economy.
• These actions collectively help reduce inflation rates by slowing down economic activity.

It's important to note that while these policies aim to stabilize inflation, they can initially lead to higher unemployment. However, this is typically a temporary effect that adjusts over time as the economy stabilizes.

Inflation Rate

The inflation rate is a measure reflecting the rate at which the general level of prices for goods and services is rising, thereby eroding purchasing power. For the public and policymakers, controlling inflation is a priority because too much inflation can decrease the value of money.

In our example, the Federal Reserve aims to reduce the inflation rate from 5% to 3%. High inflation rates mean prices are rising quickly, which can be unsettling for an economy as it decreases the purchasing power of consumers. To counter this, the Federal Reserve can use contractionary monetary policy. By controlling inflation, they help stabilize the economy and maintain consumer trust.

• If inflation is too high, people may spend quickly before prices rise further, creating a cycle of continued inflation.
• Conversely, a stable, low inflation rate like 3% fosters a predictable economic environment.
• This predictability allows businesses and consumers to make long-term financial plans.

Thus, reaching a stable inflation rate is crucial for long-term economic growth and stability.

Natural Rate of Unemployment

The natural rate of unemployment refers to the normal level of unemployment expected in a healthy economy. It includes frictional and structural unemployment. It's not zero, but rather a rate where the labor market is considered to be in equilibrium. In the exercise example, this rate is 4.5%.

Being at the natural rate means most individuals seeking employment can find jobs, and businesses can find the labor they need. However, when attempting to adjust the inflation rate through contractionary monetary policy, unemployment may temporarily rise above this natural rate due to reduced economic activity.

• Frictional unemployment occurs when people are between jobs or entering the workforce.
• Structural unemployment happens when there's a mismatch between workers' skills and job requirements.
• Efforts to manage inflation aim to minimize deviations from this natural rate over time.

Ultimately, while adjusting inflation might increase unemployment temporarily, the goal is economic equilibrium, where the natural rate is restored as policies are adjusted gradually.