In response to the current and expected levels of inflation and GDP growth, the Fed decides on a target for the federal funds rate, which impacts all other interest rates. If the economy’s issue is due to shifts in aggregate demand, monetary policy will be an important force in the fight against rising inflation or recession. This brief on monetary policy will explain the mandate of the Fed as well as the effects of the benefits or drawbacks of raising or lowering the interest rate on the economy in terms of unemployment and inflation.
Monetary policy is unable to counter both rising inflation and a recession. This is the Taylor Rule, or dual mandate of the Fed: to both watch for indicators of inflation and recession. An “inflation hawk” emphasizes the importance of fighting inflation, while comparatively unconcerned with the costs of low GDP growth. In contrast, an “inflation dove”accepts higher inflation when considering the alternative: slowed GDP or a large increase in the unemployment. A Board nominee’s response to, “Is it beneficial for the Fed to lower the Fed Funds Rate in order to encourage consumer spending?” could determine whether they are a hawk or a dove. Doves aim to keep interest rates low, stimulating the economy through increased borrowing and spending which creates jobs and increases wages. Conversely, hawks aim to limit inflation, keeping the cost of goods and services stable, at the cost of increasing economic growth. Therefore, Hawks typically advocate for higher interest rates to stop prices from increasing and slow lending (Olney, 1)
When the Fed increases interest rates to counter inflation, the dollar appreciates which reduces net exports. In addition, investment spending is slowed, starting a multiplier effect from the drop in income for workers to eventually the consumers. In order to know the causal effect of an intervention, in this case, higher interest rates on the economy, a comparison is needed of the state of both the economy in which the intervention occurred and in which it did not – the latter being the counterfactual. If the Fed had not acted, GDP would be higher, yet prices would increase, lowering consumers’ purchasing power, and making people spend more due to fear of continued inflation. In addition, as the dollar continues to depreciates, bond values fall, and hyperinflation becomes a possibility. However, with the fed’s manipulation, there will be a resulting increase in slack in the labor market, lifting pressure from wages and prices. Overall, the Fed would have fought inflation at the cost of lower GDP and employment growth. However, when the unemployment rate and the inflation rate change in the same direction, breaking the inverse relationship that exists, “all else constant,” it is due to factors causing the entire relationship between unemployment and inflation to shift. For example, supply shocks that consistently alter input prices are born from a change in supply of a particular input, such as oil prices. A decrease in the supply of an input is an exogenous factor, the fed policy will result in a higher wage and price inflation at every possible unemployment rate. Another circumstance could be when inflationary expectations change. When the public’s belief is next year’s inflation rate will increase, workers will call for a raise in wages, raising production costs which businesses pass on to consumers with higher prices, thus increasing the inflation rate. At every possible unemployment rate, wage and price inflation are higher with increased inflationary expectations (Olney, 1).
When interest rates change, investment spending and net export spending changes as well. Since there is a total change in aggregate demand, there is a change in how much output is produced, or, GDP. Therefore, when businesses alter their level of production, they have a different demand for inputs, such as labor, thus creating a change in input prices. This changes output prices that business charge, plus the inflation rate. When more output is being produced, there will be more employment in the economy. In the case that the extra employment exceeds the rise in the labor force, the unemployment rate will thus decline as GDP rises. The “Phillips curve” helps explain the trade off between inflation and unemployment that exists while holding constant inflationary expectations, supply shocks that impact the cost of inputs, as well as labor productivity growth. When the unemployment rate is low, workers have increased power to bargain for higher wages since there are alternative options for employment. Businesses pay higher wages in order to attract or keep employees. Subsequently, firms charge higher prices to make up for the higher cost of wages, making a higher inflation rate. Therefore, a low level of unemployment is associated with higher inflation rates (Olney, 1)
During 2012-2016, the downward sloping trade off between unemployment and inflation in the Phillips curve appeared mostly flat. The abnormality of the 2012-2016 period (pictured below) can be attributed to shifts as well as an overall flattening. When the Phillips curve shifts, it is generally due to adjustments in inflationary expectations, labor productivity growth, or commodity prices. However, another explanation pertains to the assumptions of the Phillips curve model. The slope of the curve illustrates how the inflation rate changes due to a change in the unemployment rate. In the event that aggregate demand rises, a rise in real GDP ensues, causing an increase in employment. This is assuming there is no change in the labor force, however labor force participation rate has been decreasing since the turn of the century. If the labor force participation rate is decreasing while the employment is increasing, the unemployment rate will decrease much faster than normally for the same increase in employment. However there is no affect on higher wages and higher prices, making the impact on inflation nonexistent, and thus a flatter curve. How should the fed react to inflation as the unemployment rate falls, when the inverse relation between low unemployment and rising inflation is lost in decent data? Will inflation still rise (Federal Reserve Bank of St. Louis)?
Labor is the time people sell in exchange for wages, demanded by businesses and supplied by workers. According to the substitution effect of higher wages, when wages increase, the supply of labor increases, since the opportunity cost of labor is now more expensive. As more workers are employed, the marginal revenue product of labor(MRP), or a workers contribution to revenue, of the last worker added is less because of the law of diminishing returns. Firms aim to maximize profit, hiring additional employees if the MRP of the last employee added is at least as large as the wage. At higher wages, the firm will demand less labor, while at lower wages, the firm will demand more. An increase in the labor supply will lower the equilibrium wage, since at the old wage there is a labor surplus, or unemployment. Wages will rise in the event of a labor shortage from a decrease in the labor supply. Labor demand increases if the price of the output the workers are producing increases in which case firms are willing to raise wages. Firms will hire more workers at every wage when there is a shift in labor demand. Labor demand is a derived demand based on the demand for the business output, which depends on aggregate demand, which influences the interest rate (Olney, 2)
Although monetary policy is unable to counter both rising inflation and a recession, it is important to understand the effects interest rates have on employment and inflation in order to have effects on aggregate demand, investment, government, the sum of consumption, and net export spending in the US economy.
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