Sep 04 2008

The Federal Reserve and the tradeoff between unemployment and inflation

Federal Reserve sees slow economy, higher prices – Sep. 3, 2008

Weak aggregate demand and rising costs due to still high energy and food prices put the US economy in a tricky situation, one in which the Federal Reserve is forced to make the tough decision between tackling the unemployment problem (jobless rates have risen to 5.7%) or the inflation problem (price levels have also risen 5.7% this year, the highest inflation in 17 years).

The nation struggled with slow economic growth and still-high prices that are weighing on consumers and businesses alike…

Fed Chairman Ben Bernanke and his colleagues are all but certain to leave a key interest rate alone at 2% when they meet next on Sept. 16 and probably through the rest of this year.

Given the fragile state of the economy, the Fed isn’t in a hurry to boost rates to fend off creeping inflation. A growing number of analysts believe the economy is likely to hit another dangerous rough patch later this year as consumers and businesses curtail their spending even more.

Heading into the fall, economic activity continued to be slow, the Fed said. Businesses described the climate as “weak” or “soft” or “subdued.”

Consumers, the lifeblood of the economy, showed caution. Shoppers “concentrated on necessary items and retrenchment in discretionary spending,” the Fed observed.

In the short run, as year 2 IB students know, society faces a trade off between high inflation and high unemployment. Rising prices and rising joblessness are both harmful to the economy, but when energy and food prices drive up the price level, while week investment and consumer spending lead lead to falling overall demand in the economy, the conditions exist where joblessness and prices can rise simultaneously. This is America’s situation at present.

The Fed must chose which problem to address. Ben Bernake, America’s central bank chief, could chose to tackle rising inflation by raising interest rates, which would discourage new investment and reduce demand for resources by firms in the economy. Investment spending by firms and consumption by households would decline, putting downward pressure on prices across the economy.

In the short-run, however, the decline in investment and consumer spending that would result from higher interest rates would exacerbate the already weak level of aggregate demand in the economy, driving unemployment even higher.

By keeping rates low, Bernanke hopes to encourage investment and consumption, which will contribute to overall demand in the economy. By encouraging new spending and investment, however, the threat that inflation will rise even more remains present.

In the trade off between unemployment and inflation, the Republican White House and the Democratic Congress made it clear that unemployment was the most important problem to address when they announced the $160 billion expansionary fiscal stimulus package earlier this year. By keeping rates at a low 2%, America’s central bank is also indicating that increasing employment is of greater importance than lowering the price level.

Discussion questions:

  1. Low interest rates are clearly a demand-side policy, since they should lead to higher investement and consumption. But how might lowering interest rates result in positive supply-side effects for the economy?
  2. Why do you think increasing employment is of a higher priority to policy-makers than bringing down the inflation rate? Does the fact that it’s an election year matter?
  3. “Workers’ wage gains – characterized as ‘modest’ – aren’t raising
    inflation worries. Wary employers have cut jobs every month so far this
    year and aren’t inclined to be overly generous in their compensation to
    workers amid ‘a general pullback in hiring,’ the Fed said.
    If wages continue to rise even as unemployment rises, is it likely that the US economy will ever “self-correct” from in times of an economic slowdown?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

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