Sep 04 2008
The Federal Reserve and the tradeoff between unemployment and inflation
Published by Jason Welker at 8:52 pm under
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WikipediaFederal 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:
- 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?
- 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?
- “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 is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". 
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Hey Mr. Welker,
I haven’t polished up on my year two economics recently, but I’m wondering how greater politics might play a role in congress’ decision to focus on unemployment over inflation. The republican anti-tax stance places consumers squarely in charge of their own financial position by limiting government assistance.
In some respects it seems like allowing a degree of inflation contributes to the greater theme of individual economic independence.
I would expect that this would be a minor consideration amongst other more important economic considerations, but just a thought.
John A. Bianchi
Although low interests do create a shift in aggregate demand, a decrease in the interest rates(also known as contractionary monetary policy) will also result in a shift out of aggregate supply. The explanation for this is as frims increase investment, they might invest in capital goods, which will result in a shift of aggregate supply.
As the philip curve states, there is a trade off between inflation and unemployment(as inflation increases unemployment decreases, and as inflation decreases unemployment increases). Therefore the government must make a decision on which one to fix, inflation or unemployment. The government for example could use expansionary fiscal policy to solve unemployment and contractionary fiscal policy to solve inflation. What is interesting is that governments usually chose to solve unemployment. The reason for this is mainly politics, the unemployed will be unhappy and will want change and to keep “the people” happy the government usually choses to solve the unemployment issue.
Lowering interest rates has positive implications for supply within an economy because firms can afford to borrow more money. As the cost of borrowing has been lowered, firms can take out loans at low interest rates from lenders and invest in capital goods. This has long term benefits, as capital equipment constantly needs to be renewed.
It would seem that tackling unemployment is a higher priority for the government in this, the year of the US elections. Although Bush virtually has nothing more to lose as he is on the out, there might be Republican party pressure exerted on him to protect citizens jobs as they forward their new candidate, John McCain.
As to the question of rising unemployment and rising wages, it is clear that this is an example of stagflation. This economic phenomena was first seen in the 1970s when despite high unemployment, economies continued to suffer from high inflation. Just as in the 70’s this phenomena has made a comeback, fuelled once again by supply shocks such as the high price of oil. As consumers have to pay higher prices, they demand higher wages. This inevitably raises costs for employers, and they begin to lay off workers, even though there is large competition for employment. The supply shock has implications for the natural rate of unemployment, since as costs to the consumer have been raised substantially, workers are not prepared to supply their labour below a certain wage level. Therefore a large pool of unemployment remains, coupled with rising inflation.
It is not likely that this situation will self correct, and therefore the government may consider the use of certain policies such as contractionary monetary policy. Increasing the interest rates would take money out of the system, so combating inflation. This could be combined with such supply side policies as decreasing the power of trade unions, allowing wages to be effectively lowered. Supply side policies were developed in the 70s to combat exactly this problem. They increase agregate supply, and so output, allowing firms to employ more workers. The only problem with these measures is that they are only effective in the long term, and so do not provide instant relief from economic trouble.
So i had written this really long response and then it said that some quote was exceeded, so now to make it brief, i said that i disagree with using contractionary monetary policy because although it would decrease investment and consumption (by lowering consumer confidence), it would simply drive the country in further recession without resolving inflation or unemployment. Instead i think that the government should introduce supply side policies. Although these do usually work in the long run, if somehow the government manages to encourage the unemployed to seek and get jobs, this would increase consumer confidence and help unemployment. Also as there are more workers, production could increase, therefore there wouldnt be such a competition for prices and so the price levels would decrease, helping inflation. This is all theoretical however, because it depends on how well the government manages to encourage work and how many people will actually listen and try finding a job.