Question

In your role as a business owner or employee and as a private consumer, you are an active participant in the economy. Your consumption and saving decisions have an impact on the economy. Keeping in mind the lessons you learned in the last two chapters about AD/AS modeling please respond to the following scenario:

Assume you are a member of the Federal Reserve Board. Over the last six months you have seen the U.S. unemployment rate drop from 5.4% to 3.8%. What would this drop indicate to you and what would be your biggest economic concern be? In your next Federal Reserve meeting, what action would you recommend be taken to mitigate or alleviate the concern you identified?

Answer 1

As the Philips curve of the economy states, there exists negative relationship between inflation rate of the economy and unemployment rate. Thus, a drop in the unemployment rate from 5.4 per cent to 3.8 per cent, will lead to rise in inflation rate of the economy as aggregate demand increases in the economy. Thus, the biggest economic concern with this drop in the unemployment rate is rise in inflation rate of the economy.

To mitigate this concern, the Fed can reduce the amount of money supplied in the economy by selling government securities in the open market. This will shift the money supply curve leftwards and thus lead to fall in aggregate demand of the economy and thus reduce inflation rate in the economy.