Question

The author states, “In short, if there is any hint of sustained inflation at this stage of the business cycle -- with low unemployment threatening to go lower with fiscal stimulus -- past behavior indicates the Fed will risk and accept a recession before it allows a truly high inflationary environment to develop. That means your medium-term risk is more recessionary than inflationary.” Explain that statement.?

Answer 1

The objectives of the Fed is to ensure maximum employment, stable prices and moderate long-term interest rates.

Now it is given that the unemployment is not only low but is expected to decline further due to the fiscal stimulus. Fiscal stimulus creates inflationary pressure by raising the level of demand in the economy through increase in income.

So, what the statement is trying to convey is that Fed will intervene in the market to prevent the economy from overheating. In other words, the Fed is more likely to conduct contractionary monetary policy to contain the inflationary pressure generated by the fiscal stimulus to ensure stable prices. By doing so, the Fed will most probably negate the impact of fiscal stimulus to a large extent.

So, in the medium term the actions of the Fed are more likely to create recession rather than inflation in response to the fiscal stimulus.