Question

The Federal Reserve has a dual mandate of full employment and price stability. Oftentimes this mandate is challenging as there is a short term trade-off between unemployment and inflation. From 2008 to 2015, however, inflation was consistently below the target rate while unemployment was well above its natural level. Should the Fed have pursued a more aggressive monetary policy to raise inflation and lower unemployment?

Choose one from below and state which school of economics your answer is subscribing. Then, explain your answer using what we have learned in this class.

A. No Inflation is always bad because it lowers the incentive to invest and we know that investment that increases productivity is the only way to raise living standards in the long run

B. No. The Fed exhausted its normal tools and the appropriate policy response then is large scale fiscal stimulus. There is only so much the Fed can do

C. Yes. The Fed could have done more and raising inflation to 3 or 4 percent would have eased the recovery without long term damage to the economy

D. No. The Fed should not over-stimulate the economy by raising inflation and lower unemployment as the current economic situation is quite stable Rather the Fed should raise the interest rate so that when there is another recession the Fed has an effective tool to use.

Answer 1

Ans. Option D

With inflation rate well below the target and unemployment above the natural rate, the economy must not be in a long run equilibrium, so, it will adjust automatically to reach at a full employment level of equilibrium. Then, unemployment will increase to natural rate. So, if Fed increases interest rates, mot only will it give it some tools to tackle recession in future but also it will fasten the process of economy's reaching the long run equilibrium as it increase in interest rate will decrease the aggregate demand (due to increased cost of borrowing private investment and consumption will fall) which will help cool the overheated economy where output is more than the full employment level and thus, help bring the economy back to long run equilibrium.

*Please don’t forget to hit the thumbs up button, if you find the answer helpful.