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Chapter 28: Problem 2

What actions should the Fed take if it wants to move from a point on the short-run Phillips curve representing high unemployment and low inflation to a point representing lower unemployment and higher inflation?

Short Answer

Expert verified
To move from high unemployment and low inflation to lower unemployment and higher inflation on the short-run Phillips curve, the Fed should use its monetary policy tools to stimulate the economy. These include lowering interest rates to encourage borrowing and investment, and conducting open market operations (buying government securities) to increase the money supply and induce inflation.

Step by step solution

01

Identify Current Situation

First, acknowledge that the Fed is currently in a situation of high unemployment and low inflation, as indicated by the starting point on the short-run Phillips curve. This is typically associated with a slow economy, where both jobs and price levels are stagnating.
02

Determine Desired Situation

The goal is to transition to a state of lower unemployment and higher inflation. This implies economic stimulation to create more jobs (decreasing unemployment) and increase price levels (inflation).
03

Implement Monetary Policy

Next, consider the monetary policy instruments in the Fed's toolkit, such as the control over interest rates and the conducting of open market operations. To stimulate the economy, the Fed could decrease interest rates, which would encourage borrowing and investing, thereby boosting economic activity and job creation. Moreover, by conducting open market operations, particularly by buying government securities, the Fed increases the money supply in the economy, which can lead to inflation.
04

Observe the Shift on the Phillips Curve

These actions would cause a movement along the short-run Phillips curve from the initial point of high unemployment and low inflation, towards the desired point of lower unemployment and higher inflation.

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Most popular questions from this chapter

An opinion column in the Wall Street Journal noted, "In a democracy, the tradeoff for a central bank's independence is accountability to the nation's elected leadership." a. Why would a country want to grant its central bank more independence than it grants, say, its department of agriculture or department of education? b. In the United States, how is the Fed held accountable to the nation's elected leadership? Source: David Wessel, "Explaining 'Audit the Fed," Wall Street Journal, February 17, 2015 .

Robert Shiller asked a sample of the general public and a sample of economists the following question: "Do you agree that preventing high inflation is an important national priority, as important as preventing drug abuse or preventing deterioration in the quality of our schools?" Fifty-two percent of the general public, but only 18 percent of economists, fully agreed. Why does the general public believe inflation is a bigger problem than economists do?

While many economists and policymakers supported the Fed's decision to maintain the federal funds rate at a nearzero level for over six years, Charles Schwab, the founder and chairman of a discount brokerage firm that bears his name, argued that the economy was harmed by keeping interest rates low for an extended period of time: U.S. households lost billions in interest income during the Fed's near-zero interest rate experiment.... Because they are often reliant on income from savings, seniors were hit the hardest.... Seniors make up \(13 \%\) of the U.S. population and spend about \(\$ 1.2\) trillion annually.... This makes for a potent multiplier effect. a. What type of spending was Schwab expecting would have increased if the Fed had raised interest rates earlier than it did? b. Would higher interest rates have had an effect on other types of spending? Briefly explain. c. Which of the types of spending that you discussed in answering parts (a) and (b) does the Fed appear to believe has the more "potent multiplier effect"? Briefly explain.

An article in the Economist started by stating that "central banks cannot endlessly reduce unemployment without sparking inflation is economic gospel. It follows from 'a substantial body of theory, informed by considerable historical evidence,' according to Janet Yellen, chair of the Federal Reserve." a. Use a graph of the Phillips curve to show that central banks cannot endlessly reduce unemployment without sparking inflation. Briefly explain how your graph illustrates this point. Give an example of historical evidence that Fed Chair Yellen could be referring to. b. The article stated that the "effects of unemployment on inflation can get lost amid temporary economic gyrations. That is most obvious when oil prices fall, as they did in late 2014." What does the article mean by the "effects of unemployment on inflation can get lost amid temporary economic gyrations?" Use a graph of the Phillips curve to show the effect on inflation of a fall in oil prices. Briefly explain what is happening in your graph. c. In discussing the effect of inflationary expectations, the article stated that "self-fulfilling expectations could explain low inflation." Use a graph of the Phillips curve to show how self-fulfilling expectations could explain low inflation. Briefly explain what is happening in your graph.

Why did Milton Friedman argue that the Phillips curve did not represent a permanent trade-off between unemployment and inflation? In your answer, be sure to explain what Friedman meant by the "natural rate of unemployment."
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