Recently, I read an article that talked about how the pandemic caused a significant policy shift in the U.S. inflation target. The shift allows the U.S. economy to maintain an average 2% inflation rate instead of a fixed 2% inflation rate, a policy that provides greater flexibility for the U.S Federal Reserve. The relaxation on inflation restriction allows the Fed to keep a low-interest rate, permitting them to carry out an expansionary monetary policy aimed at decreasing the interest rates to stimulate Investment(I) and Consumption(C) components of Aggregate Demand (AD) by means of inflation targeting.
The objective of this policy is to stimulate the growth of the U.S economy to tackle unemployment. Since the U.S inflation rate before September was 1.37%, the Fed expected an inflation rate higher than 2% to achieve its average 2% inflation target in 2020.
Low interest rates can affect aggregate demand in two ways. Firstly, as the interest rate decreases, consumers will have greater incentives to consume goods and services instead of saving their money, leading to the increased consumption (C). Meanwhile, low interest rates also mean a decrease in borrowing’s opportunity costs, leading to an increase in business investment (I). These together increase aggregate demand. According to Figure 2, when aggregate demand (AD )shifts to AD1, Y1 increases to Ye; P1 increases to Pe. The increase in AD reduces demand deficient unemployment as well as an increase in real GDP output. And the increase in the price level causes the inflation rate to increase. Hence, the recessionary gap is closed and the unemployment issue is tackled.
Figure 1: The AD/AS Diagram
Besides monetary policy, fiscal policy can also be applied to address the high unemployment rate and stimulating consumption. The policy’s advantage is that its outcome is shown quickly and effectively as the money injected into the economy is immediate, and the cut in personal tax allows citizens to have more disposable income, which will be very promptly for the current situation in the U.S. as the pandemic causes millions of people to have less income to sustain life. In this scenario, government expenditure on health care and the medical industry can create job opportunities, resolving unemployment issues. The goal of decreasing the unemployment rate and closing the recessionary gap is achieved.
However, there are also shortcomings of this policy. For example, possible government corruption can lead to the cancel out of some the effects while deteriorating the budget deficit of the U.S government. The more concerning con of the policy, however, is time delay in the decision making. When contrasted with monetary policy, the time delay is significantly less as the independence of the central bank enables very quick implementation.
There are also some assumptions that underly the expansionary monetary policy. Firstly, there exist consequences of a high inflation rate if the Fed does not control it well. For instance, people who receive fixed incomes or whose income increase less than the rate the inflation will become worse off as they have less disposable income to spend. Secondly, expectations of another wave of the pandemic could decrease the confidence of consumers and investors, hindering the ineffectiveness of the monetary policy in stimulating the AD.
Although theoretically, monetary policy is able to stimulate aggregate demand and close the recessionary gap, the specific economic environment in the U.S hinders the policy’s effectiveness. On the other hand, fiscal policy, although with the possibility of government corruption and time lag of the decision making, still seems to be able to address the unemployment issue and directly stimulate the AD. Therefore, monetary policy may not be the most effective policy to apply in this situation and perhaps the U.S. government should turn to fiscal policy instead.
Work cited:
[1] McMahon, Tim. “What Is Quantitative Tightening?” What Is the Current U.S. Inflation Rate?, 13 Oct. 2020, inflationdata.com/Inflation/Inflation_Rate/CurrentInflation.asp?reloaded=true