The Federal Reserve has one of the most unique duties in the world. Tasked with keeping both employment high and inflation low, it is the only central banking authority in the world that performs both functions as its mission. Studies performed by A. Phillips describe the inverse relationship between unemployment and the inflation of real wages. The Federal Reserve and Congress enact policies to counteract the inverse nature of unemployment and inflation. The Fed achieves its goals with manipulation of monetary policy, which is the control of the monetary supply, while Congress controls fiscal policy to help achieve similar goals. The two work side by side to increase the strength of the economy, and both frequently evaluate the other’s actions to determine the appropriate measures to implement to ensure a flawless achievement of macroeconomic goals. The parameters of the study include high unemployment, an inflation rate at 2%, and GDP growth below 2%, but it is remarkably difficult to immediately affect the unemployment rate, and even harder to positively influence GDP growth. Therefore, this case has a relevancy of 1-5 years, as economic changes take time to occur. Manipulating policy to remedy this situation may be difficult, but the Federal Reserve and government have numerous tools to alleviate the struggling economy.
In such a situation, presidents have an important decision to make. Do they raise taxes and increase federal spending in order to help increase unemployment, or do they cut taxes and therefore increase household consumption spending? Presidents in the past have slashed budgets in some areas to increase funding, and President Franklin Roosevelt dramatically increased taxes to increase employment opportunities provided by the federal government (“Tax history project -- new deal taxes -- Four things everyone should know,” 2016). FDR’s policies did not create increased consumption spending, however, because of the high tax rate. Keynesian deficit spending did not catch on until much later. The best tool a president has in his/her arsenal is deficit spending, provided the nation has strong credit. This is because deficit spending pumps more jobs into the market, serving to lower the unemployment rate. If taxes can be effectively lowered to spur increased consumption spending, so much the better. All things constant, lower taxes increase consumption/investment spending, therefore they directly increase GDP, as evident by studying tax multipliers. In the case provided, it doesn’t appear as if consumption spending is affecting unemployment, as the low interest rates dictated by the federal funds rate hasn’t increased unemployment. However, it is still important to consider this, as combining multiple factors may be enough to push consumption spending far enough into the right direction to positively impact GDP. As President, I would first seek to deficit spend and increase government jobs, or reinvest it in the economy. This would have a dual effect: it would lower unemployment, and slightly increase consumption spending across the board. I would also use some deficit spending to invest in education, preparing for long term GDP planned growth. Education would not just include universities, but would also significantly increase trade schools, providing the economy with needed skilled laborers.
The Federal Reserve has several toolkits it can use to fix the damaged economy. The federal funds rate was mentioned earlier, and that is part of the Fed’s open market purchases. The Fed purchases securities from banks, and deposits the money into the bank itself. The bank is required to maintain a certain percentage of the money on reserve (in case the Fed buys back the security), and can loan out the rest of the money (Obringer, 2002). This can significantly increase the money supply on the market, increase consumption spending, and lower interest rates. As a result of lower interest rates, it lowers mortgage rates and can stimulate housing production. As a side effect, it usually raises the inflation rate and can cause credit bubbles that helped lead to the financial crisis in 2008. If the interest rates are close to zero, it is likely that consumption spending is already significant. Therefore, the current situation is a bit of a paradox. In addition to the federal funds rates, the Federal Reserve can set the reserve requirement that banks must have in general, meaning it has another control mechanism regarding the money supply. As chairman of the Federal Reserve, I would decrease the reserve requirement to stimulate consumption spending. As unemployment dropped, I would increase the reserve requirement and federal funds rate to keep inflation low at a proportional level (“FRB: Reserve requirements,” 2015). Likely increased government spending would be the best remedy towards fixing the crisis, as it appears the Federal Reserve has already fulfilled its role.
With a country that has poor credit, it is a different story. High debt-to-GDP ratios are not necessarily bad, but they can demonstrate the likeliness of a country being able to service its debt. The danger of the debt lies in its structure: is the debt held primarily by private citizens, or is the government itself indebted? If the problem lies in the government, deficit spending must be reduced significantly. This will likely damage employment and hurt GDP, but it is a necessity. The best way to grow in this situation is to dramatically slash interest rates in domestic banks by the central bank’s monetary policy, but this is a problem that takes time to fix. Lower deficit spending and low interest rates shift the responsibility of creating jobs from the government to the private sector. Unfortunately, there is a very real chance that that may raise inflation rates, but as it is unclear of the extent, it may be the best option towards ensuring a full economic meltdown does not occur. The likeliest measure of saving the economy is to dramatically cut government spending by slashing benefits, something that is politically difficult to achieve. This would be the only viable way to ensure the government does not default on its debt, and its finances remain relatively secure.
Works Cited:
Hoover, K. D. (1988). Phillips curve. Retrieved June 5, 2016, from Library of Economics and Liberty, http://www.econlib.org/library/Enc/PhillipsCurve.html
Tax history project -- new deal taxes -- Four things everyone should know. (2016). Retrieved June 5, 2016, from Tax History Project, http://www.taxhistory.org/thp/readings.nsf/ArtWeb/1AEBAA68B74ABB918525750C0046BCAF?
Obringer, L. A. (2002, May 2). How the fed works. Retrieved June 6, 2016, from How Stuff Works, http://money.howstuffworks.com/fed10.htm
FRB: Reserve requirements. (2015, December 16). Retrieved June 6, 2016, from https://www.federalreserve.gov/monetarypolicy/reservereq.htm
