This problem is however not new to regulators who have an interest in limiting both factors. This relationship between unemployment and inflation is shown in the Philips curve which is declining in the short term. There seems to be a clear inverse relationship between the two factors in the short term. (Brinner, 1999).
However, this apparent relationship ceases in the long run with the two being more or less independent of each other. The Federal Reserve is thus acting on a well established economic theory that interventions aimed at countering inflation are only effective in the short term. Meltzer is however right in insisting that the focus of intervention should be on the long run. Expansionary policies based on the Philips curve should only be in the short run. Expansionary policies have been shown to be defective in the short run as they raise inflation expectations by constantly moving equilibriums. Expansionary policies meant at reducing unemployment rates below the natural rate are therefore just temporary and will eventually, in the long run, lead to higher inflation. (Journal of Economic Perspectives, 2009)
The policy therefore is seen to worsen the possible trade off between unemployment and inflation with more inflation resulting from each short term unemployment rate. Inflation tends to accelerate whenever unemployment rate fall below the natural rate and vice versa. Short term efforts aimed at reducing unemployment as pointed our by Prof. Meltzer are futile as they immediately case inflationary expectations.
It is believed by the classical economists that there is an equilibrium rate of unemployment or the natural rate of unemployment which is shown in the long-term Philips curve seen as vertical. Economists define full employment as that which is consistent with a stable rate of inflation-what is called the natural rate of unemployment. (Stiglitz, 1997).
Prof. Meltzer assumes that it is totally possible to regulate the unemployment rate. This position however disputes that stand especially in the long run since the two factors, unemployment and inflation is no longer in the control of the Federal reserve which perhaps explains their focus of action in the short term since its interventions are better felt at that level. In this view unemployment will remain at a certain given level no matter what the level of inflation in the economy. Prof. Meltzer implies that it is totally under the control of the Federal Reserve to completely control the two factors when it is well known that inflation and unemployment are independent in the long run.
Prof. Meltzer is also faults the Federal for the increasing money supply in the economy. While the responsibility of regulating the money supply in the economy lies with the Federal Reserve, it is not true that it is the sole determinant of this factor. The problem of money supply also lies with institutional problems such as people increasing wages for their workers thereby forcing the Federal Reserve to supply more money into the economy.
Firms increase wages for their employees to keep them happy and therefore more productive which they then have to pay for by subsequently increasing the prices of their products. While the Federal Reserve has some degree of control over this factor i.e. in regulating the interest rates, it does not have an absolute control over it in a largely laissez faire economy. (Smith, 2006).
The Federal Reserve has to automatically increase the supply of money in the economy in response to increasing wages and prices of commodities if it is to keep the economy running. The government inevitably has to issue more money to keep up with an inflationary trend. The problem here is which factor affects the other. While the classical economists are of the view that changing the money supply affects inflation, the Keynesians believe that inflation is the actual cause of the changing money supply. It is thus difficult to reach a conclusive evaluation of the Federal Reserve as Prof. Meltzer does as the correlation between the two factors is not definite.
References
Paul, S. (2008).Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve Retrospective", FRBB Conference Series 53, June 9–11, 2008, Chatham, Massachusetts.
Smith, G. (2006). Japan’s Phillips Curve Looks Japan, London. Oxford University Press.
Stiglitz, J. (1997). Reflections on the Natural Rate Hypothesis,” Journal of Economic
Stiglitz, J. (1997).. The Time-Varying Nairu and its Implications for Economic Policy,”
Journal of Economic Perspectives, vol. 11, no. 1, Winter 2009, pp. 11-32.
Brinner, E. (1999). Is Inflation Dead?,” New England Economic Review, Jan./Feb. 1999,
pp. 37-49.
