The nation’s high unemployment rate is a result of a severe drop in demand for goods and services. It’s not a reflection of longer-term structural changes in the economy but rather cyclical changes in the economy. The demand for goods has been limited because of tight credit, decreases in government budgets, suppression of demand by consumers and foreign markets, and the inability by the fed lower interest rates. Even with the low level of interest rates the Fed is currently practicing a tight monetary policy. The current 9.7 percent unemployment rate is because of cyclical forces rather than structural ones. Obama is currently trying to administer a program of active intervention to stimulate demand. This involves increasing aid to states, extending unemployment insurance benefits, stimulating small business lending and increasing energy-efficiency measures. Even though a recession can lead to permanently higher unemployment the number one priority is preventing the currently high rate of cyclical unemployment from becoming structural. Right now our current situation makes it impossible to completely stop the increase in unemployment. The Fed is focusing on keeping unemployment at a cyclical level, an increase in unemployment that occurs during recession or depression, and making sure it doesn't turn structural, unemployment that is due to changes in the structure of the economy that result in significant loss of jobs in certain industries. To help decrease unemployment the Feds would have to lower the interest rate. This would in return increase money supply and increase the risk for stagflation because it would cause a rapid increase in inflation which is even a more difficult problem to solve. High unemployment is due to cyclical changes in the economy but its possible for it to turn into structural changes. The Fed decided to implement a tight monetary policy versus an easy monetary policy because it was believed it would keep unemployment at a cyclical level. Theory Review and Analysis
Our overall goal is to decrease unemployment. Decreasing the interest rate would increase the money supply, investment, and income. In Graph 1 it shows we are currently in a recession and Graph 2 shows how one of the factors in unemployment, decreased consumption, causes aggregate expenditure (AE) to fall. According to the article the Feds have lowered the interest rates as low as possible but instead of practicing an easy monetary policy, expanding the money supply to stimulate the economy, they are still practicing a tight money policy, contracting the money supply in an effort to restrain the economy. Graph 5, 6, and 7 shows how a tight monetary policy causes the money, investment, an aggregate demand to decrease, which is the opposite of what we want with the current economic condition. By lowering the interest rate the Fed had hoped to increase the money supply, output, and price level. In Graph 9, 10, and 11 it shows how lowering the interest rate (r) would increase money (M), investment (I), and aggregate demand (AD). According to the article we cant lower the interest rate anymore because we would be at risk of stagflation. Right now the economy is in a period of high recession and lowering the interest rate would increase the overall price level. This increases the risk of stagflation, which is a significantly greater problem. When targeting the interest rate the Fed has to either accept the interest rate or money supply consequences. Besides just lowering the interest rate the Fed can change the money supply by changing the required reserve ratio and engaging in open market operations. In an easy monetary policy the Fed can increase the money supply by decreasing the RRR, which allows banks to create more deposits by making loans. To make more banks borrow money the Fed would also have to decrease the discount rate. Banks borrowing from the Fed leads to an increase in money supply so the lower the discount rate the more borrowing banks will want to do. The most effective tool used to change the money supply is open market operations. An open market purchase of securities by the Fed would result in an increase in reserve and an increase in the supply of money. This method is preferred because of its precision, flexibility, and predictability. However a tight monetary policy causes the complete opposite to happen. A possible reason for the continued increase in unemployment is the lags. Lags are a delay to the economy’s response to stabilization policies. That could cause any monetary of fiscal policy to be ineffective. According to the article one of the main reasons for high employment is the severe drop in demand for goods and services. Households can either use their income to buy goods or services or save (s), a part of the income that a household does not consume in a given period of time. According to The General Theory, Keynes argued that household consumption is directly related to income. A decrease in income would obviously cause a decrease in consumption. Other factors that are causing a high unemployment rate is a decrease in the government budget and a tight income. This decrease in the government budget causes a downward shift of wages, also referred to as sticky wages. In this situation it is hard to determine whether an increase or decrease in government taxes would help the situation. According to Graph 13 a tax cut can increase disposable income and lead to added consumption spending and increased aggregate demand (AD). However a tax (T) increase can increase government spending (G) but decrease both consumption and aggregate demand (AE). The government budget is currently decreasing which could mean that the government is spending more money then it is collecting. If that were the case a decrease in taxes (T) would cause government spending (G) to exceed government taxes, which would cause the government to borrow money from the public to finance the deficit, the difference between what the government spends and what it collects. Conclusion
Even with the low interest rates and all the focus the Fed’s are putting towards increasing the money supply they are still trying to practice a tight monetary policy even though the current condition of the economy calls for an easy monetary policy. The GDP underestimated the decline in the economy. The GDP is the total market value of all final goods and services produced within a given period by factors of production located within a country. The GDP is calculated using the expenditure approach, which measures the total amount on all final goods during a given period. GDP is calculated by adding all four components of spending (Personal Consumption, Gross private domestic investment, Government consumption and gross investment, and Net exports). It is possible that the GDP was underestimated because of the restrained spending on goods and services, which lowered the personal consumption significantly. As mentioned earlier one of the most effective ways to increase the money supply is the engaging in open market operations. However the focus is mainly on the interest rate but it has already been lowered as much as possible. Given the current economic situation the Fed should be implementing an easy monetary policy but they are practicing a tight monetary policy, which contracts the money supply. This is related to keeping unemployment at a cyclical level and preventing from stagflation from occurring. The main concern is keeping unemployment from turning structural and keeping the economy out of the stagflation. So despite the current situation, a tight monetary policy is needed to keep from getting into further problems. It comes down to weighing the consequences and the Fed chose to accept the money consequence by not lowering the interest rate any further. Structural unemployment results from the mismatch of skilled workers looking for employment and demand in the labor market. Structural unemployment is harder to solve because it causes the unemployed to become less qualified and their skills become obsolete. When the economy recovers and more jobs become available there will be less people who will meet the criteria for these jobs. Cyclical unemployment means the number of unemployed exceed the number of job vacancies so even if all the jobs are filled there are still people unemployed. So even though people will still be unemployed the economy is still at full employment since all the job vacancies are taken. When the economy recovers there will still be qualified/skilled workers available to take those spots. Stagflation is another economic condition that is very difficult to recover from. It is a combination of overall price increases (inflation) during periods of recession and high unemployment (stagnation). Stagflation has been proven to be very difficult and as budget deficits, very costly to erase once it gets started. When thinking of how to approach this economic situation I think the Fed considered mostly the long-term effect of each policy. So even though our current situation calls for an easy monetary policy the Fed decided to practice a tight monetary policy in order to keep our economic problems from getting worse. Classical economists even reject the whole idea of cyclical unemployment because it is seen as the attainment of full employment of resources.