Suppose the Federal Reserve’s policy is to maintain low and stable inflation by keeping unemployment at its natural rate. However, the Fed believes that the natural rate of unemployment is 4 percent when the actual natural rate is 5 percent. If the Fed based its policy decisions on its belief, what would happen to the economy? How might the Fed come to realize that its belief about the natural rate was mistaken?
When economists look at inflation and unemployment in the short term, they see a rough inverse correlation between the two. When unemployment is high, inflation is low. This has presented a problem to regulators who want to limit both. This relationship between inflation and unemployment is depicted by the Phillips curve. According to classical economic theory, natural rate of unemployment is 5%. If the Fed is targeting the rate of unemployment at 4% upper bound while the natural rate would be 5%, inflation will increase. Not necessarily by 1%, but still it will become evident by slightly decreased purchasing power of the U.S. dollar. Similar opinion was expressed by Keynesians. They argue that firms raise wages to keep their workers happy. Firms then have to pay for that and keep making a profit by subsequently raising the prices. This causes an increase in both wages and prices and demands an increase of money supply to keep the economy running. So, the government then issues more and more money to keep up with inflation.
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