Suppose The Government Misjudges The Natural Rate Of Unemployment ✓ Solved

Suppose the government misjudges the natural rate of unemployment to be much lower than it actually is, and thus undertakes expansionary fiscal and monetary policy, such as the recent lowering of the federal funds rate in a target range of 0 to 1/4 percent by the Federal Reserve’s Open Market Committee to try to achieve lower unemployment rates in light of the Covid-19 pandemic’s impact on the U.S. economy. Theoretically, “…an increase in the money supply lowers the interest rate, thereby increasing investment and aggregate demand” (McConnell, Brue, & Flynn, 2018, p. 246). Use the Aggregate Demand and Aggregate Supply Model and the Federal Reserve News Release (2020) to explain why these policies might at first succeed in the short-run; but have negligible or negative impact on the U.S. economy over the long-run, which some economists project will result in 9-million people being unemployed when projections at the start of the COVID-19 pandemic estimated only 1-million workers would be affected.

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The relationship between government policy and economic conditions often unfolds in complex ways, particularly when misjudgments regarding fundamental indicators like the natural rate of unemployment occur. The natural rate of unemployment is defined as the level of unemployment that persists in an economy due to the normal job turnover, and it is essential for policy-makers to accurately estimate this rate to design effective interventions. When a government misjudges this rate as being much lower than its actual level, as in the case during the COVID-19 pandemic, it may undertake aggressive expansionary policies that can have short-term benefits but detrimental long-term consequences.

To begin with, expansionary fiscal and monetary policies are typically employed to stimulate economic activity during downturns. For example, the Federal Reserve's decision to lower the federal funds rate to a target range of 0 to 0.25 percent aimed to increase money supply and reduce borrowing costs. When interest rates decrease, borrowing becomes cheaper, which can lead to increased investment by businesses and higher aggregate demand (McConnell, Brue, & Flynn, 2018). Moreover, lower interest rates can enhance consumer spending through more affordable mortgage and loan payments. Hence, in theory, these policies can initially lead to reduced unemployment as businesses respond to increased demand by hiring more workers.

In the short-run, the Aggregate Demand and Aggregate Supply (AD-AS) model can illustrate how this process may unfold. As the government injects money into the economy via fiscal stimulus (e.g., stimulus checks) and lower interest rates, the Aggregate Demand curve shifts to the right, causing the equilibrium output to increase and the unemployment rate to drop temporarily. This phenomenon aligns with the Keynesian view that demand creates its own supply in the short run. During the pandemic, such measures were aimed at counteracting the rapid loss of jobs and severe decreases in consumption caused by lockdowns and business closures.

However, while expansionary policies can stimulate immediate economic activity, the long-run implications can be starkly different. As the economy begins to recover, maintaining low interest rates and excessive monetary expansion could lead to inflationary pressures, especially if the economy is already at or near its productive capacity. This situation is particularly relevant to the projected increase in unemployment rates from an initial bad estimate of 1 million to a staggering figure of 9 million. If demand is artificially stimulated without corresponding productivity gains or structural improvements, it may lead to economic overheating, diminishing returns, and eventually, job losses as businesses face rising costs without significant increases in revenue.

Moreover, persistent expansionary policies may contribute to a cycle of dependency on low-interest rates, discouraging businesses from making long-term investments that would promote sustainable growth. Businesses may become reliant on government stimuli and might not adapt or innovate rapidly enough to thrive in a recovering economy, potentially leading to greater structural unemployment.

The Federal Reserve News Release (2020) highlights that while immediate measures were necessary to stabilize the economy, the risks associated with prolonged low-interest rates include asset bubbles and misallocation of resources. The long-term consequences of misjudging the natural rate of unemployment could lead to widespread economic stagnation if businesses fail to invest meaningfully in productive capacity. This concept is rooted in the Phillips curve, which suggests that any attempt to keep unemployment below its natural rate through expansionary policies can lead to rising inflation rates, stunting overall economic growth and stability.

Ultimately, the challenge lies in navigating these complexities. Accurate assessments of natural unemployment are vital for formulating effective policies. As economists and policymakers strive to restore economic stability, an emphasis on understanding the underlying dynamics of unemployment, inflation, aggregate supply, and demand becomes imperative. Additionally, balancing short-term stimulus with long-term structural reforms will be crucial in preventing a large, enduring unemployed workforce in the aftermath of the crisis.

This scenario illustrates that while expansionary policies provide temporary relief, merely treating symptoms without addressing the fundamental economic realities can result in more significant, long-term issues. As we move forward, employing empirical data to fine-tune policy responses will be essential for recovering from the unprecedented economic challenges posed by the COVID-19 pandemic.

References

• McConnell, C. R., Brue, S. L., & Flynn, S. M. (2018). Economics. McGraw-Hill Education.
• Federal Reserve. (2020). Press Release: Federal Reserve issues FOMC statement. Retrieved from https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315a.htm
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• Keynes, J. M. (2007). The General Theory of Employment, Interest, and Money. Prometheus Books.
• Friedman, M. (1968). The Role of Monetary Policy. The American Economic Review.
• Lucas, R. E. (1972). Expectations and the Neutrality of Money. Journal of Economic Theory.
• Taylor, J. B. (2009). The Taylor Rule and the Future of Monetary Policy. National Bureau of Economic Research.
• Summers, L. H. (2014). U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound. Business Economics.
• Stiglitz, J. E. (2015). The Great Divide: Unequal Societies and What We Can Do About Them. W.W. Norton & Company.
• Baker, D., & Schmitt, J. (2019). The U.S. Labor Market: Trends and Prospects. Center for Economic and Policy Research.