Question

1. What are the pros and cons of the Fed targeting inflation at 2 percent?

2. The unemployment rate and inflation rate have both been historically low this year. Does this mean that there is no longer any trade-off between inflation and unemployment? Explain your view.

Answer 1

1.Inflation levels of 1% to 2% per year are generally considered acceptable while inflation rates greater than 3% represents a dangerous zone that could cause the currency to become devalued.

Pros of Fed targeting inflation at 2%:

• Allows for greater transparency in Monetary Policy.
• Uncertainty among investors is reduced. Investors can predict changes in interest rates and can estimate inflation expectations.
• Central Bank can respond to economic shocks in better way.
• Central Bank can focus on domestic policies in a planned way.
• Fed hoped to promote dual mandate of low unemployment and stable prices.1.

Cons:

• It can create atmosphere in which unsustainable speculative bubbles, such as that which produced the 2008 financial crisis, can thrive unchecked.
• It encourages inadequate responses to terms-of-trade shocks or supply shocks.

2. The Phillips curve shows the inverse relationship between inflation and unemployment: as unemployment decreases, inflation increases and as unemployment increases inflation decreases. But it is accurate only in short run.There can be no trade-off between inflation and unemployment in the long run. Decreases in unemployment can lead to increases in inflation, but only in the short run. In the long run, inflation and unemployment are unrelated. This means that Phillips curve is vertical at the natural rate of unemployment, or the hypothetical unemployment rate if aggregate production is in the long-run level. Attempts to change unemployment rates only serve to move the economy up and down this vertical line.