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The Fed employs Monetary Policy in an effort to manage both the money supply and interest rates while stimulating the economy to operate close to full employment. One school of thought called Monetarism believes that the Federal Reserve should simply pursue policies to eliminate inflation. Zero inflation may help the market to avoid imbalances, stabilize the business cycle, and promote steady growth in our economy. On the other hand, zero inflation may not reduce unemployment. It may not promote a higher rate of saving and investment, and it may increase income inequality by redistributing income to the high-income people from the low-income people. The topic of a zero inflation rate is an especially interesting dilemma at the moment because monetary policy and interest rates remain at center stage of the economic policy debate. During the last recession, the question was how fast and how low the Federal Reserve should lower interest rates. Since the unemployment rate is at a twenty-three year low at the present, the question is now how high the Fed should raise rates. The dominant economic model is the theory of the non-accelerating inflation rate of unemployment, otherwise known as the "natural rate" of unemployment. This theory states that if you try to push the unemployment rate below the natural rate, the result will be an increase in inflation but no permanent fall in unemployment. This is because market forces push the economy back to the natural rate of unemployment. The only effect of sustained monetary policy, therefore, is increased inflation and the fact that policy makers cannot trade more inflation for less employment. The relationship between inflation and unemployment is shown on the Phillips curve. According to the non-accelerating inflation rate of unemployment, the curve is straight (Graph 1). This indicates that if the central bank increases inflation, there is no reduction in the unemployment rate. Conversely, lowering the inflation rate also has no effect on unemployment. This means that the inflation rate cannot be manipulated to lower unemployment. According to the natural rate of unemployment, the interaction of demand firms' and supply of labor determine the level of unemployment. There is always some unemployment resulting from workers failing to hook up with potential employers due to imperfect information. However, neither the demands nor supplies of labor nor the pattern of information among firms and employees is affected by inflation. Hence, inflation cannot affect the level of employment and unemployment and the Phillips curve is as shown. Both inflation and deflation have no affect on unemployment and output. Therefore, from this standpoint, all rates of inflation are optimal. Inflation simply does not matter. Another version of this theory maintains that the optimal rate of inflation is the actual rate. For example, if an economy currently has a 6-percent inflation rate, 6 percent is the optimal rate. The inflation itself does not matter and in the long run the Phillips curve is vertical but, lowering the equilibrium rate of inflation results in lower output. It is costly to lower inflation because economic agents have inflation expectations, which are difficult to adjust. A period of higher unemployment results from getting agents to lower expectations and this implies lost output. Since there is no benefit to reducing inflation, the implication is evident - the Fed should stick with the actual rate. There are also many economists who would agree with the claim that zero inflation is the optimal rate of inflation. This claim employs a different model than that of the non-accelerating inflation rate of unemployment. If zero inflation is optimal, it must be that inflation is costly and causes lower output and more unemployment, which is why zero inflation is preferred to inflation. This theory implies a positive sloped Phillips curve (Graph 2). Increased inflation causes a northeasterly movement along the Phillips curve that results in higher unemployment. As a result, profitability, output, and employment are all reduced. An alternative theory of inflation is the Keynesian Phillips curve (Graph 3). According to this theory, there is a negative long-run relationship between unemployment and inflation. Unemployment can be reduced at the expense of a little more inflation. In this case, the Phillips curve is convex so that as the unemployment rate falls, further reductions in unemployment cost more in terms of inflation. This is significant because the Fed now has a policy choice that involves deciding between inflation and unemployment. The logic of this theory is that inflation helps adjust the labor market. In a multisector economy different sectors are subject to random shocks. Thus, there is a need to adjust prices and wages in these sectors. In sectors where a positive shock occurs, prices and wages increase; in sectors receiving negative shocks, wages and prices fall. However, it is difficult to encourage wages and prices to fall and it may, therefore, be easier to accomplish adjustment by having prices rise in sectors with full employment. In this way, a little inflation helps the economy adjust, thereby lowering unemployment and raising output. The Keynesian Phillips curve has a number of important policy implications. First, inflation now has a positive effect on output. Second, there is nothing optimal about zero inflation. Third, there is no automatic optimal rate of inflation. Instead, the optimal rate depends on society's preference for low unemployment rather than low inflation. If a society values low unemployment, then the optimal rate of inflation will be somewhat higher; if society dislikes inflation, then the optimal rate will be lower and unemployment will be higher. The final theory of inflation comes from public finance. Inflation constitutes a tax on money. In effect, it decreases the purchasing power of real money balances, and to sustain purchasing power, agents need to acquire more real money. Since the government controls the supply of money, consumers or agents must acquire new money from the government by selling resources in return. An inflation tax is influential because it increases government revenues, and governments can therefore reduce other taxes like the income tax, thereby providing additional incentive to work. This, consequently, raises output and lowers unemployment, so that a negative relationship between inflation and unemployment can be observed (Graph 4). On the other hand, if government pushes the inflation rate too high, the public has an incentive to reduce their real money supply and reduce their exposure to the inflation tax. New expenditures to avoid the inflation tax are sought and these expenditures lower output and raise unemployment. Zero inflation is frequently said to be the optimal rate of inflation, and the Federal Reserve's stated goal of a price-level stability suggests this may also be the official view. Nonetheless, the Fed also clings to the theory of the non-accelerating inflation rate of unemployment even though this theory provides no valid reasons for a zero-inflation goal, since it states that all rates of inflation are equally optimal. The Fed.'s commitment to zero inflation is driven, therefore, by political considerations. Understanding the Fed.'s position requires introducing political considerations. Talking about a socially optimal rate of inflation is talk about a unified national interest. In reality though, no such unified interest exists because economic interests span across groups. The three core economic groups to be considered then are labor, industrial capital, and financial capital. For labor, the point of minimum unemployment constitutes the optimal rate of inflation. Here, labor's bargaining strength is at a maximum and therefore, wages are at a maximum also. Consequently, moderate inflation can usually be associated with low unemployment and rising real wages. Industrial capital prefers a higher rate of unemployment and a lower rate of inflation. When profits are at a maximum, unemployment is high enough to hold wages but no high enough to affect the health of the economy. Financial capital prefers zero inflation. Zero inflation means that the inflation tax on financial assets is zero, which benefits financial capital. However, financial capital does not want deflation because this would lead to default on existing debts. When wages and prices fall, debtors would not have the income to pay back their loans. It can be observed that sectional self-interest explains the current popularity of a zero-inflation policy, which is NOT a compelling foundation for making zero inflation the goal of public policy. Still, this fact has created the need to argue that zero inflation is the optimal policy. The reality is that it is hard to make a strong economic case for zero inflation, and there is a strong case that it is harmful. Pursuit of zero inflation risks increasing unemployment, with only financial interests standing to benefit. Bibliography: Word Count: 1470
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