Monetary Policy: Unemployment, Inflation, and Interest Rates

                Monetary Policy: Unemployment, Inflation, and Interest rates

The financial crisis had quite the impact on our economy in 2008 and it created a problem for economic stability. Before the financial crisis our economy was stable and steady and the average unemployment rate was about 4.61% with inflation and the effective federal funds rate growing steady before the crisis hit.

What is monetary policy? The Economic Times defines monetary policy as the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity. Before the crisis occurred we had a lot of economic stability in our country. The federal funds rate was consistent through 2006 and 2007 and the Consumer Price Index was also consistent through the years before the crisis. The CPI measures changes in the price level of market basket of consumer goods and services purchased by households. The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. The federal funds rate was high as shown in the graph in 2006-2007 from 4.9% to 5% and quickly dropped dramatically in 2008 to 1.9%. With the Financial crisis on its way, the unemployment rate started to arise during the crisis causing a lot of chaos within our nation.

During the Financial crisis there was a large volume of loss of income which ultimately led to the Consumer Price Index to decrease. From 2007 to 2008 the Consumer Price Index quickly dropped from 0.3 to 0.0, which is a huge decrease as you can see from the graph below. Households were not gaining a large income and that led to a drop in the CPI. Unemployment rate was quickly increasing with the amount of people losing their jobs and being laid off. From 2008-2009 the unemployment increased dramatically from 5.7% to 9.2% and you can see from the graph the huge increase and how much of an impact was on the economic stability. The Federal Open Market Committee is in charge of the interest rates and it is their call to increase or decrease them. In this case they had to decrease interest rates so more money can be added to the economy to try and gain some stability in the market. During the recession the average federal funds rate was about 0.16% as opposed to before the recession it was up to nearly 5%. This is a huge decrease in the funds rate and ultimately the goal was to decrease the rate so households can spend more which would increase the economic stability in the market.

The Taylor rule is an important factor in economics because it is a reduced form approximation of the responsiveness of the nominal interest rate, as set by the central bank, to changes in inflation, output, or other economic conditions. With the Taylor rule we are able to predict the changes in the monetary policies. In this case, the Taylor rule is being applied to the federal funds rate because it is being decreased by the FOMC to try and get more economic stability in the households. Getting households to spend more money was huge for economic growth because if households didn’t spend any money than no money would be going into the economy creating a longer recession. Also, since the unemployment rate was so high during the recession it made it harder for households to spend more and ultimately led to the decrease in the interest rates.