It’s the debate that won’t go away: Is an expansionary monetary policy good for the United States? Given the issues in the U.S. labour market, the fear is that rampant inflation will return, killing the expansionary policy’s intended goal of job creation.
The underlying concept at play (wonk warning) is known as the non-accelerating inflation rate of unemployment, or NAIRU. Milton Friedman won his Nobel Prize, in part, for showing that when the economy is at capacity and functioning normally, there is no trade-off between unemployment and inflation. Only when the economy is below potential (a demand shortage) and slack exists can monetary policy have a significant and sustainable impact on the unemployment rate. Any attempt to push the unemployment rate below NAIRU will only lead to inflation, not a sustainable reduction in the unemployment rate. The theory has become standard for introductory economics students.
But what is the current NAIRU, and has the U.S. met that level? It turns out the NAIRU has likely risen due to structural reasons. The Federal Reserve Bank of San Francisco estimates that NAIRU may now be as high as 6.7 per cent thanks to a number of factors, most notably the extension of unemployment benefits. The current U.S. unemployment rate is 8.1 per cent, so it seems unlikely that the U.S. economy is at NAIRU. If unemployment is well above NAIRU there is no reasonable way to conclude a lack of demand is not an issue.
There is a standard textbook model that can determine if the U.S. unemployment rate has fallen below NAIRU in 2012. Economic theory makes two very different predictions of what happens to the unemployment rate and the rate of inflation when monetary stimulus is applied to an economy with unemployment rates above or below NAIRU.
In the standard model, monetary stimulus increases demand for goods and services in almost any scenario. In the case where the current unemployment rate is significantly higher than NAIRU, then monetary stimulus will increase inflation somewhat, while decreasing the unemployment rate in the medium term, as there is a pool of available workers that firms can hire to meet this new demand.
If the unemployment rate is at or somewhat below NAIRU, then firms react differently to monetary stimulus. They want to hire new workers, but there is not much of a pool of talented and unavailable workers to draw from. Instead they can only obtain workers from poaching them from their competitors at higher wages. We see a great deal of inflation (far more than in the previous scenario) from both a run up in wages and in prices, but little new employment.
Given that inflation has been low and is predicted to remain low in the future, the U.S. economy is clearly well above the NAIRU. While there are no doubt structural issues in the U.S. labour market, what ails the United States is relatively straight-forward: a lack of demand. In such an environment, expansionary monetary policy should continue.
Mike Moffatt is an Assistant Professor in the Business, Economics and Public Policy (BEPP) group at the Richard Ivey School of Business – Western University