How Does Monetary Policy Affect Unemployment?

Written by shane hall
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Of all the measures that gauge the health of the economy, the unemployment rate receives the most attention from workers and elected officials. Politicians often run for office on promises to pursue economic policies that create jobs. During economic recessions, elected officials face constant pressure from constituents to do something about the unemployment rate. This sometimes results in pressure applied to central banks to adjust monetary policy in a way that lowers unemployment levels. Although monetary policy can affect the labour market, its impacts are only indirect.

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Monetary Policy

Monetary policy affects the national money supply and the availability of credit for businesses and consumers. Central banks, such as the Bank of Canada, the Reserve Bank of New Zealand and the U.S. Federal Reserve System, oversee their countries' monetary policy. By regulating the money supply and short-term interest rates, central bank policymakers seek policy that fosters conditions for sustainable economic growth and maintains a stable price system by controlling inflation.

Theories/Speculation

In 1958, New Zealand economist A.W. Phillips published a paper in which he observed a relationship between unemployment and inflation. He found that periods of low unemployment tend to have high inflation and vice versa. This negative correlation between rates of inflation and unemployment became known as the Phillips Curve. Harvard economist Gregory Mankiw, author of "Principles of Economics," writes that the trade-off between inflation and unemployment is only temporary but can last for several years. For this reason, economists and policymakers continue to debate the extent to which governments should use monetary policy to affect the unemployment rate.

Effects

The Federal Reserve Bank of Dallas reports that monetary policy by the Federal Reserve System directly affects the money supply and access to credit but only indirectly affects the labour market. Restrictive monetary policy, for example, could dampen economic growth and force firms to lay off workers, raising the unemployment rate. Fed officials could respond by increasing the money supply, but the Dallas Federal Reserve cautioned that such an action could lead to wage and price inflation, negating the effects of the monetary stimulus. A unusually low rate of unemployment, meanwhile, could suggest that the economy is at risk of overheating as companies offer higher wages to attract scarce workers. This raises production costs, leading to higher retail prices. Central banks would then respond with tighter monetary policy that slows economic growth to a more manageable level. The Dallas Federal Reserve concluded that keeping inflation at low levels fosters a stable economic environment that helps lower unemployment.

Prevention/Solution

Donald T. Brash, a former governor of the Reserve Bank of New Zealand, writes that monetary policy's best contribution to the unemployment rate is maintaining a stable price system. Using monetary policy as a tool for stimulating economic growth and job creation, he cautioned, results in higher inflation in the long run.

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