Why Does Unemployment Continue to Rise as an Expansion ‹ Begins Quizlet
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The Federal Reserve issued its fourth interest rate hike last week to fight rampant inflation in the country. It's the latest contractionary action the central bank has undergone, with more likely to come. Why does the interest rate increase help inflation?
Well, understanding the purpose behind the Fed's tightening monetary policy first requires understanding what inflation really is. Inflation is fundamentally an oversupply of money. As the demand and production of goods remains static while the supply of cash circulating in the country increases, cash will naturally shed some of its value.
This may beget the question, why is inflation so high lately? Well, for a number of reasons. During the Covid-19 pandemic, the U.S. began offering stimulus payments to nearly every working American. The U.S. also paused rental and student loan payments, and other government subsidy programs.
Some economists believe the U.S. may have given out a bit too much to too many people. The supply of cash in the U.S. soared on the strong stimulus response. Because some of the recipients didn't necessarily need the money to pay for groceries, rent, car payments, and so on, there wasn't an equitable tradeoff in goods purchased or economic output.
There is also the issue of Russia's invasion of Ukraine. War in general is an inflationary phenomenon, spurred on largely by ramped up economic output. When the two countries involved produce a substantial amount of the world's food and oil, however, the affects are compounded. Indeed fuel is the single most inflated good as per the June Consumer Price Index (CPI) report. This is almost solely a consequence of Russia's invasion of Ukraine.
Why Does the Interest Rate Increase Lower Inflation?
Raising the interest rate remains the Fed's single most impactful monetary decision — for good reason. Raising the interest rate, including the short-term lending rate banks charge other banks, known as the Fed funds rate, affectively tightens the creation and transference of money in the U.S.
By raising rates, the Fed is indirectly attempting to get American consumers to pull back their demand for, well, everything. Increasing the cost to borrow will stop many from making major purchases like cars and homes, which frequently require loans. This should curb the creation of money in the U.S., which would address the supply/demand imbalance in the country, affectively bringing down prices in the process.
Given the complexity of many macroeconomic ongoings, it's a relatively straightforward concept. The issue with raising interest rates and the consequential tightening of cash flows is the potential for a wider economic slowdown. Indeed, should aggregate demand fall too much in the country, businesses may lay off employees due to a fall in revenue.
The Fed has long been advocating for a "soft landing" where price levels ease back down without incurring too much of a penalty in unemployment, consumer spending, etc.
By some accounts, the country may already be dipping into recession territory. The country has recorded it's second straight quarter of falling GDP, a historical slowdown indicator. Confusingly, things like unemployment and spending have remained steadfast. This gave the White House grounds to make a now-infamous blog post arguing the country isn't in a recession despite foreboding GDP figures.
Things are still up in the air. Raising interest rates remains the Fed's strongest tool against inflation. But whether the central bank can truly navigate its historic rate hikes and their macroeconomic consequences remains to be seen.
On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Source: https://investorplace.com/2022/08/why-does-the-interest-rate-increase-help-inflation/
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