Stagflation
Stagflationis when the economy is experiencing negative growth in GDP with a simultaneous rise in the price level.
Monetary policymakers fight stagflation with changes in rates, reserves, and the supply of money. It is necessary to
have policies that influence aggregate demand or aggregate supply because it ensures a long-term healthy economy. To
remedy stagflation, the Fed must increase aggregate supply through proper monetary policy. The result of an increase in
aggregate supply is an increase in employment and a decrease in the price level. The effects of the Fed’s policy toward
stagflation are illustrated below.
To increase aggregate supply, the government needs to play an active role in policymaking. When the Fed implements
a monetary policy that increases aggregate supply, the government needs to follow the Fed’s lead by implementing a
fiscal policy that will do the same. The government can increase aggregate supply by making it easier and cheaper for
businesses to make their products. Tax cuts, government grants, and subsidies can all increase aggregate supply by
decreasing production costs for businesses.
Problems and Strengths of Monetary Policy
Although it is tempting to see monetary policy as a solution for most economic situations, it has both its strengths and
its weaknesses.
Strengths
Monetary policy is the primary stabilizing force for macroeconomic stability. The Federal Reserve is responsible for
monitoring instabilities in a nonbiased and coherent manner. When the government introduces action for economic sta-
bility, it can sometimes be mixed up in the “bureaucratic black hole.” Policies that the government introduces can be in-
fluenced by hidden agendas and political pressures. The Federal Reserve, on the other hand, can perform independently
of the government. This allows the Fed to function without political pressures. Fed officials are relatively isolated from
the lobbying that government officials may encounter.
The successful use of monetary policy speaks for itself when you consider the economic instability in the 1980s and
1990s. Tight monetary policy in the early 1980s reduced the inflation rate, whereas an easy money policy helped us
climb out of the recession of the early 1990s.
Monetary policy is usually more flexible and less likely to get caught up in legislation. Policymakers can create a rem-
edy for economic instability and almost immediately have it introduced to the economy. Fiscal policy, on the other
hand, can get caught up in legislation and debate, thereby making it a less effective remedy.
Problems
Sometimes the actions of the Fed have little if any impact on the economy because of uncontrollable variables, such
as the velocity of money and consumer preferences. The Fed has no control over how quickly consumers spend or
save their money. Consumer preferences can be influenced by technology, employment, the price level, and many other
variables.
Monetary policy may be highly effective in slowing macroeconomic instability, but it cannot be relied on to cure a re-
cession. Recessions often have greater complexities than the Federal Reserve can handle. The old phrase “you can lead
a horse to water but you can’t make it drink” applies to the Fed when dealing with the economy. The Fed can point the
economy in the right direction, but it cannot completely cure instability.
Part II: Macroeconomics