Discuss whether keeping interest rates low, on balance, will allow the US government to achieve price stability.
The US Federal Reserve reduced interest rates to near zero in response to the economic fallout from COVID-19, including deflationary pressures and rising unemployment. This accommodative policy stance will remain in place until the economy shows clear progress toward meeting its key objectives.
b. Discuss whether keeping interest rates low, on balance, will allow the US government to achieve price stability. [15]
Introduction
Price stability is typically defined as achieving a low and stable rate of inflation, with most central banks, including the US Federal Reserve (Fed), targeting an inflation rate of around 2%. The effectiveness of maintaining low interest rates in achieving this objective depends on the state of the economy, the causes of inflation, and external factors affecting price levels. In some scenarios, keeping interest rates low can support economic growth without triggering excessive inflation, particularly if the economy is operating below full employment. However, if the economy is close to or exceeding full capacity, continued low interest rates may lead to demand-pull inflation, pushing inflation beyond the Fed’s target. Additionally, inflation can arise from cost-push factors, such as supply chain disruptions or geopolitical shocks, which cannot be controlled through monetary policy alone. Thus, while keeping interest rates low may contribute to price stability under certain conditions, it is not always effective and must be adjusted in response to economic conditions and external inflationary pressures.
How Maintaining Low Interest Rates May Allow the US to Attain Price Stability
The effectiveness of low interest rates in maintaining price stability depends on whether the economy is operating below or near full employment.
1. When the Economy is Operating Below Full Employment
If the economy is far from full employment, such as during the COVID-19 pandemic in 2020, keeping interest rates low can stimulate economic recovery without significantly increasing inflation.
In 2020, the US unemployment rate was around 13%, indicating that the economy was operating well below full capacity.
Maintaining low interest rates encouraged borrowing and investment, improving business confidence and household spending.
As aggregate demand (AD) increased from AD₀ to AD₁, real output rose from Y₀ to Y₁, but inflation remained stable at P₀, since excess capacity prevented price pressures.
As long as inflation remained at or below 2%, price stability was achieved.
Thus, in a recessionary environment, low interest rates can increase AD and restore employment levels without creating excessive inflationary pressures.
2. When the Economy is Operating Near Full Employment
If the economy approaches full employment, such as in 2021 when the US unemployment rate fell to 5.5%, maintaining low interest rates can fuel inflation.
With businesses and consumers remaining optimistic, higher borrowing and spending drove AD from AD0 to AD1, causing output to rise from Y0 to Y1 and prices to increase from P0 to P1.
As long as inflation remains near the 2% target, price stability is maintained despite higher output.
However, if demand continues to rise from AD1 to AD2 while the economy is already near full capacity, prices may rise significantly from P1 to P2 beyond the target inflation rate, making it unsustainable to maintain low interest rates.
How Maintaining Low Interest Rates May Not Allow the US to Attain Price Stability
1. Risk of Excessive Inflation When Near Full Employment
By the end of 2021, the US economy had largely recovered from the pandemic, with unemployment at 5.5% and demand continuing to rise. Persistently low interest rates contributed to a further expansion of AD from AD₂ to AD₃, pushing prices beyond the Fed’s 2% target.
The Fed’s decision to delay raising interest rates contributed to demand-pull inflation, with businesses and consumers continuing to borrow and spend.
By 2022, inflation had surged beyond 8%, reflecting a failure to maintain price stability.
In hindsight, the Fed should have begun raising interest rates in 2021 to curb excessive inflationary pressures.
Thus, maintaining low interest rates beyond the point of full employment leads to inflation exceeding the target, making it necessary for central banks to adjust monetary policy accordingly.
2. Other Causes of Inflation: Cost-Push Factors
Low interest rates may not be the sole cause of inflation, as external supply-side shocks can also drive prices higher.
The Russia-Ukraine war in 2022 led to higher global energy and food prices due to:
Reduced grain exports from Ukraine, raising food costs.
Oil supply disruptions from Russia, increasing energy prices.
These factors increased firms' costs of production, shifting short-run aggregate supply (SRAS) leftward, leading to cost-push inflation.
Additionally, pandemic-related supply chain disruptions caused:
Higher transportation costs and shipping delays, raising the price of imported goods.
Shortages of key raw materials, leading to further price increases.
These factors would have driven inflation higher regardless of interest rate policy, meaning that keeping interest rates low or raising them would have had limited impact on cost-push inflation. Instead, supply-side policies—such as diversifying import sources, improving logistics infrastructure, and increasing domestic production—would have been more effective in addressing these inflationary pressures.
Conclusion
Whether maintaining low interest rates enables the US to achieve price stability depends on the state of the economy and the causes of inflation. If the economy is operating below full employment, low interest rates can stimulate growth without triggering excessive inflation, helping to maintain price stability. However, if the economy is near full employment, keeping interest rates low for too long can fuel excessive demand-pull inflation, as seen in the US by 2022, when inflation surged beyond 8%. Furthermore, inflation may also arise from cost-push factors, such as supply chain disruptions and geopolitical shocks, which cannot be controlled through monetary policy alone. Therefore, while low interest rates can support price stability in certain conditions, achieving long-term inflation control requires a combination of interest rate adjustments and supply-side measures to address structural inflationary pressures.
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