Explain how lowering interest rates can help reduce unemployment in the United States.
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.
a. Explain how lowering interest rates can help reduce unemployment in the United States. [10]
Introduction
During the COVID-19 pandemic, the US economy experienced a significant decline in economic activity, leading to falling prices and rising unemployment. In response, the US Federal Reserve implemented an expansionary monetary policy by cutting interest rates to near zero, aiming to stimulate aggregate demand (AD) and support job creation.
Causes of Rising Unemployment in the US During the COVID-19 Pandemic
The COVID-19 pandemic led to significant economic disruptions, resulting in widespread business closures, job losses, and reduced economic activity. The main causes of rising unemployment included:
Lockdowns and movement restrictions, which severely reduced consumer spending on retail, dining, and travel-related services, causing a fall in consumption (C).
Business uncertainty and border restrictions, which discouraged firms from expanding or investing, leading to a fall in investment (I).
Disruptions in global trade and tourism, which reduced exports (X) and increased import reliance (M), leading to a fall in net exports (X-M).
These factors collectively caused a fall in aggregate demand from AD0 to AD1, leading to a multiplied contraction in real national income from Y0 to Y1 and a decline in business revenues. As a result, firms reduced their hiring of factor inputs, including labour, leading to a sharp rise in cyclical unemployment.
How Cutting Interest Rates Helps Reduce Unemployment
A cut in interest rates is a key tool of expansionary monetary policy, aimed at stimulating aggregate demand and reducing cyclical unemployment. Lower interest rates affect the economy in several ways:
Increase in Consumption (C)
Lower interest rates reduce the incentive to save, encouraging consumers to spend more.
Loans for big-ticket purchases (e.g., cars, homes, appliances) become cheaper, making consumers more willing to finance purchases through borrowing.
As a result, consumption (C) increases, boosting aggregate demand and national income.
Increase in Investment (I)
Interest rates and investment have an inverse relationship—as interest rates fall, the cost of borrowing decreases, making more business investments financially viable.
Firms are more likely to expand operations, invest in new equipment, and hire more workers, leading to higher capital accumulation and job creation.
The increase in investment spending (I) further boosts aggregate demand, contributing to higher economic growth and employment levels.
Multiplier Effect and Reduction in Unemployment
Since consumption (C) and investment (I) are key components of AD, their increase leads to a rightward shift in AD, increasing real national income (NY).
As firms experience higher demand for goods and services, they respond by increasing production and hiring more workers, reducing cyclical unemployment.
Why Cutting Interest Rates is Effective in Achieving Low Unemployment in the US
The effectiveness of interest rate cuts in reducing unemployment depends on the type of unemployment present. In the case of the US during the COVID-19 pandemic:
The dominant form of unemployment was cyclical unemployment, which occurs due to a fall in aggregate demand. Since monetary policy primarily influences demand-side factors, cutting interest rates is well-suited to addressing cyclical unemployment by stimulating consumption and investment.
The US has a large domestic economy, meaning that changes in interest rates significantly impact consumer spending and business investments, making monetary policy highly effective in influencing AD and labour market conditions.
Conclusion
The Federal Reserve’s decision to cut interest rates to near zero was instrumental in reducing cyclical unemployment in the US by stimulating aggregate demand through higher consumption and investment. The fall in borrowing costs encouraged consumer spending on big-ticket items and made business investments more attractive, leading to higher economic growth and job creation. Given that cyclical unemployment was the dominant issue during the pandemic, monetary policy was well-suited to address the labour market crisis.
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