Analysis of the labor market and monetary policy before and after the financial crisis faced by the United States economy
The main purpose of this paper is to make a detailed analysis of the labor market and monetary policy before and after the financial crisis faced by the United States economy. One of the key economic variables to put into consideration is the unemployment rate for the period between 2006 and 2016. The unemployment rate shall be analyzed with inflation taken into account as well as the federal funds rate. The bottom line in the paper analysis is to explore the relationship between unemployment, inflation, and interest rates in the United States economy. The federal reserve plays a key in economy control and has a major mandate to fulfill during the great recession period. Taylor will be deployed in this paper to give an insight mandate of the federal reserve in the analysis of the three economic variables.
In the United States, the federal open market committee has the full responsibility to set up the monetary policy. In setting the monetary policy the committee puts into consideration several factors that ensure the economy is not subjected to constraints. One of the factors considered by the committee in the state of the economy. under these factors, the federal committee evaluates a monetary policy that encourages economic growth during a recession period. This factor is put into practice with a full mandate of Taylor’s rule. In general, the Taylor rule predicts that the federal open market committee is supposed to raise the interest rate by 1.5% with each percentage increase in the inflation rate relative to the federal rate target in about 2%.
The three economic variables considered by the federal open market committee during monetary policy decisions include unemployment, inflation, and interest rates. Monetary policy will be compared for the period before, during, and after the financial crisis. Other than setting up the monetary policy, the federal open market committee deploys policy tools such as stipulation of the federal fund rate. This is the rate at which other licensed banks can borrow funds from the federal reserves. In 1977, the Federal Reserve Act stated that the federal open market committee has the full responsibility in promoting the goals of maximum employment, relatively moderate interest rates in the long-term, and stable prices in the economy. In 2001, the federal reserve lowered the federal fund rate from 6.5% in 2000 to 1.75%.
Unemployment
During the period of recession in the U.S economy, it reached a point where the unemployment rate persistent with an increasing trend. The recession has a major impact on unemployment since it causes a domino effect. A domino effect is a recession situation where the unemployment rate increases with falling consumer spending, and then end up forcing firms to lay off a large portion of their labor force to cut costs. From figure 1 below, in 2006 the unemployment rate was at 6% with a corresponding inflation rate of 2.5%. As a result, consumer spending was minimal thus pushing the unemployment rate due to less demand for consumer goods. For figure 1, in 2008 the inflation rate dropped to 0.01% with a flat rate of 6% in the unemployment rate. During the recession period, the labor force demand dropped drastically, and thereafter in 2016 the unemployment rate dropped to 4.6%. in economic terms, the drop in unemployment rate means firms increased their labor force demand with more people employed. During the same period of recovery, the inflation rate was 2.1%. The financial crisis experienced by the U.S economy resulted in decreased revenues in various companies thus facing financial constraints in wages and salaries for their employees. The firms were in a decision dilemma where they were forced to either lower the wages or let go of some of their employees. Despite the choice taken up by the companies, the households were forced to cut their spending as a result of unemployment. Therefore, the households tightened up their spending and thus less or no savings.
Inflation
The monetary policy set up by the federal open market committee primarily determines the inflation rate which is set up in the United States economy. The committee has a fundamental capacity to set up and specify a long-term goal for the inflation rate. As pointed out earlier, the unemployment rate is greatly determined by the economic factors that are nonmonetary. These economic factors directly affect the dynamics and structure of the labor market. When the federal open market committee is setting up the monetary policy, there is a consideration of mitigating any possible deviation from the inflation long-term goals. The committee also tries to mitigate the employment deviations away from the committee’s assessment of its unemployment maximum rate. Form the figure 2 below, it is clear that the inflation dropped drastically after 2007. It is after this period that the federal open market committee declared an inflation flat rate of 2%.
[CHART]
Interest rate
One of the motives which determine individuals’ levels of spending money is speculative motive. In such a case, the interest rate plays a vital role in determining whether the households will decide to spend the money today or save for future benefits. During a period of high-interest rates, households will spend less and invest a lot because they expect that the investment will yield more return in the future. In contrast, as interest rates start to drop the households are more likely to spend a lot on consumer goods and not consider investment options because the investments will not yield enough earnings in the future. Before making consumption and investment decisions, the households take into account the labor wages which come in the form of income. With a high unemployment rate, the investment level will be low because households spend a lot on consumer goods leaving room for no investment. During the great recession period in 2007, the unemployment rate was high thus less income to households. With low income, the investment levels dropped due to a lack of disposable income. From the graph below, during the great recession, the interest rates were high to a level of 5.25%. the main reason why the federal open market committee increased the interest rate was to encourage investments by the households. At this period, the households did not have enough income to make investments. After the recession period in 2008, the interest rates dropped drastically to rates of 0.25% due to high income and savings. Such low income was to discourage savings and encourage consumption by households.
[CHART]
In conclusion, real GDP is assumed to be the total amount any given economy can sustainably produce when both labor and capital are fully employed. Application of Taylor rule predicts that the federal open market committee is supposed to raise the interest rate by 1.5% with each percentage increase in the inflation rate relative to the federal rate target in about 2%. Having this in mind, it is evident that the Fed did not follow this rule during the great recession period. From the graphs above, it became extremely difficult to apply the Taylor rule during the recession period in 2007. The Fed’s decision to employ the traditional policy actions. In this policy, the federal open market committee reduced the federal funds rate from 5.25% in September 2007 to a point of between 0 – 0.25% as of December 008.