Does targeting low inflation cause higher unemployment?
Edward Lambert | October 1, 2013 9:30 am
Does targeting low inflation lead to higher unemployment?
In other words, is it possible that a higher natural rate of unemployment is necessary to maintain a lower rate of inflation?
Output and prices move together to maintain economic momentum. Normally output increases in response to demands in the market, which keeps prices stable. Yet, at those times when output cannot respond to the momentum of the market, prices will rise giving space for output to catch up. A higher natural inflation corresponds to when consumers have strong liquidity. A lower natural inflation corresponds to when consumers have less liquidity and are less able to drive the momentum of the market. When consumers have low liquidity, output finds it easier to respond to demands in the market, so price increases are less needed.
The basic idea is that if prices are constrained from rising when there are inflation pressures from commodities or consumer demand, jobs will be cut short. Firms will not be able to maintain as much labor. The increased pressures from costs not being released through higher prices will cut into production possibilities. Thus, higher unemployment corresponds
with a lower inflation target.
Joseph Stiglitz wrote back in 2008…
“Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much impact on inflation; it will only make the task of surviving in these conditions more difficult.” (source )
Does inflation have a natural rate? This seems to be the key question. Unemployment has a natural rate. Even GDP has a natural rate. If you push unemployment below its natural rate, you get problems of economic over-heating. If you push GDP above its natural rate, there are risks of inflation and economic over-heating too. What would it mean if the natural rate of inflation for the US was 3%, and the Fed kept trying to push it to 2%?
Here is an analogy. The natural rate of inflation is like a shock absorber on a car. You have bumpy roads where you live. So you have shock absorbers on your car that have a greater range of movement for the bumpy roads. When you keep your car speed commensurate with the conditions of the road, you have a comfortable ride.