As the New Year inches closer and closer, many of us start rushing to come up with resolutions we wish to achieve in the next year. Some of us want to write more thank you notes. Others want to lose weight.
Economists, policymakers, and business leaders are also writing down New Year Resolutions. For all of us, it’s important to make sure these goals are actually attainable. Like the fact that I should not attempt to achieve body fat percentage of zero, economists at the Federal Reserve should not attempt to achieve an unemployment rate of zero.
Naturally, unemployment is natural
Having unemployed workers is actually an important feature of an economy that is growing and innovating. If the unemployment rate gets too low, things may look pretty good in the short run, but it can throw everything out of whack in the long run. Just like our bodies! If we drop down to really low levels of body fat, sure our pecs stop jiggling and our abs pop out, but we become prone to some serious health risks.
Edmund Phelps, along with Milton Friedman, coined the term the “natural rate of unemployment”—meaning that there is an innate amount of people who should be unemployed in a dynamic economy, growing with new technologies, ideas, and expectations. Importantly, it means that no matter how hard you try to eradicate unemployment, the economy will always tend to have some percentage of unemployed people—the natural rate.
It makes sense that new technologies might put people out of the job. But Phelps developed the formal models along with a ton of other game-changing contributions to macroeconomics winning him the Nobel Prize in 2004.
Unemployment is an “aggregate demand” problem
From the 1920s to the end of the 1960s, unemployment was diagnosed (and treated) as a demand problem. By increasing the level of aggregate demand, policymakers could easily reduce unemployment. Here’s a relevant New Year’s illustration:
At the beginning of the year, the demand for gym memberships increases because of the New Year’s resolutions we all make around this time. This means that more customers sign up for gym memberships. As a result, gyms hire more personal trainers and staff, maybe even open new gyms. Unemployment decreases.
The Fed can actually attempt to spur aggregate demand for the whole economy by injecting cash, i.e. inflating the economy. In theory, increasing the money supply increases aggregate demand because it allows gyms and every other type of firm, charge higher prices for their goods and services along with increasing wages of their workers. This, in turn, allows the firms to do the same thing as gyms do in the beginning of the year—get more customers, sell more stuff, hire more employees, open more shops. Thus, unemployment, in the whole economy, decreases…like magic.
It ain’t so magical…
It turns out, using inflation to alleviate unemployment not only loses its magic, but it leads to a dangerous cycle. Heading into the `70s, the U.S. economy ended up experiencing high levels of inflation along with high levels of unemployment! The problem was that even though inflation would bring down unemployment a little bit, they would have to keep on inflating to keep the unemployment rate artificially low.
Here’s how it works…
Say gyms are expecting an inflation rate of 3 percent. Yet, there is an unemployment rate of 6 percent. The Fed policymakers think there are too many unemployed personal trainers, so they decide to increase aggregate demand by injecting cash into the economy, pushing the inflation rate up to 5 percent. Same as before, more people now have the money to get gym memberships and personal training sessions.
To keep up with the flood of new gym memberships, gyms need to hire more personal trainers. Here’s the catch: To bring in the unemployed workers, gyms need to pay higher wages. In turn, these higher wages push up the prices for gym memberships. (The price of everything goes up.)
So we see the newly hired personal trainers with higher wages, a bunch of personal trainers with the same wages as before, unemployment down to 4 percent, and tons of people getting fit, and gyms are making some more profits. Win!
Not so fast…
When the next year comes around, all the personal trainers that didn’t get a wage increase notice that the price of protein bars (and everything else) is 5 percent more expensive. But, because they only got a 3 percent increase in their wages, they are short on cash and demand higher wages and pay raises for the following year.
Gyms agree to increase their wages (or else they lose a bunch of personal trainers). This pushes up prices for gym memberships even more. But, without the needed juice from the Fed, customers can’t afford the gym memberships at the new higher price. Customers fall off, gyms can’t afford to pay their personal trainers as much, so they lay a bunch of them off. And, in the end, we’re back to the 6 percent unemployment rate (the natural rate of unemployment), at a higher inflation rate.
Not so magical…
Phelps along with Friedman brought this to the attention of policymakers and we’ve never really looked back since. Now, the Fed targets an inflation rate that will keep the economy near what they think is the natural rate of unemployment, or the “non-accelerating inflation rate of unemployment” (NAIRU). According to mainstream economists, focusing on the natural rate of unemployment, as impossible as it is to figure it out with any real accuracy, has largely kept the economy from going off the rails.
What this all means is…
It’s okay to have some fat on you. In fact, it’s healthy! What’s more is that like the economy, though there may be some deficient “demand” for working out, there are other things that keep us from getting to our desired body-fat percentage. Our bodies’ supply-side inefficiencies like genetics, metabolism rates, our preference for food and other activities all hinder us from shedding the fat.
The Fed’s New Year resolution, every year, is trying to keep the economy at its NAIRU; not too fat, not too skinny, but just right. So, instead of trying to force our bodies toward some preferred level of body fat, how about we just aim for our natural rate this year.
Don’t thank me, thank Edmund Phelps.
Happy New Year!