How do Central Banks affect Unemployment and Inflation?

If you were to survey central bankers around the world and ask them what they believe should be the primary task of monetary policy, the most popular answer by far would be fighting inflation. Most central bankers believe that the neoclassical model of economics accurately represents the economy over the medium to long term. Remember that in the neoclassical model of the economy, we draw the aggregate supply curve as a vertical line at the level of potential GDP. 

In the neoclassical model, economists determine the level of potential GDP (and the natural rate of unemployment that exists when the economy is producing at potential GDP) by real economic factors. If the original level of aggregate demand is AD0, then an expansionary monetary policy that shifts aggregate demand to AD1 only creates an inflationary increase in the price level, but it does not alter GDP or unemployment. From this perspective, all that monetary policy can do is to lead to low inflation or high inflation—and low inflation provides a better climate for a healthy and growing economy. After all, low inflation means that businesses making investments can focus on real economic issues, not on figuring out ways to protect themselves from the costs and risks of inflation. In this way, a consistent pattern of low inflation can contribute to long-term growth.

In a neoclassical view, monetary policy affects only the price level, not the level of output in the economy. For example, an expansionary monetary policy causes aggregate demand to shift from the original AD0 to AD1. However, the adjustment of the economy from the original equilibrium (E0) to the new equilibrium (E1) represents an inflationary increase in the price level from P0 to P1, but has no effect in the long run on output or the unemployment rate. In fact, no shift in AD will affect the equilibrium quantity of output in this model.

This vision of focusing monetary policy on a low rate of inflation is so attractive that many countries have rewritten their central banking laws since in the 1990s to have their bank practice inflation targeting, which means that the central bank is legally required to focus primarily on keeping inflation low. 

A notable exception is the Federal Reserve in the United States, which does not practice inflation-targeting. Instead, the law governing the Federal Reserve requires it to take both unemployment and inflation into account.

Economists have no final consensus on whether a central bank should be required to focus only on inflation or should have greater discretion. For those who subscribe to the inflation targeting philosophy, the fear is that politicians who are worried about slow economic growth and unemployment will constantly pressure the central bank to conduct a loose monetary policy—even if the economy is already producing at potential GDP. In some countries, the central bank may lack the political power to resist such pressures, with the result of higher inflation, but no long-term reduction in unemployment. The U.S. Federal Reserve has a tradition of independence, but central banks in other countries may be under greater political pressure. For all of these reasons—long and variable lags, excess reserves, unstable velocity, and controversy over economic goals—monetary policy in the real world is often difficult. The basic message remains, however, that central banks can affect aggregate demand through the conduct of monetary policy and in that way influence macroeconomic outcomes.

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