MONETARY POLICY Fed’s Monetary PolicyDescribe the Fed’s objective function and how it can be used with an economic model to evaluate alternative monetary policies? In the world of economy, different policymakers may try their level best to stabilize the economy mainly by smoothing out the various business cycles in the surrounding. According to Fed’s objectives, its primary goals included the following: maximizing output, reducing the rate of unemployment and also ensuring that the rate of inflation in the economy is low. Fed’s objective function is also referred to as the Fed’s loss function mainly because when the value of the function is much higher the economy becomes worse off.
The objective function describes the tradeoff between inflation rates and the output level in the economy. Fed’s objective function can be used to evaluate alternative monetary policy. The difference between the actual inflation rate and the ideal one is the inflation gap; the inflation gap rises during economic expansion and reduces in the period of recession, and it is merely positive. The tradeoff between the output gap and inflation gap is always determined by the Fed’s objective function (Surico, 2007).
However, Fed’s objective function looks at the aggressiveness of the policymakers and during the period of economic shock the inflation rates or output levels in the economy are returned to their exact levels. Besides, the economic model depicts that when output increase for a while, the unemployment level will reduce and over a certain time inflation rate decreases (Surico, 2007). Why didn’t policy based on the Phillips curve work to help the Fed reduce the unemployment rate to a lower level than before? What happened in the 1970s as the Fed tried to take advantage of the tradeoff between inflation and unemployment?
The policy on Philip’s curve did not work to help Fed reduce unemployment level to a lower level because the tradeoff between the higher level of unemployment and higher inflation is no longer there. Therefore, there is a positive correlation between high inflation and high unemployment. In the 1970s, policymakers tried to take advantage of the tradeoff between unemployment and inflation rates but it did not work either. However, this caused the rate of expected inflation to raise hence the level of unemployment and inflation rose.
Similarly, this also led to the short-run Philips curve to shift upwards. ReferenceSurico, P. (2007). The Feds monetary policy rule and US inflation: The case of asymmetric preferences. Journal of Economic Dynamics and Control, 31(1), 305-324.