There has been a debate on whether the Fed should stop or further its expansionary monetary policy. In my opinion, if the Fed’s goal is to bring the economy back to the pre-crisis level as close as possible, the Fed should not exit from expansionary monetary policy.
According to the Bureau of Labor Statistics, the unemployment rate in November is 7.0%, reaching the all-time low since 2009 but still higher than the pre-crisis level; according to the US Inflation Calculator, the inflation rate reached 1.0% in October, hitting the lowest since 2010. The GDP growth rate is 3.6% in third quarter, which shows an slight increase from second quarter, shown by data published by the Bureau of Economic Analysis. What are the main reasons as to why this recovery has been so lackluster? The first reason is that the 2007-2009 recession was caused by the housing bubble and the collapse of the housing industry, which normally kick-starts recovery. After the 2007-2009 recession, since the housing prices are unlikely to return to previous levels, the economy is taking longer to recover. The second reason is that globalization has caused domestic employment to rise slower than if all the increase in employment goes to domestic hiring. (Joel, 2013) Compared to the past, we have more imports than exports (Olney, 2013); as the economy recovers, a greater part of the increase in GDP goes to foreign economies instead of our own. Another main reason is that banks have been holding onto excess reserves instead of lending them out because of pessimism. Even though long-term interest rates are now lower, businesses still cannot invest if banks are not willing to lend. (Olney, 2013)
When determining the timing of its exit from expansionary policy, the Fed should consider both concerns of rising inflation rates and hysteresis. The government should start raising interest rates slowly before inflationary expectations jump, to avoid shifting the Phillips Curve. However, the government should also lower the unemployment to pre-recession stage so that the cyclical unemployment will not become structural unemployment. As previously mentioned, since the inflation rate is at the lowest level since 2010 but the unemployment rate is still higher than the pre-crisis stage, there is still room for more GDP growth, which will bring unemployment rate closer to pre-crisis level, assuming that discouraged workers do not enter the labor force. Therefore, the Fed should not begin its exit from expansionary monetary policy.
If the Fed starts the contractionary policy and raises interest rates soon, GDP will decrease because of lower investment spending and net exports. Assuming ceteris paribus, since less labor input is needed to produce less output, unemployment rate will increase, giving the employers the power to keep wages low.; therefore, the inflation rate will stay low. If the Fed keeps interest rates low to stimulate higher investment spending, net exports, and...