The Federal Reserve and Maximum Employment

By Dr. John Hilston

July 3, 2012 - In challenging economic times, many businesses and individuals look to the Federal Reserve for answers.

The Fed – as the U.S. central bank is known – has two major mandates.

One is to promote price stability. The other is to promote maximum employment. While maximum employment is a noble goal, its pursuit has come with several negative consequences.

Among them is that maximum employment depends on the Fed’s ability to vary the supply of money.

When economic growth is a concern — which it is most of the time — the Fed will lower interest rates. This is done by increasing the supply of loanable funds in the banking system, which the Fed accomplishes with the purchase of U.S. bonds from banks.

The theory goes that when borrowing is cheaper due to lower interest rates, more people will do it.

Most will spend it on things like houses and cars. Small and large businesses use it to acquire machines, buildings and equipment. At times, this spending might grow the economy. Of course, this assumes that demand for the things purchased with borrowed money continues to increase.
Unfortunately, the supply of homes in Florida — and many other parts of the U.S. — still outpaces the demand. This surplus was brought about, in part, by the Fed keeping interest rates too low for too long.

Still, one cannot completely blame current or former Fed officials. They were just doing what the maximum employment mandate told them to do.

Another potential downside to the mandate is inflation.

It’s not such a good thing to “water down” the value of each dollar, which happens when the money supply is increased. When each dollar is worth less, prices rise and we have inflation. If there’s a positive thing about our slow economy, it’s that inflation has not become a problem, at least not yet.

Is there an alternative?

GOP presidential candidate Ron Paul wants a return to the gold standard, which in theory would hold money supply constant. The resulting price and monetary stability, again, in theory, would eliminate inflation, and be a major incentive for people to increase their saving.

However, the problem with gold is that it has historically been a volatile commodity, and there’s no chance the U.S. will again use it as the foundation of its monetary and economic policy.

A more realistic option is having the Fed end its maximum employment mandate.

Dr. John Hilston is an associate professor of economics at Brevard Community College’s Palm Bay campus.