How Does Monetary Policy Affect Unemployment?

Monetary policy in the U.S. is managed by the Federal Reserve and has three primary goals: to reduce inflation or deflation, thereby assuring price stability; assure a moderate long-term interest rate; and achieve maximum sustainable employment. It works toward these goals by controlling the supply of money available in the economy.

Maximum Sustainable Employment

These three goals are interdependent. If they were not, the Fed could easily reduce unemployment by injecting a lot more money into the economy. Interest rates would drop to almost nothing, and the availability of cheap capital would prompt businesses to borrow this money to expand rapidly, which would require many new hires. In the short term, the Fed would achieve the goal of maximizing employment.

The problem is that it wouldn't be sustainable. The overheated economy would soon lead to price inflation and asset bubbles as investors ran up the price of stocks and housing prices soared. The eventual result would be a crippling economic crash that could make the unemployment situation even worse than before.

How to Help a Retracting Economy in the Long Term

Instead, if the economy is retracting, which almost always leads to increasing unemployment, the Fed sets a policy course that encourages gradual and sustainable improvement. In 2009, for example, following the disastrous subprime mortgage meltdown that led to the second-largest economic retraction in U.S. history, the Fed began a program usually identified as "quantitative easing." By buying bonds with money that didn't exist before the transaction, the Fed effectively introduced more money into the economy.

The Fed continued this program as the economy gradually recovered. Some critics assailed the Fed for "printing money," which they believed would soon lead to inflation. Others criticized the Fed for not doing enough, pointing out that the recovery was almost unprecedentedly slow. The Fed, however, continued the policy of quantitative easing until October 2014, by which time unemployment had declined to 5.8 percent from the October 2009 high of 10 percent.

Taking the Punch Bowl Away

Beginning in October 2013, as the economy continued to recover, the Fed began tapering off its bond purchases. By October 2014, after injecting more than $3.5 trillion into the economy over five years, the Fed ended its quantitative easing policy.

The Fed's actions are often called "Taking the punch bowl away," which references a speech of an earlier Federal Reserve chairman, in which he likened what the Fed does to being a chaperone at a party: Once everyone has had a few drinks and the party is "really warming up," it's the Fed's job to cool things down again.

The Result

Inflation during the period from 2009 through 2014 remained low and continues to be low in 2015. Unemployment from 2009 to 2014 nearly halved and continued to lower in 2015.

Despite this, not everyone agrees with the Fed's actions. Some liberal economists believe unemployment remained unnecessarily high for far too long -- that a more aggressive Fed policy of injecting money into the economy could have achieved the same result much quicker and without precipitating inflation. Conservative economists think the best thing for the Fed to have done was to let the situation run its course -- that the Fed's intervention is counterproductive. In the opinion of most mainstream economists, however, the Fed's actions were effective and appropriate. They achieved the two interrelated goals of assuring price stability while maximizing employment in a sustainable way.