As Becker points out, the unemployment rate is a misleading figure because it ignores discouraged workers, who have left the labor force (the denominator in calculating the unemployment rate, where the numerator is the number of full-time employed), and workers involuntarily working part time. But that is to say that the Fed’s choice of 6.5 percent unemployment as the level below which the Fed will stop flooding the economy with money is conservative, in the sense that at that rate the underutilization of the labor force is considerable and warrants extraordinary measures. Similarly, an inflation rate of 2.5 percent is low, suggesting that the Fed will stop flooding the economy with money well before inflation reaches a dangerous level.
I am not a macroeconomist, but my sense is that macroeconomics is so complex, in the sense of involving so many interactive forces, that no one understands it fully. For example, it may seem obvious that “hand outs,” such as unemployment insurance, food stamps, and Medicaid, increase unemployment by reducing the financial pressure on an unemployed person to seek work. On this ground, Casey Mulligan, whom Becker cites, has argued that the hand-outs have prevented poverty from increasing during the current depression, and that this is a bad thing because poverty makes unemployed people search harder for jobs. The other side of this coin, however, is that the hand-outs increase the amount of money that people have and can spend on consumption, and consumption drives production, which in turn drives employment. If there are no jobs to be had, searching for a job has no payoff. Of course there may be methods of increasing consumer incomes that do not involve making work less attractive, such as Keynesian public projects that increase employment directly, or income tax reductions. Those are fiscal measures impeded by the dysfunctional character of our political system, from which the Federal Reserve is largely immune; and so the burden of speeding the economy’s recovery has fallen on the Fed.
The Federal Reserve’s easy money policy, adopted expressly to speed recovery, keeps interest rates very low, which reduces both the burden of debt and the cost of borrowing and therefore stimulates consumption and therefore production and so employment. Inflation, which is stimulated by an increase in the ratio of money to goods, also reduces the cost of debt. As debt falls, people save less and spend more.
It makes sense, therefore, for the Federal Reserve to increase the supply of money when employment (however measured) is abnormally high and inflation very low, which is what it is doing. And by not only doing these things but committing to continue doing them (until the 6.5 percent and 2.5 percent trigger points are reached), which is a departure from the traditional taciturnity of central bankers, the Federal Reserve is reducing uncertainty. This is important because economic uncertainty tends to impede action, whether it is hiring people or buying consumer goods. Freezing is a common and rational reaction to uncertainty—one freezes in the hope that the uncertainty will soon dissipate and then one can act with greater certitude about the consequences of one’s actions.
The Federal Reserve expands the money supply basically by buying government securities for cash. Should inflation loom, the Fed would try to reduce it by selling government securities for cash, and retiring the cash it received, thus reducing the money supply. The danger is that by reducing the money supply and thus forcing up interest rates, the Fed’s action in response to inflation could cause a recession. But today the continued weakness of the economy, given the large deficit, seems a more urgent concern, justifying the Fed’s action.