Monetary Policy

Inflation, Unemployment, and Poverty

Economists have found a connection between poverty and the performance of the economy. Unemployment clearly impacts poverty as people lose their income. As unemployment increases, the people first affected are generally low-income workers already close to poverty. Inflation can also impact poverty if the incomes of those close to the poverty level do not rise with prices. However, as social insurance and social assistance benefits become indexed to inflation, many who are close to poverty will be less impacted by inflation; for them unemployment remains a bigger threat.

James Tobin found in the United States that years of real wage growth (wages grow faster than inflation) and decreased unemployment could be empirically associated [Page 725]with reductions in poverty. He also found that in the U.S. case, this relationship has lessened in the decades since the 1970s.

He argued that the Federal Reserve had been unwilling to let the economy grow at a fast enough rate on account of its overemphasis on inflation. Alan Blinder, who served as vice chairman of the Federal Reserve Board for a period during the Bill Clinton administration, has also made this argument.

The trade-off between inflation and unemployment is one of the central tenets of monetary policy. It is encapsulated in the Phillips Curve, and it has been a source of controversy since the 1950s. The basic idea is that low unemployment causes inflation to rise, and high unemployment causes inflation to fall. This can be understood by thinking of wage negotiations between employers and employees. When unemployment is low, employees will have more bargaining power to ask for higher wages, which will increase the costs to firms and lead to higher prices.

These ideas have been refined since the 1970s to understand that it is expected inflation that matters. Because many central banks are specifically interested in maintaining low inflation, in order to provide the most stable framework for long-term economic growth, a number of people have argued that greater emphasis should be placed on maintaining low unemployment in order to fight poverty.

Tools of Monetary Policy

Having established a basis for the connection between poverty and monetary policy, we can now consider how monetary policy is conducted and works. The most important tool of monetary policy is open-market operations. With this tool, the central bank buys and sells government bonds or other financial assets in secondary markets, in order to influence the money supply. When a central bank buys a government bond from a commercial bank or individual, the money supply increases, because the central bank provides a monetary credit to the seller.

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