Central Bank Monetary Policy: Understanding the Tradeoff Between Unemployment and Inflation

What tradeoff does the Central Bank need to consider when implementing monetary policy?

A) Consumption and investment. B) Unemployment and inflation. C) Private investments and government expenditures.

Answer:

The Central Bank must consider the tradeoff between unemployment and inflation when considering monetary policy.

Explanation:

When the Central Bank is considering which monetary policy to implement, it should always stay conscious of the tradeoff between Unemployment and Inflation (Option B). The Central Bank cannot overlook the relationship described by the national savings and investment identity. If, for instance, government borrowing rises, other elements such as private investment must decrease, or private saving must escalate, or the trade deficit should reduce.

The Central Bank can decide whether to adopt an expansionary monetary policy to increase money supply and stimulate economic growth, or a contractionary monetary policy to decrease money supply to slow down an overheating economy. However, this is not without consequences. An example of the tradeoff in this scenario is visualized in the Keynesian Phillips Curve, which illustrates the inverse relationship between unemployment and inflation rates - if one decreases, the other is likely to increase.

Being concerned about slow economic growth and unemployment, politicians might constantly pressure the Central Bank to maintain a loose monetary policy. This can lead to higher inflation with no long-term reduction in unemployment. It is the bank's responsibility to resist such pressures, considering the long-term economic outcome. Thus, while the central bank can influence macroeconomic outcomes, it's always a balancing act.