Introduction
During the COVID-19 pandemic the US economy experienced a significant decline in activity, with falling prices and rising unemployment. In response, the US Federal Reserve implemented expansionary monetary policy by cutting interest rates to near zero, aiming to stimulate aggregate demand and support job creation.
Causes of rising unemployment during the pandemic
The pandemic led to widespread business closures, job losses and reduced activity. Lockdowns and movement restrictions severely reduced consumer spending on retail, dining and travel-related services, causing a fall in consumption. Business uncertainty and border restrictions discouraged firms from expanding or investing, leading to a fall in investment. Disruptions in global trade and tourism reduced exports and increased import reliance, lowering net exports. These factors collectively caused a fall in aggregate demand from AD0 to AD1, leading to a multiplied contraction in real national income from Y0 to Y1 and a decline in business revenues. As a result, firms reduced their hiring of factor inputs, including labour, causing a sharp rise in cyclical unemployment.
How cutting interest rates helps reduce unemployment
A cut in interest rates is a key tool of expansionary monetary policy, aimed at stimulating aggregate demand and reducing cyclical unemployment. Lower interest rates reduce the incentive to save, encouraging consumers to spend more, while loans for big-ticket purchases such as cars, homes and appliances become cheaper, making consumers more willing to finance purchases through borrowing. As a result, consumption increases, boosting aggregate demand and national income.
Interest rates and investment have an inverse relationship; as rates fall, the cost of borrowing decreases, making more business investments financially viable. Firms are more likely to expand operations, invest in new equipment and hire more workers, leading to higher capital accumulation and job creation. The increase in investment further boosts aggregate demand, contributing to higher growth and employment.
Since consumption and investment are key components of aggregate demand, their increase shifts AD rightward, raising real national income. As firms experience higher demand for goods and services, they respond by increasing production and hiring more workers, reducing cyclical unemployment through the multiplier effect.
Why cutting interest rates is effective in the US
The effectiveness of interest rate cuts in reducing unemployment depends on the type of unemployment present. During the pandemic, the dominant form was cyclical unemployment, which occurs due to a fall in aggregate demand. Since monetary policy primarily influences demand-side factors, cutting rates is well suited to addressing cyclical unemployment by stimulating consumption and investment. The US also has a large domestic economy, so changes in interest rates significantly affect consumer spending and business investment, making monetary policy highly effective in influencing aggregate demand and labour market conditions.
Conclusion
The Federal Reserve's decision to cut interest rates to near zero was instrumental in reducing cyclical unemployment in the US by stimulating aggregate demand through higher consumption and investment. The fall in borrowing costs encouraged consumer spending on big-ticket items and made business investment more attractive, leading to higher growth and job creation. Given that cyclical unemployment was the dominant issue during the pandemic, monetary policy was well suited to addressing the labour market crisis.