Tag: Aggregate demand and aggregate supply model

Solved Problem: The Fed’s Dilemma

Supports: Macroeconomics, Chapter 13, Section 13.3; Economics, Chapter 23, Section 23.3; and Essentials of Economics, Chapter 15, Section 15.3

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A recent article on axios.com made the following observation: “The mainstream view on the Federal Open Market Committee is based on risk management—that the possibility of a further downshift in the job market appears to be the more pressing concern than the chance that inflation will spiral higher.” The article also notes that: “Tariffs’ effects on inflation are probably a one-time bump.”

a. What is the dual mandate that Congress has given the Federal Reserve?

b. In what circumstances might the Federal Open Market Committee (FOMC) be faced with a conflict between the goals in the dual mandate?

c. What does the author mean by tariffs’ effects on inflation being a “one-time bump”?

d. What does the author mean by the FOMC engaging in “risk management”? What is a “downshift” in the labor market? If the FOMC is more concerned about a downshift in the labor market than about inflation, will the committee raise or lower its target for the federal funds rate? Briefly explain.

Solving the Problem
Step 1: Review the chapter material. This problem is about the policy dilemma the Fed can face when the unemployment rate and the inflation rate are both rising, so you may want to review Macroeconomics, Chapter 13, Section 13.3, “Macroeconomic Equilibrium in the Long Run and the Short Run.”

Step 2: Answer part a. by explaining what the Fed’s dual mandate is. Congress has given the Fed a dual mandate of achieving price stability and maximum employment.

Step 3: Answer part b. by explaining when the FOMC may face a conflict with respect to its dual mandate. When the FOMC is faced with rising unemployment and falling inflation, its preferred policy response is clear: The committee will lower its target for the federal funds rate in order to increase the growth of aggregate demand, which will increase real GDP and reduce unemployment. When the FOMC is faced with falling unemployment and rising inflation, its preferred policy response is also clear: The committee will raise its target for the federal funds rate in order to slow the growth of aggregate demand, which will reduce the inflation rate.

But when the Fed faces an aggregate supply shock, its preferred policy response is unclear. An aggregate supply shock, such as the U.S. economy experienced during the Covid pandemic and again with the tariff increases that the Trump administration began implementing in April, will shift the short-run aggregate supply curve (SRAS) will shift to the left, causing an increase in the price level, along with a decline in real GDP and employment. This combination of rising unemployment and inflation is called stagflation. In this situation, the FOMC faces a policy dilemma: Raising the target for the federal funds rate will help reduce inflation, but will likely increase unemployment, while lowering the target for the federal funds rate will lead to lower unemployment, but will likely increase inflation. The following figure shows the situation during the Covid pandemic when the economy experienced both an aggregate demand and aggregate supply shock. The aggregate demand curve and the aggregate supply curve both shifted to the left, resulting in falling real GDP (and employment) and a rising price level.

Step 4: Answer part c. by explaining what it means to refer to the effect of tariffs on inflation being a “one-time bump.” Tariffs cause the aggregate supply curve to shift to the left because by increasing the prices of raw materials and other inputs, they increase the production costs of some businesses. Assuming that tariffs are not continually increasing, their effect on the price level will end once the production costs of firms stop rising.

Step 5: Answer part d. by explaining what the author means by the FOMC engaing in “risk management,” explaining what a “downshift” in the labor is, and whether if the FOMC is more concerned about a downshift in the labor market than in inflation, it will raise or lower its target for the federal funds rate. The article refers to the “possibility” of a further downshift in the labor market. A downshift in the labor market means that the demand for labor may decline, raising the unemployment rate. Managing the risk of this possibility would involve concentrating on the maximum employment part of the Fed’s dual mandate by lowering its target for the federal funds rate. Note that the expectation that the effect of tariffs on the price level is a one-time bump makes it easier for the committee to focus on the maximum employment part of its mandate because the increase in inflation due to the tariff increases won’t persist.

A Brief Overview of Tariffs

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A tariff is a tax a government imposes on imports. Since the end of World War II, high-income countries have only occasionally used tariffs as an important policy tool. The following figure shows how the average U.S. tariff rate, expressed as a percentage of the value of total imports, has changed in the years since 1790. The ups and downs in tariff rates reflect in part political disa-greements in Congress. Generally speaking, through the early twentieth century, members of Congress who represented areas in the Midwest and Northeast that were home to many manufacturing firms favored high tariffs to protect those industries from foreign competition. Members of Congress from rural areas opposed tariffs, because farmers were primarily exporters who feared that foreign governments would respond to U.S. tariffs by imposing tariffs on U.S. agricultural exports. From the pre-Civil War period until after World War II the Republicans Party generally favored high tariffs and the Democratic Party generally favored low tariffs, reflecting the economic interests of the areas the parties represented in Congress. (Note: Because the tariffs that the Trump Administration will end up imposing are still in flux, the value for 2025 in the figure is only a rough estimate.)

By the end of World War II in 1945, government officials in the United States and Europe were looking for a way to reduce tariffs and revive international trade. To help achieve this goal, they set up the General Agreement on Tariffs and Trade (GATT) in 1948. Countries that joined the GATT agreed not to impose new tariffs or import quotas. In addition, a series of multilateral negotiations, called trade rounds, took place, in which countries agreed to reduce tariffs from the very high levels of the 1930s. The GATT primarily covered trade in goods. A new agreement to cover services and intellectual property, as well as goods, was eventually negotiated, and in January 1995, the GATT was replaced by the World Trade Organization (WTO). In 2025, 166 countries are members of the WTO.

As a result of U.S. participation in the GATT and WTO, the average U.S. tariff rate declined from nearly 20% in the early 1930s to 1.8% in 2018. The first Trump Administration increased tariffs beginning in 2018, raising the average tariff rate to 2.5%. (The Biden Administration continued most of the increases.) In 2025, the second Trump Administration’s substantial increases in tariffs raised the average tariff rate to the highest level since the 1940s.

Until the enactment in 1913 of the 16th Amendment to the U.S. Constitution, which allowed for a federal income tax, tariffs were an important source of revenue to the federal government. As the following figure shows, in the early years of the United States, more than 90% of federal government revenues came from the tariff. As tariff rates declined and federal income and payroll taxes increased, tariffs declined to only 2% of federal government revenue. It’s unclear yet how much tariff’s share of federal government revenue will rise as a result of the Trump Administration’s tariff increases.

The effect of tariff increases on the U.S. economy are complex and depend on the details of which tariffs are increased, by how much they are increased, and whether foreign governments raise their tariffs on U.S. exports in response to U.S. tariff increases. We can analyze some of the effects of tariffs using the basic aggregate demand and aggregate supply model that we discuss in Macroeconomics, Chapter 13 (Economics, Chapter 23). We need to keep in mind in the following discussion that small increases in tariffs rates—such as those enacted in 2018—will likely have only small effects on the economy given that net exports are only about 3% or U.S. GDP.

An increase in tariffs intended to protect domestic industries can cause the aggregate demand curve to shift to the right if consumers switch spending from imports to domestically produced goods, thereby increasing net exports. But this effect can be partially or wholly offset if trading partners retaliate by increasing tariffs on U.S. exports. When Congress passed the Smoot-Hawley Tariff in 1930, which raised tariff rates to historically high levels, retaliation by U.S. trading partners contributed to a sharp decline in U.S. exports during the early 1930s.

International trade can increase a country’s production and income by allowing a country to specialize in the goods and services in which it has a comparative advantage. Tariffs shift a country’s allocation of labor, capital, and other resources away from producing the goods and services it can produce most efficiently and toward producing goods and services that other countries can produce more efficiently. The result of this misallocation of resources is to reduce the productive capacity of the country, shifting the long-run aggregate supply curve (LRAS) to the left.

Tariffs raise the prices of U.S. imports. This effect can be partially offset because tariffs increase the demand for U.S. dollars relative to trading partners’ currencies, increasing the dollar exchange rate. Because a tariff effectively acts as a tax on imports, like other taxes its incidence—the division of the burden of the tax between sellers and buyers—depends partly on the price elasticity of demand and the price elasticity of supply, which vary across the goods and services on which tariffs are imposed. (We discuss the effects of demand and supply elasticity on the incidence of a tax in Microeconomics, Chapter 17, Section 17.3.)

About two-thirds of U.S. imports are raw materials, intermediate goods, or capital goods, all of which are used as inputs by U.S. firms. For example, many cars assembled in the United States contain imported parts. The popular Ford F-Series pickup trucks are assembled in the United States, but more than two-thirds of the parts are imported from other countries. That fact indicates that the automobile industry is one of many U.S. industries that depend on global supply chains that can be disrupted by tariffs. Because tariffs on imported raw materials, parts and other intermediate goods, and capital goods increase the production costs of U.S. firms, tariffs reduce the quantity of goods these firms will produce at any given price. In terms of the aggregate demand and aggregate supply model , a large unexpected increase in tariffs results in an aggregate supply shock to the economy, shifting the short-run aggregate supply curve (SRAS) to the left.

Our thanks to Fernando Quijano for preparing the two figures.