why does low unemployment cause inflation?
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Basically, the Federal Reserve has control of the money supply through two options:
* They increase the amount of money a bank has to have in proportion to the amount people deposit into it. If the bank has to keep $0.30 of every dollar deposited in reserve they have less money to lend than if they only have to keep $0.20 for every dollar deposited.
* They increase the cost of giving money to banks to lend money. Lower interest means they need to lend more to make the money back. Higher interest means they can’t afford to make riskier loans.
Low unemployment doesn’t cause inflation. People don’t buy more food or basic goods than they need just because they have more work; you can only consume so many eggs in a day or store so many in your fridge. It is not the fact that more people have income that drives up the price of eggs on its own.
What the Fed does is put the breaks on an expanding economy by restricting access to the money banks have, which means banks have less to lend and they charge higher interest rates. When interest rates are lower companies feel more confident in taking on projects because they cost less to fund. The opposite is true as well; high interest rates mean companies have to have high confidence in a highly profitable project before they will borrow.
The Fed does the opposite when there is high unemployment: they allow banks to have lower reserves and to lend at lower interest rates through easier access to cash. This makes companies more likely to take on projects that will make them hire people and get the economy back to the point where the Fed will restrict the money supply to slow the economy.
You can think of it like someone jerkily smashing the gas and the brakes on a car to try to achieve the posted speed limit on a highway. Given the limited tools they have they can’t just go on cruise control, they can only hit the breaks or the gas as hard as they can.
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