Final answer:
The Federal Reserve would be concerned about inflation increasing above 2% if the economy is operating at an employment level above full employment. This is due to the risk of accelerating inflation that can arise from excess demand in the labor market, which has historically led the Fed to adopt contractionary monetary policies to maintain price stability.
Step-by-step explanation:
If the Federal Reserve estimates that the economy is operating at an employment level above full employment, it would be concerned about inflation increasing above 2%. This is because operating above full employment can lead to upward pressures on prices, potentially causing inflation to accelerate beyond the Fed’s target rate.
Historical episodes show that when the inflation rate exceeds acceptable limits or seems likely to exceed them, the Fed adopts contractionary monetary policies such as raising the federal funds rate.
For example, throughout the 1980s to early 2000s, whenever inflation appeared to be rising above a certain threshold, notably above 3% in the late 1990s and early 2000s, the Fed responded by increasing interest rates as a way to dampen economic activity and curb inflation.
The information provided indicates that the Fed has a history of taking measures to prevent inflation from soaring too high, aligning with the notion that an inflation target of about 2% has been favored.
Thus, if inflation is expected to remain below 2%, the Fed may implement stimulative measures to close a recessionary gap and support economic growth.
However, when employment is above full employment and inflation is anticipated to rise above 2%, the Fed's response will likely involve tightening monetary policy to decrease spending and slow down the economy, aiming to stabilize prices.