Final answer:
When costs increase, the Fed typically responds by implementing an expansionary monetary policy and lowering the interest rate to achieve full employment. Repeatedly using such a strategy can lead to wage-price spiral inflation. Moreover, increasing the money supply at an increasing rate may temporarily boost GDP and reduce unemployment, but can lead to higher inflation over time.
Step-by-step explanation:
When costs increase and the Federal Reserve (Fed) wants to return the economy to full employment, the Fed responds by implementing an expansionary monetary policy and decreasing the interest rate. If the Fed continually responds to successive increases in costs, a wage-price spiral inflation evolves.
This situation can happen when businesses keep raising prices to cover their increased costs of production, and workers demand higher wages to keep up with rising living costs, creating a cycle of continuous price and wage increases.
According to the historical episodes, the Fed has a track record of reacting to higher inflation with a contractionary monetary policy and a higher interest rate to control inflation, while it resorts to an expansionary policy and a lower interest rate to combat higher unemployment. However, if the Fed aggressively uses expansionary policy to manage increasing costs, it risks fueling inflation. Hence, understanding when to apply these policies is crucial for maintaining economic stability.
If the Fed begins to increase the supply of money at an increasing rate, this would likely stimulate economic growth and reduce unemployment in the short term. However, over the long term, it may lead to higher inflation if the increase in money supply outpaces economic output.