Explainer: How high should unemployment and inflation be?

The goal of monetary and fiscal policy is to keep output, employment and inflation as close to their target values as possible. But what targets should policymakers aim for?

For inflation, which is mainly a concern of the Federal Reserve, the answer is 2 percent. Ideally, the Fed believes, prices should be increasing 2 percent per year. If they aren't, then the central bankers should take corrective action to bring inflation back on target.

But a higher inflation rate also brings higher costs, including higher prices, or the costs that inflation "hawks" worry about. Initially, the benefits from increasing the target inflation rate exceed the costs, but at some point -- again, the Fed assumes it is at 2 percent -- any further increase in the target inflation rate would bring more costs than benefits. So 2 percent is the optimal inflation target.

Just as inflation can be above or below the target value, actual output can also be above or below potential output. It's clear that output can fall short of potential. The Great Recession is evidence of that, and of course it's something policymakers try to prevent. But how can output exceed its potential? Doesn't it represent the most an economy can produce?

Yes, but it also represents the long-run sustainable level of output. A student can get by for a period of time with little sleep during finals week, or workers can put in extra time before a big report, but that level of activity is not sustainable day after day after day.

The economy is no different. Factories can be run overtime by skipping scheduled downtime for maintenance, while trucks can be kept on the road instead of being brought in for servicing. There are all sorts of ways to increase economic activity in the short-run above the long-run sustainable level. When that happens, output will be above potential, but it's not sustainable and it can be inflationary, so it's also something policymakers try to avoid.

What is the output target that policymakers aim for? Unlike the inflation target, which we know is 2 percent, the output target is unknown. Policymakers do not tell us their estimates of potential output, and they may not even have one. Instead, they mostly rely on another measure of economic activity, the unemployment rate, to determine whether the economy is running above or below its long-run potential.

The goal is to push the unemployment rate down to a rate consistent with full employment without overheating the economy and causing inflation. This requires knowledge of the rate of unemployment consistent with full employment -- the target unemployment rate at which the economy reaches its potential -- and clearly this is not known with certainty.

But by listening to speeches and other communication, it is generally possible to determine whether individual policymakers believe we are below the target unemployment rate, or close to target and at risk of inflation.

The target rates of inflation, output and unemployment are critical components of the decisions made by monetary and fiscal policymakers. Knowledge of how these targets are set, why they might change and how aggressively a particular target is pursued can be very helpful in understanding and predicting economic policy.