Central Banks often use several measures to set its interest rates. The method of targeting the “inflation rate” to set the interest rate is the most popular amongst various central banks. Now, Bank of England is targeting the unemployment rate to fix its interest rate. In my opinion, this is a very practical and efficient way of measuring the amount of stimulation the bank should provide to the economy. Some would argue that punishing the people who saves money is not the right way of healing a battered economy. On the surface, setting a low interest rate would appear to punish the saver. However, that may be necessary for the economy to survive, which will then provide a better outcome for the saver.
When the economy is as large as the modern days economy, all the parts of the said economy must work in high efficiency to yield an overall strong output. If that does not happen then the economy stalls. When people are keen towards saving and living on the interest gained from them, it indicates that a portion of the economical units will expect higher result with very low input. This could work in a small economy where there are not many moving parts supporting it. However, for a large economy where different parts are interconnected with each other, this could mean grave danger as each subsystem expects a certain amount of support from all of the components that it is attached with.
In many ways a countries economy is no different than a human body. If all the muscles are not flexed then the failure of one component (such as the leg) could bring down the physical body. The same is applicable to a complex economy. If all of its components are not supporting each other with equal efficiency then one of the components will fail and the failure of that component would trigger an overall collapse of the entire system.
This is where targeting the unemployment rate could prove to be an effective way to measure how much stimulus is needed. The unemployment rate indicates the overall inefficiency of the system. If it is used to set the interest of the central bank then what we are doing is that we are making sure that we are targeting the overall throughput of the economy.
Consider a hypothetical scenario. If the entire workforce is employed, then the economy will be strong because the underlying assumption is that the only way all the people could be employed is by filling up all the components of the economy. So that means the components must be able to employ as many people as it can. Now, the only way each component could afford to employ the workforce is by a high level of interaction with all the other related components. Thus each component would perform at peek strength and the workforce in each component would ensure that it remains high by increased interaction. So this hypothetical scenario would still work if the size of the workforce that is unemployed is low, since that would mean it is approaching the limit of how much a component can hold and if a component is in such shape then the interaction between different components must be at a high enough state. Furthermore, this would then also trigger growth. So a lower unemployment rate would lead to a stronger economy.
Now the question is how much lower the unemployment rate should be when we can consider that it is low enough for the economy to perform at a stable pace. The answer can be found by considering the major components/sectors of the economy and finding a ratio between them and the workforce that each of them can support. Each component should reach its maximum capacity and if all the components/sectors have reached maximum capacity and yet there are a high number of unemployed workforce then new competition would force to increase the size of the sector or expand to new sectors. This is ensured since the interest rate is kept low.
So in summary, the unemployment rate exhibits how inefficiently the economy is running and so targeting it to be reduced could only mean higher throughput and a better economy.