TOPIC 9

TRADE OFF BETWEEN INFLATION AND UNEMPLOYMENT

Inflation rate depends on growth in

money supply. Unemployment
depends on labor market, minimum
wage laws, and effectiveness of job
search. In a long run these problems
are unrelated. Policy makers can
expand aggregate demand, and then
unemployment will decrease and
price level will increase. On the
other hand, a tradeoff is loosely defined as any situation where making one choice means losing
something else, usually forgoing a benefit or opportunity. It is a situational decision that
involves diminishing or losing one quality, quantity, or property of a set or design in return for
gains in other aspects. In simple terms, a tradeoff is where one thing increases, and another must
decrease.

For example, you work a decent job, making Php60,000 per year. You have no debt, but you lack
savings and you’re not content in your current position. After researching potential options, you
decide that you want to become a lawyer. First, though you have to attend law school for four
years, which will cost you around Php150,000. And because of law school’s required time
investment, you can’t work for those four years. But there’s a light at the end of the tunnel; you
already have a promised Php120,000-per-year job as a lawyer once you finish. Let’s look at the
trade-off: You can go to law school, accrue debt, and have eventual savings; or you can continue
working without any savings, but incur no debt.

Now let’s gather the numbers we need. Your law school expense is Php50,000 yearly, and your
expenses are Php60,000 no matter whether you’re in law school or continue with your job. Thus,
you increase your debt by Php110,000 for each year in law school. So, what is the trade-off here?

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After you graduate with Php440,000 in debt, you’ll make Php120,000 per year, Php60,000 of
which will go toward paying off your debt. Thus, it will take seven and a quarter of years to
become debt-free. After those seven and a quarter years, you can save Php60,000 per year. Not
too shabby, right? The opportunity cost of going to law school, is working a stable job that doesn’t
put you in debt for over seven and a quarter years. The opportunity cost of continuing to work is
sacrificing savings that would begin after seven and a quarter years of hard work.

Why is there a trade-off between Unemployment and Inflation?

Looking at the extent to which policymakers face a trade-off between unemployment and
inflation. The Phillips curve suggests there is a trade-off between inflation and unemployment,
at least in the short term. Other economists argue the trade-off between inflation and
unemployment is weak.

• If the economy experiences a rise in AD, it will cause increased output.

• As the economy comes closer to full employment, we also experience a rise in inflation.
• However, with the increase in real GDP, firms take on more workers leading to a decline
in unemployment (a fall in demand deficient unemployment)
• Thus, with faster economic growth in the short-term, we experience higher inflation and
lower unemployment.

Increase in AD causing inflation

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This Keynesian view of the AS curve suggests there can be a trade-off between inflation and
demand deficient unemployment. If we get a rise in AD from AD1 to AD2 – we see a rise in real
GDP. This rise in real output creates jobs and a fall in unemployment. However, the rise in AD
also causes a rise in the price level from P1 to P2. (inflation)

THE PHILLIPS CURVE

The Phillips curve was created by William Phillips relates the rate of inflation with the rate of
unemployment. The Phillips curve argues that unemployment and inflation are inversely
related - as levels of unemployment decrease, inflation increases. The relationship, however, is
not linear. Graphically, the short-run Phillips curve traces an L-shape when the unemployment
rate is on the x-axis and the inflation rate is on the y-axis.

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Phillips Curve Showing Trade-off between unemployment and inflation

In this Phillips curve, the increase in AD has caused the economy to shift from point A to point B.
Unemployment has fallen, but a trade-off of higher inflation.

If an economy experienced inflation, then the Central Bank could raise interest rates. Higher
interest rates will reduce consumer spending and investment leading to lower aggregate
demand. This fall in aggregate demand will lead to lower inflation. However, if there is a decline
in Real GDP, firms will employ fewer workers leading to a rise in unemployment.

The Phillips Curve Related to Aggregate Demand

The Phillips curve shows the inverse trade-off between rates of inflation and rates of
unemployment. If unemployment is high, inflation will be low; if unemployment is low, inflation
will be high.

The Phillips curve and aggregate demand share similar components. The Phillips curve is the
relationship between inflation, which affects the price level aspect of aggregate demand, and
unemployment, which is dependent on the real output portion of aggregate demand.
Consequently, it is not far-fetched to say that the Phillips curve and aggregate demand are
actually closely related.

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To see the connection more clearly, consider the example illustrated below. Let’s assume that
aggregate supply, AS, is stationary, and that aggregate demand starts with the curve, AD1. There
is an initial equilibrium price level and real GDP output at point A. Now, imagine there are
increases in aggregate demand, causing the curve to shift right to curves AD2 through AD4. As
aggregate demand increases, unemployment decreases as more workers are hired, real GDP
output increases, and the price level increases; this situation describes a demand-pull inflation
scenario.

As more workers are hired, unemployment decreases. Moreover, the price level increases,
leading to increases in inflation. These two factors are captured as equivalent movements along
the Phillips curve from points A to D. At the initial equilibrium point, A in the aggregate demand
and supply graph, there is a corresponding inflation rate and unemployment rate represented by
point A in the Phillips curve graph. For every new equilibrium point (points B, C, and D) in the
aggregate graph, there is a corresponding point in the Phillips curve. This illustrates an important
point: changes in aggregate demand cause movements along the Phillips curve.

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MONETARIST VIEW

The Phillips curve is criticized by the Monetarist view. Monetarists argue that increasing
aggregate demand will only cause a temporary fall in unemployment. In the long run, higher AD
only causes inflation and no increase in real GDP in the long term.

Monetarists argue LRAS is inelastic and therefore Phillips Curve looks like this:

Monetarist Phillips Curve Diagram

Rational expectation monetarists believe there is no trade-off even in the short-term. They
believe if the government or Central Bank increased the money supply, people would
automatically expect inflation, so there would be no improvement in real GDP.

FALLING INFLATION AND FALLING UNEMPLOYMENT

In some periods, we have seen both falling unemployment and falling inflation. For example, in
the 1990s, unemployment fell, but inflation stayed low. This suggests that it is possible to reduce
unemployment without causing inflation.

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RISING INFLATION AND RISING UNEMPLOYMENT

It is also possible to have a rise in both inflation and unemployment. If there is a rise in cost-push
inflation, the aggregate supply curve would shift to the left; there would be a fall in economic
activity and higher prices. Cost-push inflation occurs when we experience rising prices due to
higher costs of production and higher costs of raw materials. Cost-push inflation is determined
by supply-side factors, such as higher wages and higher oil prices. For example, during an oil
price shock, it is possible to have a rise in inflation (cost-push) and rise in unemployment due to
lower growth. However, there is still a trade-off. If the Central Bank sought to reduce the cost-
push inflation through higher interest rates, they could. However, it would lead to an even bigger
rise in unemployment.

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Diagram Showing Cost-Push Inflation

Short-run aggregate supply curve shifts to the left, causing a higher price level and lower real
GDP.

Causes of Cost-Push Inflation

1. Higher Price of Commodities. A rise in the price of oil would lead to higher petrol prices
and higher transport costs. All firms would see some rise in costs. As the most important
commodity, higher oil prices often lead to cost-push inflation (e.g. 1970s, 2008, 2010-11)
2. Imported Inflation. A devaluation will increase the domestic price of imports. Therefore,
after a devaluation, we often get an increase in inflation due to rising cost of imports.
3. Higher Wages. Wages are one of the main costs facing firms. Rising wages will push up
prices as firms have to pay higher costs (higher wages may also cause rising demand)
4. Higher Taxes. Higher VAT and Excise duties will increase the prices of goods. This price
increase will be a temporary increase.

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5. Profit-push inflation. If firms gain increased monopoly power, they are in a position to
push up prices to make more profit
6. Higher Food Prices. In western economies, food is a smaller % of overall spending, but in
developing countries, it plays a bigger role.

[end]

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