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Inflation & unemployment

Inflation & Phillips curve:

The inflation rate is the percentage change in the price level. The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.

Causes of Inflation:

initiated by an increase in aggregate demand. Cost-push, or supply-side, inflation is inflation caused by an increase in costs.

Demand-pull inflation is inflation

Demand pull :
Increase in AD can be due to a fiscal or monetary policy, thus increasing prices

Cost push:
Upward shift of the AS will be due to increase in costs due to increase in price of inputs.


Stagflation occurs when output is

falling at the same time that prices are rising. One possible cause of stagflation is an increase in costs.

Combination of both:

Costs of inflation:

Redistribution of income and wealthborrowers gain and creditors lose.fixed income earners lose. Balance of payments effect- exports become expensive. Hence exchange rate depreciates. Uncertainty about the value of money Resource cost of changing prices menu costs Economic growth and investment suffers

Philips Curve:

It is a statistical relationship between unemployment and money wage inflation. Rate of inflation= rate of wage growth less rate of productivity growth.

Phillips Curve:

1958 Professor A.W. Phillips Expressed a statistical relationship between the rate of growth of money wages and unemployment from 1861 1957 Rate of growth of money wages linked to inflationary pressure Led to a theory expressing a trade-off between inflation and unemployment

Wage growth % (Inflation)

The Philips Curve

The Phillips Curve shows an inverse relationship between inflation and unemployment. It suggested that if governments wanted to reduce unemployment it had to accept higher inflation as a trade-off.



Money illusion wage rates rising but individuals not factoring in inflation on real wage rates.




Unemployment (%)

The curve crosses the horizontal axis at a positive value of unemployment. Hence it is not possible to have zero inflation and zero unemployment The concave shape implies that lower the level of unemployment higher the rate of inflation. Govt. should be able to use demand management policies to take the economy to acceptable levels of inflation and unemployment. In order to achieve full employment, some inflation is unavoidable. However, this relationship broke down at the end of 1960s when Britain began to experience rising inflation and unemployment. This raised a question on the application of Phillips curve in the long run.

Long run Phillips curve:

dp/dt = f(1/u) + dpe/dt To keep unemployment below the natural rate, inflation must keep on increasing every year. In the long run Philips curve will be vertical at the rate of unemployment where real aggregate demand equals real aggregate supply. This rate is called the natural rate of unemployment. It is also called NAIRU or Lowest sustainable unemployment rate (LSUR).

The Philips Curve

Long Run PC




To counter the rise in unemployment, government once again injects resources into the economy the result is a shortThere is athe economy starts with an inflation rate of Assume in unemployment but higher term fallshort term fall in unemployment but at a cost of higher high unemployment at 7%. 1% but very inflation. Individuals now base their inflation. This higher inflation fuels further wage negotiations on expectations of higher inflation in Government takes measures to reduce expectation If higher wages are granted then that the next period. of an expansionary fiscal policy firms unemployment by higher inflation and so the costs rise continues. The long run Phillips pushes AD to the right shed labour and process they start to(see the AD/AS diagram on unemployment creeps back up to 7% again. slide 15) Curve is vertical at the natural rate of unemployment. This is how economists have explained the movements in the Phillips Curve and it is termed the Expectations Augmented Phillips Curve.

1.0% PC1 7% PC3 PC2 Unemployment

7% becomes the natural rate in this case. Whenever unemployment rate is pushed below natural rate , wages increase, pushing up costs. This leads to a lower level of output which pushes unemployment back to the natural rate.

Countering inflation:
Demand -pull
Reduce demand by higher taxation, lower govt. expenditure, lower govt borrowing, higher interest rates Take steps to reduce production costs by deregulating labour markets, encouraging greater productivity, apply control over wages and prices reduce quantity of imports or their prices via trade policies.

Cost push

Import factors

Controlling inflation (cont)

Excessive growth on money supply Reduce money supply by cutting down on public sector borrowing Funding Govt borrowing from non bank Reduce bank lending Maintain interest rates Pursue policies which indicate Govts determination to reduce inflation

Expectations of inflation

Types of Unemployment:

Frictional Unemployment: Unemployment caused when people move from job to job and claim benefit in the meantime The quality of the information available for job seekers is crucial to the extent of the seriousness of frictional unemployment

Types of Unemployment:

Structural Unemployment: Unemployment caused as a result of the decline of industries and the inability of former employees to move into jobs being created in new industries Seasonal Unemployment: Unemployment caused because of the seasonal nature of employment tourism, agriculture, sports etc.

CYCLICAL UNEMPLOYMENT: Caused by a general lack of demand in the economy this type of unemployment may be widespread across a range of industries and sectors Keynes saw unemployment as primarily a lack of demand in the economy which could be influenced by the government

Okuns Law:

This law states that 1 extra point of unemployment costs 2%of GDP

1. 2. 3.

Consequences of unemployment:
Loss of potential output Loss of human capital Increasing inequalities and distribution of income Social costs