Q18-Macro+(Is+there+a+long-term+trade-off+between+inflation+and+unemployment?)

Question: 18. Is there a long-term trade-off between inflation and unemployment?

The inflation-unemployment trade-off refers to two of a government’s macroeconomic goals specifically to have a low level of unemployment and to have a low and stable rate of inflation. It is also important to remember when discussing this trade-off that unemployment is a situation that exists when people of working age, who are willing and able to work, cannot get a job and that inflation is a sustained increase in the general (average) price level in the economy, usually measured through the calculation of the consumer price index (CPI). Today’s short-run Phillips curve is drawn to represent the inverse relationship between the unemployment rate and the inflation rate in the economy.



The diagram shows that as the rate of inflation falls, the rate of unemployment increases and vice versa thereby indicating the trade-off between unemployment and inflation and how this theory is very important in government decision-making.

However Monetarists (and classical economists) believe there was no long-run trade-off between inflation and unemployment, and that the economy settled at long run equilibrium at the full employment level of output.



The diagram above shows in the long run that there is a natural rate of unemployment, which is defined as the rate of unemployment that is consistent with a stable rate of inflation. It is the rate where the long-run Phillips curve touches the x-axis.

If an economy is at point A on SRPC1 and the labor market is in equilibrium, with natural unemployment of 5% and the inflation rate is 2%. By utilizing expansionary demand-side policies, government could reduce unemployment. An increase in Aggregate Demand leads to an increase in demand for labor, and an increase in wage levels whilst the inflation rate increases to 5%. In the short-run, unemployment falls, as workers are attracted by the higher nominal wages. The economy then shifts to point B. When workers realize their real wages have not risen (money illusion), they will leave their jobs and unemployment thereby returning to the natural rate. Any attempt by government to reduce unemployment through the use of demand-management policies, will only result in higher inflation and a movement to another SRPC. As long as expansionary demand-side policies are not used, inflation will not accelerate at the natural rate of unemployment. Supply-side policies are what are necessary to reduce the long-run unemployment rate. Supply-side policies can reduce the NRU and shift the LRPC to the left. The leftward shift of the LRPC can be related to a rightward shift of the LRAS.

In general it can be said that in the short run there is a trade-off between inflation and unemployment, however that in the long run there is not trade-off and that the rate of unemployment will return a natural rate of unemployment.