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Trade off between unemployment and inflation

  • May 24, 2022
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Trade off between unemployment and inflation

Subject : Economy

Section :Inflation

Context

Typically, when an economy goes through a phase of high inflation, chances are that the unemployment rate will fall. That’s because firms, enticed by higher prices, try to ramp up production by recruiting more people.

Which is worse?

  • According to a study, one percentage point increase in the unemployment rate lowers well-being by more than five times as much as a one percentage point increase in the inflation rate.
  • However in terms of political instability- it depends on the country’s past. In India, it would appear that governments  fear high inflation more than high unemployment given the instant steps taken.

Right fiscal policy?- given the monetary tightening

Monetary policy does not have a direct solution to controlling such “cost-push” inflation. It cannot make fuel prices lower by raising interest rates. All it can do is to control demand in the economy which will have a contractionary effect leading to stagflation. 

How?

Tighter monetary policy will reduce the demand that is driven by borrowed money.

  • Say, as interest rates go up, private sector firms will reduce investment.
  • Similarly, interest rate rise induce a reduction in consumption driven by borrowing — for example, demand for housing will likely take a hit. 

Thus, fiscal alternatives:

  • Cut taxes on fuel and other imported raw materials.
  • Increase capital expenditure-Government should step up public investment especially in smaller projects with instant returns and wider participation of MSMEs in order to make up for the likely fall in private investments.

Concept:

Phillips curve- explaining the inflation unemployment trade off:

The Phillips curve is an economic concept developed by A. W. Phillips states that inflation and unemployment have a stable and inverse relationship.

The Phillips curve states that inflation and unemployment have an inverse relationship. Higher inflation is associated with lower unemployment and vice versa. As a result, high levels of employment can only be obtained when inflation is high.

Relationship between Phillips Curve and Stagflation

Stagflation happens when an economy’s growth is sluggish, unemployment is high, and price inflation is high. Stagflation scenario completely contradicts the Phillips curve idea.

It economists to examine the role of expectations in the relationship between unemployment and inflation more closely and led to following conclusions:

  • The inverse relationship between inflation and unemployment could only hold in the short run since workers and consumers can adjust their expectations about future inflation rates based on present inflation and unemployment rates.
  • Changes in expectation leads shift in the Phillips curve at natural rate of unemployment
  • This is called the natural rate of unemployment, or NAIRU (Non Accelerating Inflation Rate of Unemployment), which effectively represents the economy’s typical rate of frictional and institutional unemployment.
  • So, if expectations can adjust to changes in inflation rates in the long run, the long run Phillips curve at the NAIRU takes a vertical line shape; monetary policy merely boosts or lowers the inflation rate with no effect on unemployment.
economy Trade off between unemployment and inflation

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