Inflation and Unemployment, Essay Example

The president of Bartavia is facing an economic dilemma: Bartavia is very close to the full-employment level; the president, however, is still worried about unemployment. Among the many policy options open to the president is: enacting expansionary fiscal policy. While expanding fiscal policy may help to marginally increase the country’s employment situation, it will also likely lead to another phenomenon: inflation, at least over the short-term.

There are many ways to conceive of inflation. To Milton Friedman and the monetarists, inflation was every time and every where a monetary phenomenon. That is, too much money ultimately chasing too few goods. Keynes, although concerned with the mechanism of how to get the economy to full employment (particularly during a recession), was not concerned with what happened after the economy expanded beyond the point of full employment. He did, however, posit the theory of “demand-pull inflation” , which is most apposite for this government’s policy. “Demand pull” inflation conceives of the concept not as one necessarily caused by monetary policy, but as the “gap” between employment and output. Bartavia is facing a similar situation: the economy is already at full employment, or the point at which there is no further room for employment without causing inflation to rise.

Why is this the case? Because once an economy is at the output level related to full employment, and further demand is added via fiscal policy, the economy will adjust to the new equilibrium through a round of wage increases and price increases. That is, workers will have extra bargaining power due to the low unemployment rate. As the demand for increased wages increases through the economy, this will lead to price rises in goods and services. Thus, it can be argued there is an inverse relationship between inflation and unemployment over the short-term, particularly if there is not technological innovation that increases innovation essentially containing potential price increases.

This relationship was formalized in the Phillips Curve. The Phillips Curve was developed in the 1950s based on data sets from the early 20^th century to mid-century: the statistical analysis found a clear pattern in the data: over the short-run, a decrease in the unemployment rate often times lead to higher inflation levels. This is due to the wratcheting up of wage effect that was identified in the previous paragraph. Thus, if the president wants to pursue an active fiscal policy in the face of an already low unemployment rate, he/she should be willing to face a higher inflation rate that might need to be mitigated through tighter monetary policy.

The president should also know, however, that this relationship does not necessarily hold over the long-run. Indeed, the Phillips Curve was quite successful until the 1970s when economies faced plunging economic growth, higher inflation, and higher employment at the same time. The relationship between inflation and unemployment does not stay over the long-run due to how the economy functions in that equilibrium. Some times economic growth will decrease leading to an increase in inflation and unemployment due to cost side increases in natural resources; other times pushing the economy beyond the point of full employment will accomplish the same.

Overall, the president should carefully consider the potential effects of this policy and judiciously use fiscal and monetary policy in order to ensure that a further increase in aggregated demand does not lead to macroeconomic instability.