EC566

Macroeconomics
Essay
Discuss the role of government policy in reducing
unemployment and inflation. In your discussion make use of the
diagrammatic representation of the macro economy developed
in lectures in Term 2.

To approach the topic it will first be considered the meaning of both

inflation and unemployment by looking at the causes and tools that are
used in order to reduce them. Furthermore a comparison between
unemployment and inflation will be provided. To summarize, a critical
opinion will state which of the two has a greater impact upon the
economy, and whether inflation and unemployment can both be reduced
at the same time.

Inflation represents the rate of increase in price for goods or

services over a period of time, usually a year, which has majority of
weight. It is measured in by the Consumer Price Index (CPI) which is based
on the cost of a basket of necessities consumers are likely to buy per
month. Inflation can be influenced by a growth in consumer-demand
(demand-pull inflation), and increase in the costs of producing goods and
services (cost-push inflation).
There are many different influences that cause inflation, but as
stated before the two main ones are the demand-pull and cost-push

inflation. Demand-pull inflation appears when Aggregate Demand(AD)

exceeds Aggregate Supply(AS), and it has an inverse relationship to
unemployment.
Fig1

Such inflation might arise

from any individual factor that is
included in the AD equation, but
the main ones are the excess of
money supply and the government
spending.
As seen in Fig1 AD shifted
to AD1, increasing prices for goods
or services (P0 to P1) and quantity
(q0 to
q1),
while
decreasing
unemployment from L0 to L1, Ln
representing the total number of
people in work or actively seeking
work.
The
decrease
in
unemployment is represented by
the fact that firms are producing
more, therefore they hire more
employees, and at the same time,
if GDP increases, fewer companies
will go bankrupt meaning fewer job
losses.

Fig2

An increase in wage rates or price of raw materials, higher costs

of production and other increasing costs can result in cost-push
inflation. Opposite to demand-pull inflation, cost-push inflation appears
when there is a decrease in the Aggregate Supply. Due to the increased
costs, firms lower their output and decrease the labour employed,
therefore the unemployment gap in this case gets deeper. Cost-push
inflation can be both internal such as increase in domestic service prices,
or external, a rise in price of oil. As seen in Fig2, AS shifted to AS 2 forcing
the prices to increase from P to P 2, while the total value of goods and
services produced decreased from q to q2. At the same time,
unemployment increased from L to L2 due to the fact that firms might cut
costs in order to remain competitive.

Inflation control has become a major

objective for the government economic policy
in many countries and effective policies need
to be implemented in order to stop or stabilize
it. If the main cause of inflation is an excess in
AD as in Fig1, the government should look to
reduce the level of aggregate demand. If costpush inflation is the cause as in Fig2,
production costs need to be controlled for the
problem to be reduced.
Monetary and fiscal policies need to be
put in place in order to get the economy
balanced, and have the inflation under
control.
Since May 1997, the Bank of England
for
instance,
has
had
operational
independence in setting interest rates within
the UK, the aim being to keep inflation under
control for the next two years. This monetary policy can control the AD
through an increase in the interest rates and a reduction in the money
supply. As an example, in the late 1980s, interest rates went up to 15%
because of the excessive growth this contributing to the recession of the
1990s. The result of higher interest rates is represented by a decrease in
investment, disposable income, and borrowings by both households and
companies. Higher interest rates can also be used to reduce monetary
inflation, because a reduced demand for lending would result in a reduced
growth of broad money. At the same time, an increase in the interest rates
can result in the appreciation of the exchange rate which would make
British exports more expensive. Furthermore, a stronger currency would
reduce the import prices giving firms the ability to keep prices down by
acquiring cheaper raw materials (Tutor, 2013).
As a fiscal policy in order to reduce inflation, the government should
increase the taxes, and reduce the government spending in order to lower
the disposable income for households, which in return will result in a lower
consumption. Moreover, increased taxes will mean fewer profits for the
firms, meaning less investment, fact which will lower the AD within the
economy.
Unemployment rate can be defined as the number of people that
are actively seeking or having a job, divided by the total amount of people
that are having the legal working age. If there are 10 people of working

age, out of which 8 are in work or actively seeking work, but just 7 of
them are currently in work, the total rate of unemployment would be
12.5% because 8-7=1, therefore 1 unemployed person is divided by the
total number of people looking for a job or in work.
There are several facts that influence unemployment, but the main
causes that can best describe it are the supply side policies: structural,
frictional, seasonal, and cyclical type. The structural type of
unemployment occurs when there is a decline in demand in an industry
leading to a reduction in the number of people employed. Frictional
unemployment can be translated as an transitional type and it refers to
people that are moving between job because of various reasons, while the
seasonal type refers to a predictable seasonal change in labour patterns in
which some industries might be more or less affected than the others,
depending the activity they are performing. At last, the cyclical type
occurs when there is a lack in demand for goods and services, leading to a
recession or a slowdown in economic growth. The best example for the
cyclical type of unemployment is the recent financial crisis that increased
the unemployment level to alarming figures, Greece being one of the most
affected countries within the EU with a rate of 26.4% in 2013
(Tradingeconomics, 2013). Overall these supply side policies do not aim
to boost AD, but seek to overcome flaws in the labour market in order to
reduce the unemployment caused by the supply-side factors.
Monetary and fiscal policies need to be implemented by the
government in order for unemployment to decrease, stop, or stabilize at
an acceptable level for the economy.
On one hand, according to Keynisianism, government intervention in
implementing fiscal policies can reduce unemployment. As mentioned
earlier cyclical unemployment occurs in times of great economic
depression, but it can be influenced in a positive way by increasing the
AD. This can be achieved by cutting taxes and increasing government
spending, resulting in an increased AD. Lower taxes could mean an
increase in consumption due to the fact that prices are lower, thus people
can afford more. Firms will produce more; therefore, an increased demand
will be on the labour market as well. Increased government spending can
result in creating more jobs ultimately this fact influencing the GDP to
grow.
On the other hand, monetary policy would involve cutting interest
rates to decrease the cost of borrowings in order to encourage people to
spend and invest more. This would increase the AD and the real GDP, and
reduce the demand-deficient unemployment. At the same time, lower

interest rates would result in a depreciation of the exchange rate which

will make the exports more competitive.
When comparing the government policies both for unemployment
and inflation, it can be seen that are totally opposite, because when
unemployment is low, inflation
is high and vice versa. On one
side,
government
spending
needs to be cut in order to
Fig3
reduce inflation. On the other
side, according to Keynisianism,
government spending should
increase during recessions or
periods of financial uncertainty
in order to create additional
demand
to
reduce
unemployment.
This
relationship between inflation
and
unemployment
is
represented by the Phillips
curve (Fig3) where, inflation is inversely related to unemployment.
According to Friedman in response to the Phillips curve, if the government
uses expansionary fiscal and monetary policies to lower the
unemployment rate, the result in increasing demand for labour and
increasing consumption and spending, would encourage firms to raise
their prices faster than people anticipated. With higher profits, firms would
be willing to offer higher wages, and employ more people. Thus, the
unemployment rate falls. For a short period of time, workers will suffer for
what is known as money illusion, because they will think that with
higher wages they can afford more, where the reality is that when wages
increased, inflation increased as well. Over time the firms come to
anticipate the higher rates of price inflation, therefore they will supply less
labour in order to keep up with current inflation. The real wage is restored
to its past level, and the unemployment rate goes back to its previous
rate, while price inflation and wage inflation brought on by expansionary
policies continue at the new higher rates (Econlib, 2013).
Some argue that where is a chance of deflation, government should
seek to look for a higher rate of inflation (e.g.3-4%), in order to keep the
economic growth sustainable and avoid a recession. But, even if inflation
definitely has economic costs, however, others argue that costs of
unemployment are far greater, because lower income will result in less
consumption, lower tax revenue, increased government borrowings, and
higher government spending on benefits.

In the end, governments are limited in the number of objectives

they can achieve on short-term. As a result, they cannot put pressure on
all the aspects such as inflation, unemployment, economic growth and
currency stability, all at the same time. This cannot happen, because the
policies all together will end up being incoherent. Therefore when
considering the fiscal approach they need to first look at the magnitude
and risk it poses in the first place.

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