Unemployment Levels and Inflation

Readers Question “To what extent can government use demand management policies to reduce unemployment without affecting inflation?” (60)

1. Monetary and fiscal policy can be used to increase AD and therefore increase economic growth. For example, if the MPC cut interest rates, this makes borrowing cheaper and therefore encourages investment and consumption. This will cause a rise in AD. If there is spare capacity in the economy then there will be an increase in Real Output; as firms produce more they will demand more workers and this will reduce demand deficient unemployment.

This could cause inflation depending on the elasticity of the AS curve. If there is a lot of spare capacity rising AD will not cause inflation. However, if the rise in AD causes a multiplier effect and the economy gets close to full capacity then there will be inflation.

However, demand side policies may completely fail to reduce unemployment. Monetarists argue that rising demand only causes a temporary fall in unemployment. This is because unemployment may be due entirely to supply side factors. For example, frictional, structural and powerful unions. To reduce supply side unemployment requires supply side policies. e.g. if government increased flexibility of labour markets it may help reduce structural unemployment. These policies would be successful in reducing the natural rate of unemployment without causing inflation.

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By on May 6th, 2008