Problem of Cost Push Inflation and Unemployment

Readers Question: how to resolve unemployment associated with inflation?

Often, there is a trade off between unemployment and inflation. In an economic downturn unemployment rises, but inflation falls. This type of unemployment is known as cyclical unemployment.

The unemployment associated with inflation would be a result of cost push inflation factors. In the diagram below we see inflation and a fall in GDP. Therefore, this leads to rising unemployment and rising inflation. This is an experience known as stagflation.

Diagram Showing Inflation and Unemployment

To solve this type of unemployment it is necessary to use supply side policies. These are government policies which seek to increase productivity and reduce structural inflation and structural unemployment

See: Supply Side Policies

Suitable policies would include:

  1. Better education and training
  2. Lower taxes
  3. Increasing Flexibility of labour markets.

However, all these policies would take time to have effect. It can be difficult for the government to reduce both inflation and unemployment at the same time. Monetary policy can reduce inflation. But, higher interest rates would make the situation of unemployment worse.


By on December 1st, 2007

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