A level and O level ECONOMICS
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Government Policy Measures, Unemployment, and Inflation
In February 2016, share prices on stock exchanges fell throughout the world. There were a number of reasons for this; including concerns about the slowdown in world growth, the possibility of deflation and unemployment, and fears that some commercial banks could go out of business
Discuss whether or not government policy measures to reduce unemployment will cause inflation.
Macroeconomic Factors and Policies
[CIE O level November 2018]
Step 1 : Define ‘ unemployment’ and ‘inflation in the introduction.
Economists believe that there is a trade-off between unemployment and inflation. Consequently, government policy measures to reduce unemployment may actually cause inflation. The unemployment rate measures the proportion of the labour that is willing and able to work, but without work. Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.
Step 2 : Discuss how policies to reduce unemployment might cause inflation.
The government may use expansionary fiscal policy and expansionary monetary policy to reduce unemployment. However, this policy can also cause inflation.
Expansionary fiscal policy involves cutting taxes and increasing government spending. Monetary policy would involve cutting interest rates. Lower rates decrease the cost of borrowing and encourage people to spend and invest. These policies will increase aggregate demand, help to increase national income and reduce demand deficient unemployment. This can be shown in the diagram below.
Expansionary fiscal policy and expansionary monetary policy will shift the demand curve from AD1 to AD2 resulting in a rise in national income from Y1 to Y2. This will reduce unemployment. However, there will also be an increase in the general price level from P1 to P2.
It can be seen in the figure above than expansionary fiscal policy and expansionary monetary policy not only reduce unemployment but also cause demand-pull inflation. This occurs when prices are pulled up by increases in aggregate demand that are not matched by equivalent increases in aggregate supply. The figure above shows that an increase in aggregate demand has caused a rise in the price level from P1 to P2. A rise in aggregate demand will have a greater impact on the price level, the closer the economy comes to full capacity. Higher demand may also cause cost-push inflation as demand for workers rises firms may compete for workers causing wage rates to rise
Step 3 : Discuss why policies to reduce unemployment does not always cause inflation.
There are however certain situations where policy measures to reduce unemployment do not necessarily cause inflation.
➤ 3.1 The government may use supply-side policy measures to reduce unemployment. This policy is less likely to cause inflation.
Supply-side economic policies are policies that can be used to improve the quality and quantity of the supply of labour available to the economy. They seek to make the labour market more flexible so that it is better able to match the labour force to the demands placed upon it by employers in expanding sectors thereby reducing the risk of structural unemployment. For instance, better education and training to improve skills will improve labour productivity. This will help to reduce unemployment in the long term.
An increase in the economy's productive capacity will tend to increase national output, thereby creating jobs in the economy in the long term. Also, supply-side policies can help to reduce both frictional and structural unemployment.
Supply-side policies increase the productive potential of the economy and help to prevent the general price level from rising beyond control.
It can be seen in the figure above that supply-side policies will shift the aggregate supply curve from AS to AS1 because of higher efficiency and productivity gains. As a result, real GDP will increase from Y to Y1 and this will help to reduce unemployment. This will also actually help to reduce inflationary pressure as the general price level falls from P to P1.
➤ 3.2 It can also be noted that an increase in demand may not push up prices if unemployment is initially high, firms will be able to attract more workers by just offering jobs, they will not have to raise wages.
Step 4 : Conclude.
To conclude, government policy measures to reduce unemployment will not always cause inflation. To solve the problem of unemployment, the government may apply expansionary fiscal policy, expansionary monetary policy and supply-side policy. Expansionary fiscal policy and expansionary monetary policy are likely to cause inflation whereas supply-side policies may solve the problem of unemployment without causing inflation. This is because expansionary fiscal policy and expansionary monetary policy will increase aggregate demand causing demand-pull inflation whereas supply-side policies help to reduce costs and therefore reduce inflationary pressure.