Discuss the role of government policy in reducing unemployment and inflation

One of the main responsibilities of governments is to create a stable economic and political environment in the country. Majorly governments seek to achieve a stable rate of inflation and low level of unemployment. To accomplish this governments tend to use variety of policies and strategies according to their mission. They might choose to follow interventionist policies by controlling the market with fiscal or monetary policies or they might just let the Central Bank to allocate required changes. Central Banks are considered to be independent from the government especially in developed countries however, its likely to see governments imposing their monetary strategies under the name of Central Bank in order to avoid public pressure and criticism.

Inflation can be described as a ‘persistent’ increase in the average price level in the economy.

It can be measured through consumer price index (CPI). A small price change in the market doesn’t have any significant affect on the inflation rate, where only consistent price increases changes inflation level.

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(Blink, 2007) On the other hand, unemployment is another key factor in the economy that indicates the strength and potential of the economy that government is responsible of. By macroeconomic perspective it’s governments’ job to set a balance between unemployment and inflation level which will be analysed in this essay. Unemployment level represents the actual and potential ‘labour force’ in the economy independent from the whole population. Governments aim to keep unemployment and inflation in a level within certain limits. The trade-off-debate between two concepts will be analysed by Phillips Curve Theory throughout the essay.

(Economics.Help, 2013) Phillips Curve explains the inverse relation between unemployment and inflation.

The reason governments desire to have a low level of inflation level is to avoid the negative outcomes of it on the economy. Firstly and most importantly a rise in inflation will cause a loss of purchasing power. If the inflation level has raised this means that prices for the goods in average has increased as well. If the income of an individual is not linked to inflation rate this means that purchasing power of that person has fell down as the same amount of inflation. Furthermore high inflation will affect the savings negatively. If the annual interest rate is lower than inflation rate, money will loose value since real interest rate will be negative. This will discourage people to save money and cause them to buy more fixed assets such as estates. Also, it’s very common to see inflation causing negative consequences for international trade. Inflation will increase the attractiveness on imports from lower inflation countries, which will result a loss in export revenues and increase country’s dependency on foreign goods. (Blink, 2007) With all these uncertainties and lack of liquidity as a result of less saving, the country will loose its attractiveness for new investors. Thus, it’ll cause a recession on economic growth of the country.

In theory there are two types of inflation: Demand-Pull and Cost-Push inflation. (Blink, 2007) However, in practise it is very hard to identify which certain inflation the country is experiencing because inflation may have variety of reasons and outcomes. Thus, mixed of solutions are being used to reduce inflation. As can be understood, demand-pull inflation occurs as a result of increased aggregate demand when the economy reaches full employment level of income. This indicates that labour force compasses all the potential of the market and firms can’t produce anymore output and there’s no shortage in demand. Price increase from P1-P2 in Fig.1 below as a result of shift on AD1-AD2 shows an inflationary case where market can’t expand itself due to full employment. (Triple a Learning, 2013)

Fig.1

In this case, governments can use fiscal policies in order to pull the demand level lower, which includes reducing government spending and increase taxation or deflationary monetary policies that require higher interest rates and less money supply. Increasing taxes and lowering government spending will create problematic results from society and decrease government support. So, governments mostly let the Central Bank to take action in terms of monetary policies that is considered to be ‘independent’ from government. This might reduce inflation and avoid protests directly against governments. Commitment of society doesn’t allow government to impose fiscal policies, so monetary policies are considered to be a better solution to control aggregate demand. Anyway, fiscal policies won’t be effective in short-run since government can’t cut the spending in one day.

Another inflation type Cost-Push inflation might cause as a result of increase on the cost of factors of production. This might be based on wage-push inflation, change on the cost of raw materials, increased rents etc. This increase on costs shifts the supply curve from SRAS1-SRAS2 as demonstrated in Fig.2 below. Since the cost of doing business and production has increased suppliers lower their production level in order to balance their costs. However this change in supply level raises the average price to P2 from P1 that represents an inflationary situation.

Fig.2

To reduce cost-push inflation government should use market-based supply-side policies such as creating a more competitive market. This will increase the pressure on prices and lowers costs. Also reducing corporate taxes and applying subsidies will help firms to cover its costs. Deflationary demand-side policies might decrease the price as well however it will result a loss in national output, thus supply-side policies are more suitable for cost-push inflation. (Tutor2u, 2013)

Another key factor that governments are responsible of is unemployment level in the market. Social factors of unemployment diversify based on geographic disparities, age, ethnic background and gender. (Archibald, 1969) However, there are some economic and market oriented foundation of unemployment that government should consider. Overall unemployment rate is affected by how many jobs created in the economy. (Blink, 2007) According to this, unemployment (equilibrium) can be classified in three types. Frictional unemployment is a natural unemployment that appears when people are changing one job to another, waiting to get employed after university or army etc. This might occur as a result of unemployment benefits in certain country that doesn’t push people to seek jobs. To avoid that, government should lower the benefits in order to encourage people and increase the awareness of possible job options through media. That would be an interventionist strategy. Secondly, unemployment caused because of seasonal needs and trends is described as Seasonal unemployment.

For example, a demand for gardener on winter won’t be very high as summer. Same attempts as Frictional would be appropriate in this case to reduce Seasonal unemployment as well. Third and the most serious natural unemployment is classified as Structural unemployment. This happens when a demand for specifically skilled labour has fallen or disappears. It can occur as a result of technological factors, change on taste/preferences or cost of labour in foreign markets. Moreover, lack of geographic and occupational mobility can cause negative long-term consequences. (Blink, 2007) Government should encourage or maybe sponsor for the training and occupational improvement programs. Tax allowances and facilitations will make less-developed regions more attractive for unemployed people to work there in terms of geographic mobility. Also a long-run solution would certainly be to improve the level and diversification of education that’ll help people adopt into changing economic conditions.

Finally, to understand the relation between unemployment and inflation from government’s perspective Phillips Curve theory can be used. Phillips Curve is a macroeconomic theory created by economist Alban.W. Phillips in1958. Phillips Curve focuses on the ‘inverse relation’ between unemployment and inflation. (Blink, 2007) The theory illustrates that according to government policies unemployment rate will increase when inflation level rises or the opposite. Since wages cover the biggest proportion of firm’s cost of production, an increase on wages will result average price level to rise, which is an inflationary situation. Proportionally, this will result oppositely to unemployment rate, so it will decrease. So if government wants to reduce unemployment they can use demand management strategies in order to increase demand so firms will be encouraged to produce more by hiring people in an expense of high prices. Because increased demand will cause inflation due to increased average price. However, in practise authorities argue that Phillips theory can be applied differently since countries nowadays can experience high inflation and unemployment at the same time.

Lets assume that unemployment in a country is setting at 6% with a 2 % inflation rate (A, Fig.3) In order to reduce unemployment government might tend to apply demand policies such as increasing spending. This would push producers to increase their output. Due to higher labour demand, producers will likely to offer higher wages, which will increase prices. However this time, inflation level reaches 6% (B). Assuming that they will earn ‘higher’ wages people will take new jobs, however because of higher inflation rate their ‘real wages’ won’t change, it will only make a difference in nominal wages. This can be explained as money illusion. Due to this, some employees can quit jobs in short-run (SRPC1-SRPC2) because of unsatisfactory wage conditions. So unemployment level will return back to its initial level, however this time with higher inflation rate (C).