Inflation and Unemployment

Bartavia has two means by which it can conduct an expansionary fiscal policy to promote even lower levels of unemployment thru economic growth. To do this the government can either cut taxes or increase spending increasing the money supply for consumers. However, one of the Ten Principles of Economics is that society faces a short-run trade-off between inflation and unemployment. Therefore, to reduce unemployment in the short-run, Batavia will have to increase inflation. Aside from inflation, there are also other risks related to executing an expansionary fiscal policy that only targets unemployment. First, the fiscal policy may not be able to affect unemployment in the long-run, only in the short-run. Second, if the economy is subjected to a price-shock of a major commodity while raising inflation it could result in stagflation and a recession. And finally there can be significant lag in the time it takes for a policy to be implemented and effect the economy.

In the short-run, the relationship between unemployment and inflation is inverse. This means that the change in one will have the opposite effect on the other. So here, a fiscal policy aimed at reducing unemployment will increase the interest rate. For example, if Bartavia decides to lower taxes to increase consumption thru use of consumer’s marginal propensity to consume, and the economy in general thru the multiplier effect, it will increase the aggregate demand for goods and services. Marginal propensity to consume is the idea that that consumers will spend more money if they have more, but increases in income do not lead to equal increases in consumption because people save some of the money. With this increase in aggregate demand, firms will need to produce more in ord...

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... in an increased price level if firm’s cannot expand output to meet that demand. If there is no expansion by firms, no additional employees may be hired to reduce the rate of unemployment. Therefore, a significant risk occurs when trying to decrease unemployment in an economy operating at its production possibilities frontier.

As an economic advisor to the leadership of Bartvavia, I would not recommend attempting to adopt an expansionist fiscal policy aimed at reducing the already low unemployment. The reasons are: any reduction will only be short-run and not long-run, the interest rate will likely remain higher when unemployment returns to its natural rate and there are risks that the policy will only raise inflation which if uncontrolled can lead to stagflation and a recession. All these are because of the inverse relationship between unemployment and inflation.