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Relation between inflation and Unemployment
The interconnectedness of macroeconomic variables has long standing implication for economic policy formulation. Two such interconnected variables are inflation and unemployment. Both are important indicators in determining economic state of a nation. Inflation is a measure of general price level. It is computed as percentage change in price of a certain basket of goods needed to maintain certain standard of living over time. In times of inflation the cost of basket increases while during deflation the living cost falls (Blanchard, 2016) The rate of unemployment on the other hand is a measure for determining performance of the labor market. A low rate of unemployment means most members of the labor force are able to find suitable jobs. A high rate of unemployment on the other hand implies that a large portion of labor force is unable to find jobs. There exists a relation between inflation and unemployment at least in the short run.
Unemployment is likely to have an adverse impact on price level. This mean a low unemployment rate is generally associated with a high inflation rate and vice versa. The tradeoff between unemployment and inflation was first established by A.W.Phllips. Association between unemployment and inflation was first verified using data of United Kingdom for a long period expanding from 1861to 1957 (Daly & Hobijn, 2014). The data reveals that a tradeoff exists between the two macro variables. After validation from real world data Phillips established the general hypothesis for existence of an inverse relation between rate of unemployment and movement of price level. The projected inverse relation between the two variables came to be known as Phillips curve. When tested with Australian data on inflation and unemployment from 2001 to 2016, the following trend relationship is observed.
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Figure 1: Inflation and unemployment in Australia
(abs.gov.au, 2018)
From the above figure a general downward trend is observed between inflation and unemployment. This goes by the proposed relation of Phillips. The trend line however flattens as unemployment continues to rise. This is because in the presence of very high rate of unemployment interventionists policies are taken to maintain a balance between inflation and unemployment. The trade-off between inflation and unemployment can be understood from the effect of unemployment on labor demand and wages (Forder, 2014). Economy with a low rate of unemployment indicates presence of high labor demand in the factor market. The high labor demand increases wage and salaries of workers. This when add to production cost raises the cost of production which is reflected in form of a higher price. The labor market with excess supply of labor has a high rate of unemployment. Because of lack of jobs, the equilibrium wage in the labor market is set at a relatively lower level (Kumar & Orrenius, 2016). This by reducing burden of excess wage cost reduces inflationary pressure.
Following the inverse relation, any policy to reduce unemployment might result in a very high rate of inflation. RBA thus uses the instrument of cash rate to keep both inflation and unemployment at a balance state.
2.
Aggregate demand and aggregate supply model
a) Tariff is a form of intervention in the free movement of goods and services. Tariff has the direct consequence of reducing import demand by raising price of importable (Burfisher, 2017). The imposition of tariff on Australian chickpea raise domestic price of Chickpeas in India. Driven by high price of imported chickpeas demand of chickpea in India reduces. The equivalent reduction in Australian chickpea export reduces trade surplus or net export of Australia. With a fall in net export aggregate demand reduces as well. This shown by a downward shift of the aggregate demand curve causing both real GDP and price level to fall.
Figure 2: Imposition of import tariff
(Source: as created by Author)
b) The substantial increase in demand of Australian wine in China’s market increases export volume of wine export from China to Australia. As export increases there is a gain in trade balance of Australia. Increase in net export boosts aggregate demand of Australia. The rise in aggregate demand makes a gradual upward shift of the aggregate demand curve (Leduc & Liu, 2016). The rise in aggregate demand is associated with an increase in both price level and real GDP.
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Figure 3: Increase in Australia wine demand
(Source: as created by Author)
c) The planned government spending has a positive impact on aggregate demand. As Federal Government plans to spend $5 billion on Snowy Hydro 2.0 to generate more power capacity, this likely to increase aggregate demand. The productive investment made by government adds to aggregate demand. Increase in the aggregate demand shifts the demand curve upward from AD to AD’. Consequently, the economy reaches at a new equilibrium at a higher level of price and real GDP.
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Figure 4: Rise in government planned spending
(Source: as created by Author)
d) A fall in the price of importable improves net export and raise aggregate demand. However, for product like oil, fall in price has a supply side effect as well. As oil is used in different industries, fall in price of oil reduces cost of production in these industries. The lower production cost increases aggregate supply. With a change in both aggregate demand and aggregate supply at the same time, there is a definite increase in real GDP. The effect of price level is however uncertain (Tobin, 2017). The increase in aggregate supply has an implication for lowering price while an increase in increase in demand has an upward pressure on price. The ultimate position of price level depends on the demand and supply side force.
Figure 6: Change in AS exceeds change in AD
(Source: as created by Author)
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Figure 7: Equal change in AD and AS
(Source: as created by Author)
e) An increase in immigration intake increases the strength of labor force. The immigrants labor force when add to domestic labor supply creates an excess supply of labor. This pulls down wages in the economy. As cost of production goes down, aggregate supply increases. The increased supply shifts the aggregate supply curve outward (Keynes, 2016). Under the new equilibrium real GDP increases but price level falls.
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Figure 8: Effect of migration intake
(Source: as created by Author)
References
6202.0 - Labour Force, Australia, Mar 2018. (2018). Retrieved from https://www.abs.gov.au/ausstats/[email protected]/mf/6202.0?opendocument&ref=HPKI
Blanchard, O. (2016). The Phillips Curve: Back to the'60s?. American Economic Review, 106(5), 31-34.
Burfisher, M. E. (2017). Introduction to computable general equilibrium models. Cambridge University Press.
Daly, M. C., & Hobijn, B. (2014). Downward nominal wage rigidities bend the Phillips curve. Journal of Money, Credit and Banking, 46(S2), 51-93.
Forder, J. (2014). Macroeconomics and the Phillips curve myth. OUP Oxford.
Keynes, J. M. (2016). General theory of employment, interest and money. Atlantic Publishers & Dist.
Kumar, A., & Orrenius, P. M. (2016). A closer look at the Phillips curve using state-level data. Journal of Macroeconomics, 47, 84-102.
Leduc, S., & Liu, Z. (2016). Uncertainty shocks are aggregate demand shocks. Journal of Monetary Economics, 82, 20-35.
Tobin, J. (2017). Keynes’s policies in theory and practice. In The Policy Consequences of John Maynard Keynes (pp. 13-21). Routledge.
