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Economic analysis - Essay Example

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Unemployment and Inflation Name: Institution: Course: Tutor: Date: The link between inflation and unemployment has been debated since mid 20th century when AW Phillips published his work, which studied the link between inflation and unemployment in the United Kingdom from 1861 to 1957…
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Economic analysis
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Economic analysis

Most of the economists believe that, this relationship between inflation and unemployment is in the short run, which leads to a trade off between the two undesirables. The trade off, which has been summarised in to the Phillip’s curve shows that since the invention of economics, there has been an inverse relationship between unemployment and inflation where, when inflation is low, the rate of unemployment is high and when the rate of inflation is high, the levels of unemployment are low. Government policies that are designed to lower the levels of unemployment, for instance, during recession will usually lead to increased rates of inflation in the short run while policies that are designed to lower the rates of inflation, especially during the boom cycle will most likely increase the levels of unemployment in the short run. When discussing inflation and the effects that it has in markets, another concept that cannot be ignored is the interest rates, this is because inflation levels in a country are directly determined by the interest rates prevailing in that country. When interest rates in a country are lowered, it encourages businesses to get loans for expansion or to hire more employees; this increases money supply in the economy forcing prices to go up due to the increased demand for products and services hence inflation; however on the positive side is that more people will be employed in the economy. On the other side, if the government increases interest rates, businesses are likely to shy away from getting loans for expansion or to cover other expenses, this has the effect of reducing money supply in the market hence low demand, which in turn leads to low inflation rate. The negative side of this is that the less the amount of money that is available in the market, the higher the levels of unemployment since businesses do not have the money to hire new employees. Phillips curve The above Phillip’s curve shows the inverse relationship between unemployment and inflation. Some economists have argued that this relationship is only applicable in the short run since the in the long run, influence of some other macroeconomic factors may cause inflation and unemployment to move in the same direction or fail to show any influence on each other. Keynes, one of greatest economist of the 20th century have argued that the most important term in economics is the short term since in the long run, we will all be dead. The idea of Phillip’s curve has been criticized especially in relation to the trade off between inflation and unemployment because as data from 1970 in most of the developed countries show, these two economic parameters moved in the same direction, a situation called stagflation. This phenomenon was experienced when in 1970; shocks resulting from fluctuating in oil prices ensure that there were high levels of inflation and at the same time high rates of unemployment. This deviation from the Phillip’s curve is as a result of the fact that workers and employers are likely to take into account the effects of inflation when signing new employment contracts, which would mean employees being paid at rates near the inflation. This would cause the levels of unemployment to rise at the same time meaning that in the long run, there is not trade off between unemploym ... Read More
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