Question

On 22 February 2019 Philip Lowe, the Governor of the Reserve Bank of Australia, told the house economics committee:

“I think this country can have an unemployment rate close to 41 per cent 2

[as opposed to the commonly assumed 5, or 51 per cent] without wage 2

growth causing problems for inflation.”

Shortly after, journalist A suggested this is good news for the government. In contrast, two days later, another journalist, journalist B, argued the opposite, that this is bad news for the government, citing the high rate of underemployment in Australia.

1. a) Which well-known macroeconomic concept is Governor Lowe referring to and what is it called?

Answer 1

The Governor is referring to the well-known economic concept of the short-run trade-off between inflation and unemployment, which is highlighted by the Phillips curve.

In this premise, we say that there is a trade-off between inflation and unemployment in the short-run, which means that in the short-run, if there is high inflation, there will be low unemployment, and if there is low inflation, there will be high unemployment. This is highlighted in the statement made by the Gvernor above, where we can see that he is talking about high unemployment rate to compensate for the low inflation rate.

This can be explained in the following different ways -

1.) High inflation means that the aggregate demand exceeds the aggregate supply. This is demand-pull inflation. In these scenarios, there is a tendency of producers to hire more labour to fulfill the excess demand, anf unemployment levels are low.

2.) If there is low unemployment, there is less availability of labour in the market. This makes the employers more vulnerable to the labour unions that can now lobby for higher wages, since the employers have no choice but to offer higher wages as there is less supply of labour in the market for them to substitute. Hence, wages rise. As wages increase, the cost of production for the employers also increase, which will thus be reflected in the form oh higher prices, which will lead to cost-push inflation.  

Hence, we can see that high inflation leads to low unemployment, and unemployment leads to higher inflation. If the sitaution is thus reversed, it is easy to figure out that low inflation will lead to high unemployment and high unemployment will lead to lower inflation.