Question

Explain how the belief or not in the existence of a natural rate of unemployment can affect the choice of policies. Paragraph style answer.

Answer 1

Unemployment plays a vital role in formulating policies. The government of a country used to take either monetary policy (by controlling interest rate, purchasing or selling bonds, etc) or fiscal policy (by controlling tax rate, government spending, etc) based on the current unemployment rate. These two policies could be expansionary or contractionary; and it depends on the rate of unemployment.

Unemployment and inflation have inverse relationship --- if one increases the other decreases. Both at their higher rates or lower rates would be dangerous for an economy. If unemployment is high (as per the above relationship, inflation is low), the government has to come forward with expansionary policy (like decreasing interest rate, increasing government spending, etc); it increases money supply in the market; new projects should develop and people would get job. This thing slowly decreases unemployment rate; but inflation increases. At the highest inflation, unemployment would be the lowest; in such case the government has to take contractionary policy for slowing down the pace of the economy.