Question

With the aid of a diagram, explain the trade-off between unemployment and inflation, both for the Long Run and for the Short Run. The Bank of Canada currently targets 2% inflation. Explain the advantages and disadvantages of lowering the inflation target to 0%.

Answer 1

Short Run : The Phillips curve relates, the rate of inflation with the rate of unemployment ; The Phillips curve states that unemployment and inflation are inversely related , as with a decrease in unemployment, inflation increases. The relationship, is not linear. In the graph The short-run Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation rate is on the y-axis.

The Phillips curve shows the inverse trade-off between inflation and unemployment.With increase in one, the other must decrease. In the graph, an economy can either experience 3% unemployment at the cost of 6% of inflation, or increase unemployment to 5% to bring down the inflation levels to 2%.

Long Run : In the long run, inflation and unemployment are unrelated. Graphically, this means the Phillips curve is vertical, at the natural rate of unemployment, or the hypothetical unemployment rate if aggregate production is in the long-run level. The natural rate of unemployment theory, also known as the non-accelerating inflation rate of unemployment (NAIRU) theory. According to NAIRU theory, expansionary economic policies will create only temporary decreases in unemployment as the economy will adjust to the natural rate. Moreover, when unemployment is below the natural rate, inflation will accelerate. When unemployment is above the natural rate, inflation will decelerate. When the unemployment rate is equal to the natural rate, inflation is stable, or non-accelerating.

Although the economy starts with an initially low level of inflation at point A, attempts to decrease the unemployment rate are futile and only increase inflation to point C. The unemployment rate cannot fall below the natural rate of unemployment, or NAIRU, without increasing inflation in the long run.

Advantages:

• The zero inflation economy enables to lessen the price distortion.
• It also reduces the uncertainty involved in price drift.
• The zero inflation also aids in enhancing the economic growth along with adding liquid money to the economy.
• In an economy with zero inflation, the corporation is in a better position to plan for the economy and implement new rules, policies for the betterment of the economy.

Disadvantages:

• Rising real value of debt: With low inflation, it becomes harder than expected for people to pay back their debts – they have to spend a higher % of income on debt repayments leaving less income for other spending.
• Rising real interest rates: The fall in inflation increases real interest rates,rising real interest rates make it less attractive to borrow and invest; it encourages consumers to save. If the economy is depressed, this rise in real interest rates can make monetary policy less effective in encouraging growth.
• Low inflation is an indication of low growth: A normal period of economic growth would typically give a moderate rate of inflation (2%). If inflation has fallen to 0%, it suggests that there is intense price pressure to encourage spending and the recovery is very fragile.
• Harder for prices and wages to adjust: When inflation is 2%, it is easier for relative prices and wages to adjust because firms can freeze wages and prices – and effectively it is a cut in real terms of 2%. However, if inflation is zero, then a firm would have to cut nominal wages by 2% – cutting nominal wages is much harder psychologically – people resist cuts in wages more than they accept a nominal freeze. If firms are unable to adjust wages – it can lead to real wage unemployment.