Question

How do inflation and unemployment affect the economy in terms of growth (use U.S. as an example)? Conduct research from viable and credible sources such as, and not limited to, economic journals, periodicals, books, databases, and websites. This assignment should be submitted/uploaded via BC Online on the date the assignment is due. Any late assignment will be subject to a letter grade reduction unless an extension has been negotiated with the professor prior to the due date. In this written assignment, the quality of your writing and the application of APA format will be evaluated in addition to your content. Evaluation based on these criteria is designed to help you prepare your college projects, which must be well-written and follow APA guidelines. Each written assignment should contain a minimum of 300 words, but no more than 400 words. Make sure that you use correct spelling, grammar, and punctuation.

Answer 1

How do inflation and unemployment affect the economy in terms of growth (use U.S. as an example)?

Intuitively, it is very easy to study the relationship between inflation and unemployment. We can use the basic demand and supply model and predict that as employment level is low (i.e. unemployment level is high), people have less money to buy goods and services. As a result, demand is low, which brings down the price. However, inverse relationship between inflation and unemployment is not always this simple in the real market. Empirical studies reveal a more complicated relationship that this.

Economist A.W. Phillips studied the relationship between these two variables and he showed through the Philips curve that there is an inverse relationship between unemployment and wage inflation. The validity of the Phillips curve was quite evident in the 1960s, the decade that showed that it was possible to maintain low unemployment rate as long as the Fed could tolerate high inflation rate. However, in the same decade a group of economists such as Milton Friedman and Edmund Phelps (known as monetarists) shows that Phillips curve does not hold good in the long-run. They showed that an economy tends to reach its natural employment or unemployment level over the long-term and it adjust to the rate of inflation.

The arguments of the monetarists were not readily accepted on the backdrop of the popularity of the Phillips curve. However, 1970s, characterized by high inflation in USA, showed the validity of their arguments. This was a period of high inflation as well as high unemployment (Phillips curve predicts otherwise). However, the 1990s showed low inflation as well as low unemployment! Also, high GDP coincided with low unemployment. High inflation negatively affect GDP growth rate. Also, stagflation is characterized by high inflation and low output, which the US economy witnessed in 1970s. According to empirical studies, in USA GDP growth rate of each percentage point beyond 2.5% caused unemployment rate to come down by 0.5%. Therefore, growth in GDP tends to increase employment level. However, increasing the employment level to extreme high or unemployment low extreme low has the danger of increasing the inflation rate.

If we study the present American economy, the inflation rate is significantly low and the unemployment rate is also low. However, another important feature of this time is minimal growth in wage rate in spite of the fact that unemployment rate has come down.

References:

"The Three Pillars Of The Economy: Inflation, GDP And Unemployment". Financialnerd.com. N.p., 2017. Web. 13 Feb. 2017.