Question

Question 6 (Word limit 200 words)
Suppose that the economy is experiencing a high level of inflation rate and unemployment is below
the natural rate. How does the economy return to the natural rate of unemployment if this higher
inflation rate persists?

Answer 1

The relationship between the unemployment and inflation can be understood with the help of Phillips Curve. As this curve established the inverse relationship between unemployment and inflation for short term. As when the employment will increase then more money will go in the hands of people and more demand will be created so that will put load on the prices of essential commodities will result into higher inflation. But this theory was failed to explain the phenomena of higher inflation with higher unemployment known as stagflation. Natural rate of unemployment is the hypothetical rate at which the inflation is stable below which inflation increases and above which unemployment decreases. The Phillips curve was also unable to explain the behavior between unemployment and inflation at the long term.

As at the time of long term a vertical line is scene between inflation and unemployment stating that increasing and decreasing inflation with economy up and down there won't be no effect on the rate of unemployment. This is achieved when there is more unemployment with less inflation and more jobs are created in short term it will lead to higher demand or higher inflation but at this time the due to higher inflation workers' expectations of future inflation changes which shifts the unstable equilibrium to stable point of natural line and this is how it is achieved irrespective of higher inflation rates persists.