Question

Why an attempt to keep the unemployment rate below the natural rate will only cause inflation to accelerate?
use graph explain, thanks.

Answer 1

Unemployment is an important measure of economic perfomance.A fall in unemployment is associated with rise in GDP and increased industrial production.Expansionary fiscal and monetary policies can be opted to maintain lower unemployment level.

In general, economists have found that when the unemployment rate drops below a certain level, referred to as the natural rate, the inflation rate will tend to increase and continue to rise until the unemployment rate returns to its natural rate. Alternatively, when the unemployment rate rises above the natural rate, the inflation rate will tend to decelerate.Inflation is a general increase in the price of goods and services across the economy.The natural rate of unemployment is the level of unemployment consistent with sustainable economic growth. An unemployment rate below the natural rate suggests that the economy is growing faster than its maximum sustainable rate, which places upward pressure on wages and prices in general leading to increased inflation.

New Zealand economist William Phillips in 1958 wrote a paper titled "The Relation between Unemployment and the Rate of Money Wage Rates" . In his paper, Phillips described the inverse relationship between unemployment levels and the rate of inflation. This relationship was referred to as the Phillips curve. Phillips curve states the change in unemployment within an economy has a predictable effect on price inflation.

The natural rate model suggests that there is a certain level of unemployment that is consistent with a stable inflation rate, known as the natural rate of unemployment. When the unemployment rate falls below the natural rate of unemployment,the inflation rate is expected to accelerate.

The inverse relationship between unemployment and inflation is depicted as a downward sloping, concave curve, with inflation on the Y-axis and unemployment on the X-axis. In th above figure inflation increases from 2 to 5 when unemployment decreases from 7 to 4.