Is it possible to reduce unemployment without increasing inflation

Authors Avatar

Is it possible to reduce unemployment without increasing inflation?

This question is one of the most exciting and important in macroeconomics and economic policies. Unemployment and inflation are the two most salient features in the evolution of the business cycle and that have the most direct effect on social welfare. Low inflation and low unemployment, both in the short term and in the long term, are the key indicators of good economic conditions in a country and how successful the national macroeconomic policies are. Beyond the economic sphere, inflation and unemployment have a significant impact on the overall welfare of the society: both economic phenomena affect negatively the average citizen to a degree which might become unacceptable for certain individuals, like structural unemployed workers or hyperinflation.

To answer the question of whether it is possible to reduce unemployment without increasing inflation it is important to analyze the causes of unemployment and inflation. As economics is a non-experimental discipline, where a solution can be proved wrong or right through an experiment, different and seemingly valid answers can be given to solve the same economic problem. In the case of inflation and unemployment, the policies to reduce them are well summarized by the Keynesian versus monetarist respective approaches.

The monetarist approach views unemployment, in the long term, as an anomaly in the functioning of the labour market. As for any other market, monetarists will argue that unemployment is just an excess of supply of labour over the demand for it, at the prevailing wages. This should be a temporary phenomenon, only expected in the short-term unless there is a malfunctioning of the labour market. The latter, in turn, can happen if there are exogenous causes like government intervention or the existence of too powerful trade unions.  Both types of “ exogenous distortions” would prevent the functioning of a free, effective and efficient market that in the long term would clear the labour excess of supply through the adjustment of the price of labour, i.e. real wages.  At the same time, monetarists/neoliberals do not deny the possibility of observing the existence of unemployment in the long term: however, this unemployment would be voluntary or a consequence of the decision of the unemployed workers of not accepting the real wage of equilibrium for the labor productivity they can offer in the market.

Join now!

As for inflation, monetarists see it even simpler and easier to tackle.  This is because in the long term, as Friedman said at the Wincott Memorial Lecture in London in 1970, inflation is always and everywhere a monetary phenomenon.  Therefore, what it is needed is that the government, i.e. the central bank, keeps the growth of monetary supply in line with the long term real GDP growth which in turn is determined by the  trend of its potential. The central bank may only need to take into account changes in the velocity of circulation of the money stock and adjust ...

This is a preview of the whole essay