Discuss the role of government policy in reducing unemployment and inflation

by faros88 (student)

University Degree Business and Administrative studies

Discuss the role of government policy in reducing unemployment and inflation. In your discussion make use of the diagrammatic representation of the macroeconomy developed in lectures in Term 2.

One of the main responsibilities of governments is to create a stable economic and political environment in the country. Majorly governments seek to achieve a stable rate of inflation and low level of unemployment. To accomplish this governments tend to use variety of policies and strategies according to their mission. They might choose to follow interventionist policies by controlling the market with fiscal or monetary policies or they might just let the Central Bank to allocate required changes. Central Banks are considered to be independent from the government especially in developed countries however, its likely to see governments imposing their monetary strategies under the name of Central Bank in order to avoid public pressure and criticism. Inflation can be described as a ‘persistent’ increase in the average price level in the economy. It can be measured through consumer price index (CPI). A small price change in the market doesn’t have any significant affect on the inflation rate, where only consistent price increases changes inflation level. (Blink, 2007) On the other hand, unemployment is another key factor in the economy that indicates the strength and potential of the economy that government is responsible of. By macroeconomic perspective it’s governments’ job to set a balance between unemployment and inflation level which will be analysed in this essay. Unemployment level represents the actual and potential ‘labour force’ in the economy independent from the whole population. Governments aim to keep unemployment and inflation in a level within certain limits. The trade-off-debate between two concepts will be analysed by Phillips Curve Theory throughout the essay. (Economics.Help, 2013) Phillips Curve explains the inverse relation between unemployment and inflation.

The reason governments desire to have a low level of inflation level is to avoid the negative outcomes of it on the economy. Firstly and most importantly a rise in inflation will cause a loss of purchasing power. If the inflation level has raised this means that prices for the goods in average has increased as well. If the income of an individual is not linked to inflation rate this means that purchasing power of that person has fell down as the same amount of inflation. Furthermore high inflation will affect the savings negatively. If the annual interest rate is lower than inflation rate, money will loose value since real interest rate will be negative. This will discourage people to save money and cause them to buy more fixed assets such as estates. Also, it’s very common to see inflation causing negative consequences for international trade. Inflation will increase the attractiveness on imports from lower inflation countries, which will result a loss in export revenues and increase country’s dependency on foreign goods. (Blink, 2007) With all these uncertainties and lack of liquidity as a result of less saving, the country will loose its attractiveness for new investors. Thus, it’ll cause a recession on economic growth of the country.

In theory there are two types of inflation: Demand-Pull and Cost-Push inflation. (Blink, 2007) However, in practise it is very hard to identify which certain inflation the country is experiencing because inflation may have variety of reasons and outcomes. Thus, mixed of solutions are being used to reduce inflation. As can be understood, demand-pull inflation occurs as a result of increased aggregate demand when the economy reaches full employment level of income. This indicates that labour force compasses all the potential of the market and firms can’t produce anymore output and there’s no shortage in demand. Price increase from ...