Quiz 34: The Trade-Off Between Inflation and Unemployment

Rejecting inflation unemployment tradeoff is incorrect When inflation and unemployment fell together in the 1990s, some observers claimed that policy makers no longer faced a trade-off between inflation and unemployment. This observation is incorrect because inflation and unemployment will fall/rise together when there is a supply shock in an economy. On the other hand, tradeoff between inflation and unemployment occurs when there is a demand shock in an economy. Hence, rejecting inflation unemployment tradeoff based on supply shock analysis is incorrect.

Fluctuation in aggregate demand will not affect output If the supply curve is vertical, then any fluctuation in growth of aggregate demand will be adjusted only by change in price. This is explained in Figure-1. In Figure-1, price level is measured on vertical axis and output is measured on horizontal axis. The supply of output is fixed; hence, the supply curve is vertical. The increase in aggregate demand shifts the demand curve upward from to . Since the supply curve is vertical, the increase in demand will increase the price level from to , and output will remained unchanged at level. Figure - 1

The Phillips curve found that the rate of employment and output remain constant in the long run; hence, there is no tradeoff between inflation and unemployment rate. It means any change in the monetary or fiscal policy will cause only the price level to change. Whereas there is a tradeoff between inflation and unemployment rate in short run. It means any change in the monetary or fiscal policy will have a temporary effect on both inflation and unemployment rate. Therefore, expansionary monetary or fiscal policy to shut out recession will cause inflation rate to go up, which will lead to a temporary effect on unemployment rate.