Economic Policy Recommendation. Unemployment and Inflation: Can we find a balance - Essay Example

? Unemployment and Inflation: Can we find a balance? This paper explores the relationship between inflation and unemployment and identifies an economic problem which economies face stemming from the business cycle of economic growth. Implications of different policies which the governments adopt along with the possible changes which could be made in the latter in order to create a balance between the policies which can keep inflation in control and keep unemployment at a minimum, will be pointed out. The impact of inflation and unemployment on the society’s welfare will also be discussed along with its possible solutions. These solutions would be backed by economic theories and reasoning which will explain why the suggested solutions would prove to be favorable for the society, economy and the markets. All the theories and proposed policies will be backed by scholarly researches which will be cited in-text and at the end of this paper. Unemployment and Inflation: Can We Find a Balance? Relationship between Unemployment and Inflation As the theory of economic cycle depicts, there is inevitably an inverse relationship between inflation and unemployment. Most economies, irrespective of being developed or developing, face the economic problem of low or no economic growth. This has been further elaborated by Weil, D. N. (2005). In his book Economic growth, that it is owes to low economic activity that an economy faces stagnant or no growth. When there is no growth in the economy, no jobs are created and hence, aggregate demand remains low which keeps inflation levels low. On the hand, the unemployment levels are high as owing to no or less economic activity, there will be no jobs in the market. In contrast, when economic activity rises, the economy makes room for more workers and as a result, aggregate demand starts to rise. This causes demand-pull inflation and conversely the unemployment level declines in the economy (Weil, 2005). Fellner, W. (1956) explain the business cycle in his book: “Trends and cycles in economic activity: An introduction to problems of economic growth”. They state their slow or no economic growth is an economic problem which most economies face regardless of the level of development they are at. Developed or underdeveloped, if there is no economic growth, it would either mean that the economy’s resources are lying idle or it has reach at a stagnant point of growth. In the latter scenario, the economy would be facing high inflation as the economic activity in the economy would be at its maximum. Simultaneously, Fellner, W. (1956) further explains that when there is more economic activity in the economy, the employment levels are also high along with the inflation levels. Hypothetically, as the workforce is fully employed, it would demand more and more commodities which will increase the demand pull-inflation. At this point, the economy’s growth would become stagnant as because of inflation, firms would want to cut back their costs and moreover, purchasing power of the households would gradually start to fall. This slows down economic activity and hence, growth becomes stagnant (Fellner, 1956). As firms try to cut back its production, workers will have to be made redundant and as the households lose their jobs, the level of aggregate demand falls which does help reduce inflation but also creates unemployment concurrently. The economic downturn is inevitable after an economy reaches its ultimate point of growth and further takes the economy at a nosedive and takes it to the point where there is low inflation but conversely, unemployment is at a high rate. Impact of low economic growth on the society Friedman, B. M. (2005), mentions in his publication: “The moral consequences of economic growth” that low economic growth, besides causing unemployment, slows down the improvement of the society’s welfare and the standard of living. It also undermines the economy’s potential to earn the GDP in accordance with the resources’ capacity in the economy. Not only this, slow economic growth coupled with high inflation also impacts an economy’s performance in the international trade. The country’s exports become expensive and imports become cheaper which worsens the balance of payments. Moreover as exports become expensive, demand for the country’s goods and services fall and this resonates on the economy’s employment. At a point where the economic growth becomes stagnant, inflation is most likely to be at its highest. This is because, Friedman, B. M. (2005) explains that when there is no or less room for growth in the economy, economic activity is at its highest with the highest level of employment however, the inflation on the other hand is also high. It is after this point of a boom from which the economic activity starts to slow down. High inflation would mean that the consumer’s basket of goods according to the CPI calculation would start shrinking as the consumers’ savings and purchasing power would take the hit. Along with this, firms’ cost of borrowing would also increase as with inflation, interest rates would also rise, which would discourage further investment from the firms’ and businesses’ side (Friedman, 2005). Duesenberry, J. S. (1958) writes in “Business cycles and economic growth” that high unemployment would mean less tax revenue and increased expenditure for the government. Country’s GDP will fall along with its per capita income. As standard of living would start to fall, the government would be constrained to either subsidize local firms to keep unemployment in control. This would cause further drains in the government’s treasuries with decreased tax revenue for the government (Duesenberry, 1958). As far as the human development index is concerned, slow economic growth and a recession would increase the crime rate in the economy as unemployment would be at a rise. Apart from this, as people’s living standards would fall, it can also be induced that the public would be forced to cut down on their meal budgets which would directly put a negative impact on their productivity at work and earning capacity over all. The children of the same households would also show deterioration in their performance at school (Friedman, 2005). As the government itself would be going through a financial crunch, both the availability and the quality of public goods and merit goods would be negatively affected which would further add to the welfare of the people (Friedman, 2005). Proposed Economic Solution In order to tackle the problem of low economic growth, financial crisis in the economy, unemployment and inflation, the government has some tools with which it can effectively manage the impact which the economy would face from the cycle of booms and recessions in the economy. Avoiding the repercussions of slumps and gaining from the booms in the economy is impossible. The effects which these booms and slumps will have on the economy are inevitable. Economists therefore have to find a correct mix of policies which would prolong the time period in which the economy can grow to its full capacity and eventually cause a recession. Along with this, policies will have to be altered to steer the economy out of a recession as fast as possible. In other context, if the economic policies are managed efficiently, the economy can remain at a certain constant level of growth where the levels of unemployment and inflation can be kept stationary to some extent. Alvin Hansen Symposium on Public Policy, Solow, R. M., & Taylor, J. B. (1998) illustrate the use of monetary policy by the governments to help the economy stabilize in their publication. They state that the government uses monetary policy to control the money supply in the economy by altering the interest rates. It entirely depends on what cycle the economy is on and what trend is the economy facing in terms of growth, inflation and unemployment. Inflation can be explained as a situation in which, too much money is chasing too few goods. In other words, the value of money deteriorates and falls below the actual worth or value of the good which it buys. The value can be equated to the possible utility which can be derived from consumption of a commodity. In order to increase the value of money, the government can reduce the money supply. The injection of money must have been done more than the outflow of money which is most likely to leave too much money floating in the economy. The governments reduce the money supply by increasing the interest rates prevalent in the economy. This means that with higher interest rates, firms and households would be discouraged to borrow from the banks. Investment in the economy would fall and hence, injection of money in the economy will be reduced. Simultaneously, high interest rates would give the firms and households, an incentive to save as the returns of saving over the returns of spending the money would be higher. In other words, the opportunity cost of spending the money over saving it would be high therefore firms and households would rather keep their money in the banks to earn the extra interest than invest it in any venture. This would reduce the flow of currency in the economy and raise the value of money. Alternatively, the government can also choose to reduce the printing of money (Alvin Hansen Symposium on Public Policy et al, 1998). Not only can it save its costs but also evade the situation of too much money chasing too few goods. The governments must ideally adopt Contractionary Monetary (increase interest rates and reduce the money supply) when the economy is reaching at a peak of its boom. This would help reduce the money supply and economic activity in the economy hence, inflation will eventually be reduced and the ramifications of a recession after a full on boom can be avoided. Moreover with this policy, an economy’s growth and rising economic activity towards its boom can be slowed down with controlled money supply. Conversely, Expansionary Monetary policy (decreasing interest rates along with the money supply) is adopted to steer an economy towards growth when it is in a recession. Interest rates are lowered so as to encourage borrowing in the economy. Cost of borrowing becomes low and hence, the opportunity cost of investing the money would be less than saving it therefore, firms would rather invest it to gain profit rather than earn minimal interest on the latter (Alvin Hansen Symposium on Public Policy et al, 1998). In line with the monetary policy, Mankiw, N. G., and National Bureau of Economic Research. (2000) explain the effectiveness of Fiscal Policy as another economic stabilizer to control the economic growth and manage the business cycle effectively. “The savers-spenders theory of fiscal policy” explains how the governments use Fiscal Policy by controlling the taxes and government expenditure. In an ailing economy which is going through a recession, lowering the taxes and increasing the government’s expenditure would help regain the path of growth for an economy. Low taxes would leave a higher disposable income with the households and firms which would encourage spending. Alongside this, increased government spending in the form of subsidies, provision of public and merit goods would increase the aggregate demand in the economy which will give rise to the economic activity. Alternatively, when the economy is at a boom, increasing the taxes and reducing the government’s spending would slow down the economic activity as the households and firms would be left with lesser disposable income (Mankiw, 2000). Proposed Economic Solution Foley, D. K., & Sidrauski, M. (1971) mention in their book: “Monetary and fiscal policy in a growing economy” that Monetary Policy and Fiscal policy are used interchangeably to stabilize the economy and to prevent it from reaching a boom too early. The policies aim to sustain and prolong the period of high economic growth and boom and steer the economy from a recession as quickly as possible. For a situation in which the economic activity is low, it needs to be seen whether the economy has achieved the maturity of its boom or is going through a recession. In the latter case, both expansionary fiscal and monetary policy will be applied to increase the aggregate demand and spending levels in the economy by releasing more money in the economy through lowering interest rates, increasing government spending and decreasing the taxes. When the interest rates are lowered, as mentioned above, firms would be willing to spend which will trigger economic activity and hence create more employment. Concurrently, an increase in government spending would compliment further growth in the economy in form of subsidies, tax incentives, grants etc. Lowering taxes simultaneously would encourage firms to invest more so as to earn more profit. Households on the other hand, would be left with more disposable income as before and hence, more money to purchase the goods produced by the same firms. Aggregate demand would start rising and hence, would drive economic activity in the economy (Foley, 1971). Persson, T., & Tabellini, G. E. (1994) further claim in their book: “Monetary and fiscal policy” that in a situation where the economy is at a boom and is registering low economic growth, the government must use Contractionary fiscal and monetary policy to reduce the level of economic activity. This would be done by decreasing the government spending, increasing the taxes and interest rates which will discourage the spending levels in the economy and hence reduce the aggregate demand. This would prolong the time period which it would take for an economy to eventually go into a recession. However, if a pulse check is kept on the inflation and unemployment, the stabilizers of fiscal and monetary policy can be applied more effectively in a manner which would make an economy more responsive to the changes (Persson, 1994). Impact of the chosen economic policy It is the economy’s spending patterns and aggregate demand which basically cause the economy to go into boom and even a recession. The tools which are mentioned above namely Fiscal and Monetary policy are used to control the aggregate demand and the level of spending in an economy. In order to make the policies effective, the trend of the economy must be carefully observed. When the economy is in recession, economic theories explained above suggest that Expansionary Fiscal and Monetary policy would help maneuver the economy from the recession. Once the economy sustains a favorable economic growth, the government will need to maintain the then current level of its expenditure, taxes and interest rates to sustain a certain level of growth, inflation and unemployment in the economy. As mentioned at the start of the paper, the economy will have to bear a certain level of unemployment and a certain level of inflation in order to sustain an economy at a certain growth level (Foley, 1971; Persson, 1994). Alternatively, if the economy is on the boom, a recession would be inevitable before the big firms start to lay off its workforce and owing to the multiplier effect, unemployment starts to rise. At a certain point where a certain level of inflation and unemployment are desirable, the government must start funding the economy and set interest rates at the same level to prevent the economy from going down. Not only would this prolong the time until the economy can reach a boom, but will also keep unemployment and inflation in control (Foley, 1971; Persson, 1994). References Weil, D. N. (2005). Economic growth. Boston: Addison-Wesley Friedman, B. M. (2005). The moral consequences of economic growth. New York: Knopf. Alvin Hansen Symposium on Public Policy, Solow, R. M., & Taylor, J. B. (1998). Inflation, unemployment, and monetary policy. Cambridge, Mass: MIT Press. Baily, M. N., & Okun, A. M. (1982). The Battle against unemployment and inflation. New York: Norton. Fellner, W. (1956). Trends and cycles in economic activity: An introduction to problems of economic growth. New York: Holt. Duesenberry, J. S. (1958). Business cycles and economic growth. New York: McGraw-Hill. Mankiw, N. G., & National Bureau of Economic Research. (2000). The savers-spenders theory of fiscal policy. Cambridge, MA: National Bureau of Economic Research. Persson, T., & Tabellini, G. E. (1994). Monetary and fiscal policy. Cambridge, Mass: MIT Press. Foley, D. K., & Sidrauski, M. (1971). Monetary and fiscal policy in a growing economy. New York: Macmillan. Read More