Q7. With the help of a diagram, explain why a trade-off between price stability and low
unemployment might occur. (9 marks)
Stable prices are often defined as those where inflation is 2%, a target set by the Bank of
England, which was ‘given operational independence for the conduct of monetary policy in
1997’ (Extract E). Price stability enables confidence and real growth. Along with inflation, other
government objectives include low unemployment, growth and a stable balance of payments.
Whilst these objectives often come into conflict in policy making, inflation and unemployment
share an inverse relationship, and ‘some argue that trying to maintain stable prices and low
unemployment could create trade-offs.’
As unemployment is the level of the population who are willing and able to work but are not in a
job, it is obvious that low unemployment means more people are working, and thus more money
is flowing around the economy. As people have higher disposable incomes there is greater
consumption, and those who were previously unemployed before an economic boom are likely
to be in low income groups, and thus have the greatest marginal propensity to consume, and so
this large increase in consumption will be fuelled by the multiplier effect. Such an increase in
national income usually leads to a proportionately greater increase in investment (the
accelerator effect), another component of AD, pushing it even higher. High aggregate demand
is likely to place demand-pull inflationary pressures on prices, especially if an economy is close
to full capacity, and supply cannot increase to meet excess demand. In this situation, low
unemployment has led to high inflation.
The Phillips curve highlights this relationship, and Point B likely represents a positive output gap
on the economic cycle and Point A a negative output gap. As displayed, a reduction in inflation
from around 5% to 2% (beneficial) may lead to a rise in unemployment from 3% to 6%
(detrimental) and thus policy makers are forced into a trade off.
The UK is oddly experiencing historically-low unemployment currently, and simultaneously
unemployment might occur. (9 marks)
Stable prices are often defined as those where inflation is 2%, a target set by the Bank of
England, which was ‘given operational independence for the conduct of monetary policy in
1997’ (Extract E). Price stability enables confidence and real growth. Along with inflation, other
government objectives include low unemployment, growth and a stable balance of payments.
Whilst these objectives often come into conflict in policy making, inflation and unemployment
share an inverse relationship, and ‘some argue that trying to maintain stable prices and low
unemployment could create trade-offs.’
As unemployment is the level of the population who are willing and able to work but are not in a
job, it is obvious that low unemployment means more people are working, and thus more money
is flowing around the economy. As people have higher disposable incomes there is greater
consumption, and those who were previously unemployed before an economic boom are likely
to be in low income groups, and thus have the greatest marginal propensity to consume, and so
this large increase in consumption will be fuelled by the multiplier effect. Such an increase in
national income usually leads to a proportionately greater increase in investment (the
accelerator effect), another component of AD, pushing it even higher. High aggregate demand
is likely to place demand-pull inflationary pressures on prices, especially if an economy is close
to full capacity, and supply cannot increase to meet excess demand. In this situation, low
unemployment has led to high inflation.
The Phillips curve highlights this relationship, and Point B likely represents a positive output gap
on the economic cycle and Point A a negative output gap. As displayed, a reduction in inflation
from around 5% to 2% (beneficial) may lead to a rise in unemployment from 3% to 6%
(detrimental) and thus policy makers are forced into a trade off.
The UK is oddly experiencing historically-low unemployment currently, and simultaneously
