Q&A: Full employment and inflation

When the economy is at full employment, what measure is most effective in reducing inflation in the short run?

This question hints at the possible trade-off between two macroeconomic objectives - namely high employment and stable prices.

Full employment implies that the available factor inputs including labour and capital resources are being fully utilised. It does not mean zero unemployment since there will always be some people who are jobless at the prevailing wage rates - frictional and structural unemployment are an inevitable feature of a modern economic system.

The conventional view is that full-employment can lead to inflationary pressures within an economy as high demand for goods and services leads to higher demand-pull inflation. And increasing demand for factor resources drives their prices up too - leading to cost-push inflation.

Before tackling policies designed to limit price rises you might want to question whether full employment will actually lead to higher inflation.

Providing that existing resources are becoming more productive, or if an economy is open to trade allowing goods and services to flow in to dampen down any excess demand - then accelerating inflation is NOT inevitable! Indeed the experience of many advanced economies from 1995 through to around 2007 was a decade or more of falling inflation and falling unemployment at the same time!

That said if prices are rising at a faster rate, the obvious short-term policy responses are:

(1) A tightening of monetary policy via higher interest rates or measures designed to control the supply of money and credit (quantitative tightening!)

(2) A deflationary fiscal policy i.e. through higher direct taxes or an attempt to control government spending

In the medium term - supply-side policies can help to boost an economy’s productive potential, make labour and product markets more flexible and competitive and reduce the rate of unemployment at which there is a risk of inflation accelerating.

As always in exam questions these days it is important to include some analysis diagrams in your answer and examiners will always reward references to current events and issues in the UK and overseas economies.

To bolster your evaluation consider:

Which policies are likely to have most impact on demand if the problem is excess demand for goods and services?
Which policies will be best for improving productivity and raising productive capacity in the economy?
The effect that short term policies can have on other economic objectives such as unemployment, living standards etc