IB Economics - Possible relationships between unemployment and inflation

This study note for IB economics covers possible relationships between unemployment and inflation

1 Introduction

Unemployment and inflation are two critical indicators of an economy's health. The relationship between these two variables is a key focus of macroeconomic theory and policy. Economists analyze this relationship using concepts such as the Phillips Curve, which illustrates potential trade-offs between inflation and unemployment in different economic contexts.

2. The Short-Run Phillips Curve (SRPC)

2.1 Concept

• The SRPC shows an inverse relationship between inflation and unemployment in the short run.
• This curve suggests that lower unemployment can lead to higher inflation and vice versa.

2.2 Diagram and Explanation

• Diagram: The SRPC is typically downward-sloping. The y-axis represents the inflation rate, while the x-axis represents the unemployment rate.
• Explanation:
  • When the economy operates below its full capacity (high unemployment), there's less pressure on prices and wages, leading to lower inflation.
  • Conversely, as unemployment falls and the labor market tightens, firms may raise wages to attract scarce labor, increasing their costs and potentially leading to higher prices (inflation).

2.3 Real-World Example

• 1970s U.S. Economy: The U.S. experienced low unemployment and rising inflation, highlighting the trade-off between these two variables in the short run.

3. Outward Shifts in the Short-Run Phillips Curve (Stagflation)

3.1 Concept

• The SRPC can shift outwards, indicating a situation where both inflation and unemployment increase simultaneously, known as stagflation.

3.2 Causes of Outward Shifts

• Supply Shocks: Events such as oil price shocks or natural disasters can increase production costs, shifting the SRAS curve leftward.
• Cost-Push Inflation: Rising costs of inputs (e.g., wages, raw materials) increase overall prices, leading to higher inflation at the same level of unemployment.

3.3 Diagram and Explanation

• Diagram: A new SRPC to the right of the original curve represents higher inflation and unemployment.
• Explanation:
  • A leftward shift in the SRAS curve raises the price level, increasing inflation. The reduced output leads to higher unemployment, shifting the SRPC upwards and to the right.

3.4 Real-World Example

• 1970s Oil Crisis: The oil price shock led to increased production costs, resulting in both high inflation and unemployment.

4. The Long-Run Phillips Curve (LRPC)

4.1 Concept

• In the long run, the Phillips Curve is vertical at the Natural Rate of Unemployment (NRU).
• The NRU represents the unemployment rate when the economy is producing at its full employment output level.

4.2 Diagram and Explanation

• Diagram: The LRPC is a vertical line at the NRU.
• Explanation:
  • In the long run, inflation expectations adjust, negating the short-run trade-off between inflation and unemployment.
  • At the NRU, attempts to reduce unemployment below this level result in accelerating inflation without long-term decreases in unemployment.

4.3 Natural Rate of Unemployment (NRU)

• Definition: The NRU is the level of unemployment that exists when the economy is at full employment, considering frictional and structural unemployment.
• Implications: Policies aimed at reducing unemployment below the NRU may only cause inflation without affecting long-term employment.

4.4 Real-World Example

• 1980s U.S. Economy: After high inflation in the 1970s, the U.S. Federal Reserve raised interest rates to curb inflation, leading to high unemployment. This event illustrates the economy's return to the NRU in the long run.

5. Glossary of Key Terms

• Cost-Push Inflation: Inflation caused by rising costs of production.
• Inflation: The rate at which the general level of prices for goods and services rises, eroding purchasing power.
• Natural Rate of Unemployment (NRU): The rate of unemployment when the economy is at full employment, including frictional and structural unemployment.
• Phillips Curve: A graph showing the inverse relationship between inflation and unemployment.
• Short-Run Aggregate Supply (SRAS): The total supply of goods and services produced in an economy at a given overall price level in the short run.
• Stagflation: A situation in an economy where inflation and unemployment are high simultaneously.

6. Possible IB Economics Essay-Style Questions

1. Discuss the concept of the short-run Phillips curve and the potential trade-off between inflation and unemployment.
2. Explain the factors that can cause an outward shift in the short-run Phillips curve, and discuss the implications of such a shift for an economy.
3. Evaluate the view that in the long run, there is no trade-off between unemployment and inflation, as represented by the long-run Phillips curve.
4. Analyze the concept of the natural rate of unemployment and discuss its significance for macroeconomic policy.
5. Using real-world examples, discuss how supply-side shocks can impact the relationship between inflation and unemployment.

These notes provide a comprehensive understanding of the relationship between unemployment and inflation, using key economic concepts and real-world examples. Students should use diagrams to illustrate these relationships and deepen their understanding of the underlying theories.