At a quarterly meeting, the central bank of Lydora reviewed the relationship between the unemployment rate and the annual rate of price inflation. Fig. 2 is...
Question 1 Report
At a quarterly meeting, the central bank of Lydora reviewed the relationship between the unemployment rate and the annual rate of price inflation. Fig. 2 is based on labour-market and consumer-price data collected over several years. Point R records a period when weak household demand led shops to cut prices and firms reduced their demand for labour. Point S records a later period after a large fall in the policy interest rate encouraged credit, consumption and new investment. The government wants stronger economic growth, but is concerned that rapid price increases will reduce the purchasing power of wages and raise production costs for domestic firms.
Fig. 2: Inflation and unemployment in Lydora
(a) Identify the point, R or S, at which Lydora has the higher unemployment rate. [2]
(b) Which economic objective is most directly represented by a low rate of inflation? [2]
(c) Explain how a reduction in the policy interest rate could move the economy from R towards S. [6]
(d) Examine whether the government should give priority to reducing unemployment rather than reducing inflation in Lydora. [10]
Answer Details
(a) R has the higher unemployment rate. [1] It is further right on the unemployment-rate axis. [1]
(b) A low inflation rate represents price stability. [1] This means avoiding a sustained rise in the general price level. [1]
(c) Lower interest rates reduce borrowing costs for households and firms. [1] Households may borrow more or save less, raising consumption. [2] Firms may borrow to finance investment. [1] Consumption and investment increase aggregate demand. [1] Firms raise output and demand more labour, reducing unemployment and moving the economy from R towards S. [1] Higher aggregate demand can also create upward pressure on prices.
(d) Reducing unemployment can prevent waste of labour and lost national output. [1] It raises household income and living standards. [1] It can reduce benefit spending and increase tax revenue. [1] Avoiding long-term unemployment also prevents skill loss and lower future productive potential. [1] Higher employment supports demand and growth. [1]
Reducing inflation is also important: rising prices reduce real incomes, particularly for people on fixed incomes. [1] Inflation can raise firms' costs and reduce international competitiveness. [1] Uncertainty over future prices can discourage saving and investment. [1] Demand expansion designed to reduce unemployment may worsen demand-pull inflation. [1]
Judgement: Priority depends on the severity and causes of both problems. With substantial spare capacity, reducing unemployment may be preferable. High or accelerating inflation may instead require restraint. [2]
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