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Macro Economics

Notes In some advanced capitalist countries including the USA, high rates of inflation have co-existed
with high rates of unemployment.

Example: In the 60s, when the US economy came to experience a very high rate of
inflation and Nixon administration clamped restrictive monetary and fiscal controls on the
economy in an attempt to curb inflation, there was a sharp rise in unemployment but virtually
no reduction in inflation. Such a situation where unabated inflation co exists with recession or
stagnation in the economic activity, which has come to be called stagflation, poses a negation to
the PC.

Some economists like Paul Samuelson, James Tobin, Milton Friedman and Robert Solow
maintain that there is a natural rate of unemployment. Basically, it is the rate of unemployment
associated with the output level at which the aggregate supply becomes vertical – that is the full
employment level of output. At this rate of unemployment the long run PC tends to be a vertical
line. There is no way by which the government can bring down the rate of unemployment
below this natural rate without setting off an inflationary spiral. In Figure 11.2 below, the
unemployment rate OA represents the long run natural rate of unemployment. The shape of the
long run PC-LPC suggests that there is no trade-off between inflation and unemployment in the
long run.
Figure 11.2

Thus, several economists opine that the negative relation between inflation rate and
unemployment rate holds good at the most only in the short run. Further, the data on the US
economy for the 60s and 70s showed that the PC, if applicable, tended to shift to the right over
time. A shifting PC, creates problems to the policy makers in that they cannot be sure as to what
rate of inflation is required in order to keep unemployment rate to a certain minimum. In the
figure above, SPC and SPC are short-run PCs and LPC is the long run curve. Note that if the
1 2
short run curve shifts from SPC to SPC the inflation rates rises from P to P at the same rate of
1 2 1 2
unemployment, OA or, maintenance of P rate of inflation calls for DE rate of OA. Thus, the
1
rightward shifting of the PC implies that a given rate of unemployment is associated with a
higher rate of inflation, or a given inflation rate means a higher rate of unemployment.
One of the explanations offered for the shifting PC is the changes in the composition of labour
force. In recent decades youths and women have come to constitute a larger proportion of the
labour force. In most industrial economies, the unemployment rates among youths and women
workers are substantially above that for the labour force as a whole. With these high
unemployment groups more dominant in the labour force, the level of aggregate demand

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