Relationship between inflation and unemployment

One of my Year 12 AS Economics students asks what is the relationship between inflation and unemployment. The first theory that springs to mind is the Phillips curve but this is generally not expected on the OCR AS economics course.

At AS I'd expect students to use a standard AS- AD diagram to show any link between inflation and unemployment. For instance,an increase in AD causes short run economic growth. Higher output requires more labour so unemployment falls. 

However given spare capacity in the upward sloping shape of the AS curve beyond Y1 (due to shortages and bottlenecks in key industries), the increase in AD results in a rise in the price level from P1 to P2, thus exerting inflationary pressure.

So an increase in aggregate demand results in inflation and reduce unemployment.  

However, does a fall in unemployment always coincide with inflation? No. Any increase in real GDP up to Y1 results in more output and less unemployment but with a constant price level - there is non-inflationary growth

So like so many things in economics, falling unemployment may or may not be associated with inflation depending upon assumptions eg the starting position and the price elasticity of aggregate supply.

The above analysis suggests that unemployment and inflation can be linked but the cause an increase in AD. any relationship between unemployment and inflation is best analysed using the Phillips curve - an A2 topic

Revision video: Using AD-AS diagrams to answer extended questions

In this video I develop Revision video: using AD-AS diagrams to analyse economic performance to see how to use AD-AS diagrams to answer extended questions set by OCR in Macroeconomics F582.

OCR typically set three types of last question

·         Discuss whether a policy (SS) or policy instrument (R, $/£) can affect: a component of AD (C & I) | an economic indicator eg economic growth | an economic objective eg low and stable prices | economic performance eg GDP and inflation

·         Discuss whether a change in a factor influencing a component of AD can affect a performance indicator eg inflation

·         Discuss whether a change in an indicator of economic performance (economic growth, inflation) is beneficial (do benefits outweigh costs)

NB: R affects I; I affects both AD and AS | G on infrastructure and education affects both AD and AS

Evaluation: L3 assumes cet par – what if there is an unexpected event| is a variable eg R the most important | depends on starting position ie capacity | impacts vary between time periods