“Governments should paly active roles in managing short run instability caused by
Unemployment and inflation problems”
Introduction
The reverse of the above statement is true, whereby if governments do not play an active role in fighting inflation and unemployment, the adverse effects associated with these two economic eventualities do sometimes dissipate on their own. Therefore, this paper agrees with the above statement, but will also attempt to show that various economic solutions to the short run instability which is associated with unemployment and inflation can sometimes lead to a worsening of the situation at hand, rather than its subsequent improvements (Quiggin, 2012, pg.13).
Positive Sustainable Economic Growth
According to Mukesh (2015, pg.69), one of the main motivations why government may intervene in managing the short run instability which is caused by both unemployment and inflation is so that it can ensure a positive economic growth rate during a given fiscal period. However, Mukesh (2015, pg.69) argues that by implementing fiscal and monetary policies that are geared towards eliminating these effects, the resulting positive economic growth rate will result in an increase in the overall inflation rate in the short run.
According to Mukesh (2015, pg.69), inflation, which is described as a general increase in the price level of goods and services, arises when the economic growth rate exceeds the long run trend rate leading to an economic scenario whereby the Aggregate Demand increases at a faster rate than the underlying Aggregate Supply in a given economy. This faster increases in AD above AS tend to result in inflationary pressures that reverberate across the economy (Mukesh, 2015, pg.69).
According to Philippe (2013, 34), a classic demonstration of a scenario whereby the positive economic growth rate resulted in inflationary pressures is the United Kingdom towards the end of the 1980s. During this duration, the Lawson Boom led to a constant growth rate of about 4.5%, but this economic growth was primarily driven by consumer spending as opposed to other more stable economic factors such as a growth in total exports.
Consequently, this high growth rate resulted in supply constraints that eventually pushed up commodity prices to a level that was untenable to the economic stakeholders. These high commodities prices eventually resulted in a recession in 1991 just as the government was moving to tame the short run effects of the associated inflation by increasing interest rates (Mullard, 2015, pg.112).
Low Inflation Rates
On the contrary, Granett (2012, pg.346) argues that the most ideal approach which a government can adopt in managing the short run instability caused by inflation and unemployment, while at the same time achieving its objective of a steady and increasing growth rate is to keep the inflation rate at a low level.
Granett (2012, pg.346) argues that this objective can only be achieved if a government was to adopt an inflation targeting monetary policy in which i regularly engages in various actions that are intended at keeping the inflation rate at a desired low level. These actions include open market operations in which a government buys and sells treasury securities in the open market with the intention of influencing the interest rates to remain at certain levels and thereby tame any emerging inflationary pressures that could be associated with a positive and steady economic growth rate (Granett, 2012, pg.346).
However, Granett (2012, pg.346) cautions that inflation could reduce in the short run and gradually increase in the long run if the economic growth rate is supported mainly by increased consumer spending as opposed to other more impactful factors such as increased government spending.
This argument is based on the fact that increased consumer spending would most likely be caused by a low interest rate that enables consumers to borrow funds and subsequently increase their disposable income (Granett, 2012, pg.346). If the government increases interest rates so as to tame an increasing inflation rate, then the resulting effect would be a decline in the consumer purchasing power and subsequent fall in the economic growth rate according to Granett (2012, pg.246).
Maintaining a Balance of Payments
According to Fikret (2015, pg.53) one of the main objectives of a government that would influence its decision to manage the short run instability which is associated with inflation and unemployment is so as to maintain its current account at a desired level. In most instances, the government would strive for a scenario whereby the current account deficit if any is narrowed or eventually eliminated (Fikret, 2015, pg.53).
However, Fikret (2015, pg.53) argues that the pursuit of this objective by a government may actually result in increasing the short run effects associated more so with inflation, as opposed to eliminating them entirely. To better understand this eventuality, Fikret (215, pg.53) defines the current account as the difference between the goods that are imported into a country when compared to those that are exported within a given fiscal period. A current account deficit thus, occurs when a country imports more goods than it exports while a current account surplus occurs when a country exports more goods and services than it imports. A balance of payments refers to an optimal situation whereby the imports are equal to the exports accruing to Fikret (2015, pg.53).
However, Fikret (2015, pg.53) argues that by pursuing a reduction in the current account deficit, a country will subsequently be exporting more than it is importing yet an economic growth backed by consumer spending increases tends to result in an increase in imported goods by consumers (Fikret, 2015, pg.53). Therefore, the pursuit of this objective may end up being more detrimental to a government’s desire to increase its economic growth rate rather than be beneficial (Fikret, 251, pg.53).
Reduction of Budget Deficit
According to Maaike (2012, pg.109) a government may feel it needs to intervene and manage the short run instability which is caused by unemployment and inflation levels because this instability may prevent the government from achieving its goal of reducing its budget deficit.
A budget deficit refers to a situation whereby the government does not have all the revenue it requires to finance its spending for a given fiscal year and it is forced to borrow externally to fund this expenditure (Maaike, 2012, pg.109). The more a government borrows through the issue of treasury securities, the more its deficit and vice versa.
The motivation behind reducing the government deficit is the realization that the bigger the budget deficit, the more the government is forced to spend on recurrent expenditure to repay is debt, yet these funds could have been used as capital expenditure which could instead spur economic growth in the long run (Maaike, 2012, pg.109). However, the short run effects of unemployment usually impedes a government’s ability to achieve this objective according to Maaike (2012, pg.109).
According to Maaike (2012, pg.109), increasing unemployment rates usually force a government to spend more on welfare and other social initiatives that are aimed at supporting the unemployed population. The higher the number of unemployed people, the higher the welfare expenditure is, yet these funds could have instead been redirected into capital investment projects (Maaike, 2012, pg.109).
Therefore, a government needs to urgently manage the short run instability which is caused by unemployment because the failure to do so will result in a ballooning welfare bill which may eventually be supported by external borrowing by the government, thereby widening its budget deficit (Maaike, 2012, pg.109).
Economic Growth and the Environment
According to Sander (2012, pg.2), the conservation of the environment has become a major objective of governments as well as private sector players due to the adverse effects that are associated with pollution and the failure to conserve the natural heritage. These effects include an overall increase in greenhouse gas emissions that have not only led to the destruction of the Ozone layer, but have also led to adverse weather conditions that have been witnessed in recent times (Sander, 2012, pg.2).
However, Sander (2012, pg.2) notes that the overall objective of a government to increase its economic growth rate may contradict its goal of conserving the environment because increasing GDP levels tend to result in increased pollution of the environment as a result of increasing consumption as well as destruction of the renewable resources that are used in supporting the GDP growth rate.
Consequently, Sander (2012, pg.2) proposes that by maintaining the inflation rate at a low level, the economic growth rate may slow down but the corresponding level of the destruction of the natural environment will also be tamed in the long run. This objective significantly contradicts the objective of pursuing an increasing economic growth rate.
Therefore, Sander (2012, pg.2) proposes that in order to achieve the objective of a low inflation rate that ensures an economic growth rate that does not hurt the environment, the Aggregate Supply must increase at the same rate as the Aggregate Demand. This constant increase will mitigate the risk of the emergence of extreme inflationary pressures which will prevent the government from achieving its twin objectives of environmental conservation and a stable economic growth rate (Sander, 2012, pg.2).
Unemployment and Inflation
In evaluating the short run instability effects that are associated with unemployment and inflation within an economy, it is important to evaluate whether there exists a direct relationship between these two economic concepts and the implication of this relationship from an economic perspective.
According to Hubbard (2014, pg.390) the relationship between unemployment and inflation can be summarized as being directly proportional in the sense that during periods of high recorded economic growth rates, the economy is able to create jobs within the different sectors. Consequently, the creation of these jobs leads to an overall decline in the unemployment rate. However, the fall in the unemployment rate can at times result in an upward pressure on the prevailing wage rate leading to a corresponding increase in the inflation rate (Hubbard, 2014, pg.390).
However, Dwivedi (2010, pg.497) notes that there exists a tradeoff between the prevailing unemployment rate and the underlying inflation rate as suggested by the Phillips Curve. Within this framework, the prevailing unemployment rate in an economy can be reduced by reducing the rate of the structural unemployment in an economy.
This reduction is expected to result in a fall in the overall unemployment rate while preventing a rise in the wage inflation rate (Dwivedi (2010, pg. 497). Furthermore, if the growth rates are kept stable, the overall rate of inflation is expected to remain low according to Dwivedi (2010, pg. 497).
Conclusion
This paper sought to investigate and demystify the statement that “Governments should paly active roles in managing short run instability caused by unemployment and inflation problems.” The paper has concurred with the above statement but has gone on to show that certain undesired economic effects can arise from the proactive actions of government bodies that try to address these short run effects.
The paper has used the example of the United Kingdom and demonstrated the effect of various macroeconomic fiscal policies that are intended at fighting these effects and their eventual outcome. In closing, the arguments made in this paper provide an objective view in regards to the short run economic effects that are attributed to inflation and unemployment.
Reference List
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Garnett, A., 2012. Essentials of Economics. Sydney: Pearson
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Maaike, S., 2012. The Determinants of Economic Growth. New York: Springer
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Philippe, A., 2013. Handbook of Economic Growth, Volume 2. NJ: Newnes
Quiggin, J., 2012. Zombie Economics: How Dead Ideas Still Walk among Us. Princeton:
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