Inflation, deflation and employment

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causes of inflation:

  • demand-side factors: lead to demand-pull inflation where excess demand pulls prices up. These factors are anything that causes an increase in AD, but in a -ve output gap, an increase in AD is beneficial. In a +ve output gap, it fuels inflation. 
    • the 'Lawson Boom' in the late 1980s where AD grew too rapidly. The Bank Of England was given operational independence in terms of setting interest rates to prevent increases in AD.
  • Cost-push inflation: prices are pushed up by increases in costs of production:
    • a rise in costs of imported raw materials
    • an increase in wage levels due to tight labout markets or powerful trade unions pushing up wages.
    • a rise in indirect taxes or government measures that increase firms' costs
  • cost push inflation leads to increased levels of unemployment
  • Types of inflation can be linked. A rise in the general level of prices caused by excess demand can quickly give rise to wage claims from groups who think that increased prices has reduced their standards of living. 
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Full employment and measuring unemployment

  • in reality, 100% employment cannot be achieved as there will always be some eunmployment due to labour turnover, moevemtn between jobs and incapacity to work. 
  • jobs can be lost in industries that are declining and increasing in growing areas requiring people to be mobile and transfer between jobs. 
  • Full employment is shown when the AS curve becomes VERTICAL. 
  • there are also restrictions as skills needed by most firms are scarce

unemployment and inflation:

  • there is some conflict between the objectives of full employment and stable prices and an inflation level of 2% CPI may mean that levels of employment would be lower than we like. 
  • falling unemployment is likely to lead to increased wages as workers will be in that position and firms will offer higher wages to retain and attract stronger workers. This will increase inflationary pressures, making UK less competitive. 
  • If inflation is kept to a level equal to or under our major trading partners, the UK will be competitive. This will lead to less unemployment as long as inflation is constant.
  • Therefore, while in the short run, they are conflicting objectives, in the long term the cause of full employment may be better served by inflationary pressure at a steady rate.
  • **This needs to be in cooperation with expanding the productive capacity**
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demand and supply-side causes of unemployment


  • cyclical and demand-deficient unemployment is caused by a deficiency of AD.
  • Cyclical unemployment occurs in a negative output gap. There is insufficient demand in the economy to employ the available factors of production. The govt. would increase AD.


  • Fricional unemployment: called 'frictional' as labour markets do not operate immediately to match supply of labour to demand. This can be seen as voluntary unemployment. 
  • Structural unemployment occurs when both the demand and supply patterns of the economy change e.g. in the UK coal mining industry, as demand for gas increased/ coal decreased coal became cheaper in other countries and UK workers lost their jobs. 
    • this unemployment can be caused by both technological changes and foreign competitions.
    • overcoming it requires occupational retraining, financial grants to attract foreign workers and assistance to workers to help move to other available jobs. 
    • Does the govt. have enough information to judge the needs of the provate sector or will it lead to govt. failure?
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