Inflation & Unemployment

SPEC 2.3 & 2.4 • THE UK ECONOMY

Causes, consequences, measurement, the Phillips Curve, NAIRU, and the Friedman-Phelps expectations model

Inflation — Key Definitions

Three terms that students constantly confuse. Get these locked in first.

Inflation

A sustained increase in the general price level of goods and services over time.

Deflation

A sustained decrease in the general price level. Negative inflation rate. Can signal economic crisis (falling demand, rising unemployment).

Disinflation

A fall in the rate of inflation — prices are still rising, but more slowly. Example: inflation falls from 5% to 2%. Prices are NOT falling.

Examiner Alert

Disinflation ≠ deflation. This distinction is heavily tested in multiple choice. Disinflation means the rate of increase is slowing. Deflation means prices are actually falling. Mix these up and you lose easy marks.

Measuring Inflation: CPI & RPI

Consumer Prices Index (CPI)

A measure of inflation tracking price changes of a weighted basket of goods and services purchased by a representative household. The basket is updated annually. The UK inflation target is CPI = 2%.

CPI vs RPI

RPI (Retail Prices Index): An older measure that includes housing costs (mortgage interest payments). Generally higher than CPI. Still used for index-linking rail fares, gilt yields, and some benefits.

Limitations of CPI

Basket may not reflect spending patterns of specific groups (elderly, low-income)

Does not directly capture housing costs

Cannot fully capture quality improvements — hedonics problem (a smartphone today does far more than one 10 years ago at the same price)

Substitution bias — consumers switch to cheaper alternatives but CPI basket is fixed between updates

Three Causes of Inflation

Every inflation question requires you to identify which type and draw the correct diagram.

1. Demand-Pull Inflation

Caused by an increase in aggregate demand — "too much money chasing too few goods." AD shifts right → economy pushed beyond potential output → price level rises.AD shifts right→Output > Y_f→Price level ↑

2. Cost-Push Inflation

Caused by rising costs of production (wages, oil prices, raw materials) → SRAS shifts left → price level rises AND output falls = stagflation.Costs rise→SRAS shifts left→P↑ and Y↓

3. Monetary Inflation (Monetarist View)

Milton Friedman: "Inflation is always and everywhere a monetary phenomenon." If money supply grows faster than output → more money chases same goods → prices rise. Key to QE evaluation.

Inflation on AD/AS Diagrams

Exam Tip

Always identify the type of inflation before drawing the diagram. Demand-pull = AD shifts right. Cost-push = SRAS shifts left. Drawing the wrong shift invalidates your entire answer.

Effects of Inflation — Four Groups

GroupEffects

ConsumersPurchasing power falls. Fixed-income groups (pensioners) hit hardest. Savers lose if real interest rates are negative. Menu costs — time wasted updating prices.

FirmsHigher input costs squeeze profit margins. Uncertainty reduces investment. Exporters suffer if domestic inflation exceeds competitors' — loss of international competitiveness.

GovernmentReduces real value of national debt (inflation "erodes" debt). But high inflation damages credibility of inflation targeting. Risk of wage-price spiral.

WorkersReal wages fall if nominal wage rises lag behind inflation. Workers with strong unions can demand wage increases — but this risks a wage-price spiral .

Wage-Price Spiral

Workers demand higher wages to match inflation → firms face higher costs → firms raise prices → workers demand even higher wages → self-reinforcing cycle of accelerating inflation.

Unemployment — Five Types

Every type has a different cause and requires a different policy solution.

TypeCauseSolution

Cyclical (demand-deficient)Fall in AD during recession — largest type in downturnsDemand-side policy (fiscal / monetary expansion)

StructuralMismatch between workers' skills and jobs available (e.g. decline of coal/steel)Supply-side policy (retraining, education)

FrictionalWorkers between jobs — searching for new positionsBetter job market information, job centres

SeasonalIndustries with seasonal demand (tourism, agriculture)Diversification of local economies

VoluntaryWorkers choose not to accept jobs at current wagesReduce benefit replacement ratio

Measuring Unemployment — Two Methods

Claimant Count

Number of people claiming unemployment-related benefits (Universal Credit).

Advantages: Simple, cheap, up-to-date, covers entire population.

Limitations: Excludes job-seekers who don't claim benefits. Government can manipulate eligibility rules to reduce the count.

Labour Force Survey (ILO)

Quarterly survey — counts people without a job, actively seeking work, and available to start within two weeks.

Advantages: More comprehensive. Internationally comparable (preferred measure).

Limitations: Sample-based (survey error). Published quarterly so less timely. May undercount discouraged workers who've stopped looking.

Costs of Unemployment

Individual: Lost income, psychological harm, skills atrophy.

Government: Higher benefit expenditure, lower tax revenue → worsening fiscal position.

Economy: Lost output — actual GDP below potential. Economy inside PPF. Long-term unemployment leads to deskilling → structural unemployment.

The Phillips Curve

Phillips Curve

A diagram showing the short-run trade-off between inflation and unemployment — as unemployment falls (economy moves toward capacity), wage pressures and demand-pull inflation rise. Named after A.W. Phillips (UK data, 1861–1957).

Why the Trade-Off Exists

AD increases→Output rises→Unemployment falls→Labour market tightens→Wages bid up→Inflation rises

Exam Tip

The Phillips Curve is not on its own diagram page in the exam — you must draw it yourself. Axes: Inflation rate (vertical), Unemployment rate (horizontal). Draw a downward-sloping curve. This is the SRPC.

Short-Run Phillips Curve

The SRPC shows the trade-off at a given level of inflation expectations. Moving along it = policy choice between inflation and unemployment.

Point A: Low unemployment (3%), high inflation (6%) — economy near/above capacity.

Point B: High unemployment (8%), low inflation (1%) — economy has spare capacity.

NAIRU — The Natural Rate

NAIRU

Non-Accelerating Inflation Rate of Unemployment — the rate of unemployment at which inflation is stable. Roughly 4–5% in UK context. At NAIRU, inflation expectations are met and there is no upward or downward pressure on inflation.

What Makes Up NAIRU?

NAIRU consists of all non-cyclical unemployment: structural + frictional + seasonal + voluntary. It exists even when the economy is at "full employment." NAIRU cannot be reduced by demand-side policy — only supply-side policy can lower it (better training, improved labour market flexibility, reduced occupational/geographical immobility).

Why It Matters

If the government pushes unemployment below NAIRU using demand-side policy, inflation will accelerate. This is the central argument of the Friedman-Phelps model and the theoretical backbone of modern monetary policy (inflation targeting).

Long-Run Phillips Curve (LRPC)

The LRPC is vertical at NAIRU. In the long run, there is no trade-off between inflation and unemployment.

A→B: Government expands AD → unemployment falls below NAIRU, inflation rises (move along SRPC₁).

B→C: Workers realise real wages haven't risen → demand higher wages → costs rise → SRAS shifts left → unemployment returns to NAIRU but inflation is permanently higher (SRPC shifts up to SRPC₂).

Friedman-Phelps Expectations Model

This is the theoretical backbone of modern monetary policy. Learn the full chain.

Gov. expands AD

U falls below NAIRU

Workers accept higher nominal wages

Workers realise real wages unchanged

Demand even higher wages

Firms' costs rise

SRAS shifts left

U returns to NAIRU

But π is now higher

SRPC shifts up

The Conclusion

In the long run, there is no permanent trade-off. Repeated demand-side stimulus produces accelerating inflation with no lasting employment gain. The LRPC is vertical. Only supply-side policy can reduce NAIRU and achieve lower unemployment without inflation.

Exam Tip

This model is the key AO4 evaluation for any question about demand-side policy and unemployment. Write: "According to the Friedman-Phelps model, demand-side expansion can only reduce unemployment below NAIRU temporarily. In the long run, expectations adjust and inflation accelerates with no permanent employment gain."

What Shifts the Phillips Curves?

SRPC Shifts Outward (Worse Trade-Off)

Rising inflation expectations

Supply-side shock (oil prices ↑)

Wage-price spiral

Higher inflation at every unemployment rate = stagflation.

LRPC Shifts Left (Lower NAIRU)

Better education/training → less structural U

Improved labour market flexibility

Reduced occupational/geographical immobility

Better job market information → less frictional U

Only supply-side policy can shift LRPC left.

Examiner Alert

Demand-side policy moves you along the SRPC. Only supply-side policy can shift the LRPC. If you say "expansionary fiscal policy shifts the Phillips Curve left" you will lose marks. It moves the economy along the existing curve.

Policy Conflict Matrix — AO4 Gold

These conflicts appear in virtually every Paper 2 essay. Know the mechanism for each.

ConflictMechanism

Growth ↑ vs Inflation ↑Higher AD boosts output but risks demand-pull inflation — core Phillips Curve trade-off

Growth ↑ vs BoP deficit ↑Higher income → more imports → current account worsens

Low U vs Low πTight labour market → wages bid up → cost-push inflation

Low π vs GrowthHigh interest rates to control inflation → reduce I and C → lower growth

Fiscal balance vs GrowthAusterity to reduce deficit → cuts G → negative multiplier → lower growth

Key Evaluation

Not all conflicts are inevitable — supply-side policy can raise output AND reduce inflation simultaneously, resolving the growth–inflation trade-off. This is the supply-side ideal.

Examiner Alert: Common Errors

Examiner Alert

Confusing disinflation and deflation. Disinflation = rate slows. Deflation = prices fall. This costs marks every single series.

Not identifying the type of inflation. "Inflation increases" is not enough. State demand-pull or cost-push and draw the correct diagram.

Saying demand-side policy can permanently reduce unemployment below NAIRU. It cannot — Friedman-Phelps shows why. This caps your evaluation at Level 2.

Drawing the Phillips Curve with wrong axes. Inflation rate (vertical), unemployment rate (horizontal). NOT price level.

Forgetting to link unemployment type to policy solution. Cyclical U = demand-side. Structural U = supply-side. Wrong policy = zero analysis marks.

Treating all unemployment as identical. You must specify the type when analysing any policy's effect on unemployment.

AO4 Evaluation Toolkit

Use these developed evaluative points in any inflation/unemployment essay.

1. Short Run vs Long Run (Friedman-Phelps)

"In the short run, expansionary policy can reduce unemployment below NAIRU. In the long run, expectations adjust and inflation accelerates with no permanent employment gain. The appropriate time horizon determines the policy recommendation."

2. Type of Unemployment

"The effectiveness of policy depends on the type of unemployment. Demand-side policy can reduce cyclical unemployment but cannot address structural mismatch. Only supply-side policy — retraining, education, reducing immobility — can lower the natural rate."

3. Type of Inflation

"The appropriate policy response depends on whether inflation is demand-pull or cost-push. Contractionary monetary policy (raising Bank Rate) is effective against demand-pull but worsens the output loss from cost-push inflation."

4. Supply-Side Resolution

"Supply-side policy can resolve the inflation–unemployment trade-off by shifting LRAS right and LRPC left simultaneously — raising output while reducing inflationary pressure. However, this takes years and its effectiveness is uncertain."

5. Inflation Expectations

"The impact of any policy depends on how it affects inflation expectations. If the central bank maintains credibility (inflation targeting at 2%), expectations remain anchored and the SRPC stays stable. Loss of credibility shifts SRPC outward."

Practice Question

Explain why the long-run Phillips Curve is vertical. Use a diagram in your answer. (5 marks)

1

Define: The Phillips Curve shows the short-run trade-off between inflation and unemployment. The LRPC is vertical at the NAIRU (Non-Accelerating Inflation Rate of Unemployment).

2

Diagram: Draw axes (inflation rate vertical, unemployment rate horizontal). Draw downward-sloping SRPC₁. Draw vertical LRPC at NAIRU. Mark points A (on SRPC₁ at NAIRU), B (below NAIRU on SRPC₁, higher inflation), and C (back at NAIRU on SRPC₂, even higher inflation).

3

Explain (Friedman-Phelps): If government expands AD to push unemployment below NAIRU (A→B), workers initially accept higher nominal wages. But they realise real wages are unchanged → demand higher wages → firms' costs rise → SRAS shifts left → unemployment returns to NAIRU at a higher inflation rate (B→C). SRPC shifts up.

4

Conclude: In the long run, any attempt to hold unemployment below NAIRU simply produces accelerating inflation. The trade-off disappears — LRPC is vertical. Only supply-side policy can reduce NAIRU itself.

Practice Question 2

Assess the likely macroeconomic effects of a sustained rise in UK inflation from 2% to 8%, caused by a sharp increase in global energy prices. (8 marks)

1

Identify type: This is cost-push inflation — rising energy costs shift SRAS left. Price level rises while output falls = stagflation.

2

KAA Point 1: Consumers face falling real incomes (nominal wages lag behind 8% inflation) → purchasing power falls → consumption falls. Fixed-income groups (pensioners) hit hardest. Savers lose if Bank Rate < 8% (negative real interest rates). International competitiveness worsens → exports fall → current account deficit widens.

3

KAA Point 2: Firms face higher input costs → profit margins squeezed → uncertainty rises → investment falls. As shown in the AD/AS diagram, SRAS shifts left → output falls and unemployment rises simultaneously. Government faces the policy dilemma: raising rates tackles inflation but worsens the recession; cutting rates supports growth but fuels further inflation.

4

Evaluation: The severity depends on whether the energy shock is temporary (SRAS self-corrects) or permanent (structural adjustment needed). If wage-price spiral begins (workers demand 8%+ rises), SRPC shifts outward and inflation becomes self-reinforcing. The Bank of England's response is critical — if it maintains credibility by signalling it will return inflation to 2%, expectations may remain anchored.

Summary

Key Takeaways

ConceptKey Point

3 causes of inflationDemand-pull (AD right), cost-push (SRAS left), monetary (money supply > output growth)

5 types of unemploymentCyclical, structural, frictional, seasonal, voluntary — each needs different policy

2 measuresClaimant count (benefits) vs ILO/LFS (survey, preferred, internationally comparable)

SRPCDownward-sloping — short-run trade-off between inflation and unemployment

LRPCVertical at NAIRU — no long-run trade-off. Friedman-Phelps expectations model.

Policy conflictsGrowth vs inflation, growth vs BoP, low U vs low π — supply-side can resolve

Critical Distinctions

Disinflation ≠ deflation

Demand-pull ≠ cost-push

Cyclical ≠ structural U

SRPC movement ≠ LRPC shift

Evaluation Framework

SR vs LR (Friedman-Phelps) · Type of U · Type of π · Supply-side resolution · Expectations anchoring

Exam Tip

In every macro essay involving inflation or unemployment, draw the appropriate diagram (AD/AS or Phillips Curve), identify the specific type, and evaluate using the Friedman-Phelps model and policy conflict matrix.