What is inflation? What is unemployment? Is there a relationship between them? If yes, how can we describe this relationship?
In this article we’ll be trying to answer these questions in an attempt to bring you closer to these important economic concepts.
The inflation: described as a general and durable increase in prices level because of the decline of purchasing power of a given currency over the time.
This phenomenon is generally due to an excess money supply in the economy, it’s described as a disorder attributed to the increase in the money supply in the economy.
Inflation may also be caused by an imbalance between demand and supply, if the demand for an essential product or service exceeds supply and producers are unable or unwilling to increase production immediately then the excess demand will lead to higher prices which means an inflationary gap.
The increase of production costs, especially imported raw materials, is also a considerable factor that causes inflation.
Unemployment: the state of a person able to work and who is looking for a job. Unemployment is one of the major social and economic problems most countries face, and the determination of the level of employment is one of the most fundamental questions of the economic reflection.
To explain the relationship between inflation and unemployment we have to go through some other important concepts: GDP, potential GDP growth and the output gap.
GDP (gross domestic product): is the total market value of all goods and services produced in the economy in a given year .
Potential GDP growth:can be defined as the ideal GDP growth we aspire to achieve to maintain our economic stability and avoid high inflation and unemployment rates.
The output gap: the difference between how much the economy is growing and how much it should grow, which means the difference between the actual GDP and the potential GDP.
-When the output GDP is positive (actual GDP > potential GDP): we call it an inflationary gap where we have high inflation but the good thing about this phase is the low unemployment rates (the employment goes up).
-When the output gap is negative ( the actual GDP < potential GDP): we call a recessionary gap, in this phase the prices level is low and the inflation is decreasing, on the other hand the unemployment rates go up.
We observe that there is a contradictory rerelationship between the inflation an the unemployment: when the inflation is high the unemployment is low and when the inflation is low the unemployment is high.
How can we explain this contradictory relationship?
The inflationary gap is characterized by an increasing production. To achieve this high production we need more people to work which means low unemployment rates and this will lead to increasing people’s purchasing power. High purchasing power means more consumption (the demand goes up), according to the low of supply and demand: higher demand means higher prices (the inflation keeps increasing).
And the opposite happens in the recessionary gap: less production causes high unemployment which results in a low purchasing power, so ,obviously , the consumption will decrease (the demand does down) in this case the law of supply and demand says that the prices will go down (decreasing inflation).
This is why governments and central banks always try to keep the GDP as close as possible to the potential GDP growth to avoid high inflation or unemployment rates.
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