Now that we have looked at money and interest rates, we are in a position to give a more complete explanation of the relationship between inflation and unemployment, and how these vary with the course of the business cycle. This has been one of the most controversial areas of macroeconomics for decades, with considerable disagreement between Keynesians, monetarists and new classical economists. We will be examining their various viewpoints as the chapter progresses. We will also be seeing whether, in recent years, there has emerged any general agreement between economists over these issues.
We start by having a look at the relationship between money supply and prices. If money supply rises, does this just lead to higher prices, or does it lead to higher output too? Is the answer to controlling inflation merely to restrict the growth of the money supply (by raising interest rates), or will doing so lead to a recession?
Then there is the issue of unemployment. If keeping inflation low involves running the economy at less than full capacity, does this mean that higher unemployment is the price of lower inflation? Is there a ‘trade-off’ between the two?
We will look at the views of the different schools (monetarist, new classical and Keynesian) about the relationship between inflation and unemployment: whether there is a trade-off between them. As we shall see, there is considerable disagreement. There is similar disagreement over the most appropriate policies to tackle the two problems. So let battle commence!
