Inflation, Unemployment and Stabilization: Causes, Effects and Policy Measures (Overview) Questions

Question 1

Define inflation.

Accepted Answer

**Inflation** is a sustained rise in the general price level of goods and services over time, reducing the purchasing power of money.

Question 2

What is demand-pull inflation?

Accepted Answer

**Demand-pull inflation** occurs when **aggregate demand** increases faster than aggregate supply, pushing prices up.

Question 3

Define unemployment.

Accepted Answer

**Unemployment** refers to a situation where people who are willing and able to work at prevailing wage rates cannot find jobs.

Question 4

What is cyclical unemployment?

Accepted Answer

**Cyclical unemployment** arises due to a **recession or downturn** in the business cycle when demand and output fall.

Question 5

What is stagflation?

Accepted Answer

**Stagflation** is a situation of **high inflation + high unemployment** along with slow or stagnant economic growth.

Question 6

State one effect of inflation on consumers.

Accepted Answer

Inflation reduces **purchasing power** of consumers, so the same income buys fewer goods and services.

Question 7

Explain causes of inflation (demand-pull and cost-push) with examples (any three points).

Accepted Answer

Causes of inflation (any three):

- **Demand-pull inflation**: when **aggregate demand** rises faster than supply.
  - Example: easy credit and higher government spending increase demand.
- **Cost-push inflation**: when **cost of production** rises and firms increase prices.
  - Example: rise in fuel prices or wage increases beyond productivity.
- **Structural/bottleneck factors**: supply constraints like poor storage/transport causing shortages.
  - Example: food prices rise due to supply disruptions.

Thus, inflation can originate from excess demand, rising costs, or supply bottlenecks.

Question 8

Explain effects of inflation on business (any three points).

Accepted Answer

Effects of inflation on business (any three):

- **Rising input costs**: raw materials, wages and power costs increase, reducing margins if prices cannot be raised fully.
- **Pricing uncertainty**: frequent price changes make planning difficult and may reduce consumer confidence.
- **Higher interest rates**: to control inflation, monetary tightening may raise borrowing costs, increasing finance expense.
- **Wage pressure**: workers demand higher wages to match cost of living, raising labour cost.

Hence, inflation increases costs and uncertainty for firms and can affect profitability and investment decisions.

Question 9

Explain types of unemployment (any four) with brief meaning.

Accepted Answer

Types of unemployment (any four):

- **Frictional**: temporary unemployment during job search or job change.
- **Structural**: mismatch between workers’ skills/locations and job requirements.
- **Cyclical**: caused by recession/business cycle downturn.
- **Seasonal**: due to seasonal nature of work (agriculture, tourism).
- **Disguised**: surplus labour where marginal productivity is very low (common in agriculture).

Thus, unemployment may arise due to both short-term factors and long-term structural issues.

Question 10

Explain effects of unemployment on the economy and business (any three points).

Accepted Answer

Effects of unemployment (any three):

- **Loss of output (GDP)**: economy produces below potential, reducing national income.
- **Lower demand for goods/services**: unemployed people have lower income, so consumption falls; firms face lower sales.
- **Poverty and social issues**: increases poverty and inequality; can raise social tension and instability.
- **Wastage of human resources**: skills may deteriorate with long joblessness, reducing productivity.

Thus, unemployment harms both economic growth and business profitability through weak demand and lower output.

Question 11

Explain policies/measures to control inflation (any three) with brief explanation.

Accepted Answer

Measures to control inflation (any three):

- **Monetary policy tightening**: raise interest rates, increase CRR/SLR, reduce credit to lower demand.
- **Fiscal policy**: reduce deficit spending, increase taxes, cut unnecessary public expenditure to control excess demand.
- **Supply-side measures**: increase production, improve distribution, remove bottlenecks, reduce hoarding.
- **Price controls/rationing**: short-term control in essential goods (but may create shortages if overused).

Hence, effective control needs both demand management and supply improvement.

Question 12

Explain policies to reduce unemployment (any three) with brief explanation.

Accepted Answer

Policies to reduce unemployment (any three):

- **Promote investment and growth**: infrastructure and industrial investment increases output and job creation.
- **Skill development**: vocational training and reskilling reduce **structural unemployment** by matching skills to job needs.
- **Support MSMEs and entrepreneurship**: easier credit, startup support and market access encourage small firms that create many jobs.
- **Public works/employment programs**: during recession, government programs provide temporary employment and raise demand.

Thus, unemployment reduction needs both demand-side (growth) and supply-side (skills) measures.

Question 13

Explain stabilization policy and its objectives (exam-style).

Accepted Answer

### **Stabilization Policy (Exam-Style)**

**Stabilization policy** refers to government and central bank actions aimed at maintaining a stable economy with **steady growth**, **low inflation**, and **low unemployment**. It mainly uses **monetary policy** and **fiscal policy**, supported by structural reforms.

#### **Objectives**
- **Price stability**: control inflation and prevent sharp rises in cost of living.
- **High employment**: reduce unemployment by supporting output and job creation.
- **Stable economic growth**: avoid large booms and recessions; maintain sustainable growth.
- **External stability**: maintain balance of payments and avoid excessive exchange rate volatility.
- **Financial stability**: ensure stable banking system and credit flow.

#### **How it works (overview)**
- During inflation/overheating: tighten money (rates ↑) and reduce deficit spending.
- During recession/unemployment: ease money (rates ↓) and increase productive government spending.

**Conclusion:** Stabilization policy tries to smooth business cycles and create a predictable environment for households and firms.

Question 14

Explain Phillips curve (basic) and discuss why the trade-off may not hold in the long run (with a simple diagram/flow).

Accepted Answer

### **Phillips Curve (Basic) and Long-Run View**

**Phillips curve** shows a relationship between **inflation** and **unemployment**.

#### **Short-run idea (trade-off)**
- When unemployment is low, wages and demand rise → inflation tends to rise.
- When unemployment is high, demand is weak → inflation tends to fall.

Simple diagram (concept):

```text
Inflation
  ^
  |   \
  |    \
  |     \
  +------------> Unemployment
+   (Short-run downward sloping)
+```

#### **Why trade-off may not hold in long run**
- **Expectations**: workers and firms adjust expectations; wage and price setting changes.
- **Supply shocks**: oil/food price shocks can raise inflation even when unemployment is high.
- **Natural rate of unemployment**: in the long run, inflation may not permanently reduce unemployment.

Flow:

```text
Policy tries to reduce unemployment → demand rises → inflation rises
Expectations adjust → wages/prices rise further → unemployment returns to normal level
```

**Conclusion:** Phillips curve trade-off is more visible in the short run, but in the long run it becomes weak/unstable due to expectations and supply shocks.

Question 15

Explain stagflation and suggest suitable policy measures to handle it (exam-style with table).

Accepted Answer

### **Stagflation and Policy Measures (Exam-Style)**

**Stagflation** is a difficult situation where:
- **inflation is high**,
- **unemployment is high**, and
- **growth is slow/stagnant**.

It is often caused by **supply shocks** (e.g., oil price rise), structural bottlenecks and weak productivity.

#### **Why it is challenging**
- Policies that reduce inflation (tight money) may further reduce demand and increase unemployment.
- Policies that reduce unemployment (stimulus) may increase inflation.

#### **Suitable policy mix**

| Problem | Main focus | Examples of measures |
|---|---|---|
| High inflation | control demand + costs | moderate monetary tightening, reduce deficit, improve supply |
| High unemployment | improve employment + productivity | skill training, MSME support, infrastructure projects |
| Supply bottlenecks | raise output capacity | remove bottlenecks, improve logistics, energy policy |

**Conclusion:** Stagflation needs a balanced policy mix—**supply-side reforms** plus careful demand management—to reduce inflation without worsening unemployment too much.

Inflation, Unemployment and Stabilization: Causes, Effects and Policy Measures (Overview)

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