Economic Policy and the Inflation-Unemployment Tradeoff

Policy

Two types of economic policy exist:

Fiscal policy is determined by the President and Congress when they agree on a budget.  The two tools are government expenditures and taxes.  To expand the economy and push rightward the AD curve the government would have to increase expenditures or decrease taxes (so that consumers could increase spending).  To engage in contractionary fiscal policy, the government would have to raise taxes or decrease expenditures.

Monetary policy is administered by the Federal Reserve system.  By increasing the money supply and reducing interest rates, the Fed can give banks the ability to loan more, which will raise investment and consumption, and shift the AD curve to the right.  Contractionary monetary policy would result from lowering the money supply and increasing interest rates.

Both fiscal and monetary policy operate through the Aggregate Demand curve in the short run.  Expansionary fiscal policy will shift Aggregate demand to the right, resulting in more output and a higher price level:

Contractionary policy shifts Aggregate Demand to the left, resulting in less output and a lower price level:

Tradeoff

This result comes from considering how policy shifts the Aggregate Demand curve.  If the President wanted to lower the unemployment rate, he would have to raise output (the only way to increase production in the short run is to employ more workers).  This is expansionary policy.  However, as the diagram above shows, this will also raise the price level (leading to a period with a higher inflation rate).  Thus, the President's attempt to decrease the unemployment rate comes at the expense of raising the inflation rate.

Suppose that the President wants to lower the inflation rate.  He would engage in contractionary policy.  As the diagram above shows, this will lower the price level and the inflation rate (instead of seeing an actual drop in the price level, we will most likely see a reduction in the inflation rate).  However, contractionary policy will also decrease output, which will raise the unemployment rate (when production falls, workers lose their jobs).  Thus, the President's attempt to decrease the inflation rate comes at the expense of raising the unemployment rate.

Issues

Yes.  Since most policy is expected to influence Aggregate Demand, then the tradeoff always exists.  If policy influences the Aggregate Supply curve, however, it is possible to reduce both the inflation rate and unemployment rate.  Such Supply Side Economics was tried during Reagan's presidential term, but the results do not point to strong influences of discretionary policy on Aggregate Supply.

2.  The current U.S. inflation rate and unemployment rate are both at thirty-year lows.  Doesn't this violate the tradeoff?

No.  A low unemployment rate and inflation rate might be the result of an increase in Aggregate Supply.  This shift in Supply occurs along side and independent of economic policy.  But economic policy that shifts the Aggregate Demand curve will always face the tradeoff.  Thus, policy makers can lower today's unemployment even lower but the result will be higher inflation as long as other changes to the economy do not occur.

3.  What is the best mix between unemployment and inflation?

There is no simple answer and many Economists disagree as to the correct direction for current policy.  The direction that policy should take depends on the levels of unemployment and inflation, political considerations, and preferences in general. 

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