There seems to be a tension between the Bank of Canada who wants to achieve price stability first and output stability second, versus the Department of Finance who is more concerned with output...

There seems to be a tension between the Bank of Canada who wants to achieve price stability first and output stability second, versus the Department of Finance who is more concerned with output stability and employment creation.  Class, please outline the costs and benefits of achieving price stability relative to output stability (In your answer be sure to discuss the fact that there is no trade-off between inflation and unemployment in the long run).  Be sure to discuss the costs of inflation, the costs and benefits of reducing it and how this compares to reducing unemployment if at all possible.  Can a case be made for targeting zero inflation as the primary objective, especially in the long run?  If so, what things can governments do to tackle unemployment, especially structural? 

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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In the long run, most economists would say, there is no tension between trying to achieve price stability and trying to achieve output stability.  This is because, as your question states, economists believe that there is no tradeoff between inflation and unemployment in the long run.  In the long run, it should be possible to have both low inflation and low unemployment.

The reason for this is the fact that (according to many economists) the long range supply curve is vertical.  If the long range supply curve is vertical, the real level of output will remain the same regardless of the price level.  Changes in price level may result in temporary gaps between potential and actual output, but the economy will adjust and return to its natural level of output.

When high levels of inflation exist (particularly if they are unpredictable) an economy suffers badly.  Saving and investment declines in favor of spending on short-term consumption.  Individuals and firms worry about the value of money in the future and therefore engage in more speculation in an attempt to make money fast enough to increase their real wealth.  This is bad for the economy in the long term.

Controlling inflation is good for the economy in the long term, but it has costs in the short term.  Inflation is typically controlled by reducing government spending and/or increasing taxes (fiscal policy) or by reducing the money supply through such things as higher interest rates (monetary policy).  If governments take this sort of action, they will reduce aggregate supply and demand in the short term.  If, for example, interest rates rise, individuals and firms will not borrow as much and will therefore not spend as much money.  This is bad for economic output in the short term.

Trying to decrease unemployment is much harder unless the government simply puts people to work through creating government programs.  Otherwise, the government has to try to coax businesses to hire more people.  The government can try to do this through such methods as lowering taxes and interest rates, but it cannot force firms to hire if the firms are too worried about the state of the economy as a whole.  This was one reason why the US economy did not rebound as much as it might have given the government stimulus packages after the financial crisis of 2008.

There are also costs associated with trying to reduce unemployment.  The most common cost is an increase in governmental deficits and debts.  Governments typically try to reduce unemployment by increasing government spending and/or lowering taxes.  This harms the government’s budget balance, increasing the size of the government deficit.  This may be relatively harmless in the short term, but it can have serious long-term effects.

In my view, zero inflation is not a wise target.  In a perfect economic world, it would be a good thing.  There would be complete certainty, which would lead to greater economic growth.  However, in the real world, sticky prices and (more importantly) wages make zero inflation a bad idea.  If there were no inflation, firms would not hire as many people as they otherwise would.  They would not hire as much because they would not have any acceptable way of cutting their wages relative to their costs.  The only thing they could do would be to lower nominal wages, but this would generally make their workers very upset and would harm the firm.

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