Short Run Trade Off Between Inflation and Unemployment

In the short run, an increase in the quantity of money stimulates spending, which raises both prices and production. The increase in production requires more hiring, which reduces unemployment. Thus, in the short run, an increase in inflation tends to reduce unemployment, causing a trade-off between inflation and unemployment. The trade-off is temporary but can last for a year or two. Understanding this trade-off is important for understanding the fluctuations in economic activity known as the business cycle. In the short run, policy makers may be able to affect the mix of inflation and unemployment by changing government spending, taxes, and the quantity of money.


Although a higher level of prices is, in the long run, the primary effect of increasing the quantity of money, the short-run story is more complex and controversial. Most economists describe the short-run effects of monetary injections as follows:

• Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services.
• Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services.
• More hiring means lower unemployment.

This line of reasoning leads to one final economy-wide trade-off: a short-run tradeoff between inflation and unemployment. Although some economists still question these ideas, most accept that society faces a short-run trade-off between inflation and unemployment. This simply means that, over a period of a year or two, many economic policies push inflation and unemployment in opposite directions. Policymakers face this trade-off regardless of whether inflation and unemployment both start out at high levels (as they were in the early 1980s), at low levels (as they were in the late 1990s), or someplace in between. This short-run trade-off plays a key role in the analysis of the business cycle—the irregular and largely unpredictable fluctuations in economic activity, as measured by the production of goods and services or the number of people employed.

Policymakers can exploit the short-run trade-off between inflation and unemployment using various policy instruments. By changing the amount that the government spends, the amount it taxes, and the amount of money it prints, policymakers can influence the overall demand for goods and services. Changes in demand in turn influence the combination of inflation and unemployment that the economy experiences in the short-run. Because these instruments of economic policy are potentially so powerful, how policymakers should use these instruments to control the economy, if at all, is a subject of continuing debate.