Unit 4 Inflation and unemployment
How fluctuations in aggregate demand and changes on the supply side of the economy affect inflation and unemployment
Before you start
This unit builds on the concepts and examples introduced in Units 1, 2, and 3. You should work through those units before beginning work on Unit 4.
4.1 Cost of living crisis
After nearly four decades of prices going up by just a few per cent a year in the high-income countries, inflation, which some thought to have become a thing of the past, took off around the world. The overall price level in the UK was rising by more than 10% at an annual rate in mid-2022. This was higher than in the European Union or the United States, but in all three economies inflation was at its highest for a generation.
Inflation was back!
Between 2020 and 2023 the average cost of energy—heating your home, driving a vehicle—doubled. Nominal wages in pounds, euros, or dollars did not go up anything like as fast as prices, which is why in the UK this was branded a ‘cost of living’ crisis.
Just before Christmas 2022, Ollie Vaulkhard, who runs three pubs in Newcastle in the north-east of England, provided a snapshot of inflation’s impact on people and businesses:
There is a camp of people, let’s say a third of the population, who genuinely are struggling to heat and eat.
There’s going to be a squeezed middle, say that’s a third, and those people will be under pressure. Do they go on holiday or out for a meal? Where do they find their savings?
And there’s another third of the population I really believe are untouched by this, so where your customers are drawn from will have a direct impact on how your business reacts.
Many pubs were losing money due primarily to the increased energy costs.
- inflation
- An increase in the general price level in the economy, usually measured as the percentage increase in prices over the last year. See also: deflation, disinflation.
- deflation
- A decrease in the general price level. See also: inflation.
- disinflation
- A decrease in the rate of inflation. See also: inflation, deflation.
The price rises that affected households in the UK in 2022 and 2023 were a shock for many because there had been a long period of very limited price increases before then. In Figure 4.1, we show the rate of inflation—the average yearly percentage increase in prices—in the UK from 1875 to 2020. The spike in prices in 2022–2023 was quite modest compared to the inflation of the 1970s prompted by a massive increase in the cost of imported oil.
Figure 4.1 UK inflation rate (1875–2022).
Ryland Thomas and Nicholas Dimsdale. 2017. ‘A Millennium of UK Data’. Bank of England OBRA dataset; UK Office for National Statistics. UK Economic Accounts time series.
- deflation
- A decrease in the general price level. See also: inflation.
- disinflation
- A decrease in the rate of inflation. See also: inflation, deflation.
In contrast, prices were actually falling (deflation) for much of the period between the First and Second World Wars, including the Great Depression. In several periods, for example the mid-1980s and mid-1990s, we observe disinflation where the rate of change in the general price level (inflation) is positive but declining. From the early 1990s up to 2022, inflation was relatively stable, with only a small increase after the global financial crisis in 2007–2009.
Inflation rose after the onset of the COVID-19 pandemic and more sharply after Russia’s invasion of Ukraine in 2022. The ‘inflation is back’ shock can be traced in people’s online searches for words like ‘inflation’ or ‘cost of living’ as shown in Figure 4.2.
Figure 4.2 Number of online searches for the terms ‘inflation’ (blue), ‘cost of living’ (red), and ‘unemployment’ (green) in the UK, 2004–2023.
Google Trends. Numbers represent relative search intensity, where the highest observed search intensity is equal to 100 in the raw data. The figure shows 9-month moving averages.
Figure 4.3 shows average rates of inflation in different regions of the world, and how they have changed over time. Upward spikes in inflation have tended to occur in periods of economic crisis, but the general trend worldwide from the 1970s until 2020 was a decline in inflation rates. The figure also shows that inflation tends to be higher and more volatile in poor countries than in rich countries. For instance, since 2000, inflation has averaged 6.0% in sub-Saharan Africa and 6.6% in South Asia, in contrast to only 2.2% in the high-income OECD countries.
Figure 4.3 Inflation levels and volatility in high- and low-income economies.
The World Bank. 2023. World Development Indicators.
Argentina has gone from having income per capita equal to Western Europe to being an upper middle income country today, although inflation alone is not the only causal factor.
The high and volatile levels of inflation in some countries can have devastating impacts on the lives of their citizens. In August 2023, Argentina’s annual inflation rate reached nearly 125%—leaving 40% of the population living in poverty, compared to 25% at the end of 2017. In this situation it becomes almost impossible to plan how to make ends meet—even for those not in poverty—or to make decisions about where to find work or what products to sell.
