Economic Growth, Inflation, and Unemployment: Limits to Economic Policy

Publication Date: November 2006

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

Type:

Abstract:

For some time, economic growth has been steady, unemployment has been low, and inflation has been subdued. Absent other considerations, faster economic growth is desirable, as are lower unemployment and inflation rates. However, there may be limits to how compatible those goals are. The success of macroeconomic policy cannot be measured by just one of these variables in isolation, because they are interdependent.

Over the long run, the faster the economy grows, the better off people are materially. In the short run, however, the rate of growth has consequences for other economic variables. If growth persists at too rapid a rate, there is a risk that inflation may accelerate. If growth is too slow, then there is a risk of rising unemployment. Although rising unemployment is typically associated with economic contractions, or recessions, it is entirely possible for the economy to be growing but not rapidly enough to prevent the unemployment rate from rising.

There is an inverse relation between economic growth and unemployment. A simple statistical analysis suggests that the critical rate of economic growth between 1950 and 2005 was 3.4%. Growth above that rate tended to push the unemployment rate down, and growth below that rate was associated with an increase in the unemployment rate. Because labor force growth is expected to slow somewhat in coming years, the rate of economic growth needed to prevent the unemployment rate from rising might be expected to be closer to 3% for the foreseeable future.

There is also a relationship between unemployment and inflation. For some time, it was believed that there was a trade-off between inflation and unemployment that policymakers could exploit. That is no longer widely considered to be a sustainable policy. While minimal unemployment might seem a desirable policy goal, few economists would define full employment as employment for everyone who wants a job. Instead, many would argue that full employment is the lowest rate of unemployment consistent with a stable rate of inflation.

It seems safe to say, given recent evidence, that an unemployment rate of 2% is too low if a rising rate of inflation is to be avoided. Similarly an unemployment rate of 8% would appear to be unnecessarily high. Most estimates suggest that an unemployment rate somewhere between 5% and 6% might be consistent with a stable rate of inflation. While inexact, it may be a guide that policymakers use in an effort to benefit the overall economy.

This report will not be updated.