Two problems worry every government: prices that keep rising and people who cannot find work. They are linked, but not simply. Inflation erodes what money buys. Unemployment wastes the labour that an economy could use. This topic covers both: the theories, causes and types of inflation, the types and causes of unemployment, and the Phillips curve, which describes the trade-off between them.
The Institute of Chartered Accountants of Nigeria (ICAN) syllabus asks you to identify and explain the issues of inflation and unemployment. Expect definitions and lists in Section A and explanation questions in Section B, and be ready to calculate an inflation rate or an unemployment rate.
In 30 seconds
Inflation is a sustained rise in the general price level, measured as the percentage change in a price index such as the consumer price index. Demand-pull inflation comes from excess aggregate demand and cost-push inflation from rising costs. Its types are moderate, galloping, hyper, stagflation, deflation and core inflation. Unemployment means people willing and able to work cannot find jobs at the existing wage.
Its types are frictional, structural, cyclical and seasonal. The Phillips curve shows that lower unemployment tends to go with higher inflation.
Inflation
Inflation is a sustained increase in the general price level. The inflation rate is the percentage change in a price index, such as the consumer price index (CPI). A rise in the price of one good is not inflation. The rise must be general and it must continue.
Inflation rate = (CPI this year − CPI last year) ÷ CPI last year × 100
If the CPI rises from 100 to 125, the inflation rate is (125 − 100) ÷ 100 = 25%.
Theories of inflation
| Theory | What drives it | How it works |
|---|---|---|
| Demand-pull | A rise in aggregate demand | When aggregate demand exceeds aggregate supply at the current price, buyers compete and the price level is pushed up to a new equilibrium. Repeated rises give sustained inflation |
| Cost-push | A rise in the cost of factors of production, especially wages | Higher costs shift supply left, so prices rise. Workers then ask for higher pay to restore what the price rises took, and the cycle continues |
Causes of inflation
- Wage rises out of line with productivity. Costs and demand both rise faster than output. Higher government spending can also raise aggregate demand and the price level.
- Price shocks. Sharp rises in the cost of particular goods, from flooding, drought or an oil price jump, raise production costs even when output falls.
- Excessive growth of the money supply compared with the economy’s productive capacity, which creates shortages and lifts prices.
Types of inflation
| Type | Meaning |
|---|---|
| Moderate | A gradual, steady rise in prices, often within a target range |
| Galloping | A steady and relatively high rate, in double digits such as 20% or 40%, and sometimes triple digits |
| Hyperinflation | An extremely high rate, so money loses value fast and households hold less of it. It often follows war or crisis, when a government cannot tax and funds its deficit by creating money |
| Stagflation | Slow or zero growth together with rising prices and unemployment. Policies that cure one problem can worsen the other, as in the 1970s oil price shocks |
| Deflation | A sustained fall in the general price level, when aggregate demand is below aggregate supply. Output falls and unemployment rises. It raises the real value of debt and discourages production |
| Core inflation | Inflation after removing temporary price swings, calculated from manufactured goods and excluding agricultural produce, fuel, energy and food |
Effect on real wages: a numerical example
Suppose money wages rise by 8% while prices rise by 12%. Real wages change by 1.08 ÷ 1.12 − 1 = −3.6%. Workers have more naira but can buy less. This is why they press for higher pay, which feeds cost-push inflation.
Unemployment
Unemployment exists when people who are willing and able to work, and qualified for a job, cannot find work at the existing wage rate. The unemployment rate is the number unemployed as a percentage of the labour force. If a labour force of 60 million has 54 million in work, 6 million are unemployed and the rate is 6 ÷ 60 = 10%.
Types of unemployment
| Type | Cause | Example |
|---|---|---|
| Frictional | The time people take moving between jobs, or entering or re-entering the workforce | A graduate looking for a first job. Someone who left one job to find a better one |
| Structural | Changes in technology or in the pattern of demand make some skills obsolete while the workforce is slow to adapt | Typists made redundant by computers |
| Cyclical (deficient demand) | A fall in real aggregate output and total spending in a recession | Factory layoffs in a downturn |
| Seasonal | Work that varies with the season | Farm labour needed only at harvest |
Causes of unemployment
- A growing population, so that there are more people than jobs, especially among the young.
- Poverty and illiteracy, which leave people without the skills formal employers want.
- Inflation, which cuts real income and can lower wages when labour supply is high.
- Agricultural work that lasts only part of the year.
- Casual and informal work that is poorly paid and irregular.
- Industry operating below capacity because of shortages of raw materials and machinery.
- Corruption in government, neglect of agriculture and other natural resources, poor quality education and a lack of working skills.
The Phillips curve
In 1958 A. W. Phillips found an inverse relationship between the rate of unemployment and the rate of change of money wages. When unemployment is very high, demand for labour is weak, so wages rise slowly or fall. When unemployment is very low, firms compete for scarce workers and wages rise fast. Wages fall slowly in a slump because workers and unions resist pay cuts, so firms lay workers off instead.
The curve is therefore non-linear. Later work extended it to inflation.
The policy lesson is a trade-off. According to the Phillips curve, a lower rate of unemployment can be reached only by accepting a higher rate of inflation. Stagflation is a case that the simple curve does not explain, because prices and unemployment rise together.
Worked example: calculating and classifying
Scenario. The CPI was 140 last year and is 161 this year. The labour force is 80 million, of whom 8 million have no job. Of these, 2 million are between jobs, 3 million lost jobs when a factory closed in a recession, and 3 million have skills that firms no longer need.
| Question | Working | Answer |
|---|---|---|
| Inflation rate | (161 − 140) ÷ 140 × 100 | 15% |
| Unemployment rate | 8 ÷ 80 × 100 | 10% |
| The 2 million between jobs | Moving between jobs | Frictional |
| The 3 million laid off in the recession | Deficient demand | Cyclical |
| The 3 million with outdated skills | Change in the pattern of demand for skills | Structural |
Inflation and unemployment in more detail
Who gains and who loses from inflation
Inflation redistributes wealth. Borrowers gain because they repay with money that is worth less. Lenders and savers lose when interest rates are below inflation. People on fixed incomes lose purchasing power. Firms face rising costs and uncertainty about pricing, and exporters become less competitive if domestic prices rise faster than abroad. Very high inflation destroys confidence in money and discourages saving and investment.
Measuring inflation and real wages
The consumer price index tracks the cost of a typical basket of goods and services. Inflation is the percentage change in the index. Real wages adjust money wages for inflation. If wages rise 8% when inflation is 15%, real wages change by 1.08 ÷ 1.15 − 1 = −6.1%, so workers can buy less despite higher pay.
Demand-pull and cost-push in practice
| Cause | Example |
|---|---|
| Demand-pull | Government spending and easy credit raise demand faster than supply can grow, so prices rise |
| Cost-push (wages) | A union wins a pay rise above productivity growth, and firms raise prices to cover it |
| Cost-push (import prices) | A fall in the naira makes imported inputs dearer, so firms raise prices |
| Excess money supply | The money supply grows faster than output, so more money chases the same goods |
The four types of unemployment, with remedies
| Type | Cause | Remedy |
|---|---|---|
| Frictional | The time taken to move between jobs | Better job information and matching services |
| Structural | Skills or location no longer match available jobs | Training, retraining and help with relocation |
| Cyclical | A fall in aggregate demand in a recession | Expansionary monetary or fiscal policy |
| Seasonal | Work that varies with the season | Planning off-season work, diversification |
The Phillips curve: what it implies and its weakness
The curve suggests a trade-off: policy that lowers unemployment may raise inflation. A government deciding how much to stimulate demand must weigh the two. The trade-off broke down in the 1970s, when stagflation raised both unemployment and inflation together, because supply shocks such as oil prices push costs up whatever the level of demand. Many economists now think the trade-off holds only in the short run.
Everything the syllabus says: complete notes
Inflation: the definition and the two theories with their diagrams
Inflation is a sustained increase in the overall price level. The inflation rate is the percentage change in a price index such as the consumer price index (CPI). The two words that matter are ‘overall’ and ‘sustained’: a rise in the price of one good, or a one-off jump, is not inflation.
Demand-pull inflation
Demand-pull inflation comes from an increase in aggregate demand. When aggregate demand surpasses aggregate supply at current prices, prices are pushed up until aggregate supply and demand are equal again. It describes a persistent rise in the general price level caused by a permanent increase in nominal aggregate demand. In the diagram, aggregate demand rises from AD0 to AD1 for a given aggregate supply.
There is excess demand at P0, which pushes the price level from P0 to P1, and a new equilibrium forms at E1 with output Y1 and the higher price level P1. If the process repeats often, the result is a sustained rise in prices.
Cost-push inflation
Cost-push inflation is caused by an increase in the cost of the factors of production, especially wages. If workers’ cost of living rises unexpectedly and they demand and win higher wages, the cost of production rises.
This forces up the prices of the goods that workers and consumers buy, so workers then demand still higher pay because the earlier rise has been eaten away by price increases, and the cycle continues. In the diagram, supply falls from AS1 to AS2 because production costs rise, so the price goes up from P1 to P2.
Causes of inflation in the syllabus
- Wage increases in excess of productivity. Prices rise and aggregate demand rises relative to aggregate supply. Higher government spending can also raise the price level by raising aggregate demand.
- Price shocks. Sharp rises in the cost of particular goods, caused by flooding, drought or a jump in the price of oil, raise production costs. The price level goes up even when total output may fall, for a given level of total demand.
- Excessive growth of the money supply compared with the economy’s productive level. Shortages appear, prices rise, and aggregate demand grows relative to aggregate output.
The six types of inflation, with the syllabus’s detail
| Type | Detail |
|---|---|
| Moderate | A gradual but steady rise in the general price level. As an example, the Monetary Policy Committee of India uses inflation targeting, aiming to hold inflation at 4% a year, and under the target the annual rate should not go beyond a range of 2% to 6% |
| Galloping | A steady and relatively high rate of increase, in double digits such as 20% or 40%, and occasionally in triple digits such as 200% |
| Hyperinflation | An extremely high rate, so that money loses value quickly and households hold less local currency. It typically follows wars, socio-political upheaval or other crises when it is very hard for the government to collect taxes. The result is a fiscal deficit that the government mainly finances by creating money, not by taxation or borrowing |
| Stagflation | An economy growing very slowly or not at all (stagnant) while prices keep rising, with rising unemployment as a side-effect. It is a conundrum, because measures to curb inflation can worsen unemployment and the reverse. It occurred in the 1970s when the price of crude oil rose sharply and industrialised economies suffered severe inflation |
| Deflation | A situation in which the price level declines consistently, so the words ‘price level’ and ‘consistent’ matter, and a fall in the price of one good is not deflation. It occurs when aggregate demand is below aggregate supply, with falling output, rising unemployment and a general slowdown. The Great Depression of the 1930s is an acute example: prices plummeted, unemployment soared and the gross domestic product (GDP) of wealthy nations fell. In a modern economy deflation is harmful, because it raises the real value of debt and discourages production as prices keep falling |
| Core inflation | Inflation measured after removing transitory or temporary price swings. It is calculated from price increases in manufactured products, excluding food, so it leaves out agricultural commodities, fuel, energy and food. Temporary shocks could distort the headline figure so that it does not match the true underlying inflation, and core inflation removes them |
Unemployment: the three tests for being counted as unemployed
Unemployment occurs when people who are willing and able to work cannot find jobs at the existing wage rate. To be classified as unemployed a person must be able to obtain employment, willing to work at the present wage rate and qualified for a job. Someone who is not looking, or who will work only at a wage far above the going rate, is not counted.
Types of unemployment as the syllabus describes them
- Frictional: caused by shifts in certain labour markets. It consists of people who voluntarily left jobs and are looking for new ones, and people entering or re-entering the workforce.
- Structural: caused by changes in technology or in the pattern of demand for goods and services. Some skills become less in demand or obsolete, and the need for other skills may grow. Unemployment results because the labour force is slow to adapt to the changing pattern of job opportunities.
- Cyclical, also called deficient-demand unemployment: caused by a fall in the economy’s real aggregate output, that is, by a lack of aggregate or total expenditure.
- Seasonal: caused by seasonal changes in employment, for example extra farm labour at harvest, laid off afterwards.
Causes of unemployment in full
| Cause | Explanation |
|---|---|
| Growing population | The rate of population growth has risen steadily for decades, so there are far more people than jobs, especially among the young |
| Poverty and illiteracy | Fewer people are educated and literate, and the poor and illiterate struggle to find formal work because they lack the skills required, as a result of low income and way of living |
| Inflation | When prices rise without matching growth in output, real income falls. With a growing population, labour supply exceeds demand and wages are pushed down, and dissatisfied people drop out of work |
| Agricultural workers | People in agriculture are employed only for part of the year and cannot find jobs the rest of the year |
| Casual and informal labour | Because there are fewer jobs than people who need them, many work in the informal sector, which pays poorly and irregularly |
| Industry below capacity | Shortage of raw materials and adequate machinery stops factories hiring as many workers as they could |
| Other factors | Corruption in government; neglect of agriculture and other natural resources; poor quality education; lack of working skills |
The Phillips curve in full
A. W. Phillips explained the connection between inflation and unemployment in 1958. He found that the rate of unemployment and the rate of change of money wages were inversely related, and gave two explanations. First, when unemployment is very high, the demand for labour is low, so wage rates fall only slowly because workers are generally unwilling to offer their services below the going rate.
When unemployment is very low and demand for labour is high, wages rise rapidly to attract the few available workers. Second, in a downturn firms are reluctant to raise wages and will want to cut them, but unions and employees resist pay cuts, so firms are forced to dismiss workers. A slight fall in earnings therefore goes with a large rise in unemployment in a weak labour market.
From this Phillips concluded that the relationship between the unemployment rate and the change in money earnings is highly non-linear, and the curve that shows it is the Phillips curve. The curve links the unemployment rate (U) on the horizontal axis to the percentage change in the money wage rate (w) on the vertical axis.
His study was later widened to the relationship between unemployment and inflation, and a study in the United States supported a positive association between rising wages and price levels. The policy meaning is a trade-off: a lower unemployment rate can be reached only by letting the inflation rate rise.
Questions that could be asked on this topic, and how to answer them
| Question | What a full answer contains |
|---|---|
| Explain inflation, its theories and causes | The definition, demand-pull and cost-push with a diagram of each, and the three causes |
| Explain the types of inflation | Moderate, galloping, hyper, stagflation, deflation and core, with the distinguishing feature and an example of each |
| Explain the types and causes of unemployment | Four types with examples, the three tests for being unemployed, and the causes in full |
| Explain the Phillips curve and its policy implication | Phillips’ 1958 finding, the two reasons for the inverse relation, the non-linear shape, the trade-off, and the stagflation limitation |
| Calculate an inflation rate, real wage change or unemployment rate | The formulas with the working shown and the interpretation |
Exam focus: the Phillips curve
A. W. Phillips showed in 1958 that the rate of unemployment and the rate of change in money wages were inversely related. When unemployment is very high, labour demand is low and wages rise slowly. When unemployment is very low, firms compete for scarce workers and wages rise fast.
In a downturn, firms prefer to dismiss staff than cut pay, because workers and unions resist pay cuts, so a small fall in wages goes with a large rise in unemployment. The curve is therefore non-linear. It plots the unemployment rate on the horizontal axis and the percentage change in money wages on the vertical axis.
Later work replaced wage change with the inflation rate, since rising wages and rising prices move together. The policy lesson is a trade-off: a lower unemployment rate can be reached only by accepting a higher inflation rate.
Common mistakes in the exam
- Calling a rise in the price of one good inflation. It must be a sustained, general rise.
- Mixing demand-pull and cost-push. Demand-pull starts with demand. Cost-push starts with cost.
- Confusing deflation with disinflation, which is a slower rate of inflation.
- Counting people who are not looking for work, or are unwilling to work at the going wage, as unemployed.
- Giving a type of unemployment with no example or cause.
- Stating the Phillips curve as a positive relationship between unemployment and inflation.
Quick revision
- Inflation = sustained rise in the general price level. Rate = change in CPI ÷ earlier CPI.
- Demand-pull from demand. Cost-push from costs. Causes: wages beyond productivity, price shocks, excess money supply.
- Types: moderate, galloping, hyper, stagflation, deflation, core.
- Unemployment rate = unemployed ÷ labour force. Types: frictional, structural, cyclical, seasonal.
- Phillips curve: inverse link between unemployment and wage or price change, so a trade-off.
Practice questions
These are original questions written in the style of the ICAN exam. Try each one before you open the answer.
Section A style: multiple choice
Question 1. Inflation caused by aggregate demand rising above aggregate supply is called:
- Cost-push inflation
- Demand-pull inflation
- Core inflation
- Deflation
Show the answer
B. Excess demand pulls the price level up.
Question 2. Stagflation is a situation of:
- Fast growth and falling prices
- Slow or zero growth with rising prices
- Falling prices and rising output
- Full employment with stable prices
Show the answer
B. It combines stagnation and inflation, often with rising unemployment.
Question 3. A person who has left a job to look for a better one is:
- Structurally unemployed
- Cyclically unemployed
- Frictionally unemployed
- Seasonally unemployed
Show the answer
C. Frictional unemployment is the time spent between jobs.
Question 4. Unemployment caused by a fall in total spending in a recession is:
- Frictional
- Structural
- Cyclical
- Seasonal
Show the answer
C. Cyclical, or deficient-demand, unemployment.
Question 5. The Phillips curve shows:
- A positive link between unemployment and wage growth
- An inverse link between unemployment and the rate of change of money wages
- No link between unemployment and prices
- That inflation always causes unemployment
Show the answer
B. Lower unemployment goes with faster wage growth, which implies a trade-off with inflation.
Question 6. Core inflation is measured:
- Including all temporary price shocks
- After removing temporary price volatility, such as food and energy
- Only for imports
- Only for services
Show the answer
B. Removing temporary swings gives a better picture of the underlying trend.
Question 7. Who gains from unexpected inflation?
- Lenders on fixed rates
- Savers on low rates
- Borrowers
- People on fixed incomes
Show the answer
C. They repay with money worth less.
Question 8. Wages rise 5% and prices rise 10%. Real wages:
- Rise
- Fall
- Stay the same
- Double
Show the answer
B. 1.05 ÷ 1.10 − 1 is about −4.5%.
Question 9. Unemployment caused by a mismatch of skills and available jobs is:
- Frictional
- Structural
- Cyclical
- Seasonal
Show the answer
B. Retraining is the usual remedy.
Question 10. The 1970s experience of high unemployment and high inflation together is called:
- Deflation
- Stagflation
- Hyperinflation
- Disinflation
Show the answer
B. It undermined the simple Phillips curve.
Section B style: written questions
Question 11 (10 marks). Distinguish between demand-pull and cost-push inflation, and state three causes of inflation.
Show the marking guide
Demand-pull (3 marks). Caused by a rise in aggregate demand above aggregate supply, which pushes the price level up.
Cost-push (3 marks). Caused by rising costs of production, especially wages, which shift supply left and raise prices, starting a wage-price spiral.
Causes (4 marks). Wage rises beyond productivity, price shocks such as oil or floods, and excessive growth of the money supply, 1 mark each, with one extra for an example or explanation.
Question 12 (20 marks). The consumer price index was 140 last year and is 161 this year. Money wages rose by 8%. The labour force is 80 million and 8 million are without jobs.
(a) Calculate the inflation rate, and the change in real wages. (6 marks)
(b) Calculate the unemployment rate and explain four types of unemployment. (8 marks)
(c) Explain the Phillips curve and the policy trade-off it suggests. (6 marks)
Show the marking guide
(a) 6 marks.
- Inflation = (161 − 140) ÷ 140 = 15% (3).
- Real wages.
1.08 ÷ 1.15 − 1 = −6.1%, so real wages fall (3).
(b) 8 marks.
- Unemployment rate.
8 ÷ 80 = 10% (2). - Four types explained: frictional, structural, cyclical and seasonal (6 marks in all).
(c) 6 marks. Inverse relation between unemployment and the rate of change of money wages (2). Low unemployment, high demand for labour, wages rise fast (2). The trade-off: lower unemployment is bought with higher inflation (2).
A further written question
Question 13 (10 marks). Explain the effects of inflation on different groups in the economy.
Model answers
Show the model answer to Question 11
Demand-pull inflation is caused by a rise in aggregate demand above aggregate supply, which pulls the price level up. Cost-push inflation is caused by a rise in the costs of production, especially wages and imported inputs, which shifts supply to the left and raises prices, often starting a wage-price spiral.
Three causes of inflation are:
- wage rises that exceed productivity growth
- price shocks, such as an oil price rise or flood damage, that raise costs
- excessive growth of the money supply compared with output
Show the model answer to Question 12
(a)
- Inflation = (161 − 140) ÷ 140 × 100 = 15%.
- Real wages.
1.08 ÷ 1.15 − 1 = −6.1%, so real wages fall by about 6.1%: workers have more naira but can buy less.
(b) Unemployment rate = 8 ÷ 80 × 100 = 10%. Frictional unemployment is the time spent between jobs, for example a graduate seeking a first job. Structural unemployment arises when skills or location no longer match available jobs, for example typists made redundant by computers. Cyclical unemployment is caused by deficient demand in a recession. Seasonal unemployment follows work that varies with the season, such as farm labour at harvest.
(c) The Phillips curve shows an inverse relationship between unemployment and the rate of change of money wages, later extended to inflation. When unemployment is low, firms compete for scarce workers and wages rise fast. When unemployment is high, wage growth is slow. The policy trade-off is that lower unemployment can be bought only by accepting higher inflation. Stagflation, with both high, shows the limits of the simple curve.
Show the model answer to Question 13
Inflation affects groups differently. Borrowers gain, because they repay loans with money that has lost value. Lenders and savers lose if interest rates are below the rate of inflation, because the real value of what they are repaid falls. People on fixed incomes, such as some pensioners, lose purchasing power. Workers lose if wages rise more slowly than prices, but may gain if strong unions win increases above inflation.
Firms face rising costs and uncertainty, and exporters lose competitiveness if domestic prices rise faster than those of their rivals. Government gains if it is a net debtor, but faces pressure to raise public pay and benefits. High and unpredictable inflation also discourages saving and investment and damages confidence in the currency.
Pathfinder on inflation and unemployment
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the earlier Business, Management and Finance paper. Part (a) asks for the meaning of economic stagnation, which links to stagflation and the types of inflation, and the rest asks about macroeconomic policy.
Revise first: Types of inflation
Multiple-choice questions can test the types of inflation and unemployment and the Phillips curve. Check Section A of every diet you practise for items on these points.
Revise first: Unemployment
Source: ICAN Pathfinder, Business Environment. Diets covered: May Diet, 2021 to May Diet, 2026. November Diet, 2024 is not yet mapped.
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