Phin Godfrey
The response of a London eatery to rapidly rising prices, 2023.

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.

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.

This line chart depicts the historical inflation rate in the UK from 1875 to 2022. The horizontal axis displays years from 1875 to 2025, while the vertical axis displays the CPI inflation rate changes in percentages, ranging from -20% to 30%. The graph demonstrates significant fluctuations in inflation over time. Highlighted at the top of the graph are major historical events and their corresponding years, marked by arrows pointing to specific points on the line. These events include the End of WWI, Start of the Great Depression, End of WWII, the 1970s oil shocks, Start of the Global Financial Crisis, COVID-19, and the Russian Invasion of Ukraine, listed in chronological order. All events except for the End of WWII coincided with sudden increases in the CPI inflation rate in the subsequent years.
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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 2008–2009.

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.

This line chart shows the number of online searches for the terms ‘inflation’, ‘cost of living’, and ‘unemployment’ in the UK over the period from 2004 to 2023. The horizontal axis displays the years from 2004 to 2024, while the vertical axis indicates the relative research intensity, ranging from 0 to 60. The data is displayed as a 9-month moving average. Online searches for all terms exhibited spikes around 2022. The term ‘cost of living’ saw the most substantial surge in 2022, peaking at over 50, followed by sporadic declines with a small rise in 2023. Similarly, searches for ‘inflation’ increased significantly but at a slower pace, reaching a peak of 20 in early 2022. On the other hand, searches for ‘unemployment’ began to increase in late 2019, reaching a peak around 5 in early 2020 before gradually decreasing back to previous levels.
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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.

In this line chart, the horizontal axis displays years from 1960 to 2025, while the vertical axis indicates CPI inflation rates in percentages from −5% to 30%. The chart illustrates historical inflation rates for for economies in East Asia and Pacific, High Income (according to OECD), Latin America and Caribbean, Middle East and North Africa, South Asia, and Sub-Saharan Africa. Inflation rates in all economies decline over time, though with notable variations among regions. High-income countries generally maintained the lowest and most stable inflation rates, with a gradual decline from 15% in 1975 to slightly above 0 in 2020. Economies in the Middle East and North Africa showed similar trends but with higher inflation rates and greater fluctuations. Data for inflation rates in East Asia and Pacific was not available until around 1987, which also showed a similarly gradual decline from then on. In contrast, regions with lower income levels in Latin America and Caribbean, South Asia, and Sub-Saharan Africa, despite an overall declining trend, experienced much more pronounced fluctuations in their inflation rates.
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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.