Relationship between unemployment and inflation
Yalancia Palmer
ECO:203 Principles of microeconomics
Greg Kropkowski
December 10, 2018
The Phillips curve argues that unemployment and inflation are inversely
related: as levels of unemployment decrease, inflation increases. The
relationship, however, is not linear Inflation refers to an increase in
overall level of prices within an economy. In simple words, it means
you have to pay more money to get the same amount of goods or
services as you acquired before. By contrast, the term unemployment is
easier to understand. Generally, it refers to those people who are
available for work but do not find a work. And unemployment rate,
which is the percentage of the labour force that is unemployed, is
usually used to measure unemployment The debate of the relationship
between inflation and unemployment is mainly based on the famous
“Phillips Curve”. This curve was first discovered by a New Zealand
born economist called Allan William Phillips. In 1958, A. W. Phillips
published an article “The relationship between unemployment and the
rate of change of money wages in the United Kingdom, 1861-1957”, in
which he showed a negative correlation between inflation and
unemployment. the slope of the Phillips curve appears to have declined
and there has been significant questioning of the usefulness of the
Phillips curve in predicting inflation. Nonetheless, the Phillips curve
remains the primary framework for understanding and forecasting
inflation used in central banks.
Modern Phillips curve models include both a short-run Phillips Curve and a long-run Phillips Curve. This is because in the short run, there is generally an inverse relationship between inflation and the unemployment rate; as illustrated in the downward sloping short-run Phillips curve. In the long run, that relationship breaks down and the economy eventually returns to the natural rate of unemployment regardless of the inflation rate. The "short-run Phillips curve" is also called the "expectations-augmented Phillips curve", since it shifts up when inflationary expectations rise, Edmund Phelps and Milton Friedman argued. In the long run, this implies that monetary policy cannot affect unemployment, which adjusts back to its "natural rate", also called the "NAIRU" or "long-run Phillips curve". However, this long-run "neutrality" of monetary policy does allow for short run fluctuations and the ability of the monetary authority. changes in labour-market policies, such as changes in minimum-wage laws and unemployment insurance that lower the natural rate of unemployment, shift the long-run Phillips curve to the left and the long-run aggregate-supply curve to the right.
Even though Friedman and Phelps argued that the long-run Phillips curve is vertical, they also argued that, in the short run, inflation can have a substantial impact on unemployment. Their reasoning is similar to that surrounding the short-run aggregate-supply curve in that they assume that, in the short run, price expectations are fixed. Just as with short-run aggregate supply, if price expectations are fixed in the short-run, an increase in inflation could temporarily increase output and lower unemployment below the natural rate. known as ‘natural rate of unemployment’ is distinguished between the ‘short-term’ Phillips curve and the ‘long-term’ one. The short-term Phillips curve looks like a normal Phillips curve but shifts in the long run as expectations changes. In the long run, only a single rate of unemployment (‘natural’ rate) is consistent with a steady rate of inflation. Thus, the long-run Phillips curve is vertical, so there is no trade-off between inflation and unemployment.
Phillips conjectured that the lower the unemployment rate, the tighter the labor market and, therefore, the faster firms must raise wages to attract scarce labor. At higher rates of unemployment, the pressure abated. Phillips’s “curve” represented the average relationship between unemployment and wage behavior over the business cycle. It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time. With higher revenues, firms are willing to employ more workers at the old wage rates and even to raise those rates somewhat. For a short time, workers suffer from what economists call money illusion: they see that their money wages have risen and willingly supply more labor. Thus, the unemployment rate falls. They do not realize right away that their purchasing power has fallen because prices have risen more rapidly than they expected. But, over time, as workers come to anticipate higher rates of price inflation, they supply less labor and insist on increases in wages that keep up with inflation. The real wage is restored to its old level, and the unemployment rate returns to the natural rate. But the price inflation and Most economists now accept a central tenet of both Friedman’s and Phelps’s analyses: there is some rate of unemployment that, if maintained, would be compatible with a stable rate of inflation. Many, however, call this the “nonaccelerating inflation rate of unemployment” (NAIRU) because, unlike the term “natural rate,” NAIRU does not suggest that an unemployment rate is socially optimal, unchanging, or impervious to policy.wage inflation brought on by expansionary policies continue at the new, higher rates. They argue that there is no natural rate of unemployment to which the actual rate tends to return. Instead, when actual unemployment rises and remains high for some time, NAIRU also rises. The dependence of NAIRU on actual unemployment is known as the hysteresis hypothesis. One explanation for hysteresis in a heavily unionized economy is that unions directly represent the interests only of those who are currently employed. Unionization, by keeping wages high, undermines the ability of those outside the union to compete for employment. After prolonged layoffs, employed union workers may seek the benefits of higher wages for themselves rather than moderating their wage demands to promote the rehiring of unemployed workers.
Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, like the oil crisis of the mid-1970s, which first brought stagflation into our vocabulary. The second is changes in people’s expectations about inflation. In other words, there may be a tradeoff between inflation and unemployment when people expect no inflation, but when they realize inflation is occurring, the tradeoff disappears. Both factors—supply shocks and changes in inflationary expectations—cause the aggregate supply curve, and thus the Phillips curve, to shift. In short, a downward-sloping Phillips curve should be interpreted as valid for short-run periods of several years, but over longer periods—when aggregate supply shifts—the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher—as happened in the 1970s and early 1980s—or both lower—as happened in the early 1990s or first decade of the 2000s. It would be nice if the government could spend additional money on housing, roads, and other amenities, if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways. Following the 2007-2009 recession, the actual unemployment rate remained significantly elevated compared with estimates of the natural rate of unemployment for multiple years. However, the average inflation rate decreased by less than one percentage point during this period despite predictions of negative inflation rates based on the natural rate model. Likewise, inflation has recently shown no sign of accelerating as unemployment has approached the natural rate. Some economists have used this as evidence to abandon the concept of a natural rate of unemployment in favor of other alternative indicators to explain fluctuations in inflation. Some researchers have largely upheld the natural rate model while looking at broader changes in the economy and the specific consequences of the 2007-2009 recession to explain the modest decrease in inflation after the recession. One potential explanation involves the limited supply of financing available to businesses after the breakdown of the financial sector. Another explanation cites changes in how inflation expectations are formed following changes in how the Federal Reserve responds to economic shocks and the establishment of an unofficial inflation target. Others researchers have cited the unprecedented increase in long-term unemployment that followed the recession, which significantly decreased bargaining power among workers. According to the natural rate model, if government attempts to maintain an unemployment rate below the natural rate of unemployment, inflation will increase and continuously rise until unemployment returns to its natural rate. As a result, growth will be more volatile than if policymakers had attempted to maintain the unemployment rate at the natural rate of unemployment. As higher levels of inflation tend to hurt economic growth, expansionary economic policy can actually end up limiting economic growth in the long run by causing accelerating inflation. Alternatively, the Federal Reserve's inability to meet their inflation target despite the unemployment rate falling to levels consistent with the natural rate of unemployment, may suggest that the unemployment gap is no longer an accurate proxy for the output gap. In the second quarter of 2016, the unemployment rate was about 4.9%, consistent with estimates of the natural rate of unemployment Policies to improve the labor force, by either making employees more desirable to employers or improving the efficiency of the matching process between employees and employers, would drive down the natural rate of unemployment. In addition, changes to labor market institutions and public policy that ease the process of finding and hiring qualified employees, such as increased job training or apprenticeship programs, could also help lower the natural unemployment rate. Increasing government investment in infrastructure, reducing government regulation of industry, and increasing incentives for research and development in addition with a more aggressive policy interventions to help individuals find work during economic downturns may help to prevent spikes in long-term unemployment and avoid increases in the natural rate of unemployment. I would go with the fiscal policy to get things back on track.
References
A. W. Phillips, "The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957," Economica, vol. 25 (1958), pp. 283-299.
Paul A. Samuelson and Robert M. Solow, "Analytical Aspects of Anti-Inflation Policy," The American Economic Review, vol. 50, no. 2 (May 1960), pp. 177-194.
. Robert J. Gordon, "The Time-Varying NAIRU and its Implications for Economic Policy," Journal of Economic Perspectives, vol. 11, no. 1 (Winter 1997), p. 12.
J. Bradford Delong and Martha L. Olney, Macroeconomics, 2nd ed. (New York: McGraw-Hill Irwin, 2006), pp. 358-361.
Robert J. Gordon, "Foundations of the Goldilocks Economy," Brookings Institution, Brookings Papers on Economic Activity no. 2, 1998, pp. 297-333.