Relationship Between Unemployment and Inflation Research

Introduction

The term unemployment or in other words, joblessness is used to refer to a situation where non-disabled individuals who are looking for a job fails to find one. Across the globe, the causes of unemployment are always heavily debated. The Australian school of economics, classical economics, as well as the new classical economics, argued that to resolve the issue of unemployment, the market mechanisms may help in providing the means. Inflation is another economics term used to refer to a constant increase in the overall price level of goods and services that are circulating in an economy over a certain period (Blanchard, 2016). This means that when the general price level of goods and services rise, then every unit of the currency has the power to purchase fewer products and services hence inflation is realized when the purchasing power per unit currency reduces and its value in the medium of exchange as well as its unit of account in the economy is lost. This paper tries to explain the relationship as well as the difference between the two factors in economics unemployment and inflation.

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Unemployment always takes place whenever individuals are willing to work at the current wage rates and yet no work available for them. In the business cycle, unemployment and inflation are usually crucial economic issues, and they both act as significant financial performance indicators in any country in the globe. According to the Philips curve, both unemployment and inflation are related in the short run; this is because inflation always affects the unemployment level in any economy. When the fiscal or monetary policymakers through the moving upwards lateral to the aggregate-supply curve expand the aggregate demand, the total output expands while the level of unemployment reduces meaning that to produce more, then there would be a need for more labor input.

Research shows that doing this increases the price level; hence, there exists a trade-off between unemployment and inflation. When there is low unemployment, there exists a high inflationary pressure on the economy. Philips curve explains more about this trade-off between the unemployment rate and inflation. The curve explains that the relationship between inflation and unemployment is inverse meaning that when unemployment increases in any given economy, the rate of inflation, on the other hand, decreases.

Formation of The Philips Curve

In 1958, Economist A.W Phillips reported the trade-off between inflation and unemployment the first time. He argued that policymakers could target either low rate of inflation or low rate of unemployment in an economy but could never target both low rate of inflation and a low rate of unemployment at the same time. This idea by Philips was published in an article 'The relationship between Unemployment and the Rate of change of money wages in the United Kingdom, 1861 - 1957' in 1958. In the article, Philips drew a diagram that showed the connection between the rate of inflation and unemployment in the United Kingdom every year from 1861 to 1957.

In the diagram, he gave evidence of a negative connection between the rate of inflation and unemployment with those years having high inflation having a low rate of unemployment and those having high unemployment rate having a low inflation rate. Robert Solow and Paul Samuelson in 1960 decided to carry out the same study as Philip's, but this time they tried to find out the connection between inflation and unemployment in the United States using data from 1890 to 1960.

In their study, they noted a more or less stable non-linear connection between inflation and unemployment, and they labeled it as Philips Curve. Philips curve traces the relationship between inflation and unemployment with unemployment being on the x-axis during inflation on the y-axis. The curve usually describes varying possible economic outcomes. On the curve, policymakers may choose to be anywhere through influencing aggregate demand through fiscal and monetary policy.

Linking the AD-AS Model and the Philips Curve

The AD-AS model tries to explain the combination of inflation and unemployment as the Philips curve shows. The curve usually shows all the possible combinations of unemployment and inflation, which arise due to short-run shifts in Aggregate demand curve, which moves the Aggregate supply curve laterally.

Considering an economy that is currently at equilibrium at point E with the level of output Q1 being produced at P1 the price level. The level of unemployment in the marketplace is presently u1, and the inflation rate stands at p1%. Suppose due to monetary or fiscal policy the aggregate demand increases from AD1 to AD2 or in other words shifts rightwards, in the short run, the level of output of goods and services will rise from Q1 to Q2 while the price level will shift from P1 to P2. The economy's new equilibrium will now be found at E' which is comprised of a higher price level and a higher level of output.

By more massive output, it means that the level of employment is high hence a lower unemployment level u1 to u2. A higher level of inflation P2% is indicated by the higher price level in the economy. Thus, in the short run, the aggregate demand shift impacts unemployment and inflation rates in opposite directions. Since fiscal and monetary policies can shift the total demand curve as well as impact the unemployment and inflation rate on the Philips curve, policymakers could use such systems to choose the appropriate combination of inflation and unemployment.

The increase in tax cuts, money supply, or increase in government spending expands the aggregate demand and therefore moving the economy on a specific point on the Philips curve with the higher inflation rate and lower unemployment. On the other hand, an increase in tax rates, a decrease in money supply or a reduction in the spending by government leads to the contraction of the aggregate demand hence moving the economy on a specific point on the Philips curve where there are a lower inflation rate and a higher rate of unemployment.

The original Philips curve relation collapsed in the 1970s a period when high unemployment and high inflation was recorded hence contradicting the initial Philips curve. The high unemployment and high inflation resulted from a significant increase in oil prices in the United States, which occurred twice in the 1970s leading to the rise in non-labor costs which forced the firms to increase prices. As a result, the inflation rate increased even at any given rate of unemployment. This occurrence, therefore, proved that Robert Solow, A.W Philips, and Paul Samuelson had done their study in a period when the average inflation stood at zero.

Hence the wage settlers always expected the inflation to be zero. Though the wage settlers changed how they formed their expectations, and since the 1960s forwards inflation was consistently persistent and positive making, the wage settlers predict continuous higher inflation in the future. The change in the formation of expectation affected the nature of the connection between inflation and unemployment.

Long Run Philips Curve and the Natural Rate of Unemployment

Two economists, Edmund Phelps and Milton Friedman emerged in the 1960s who argued that the trade-off between unemployment and inflation was a short run phenomenon and in the long run no such a connection existed. They argued that the trade-off would vanish ultimately once the government tried to sustain the lower rate of unemployment through acceptance of higher rates of inflation. The two economists believed that once unemployment reached below a certain level, it could never be sustained. The referred to this level as the natural rate of unemployment, which is also known as NAIRU or non-accelerating inflation rate. Edmund and Milton stated that in an economy, the inflation rate depends on the alteration between the natural rate of unemployment (un) and the actual rate of unemployment (ut).

In the short run, the rate of inflation decreases when the actual price of unemployment is higher than the natural rate of unemployment while the rate of inflation increases when the real rate is lower than the natural rate of unemployment. In the long run, the change in inflation rate is zero when the actual unemployment rate is equal to the natural rate of unemployment. Hence the natural rate of unemployment is one required for the achievement of a constant rate of inflation. On the Philips curve, the long run is a vertical line at the point of the natural rate of unemployment; hence, unemployment and inflation are not related in the long term. As a result, Philips curve vertical long-run concludes that unemployment does not depend on the level of inflation.

Long Run Philips Curve

The short-run Philips curve usually shifts as a result of changes in the workers' future expectations of inflation. The reason why the long-run Philips curve is vertical is mainly due to two expectation theories that try to explain how people predict future inflation.

Theory of Adaptive Expectations

This theory argues that people tend to form their future expectations based on past events. An example is if the inflation last year was higher than the average inflation in the past, people will consider this alongside the current economic indicators to forestall its performance in the future.

Theory of Rational Expectations

This theory states that people form their expectations in the future based on the information available to them today; this includes the past and current information. This means that if the inflation were higher than the average rate in the past, people would consider this alongside the current economic indicators to predict the future behavior of inflation. In the Philips curve, the people are well aware of the past variables of the economy as they form their future expectations about variables. This generally means that workers are usually fully aware of the subsequent increase in inflation as well as the possible increase in the aggregate demand. Hence these workers will demand form higher nominal wages to avoid a fall in the real wages, and as in the case of adaptive expectations, there will be no adjustment period.

This means that as from the figure above, the economy will start moving from point A to C immediately without moving to point B. Any attempts of changing the unemployment rates by shifting of the aggregate demand shall be predicted by the work quickly, and therefore such efforts will lead to a rise in actual inflation while the rate of unemployment will not fluctuate from its original price. Below is a table of the recent 20-year U.S. unemployment and inflation data. The table begins with the year, then the unemployment rate per year, GDP growth per year, inflation rate and events that took place respectively (Hamilton et al. 2016)