The Short-Run and Long-Run Relationship Between Unemployment and Inflation - Essay Example

Introduction

Unemployment and inflation rates are among the major indicators of any country's macroeconomic status across the globe. The United States is among the countries hit hard by the two components, making it hard for the country to achieve its macroeconomic goals for its fast-growing population. The short-run and the long-run connection between the two macroeconomic elements have led to several discussions among many economists and researchers (Gomis-Porqueras et al., 2020). To understand the relationship between inflation rates and unemployment, it is crucial to focus on the different models such as the Philips curve and autoregressive developed by economists to ensure correlations are critically analyzed. Therefore, to successfully resolve the relationship, this paper will focus on the finding of Alban William Philips to assess, evaluate, and analyze the U.S. data in an attempt to determine the short-run and the long-run relationship between unemployment and inflation. Lastly, the paper will provide a recommendation on the opinion that the fiscal and monetary policymakers should implement to ensure that more jobs are created so that the level of unemployment and inflation rates are maintained to avoid any economic slack.

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Evaluate the Historical Relationship Between Unemployment and Inflation

Over the years, inflation and unemployment have shown changes in correlation as exhibited by research studies, and these changes result from various factors. In some years, a positive correlation was realized, while at some point, an inverse and negative correlation were experienced, which negatively impacted the U.S.

The Findings of Alban W. Philips

The history of the relationship between unemployment and inflation rates dates back to 1958 when Alban William Philips published an article on how unemployment was linked to the rate of money change in the U.K. From his findings, Philips demonstrated that a negative correlation existed between the unemployment rates and inflation. That is, the high levels of unemployment resulted in low inflation and vice-versa. In his research, he hypothesizes that when labor demand exceeds the unemployment of workers, then the wages' bidding rate is likely to be high (Stock & Watson 2008). On the other hand, when the unemployment rate is higher than labor demands, workers' possibilities of rejecting low wages are high. This leads to a slow reduction in wage rates.

However, in 1960, another research was conducted by other monetary economists, who argued that the Philips curve was only essential for the short-run and could not apply over a longer period. Their argument was based on the fact that most of the economies often change to the natural rate of unemployment to balance the inflation rates over the long run (Blanchard, 2016). Therefore, the natural rate is referred to as the long-run unemployment level, which begins immediately after the dissipation of the factors causing short-run effects. This is the time when the wages are expected to adjust so that labor supply and demand in the market balances.

In the 1970s, Friedman's theory was confirmed, and this was the time when the United States experienced high inflation and unemployment rates caused by oil deficiency in the country. The shocks led to the doubling of oil prices and the eventual increase in unemployment and inflation rates. In the 1990s, a positive correlation between unemployment and inflation occurred due to various improvements such as productivity improvements and changes within the labor force. In 2001, an inverse correlation occurred due to a mild recession that led to an increase in unemployment rates, while the inflation rate fell by almost two percent. After the mild recession, the great depression led to a dramatic fall in inflation, as the unemployment rate rose to a higher percentage. However, from 2010 to 2015, the inverse correlation experienced in the past years began to break down. As a result, the gap between inflation and unemployment narrowed. As a result, the inflation rates in the United States have been kept quite low, and the rate at which people lost their jobs during the period was steadily low. However, with the ongoing COVID-19 pandemic that has adversely affected the United States, there is a higher likelihood that a negative correlation between inflation and unemployment will be realized. The reason is, that most of the economic activities have been shut down, rendering so many people jobless.

The Difference Between the Short-Run and the Long-Run in a Macroeconomic Analysis

The short-run and long-run are important aspects of microeconomic analysis that determine how wages respond or do not respond to the different changes presented by the prevailing economic conditions. In microeconomics, the short run illustrates a point when there is no correspondence between wages and economic changes, making it hard to maintain an equilibrium in the market. The prices result from changes being experienced in the economic conditions. Due to the slow adjustment of the prices to their equilibrium level, a period of shortage is created within the economy. Often, any wage or price that adjusts slowly to its equilibrium presents various challenges to an economy. For instance, an economy may not be in a position to attain the needed employment levels. Thus, a country faced with such challenges may be limited in its operation to achieve any potential output.

On the other hand, Long-run in macroeconomics refers to when an economy experiences flexibility in its wages and other prices. Besides, the long run is also considered as a time when almost all businesses plan for their future. The business planning processes may include decision-making to withdraw operations from a given market or shift the existing business model to be part of the emerging technology. This means that employment will finally attain its natural level in the long run, resulting in potential output. The flexibility in prices and wages leads to maintaining a long-run macroeconomic equilibrium, enabling economists to analyze an economy after achieving all the market adjustments. However, to get better results, macroeconomics provides a combination of both the short-run and long-run processes to identify the activities that can foster the faster growth of an economy (Dutt 2006). For example, when a country focuses on long-run solutions, it should also consider some of the short-run impacts that can be experienced in the process.

From the above discussion, it is apparent that the relationship between inflation and unemployment is different in the short-run and the long-run as exhibited in the Philips Curve. Generally, the Philips curve helps to show the relationship between inflation and unemployment, while the shape of the curve would determine whether the correlation is short-run or long-run. The curve shows that the two macroeconomic elements are inversely related, meaning that a decrease in the unemployment levels leads to an increase in the inflation rate. The changes experienced along the L-shaped curve are due to the shifts in a country's inflation expectation. Graphically, the correlation is not linear; instead, the short-run Philips curve takes an L-shape, as shown below.

In contrast, the long-run relationship between unemployment and inflation takes the shape of a vertical line represented in the Philips Curve, showing a correlation between inflation and unemployment since the vertical line is at the natural rate of employment. This is a true reflection of economists' hypothesis that the long run does not allow for any trade-off between inflation and unemployment, meaning that the two elements are unrelated, which results in the vertical line. Thus, when the unemployment rates are changed, then the economy of the county moves along the line.

An Assessment of the U.S. Unemployment and Inflation Data and Analysis of the Philips Curve

The assessment of the U.S. data shows that the country has enjoyed a higher rate of job vacancies that have helped to reduce the unemployment rates within its borders. The inflation rate has also been kept at a certain level, and the country has avoided the impacts of increased inflation. Awing to the above combination, it is evident that the U.S. data does not confirm the short-run Philips curve. Since the short-run is only valid in a case where inflation and unemployment are inversely related, the U.S economy's current data does not indicate the possibility of the U.S economy experiencing a lower number of unemployment rates, which is below 3.8% since the middle of 2018 (Gallegati et al. 2011). Up to last year, the data shows that the country has been doing well, and could be above the needed long-run sustainable growth due to many factors and reforms. Thus, it is apparent that the country's potential output has been growing faster than the projected increase at a sustainable rate. All these indicate that the chances of the United States an economic slack is very low. However, the above situations are most likely to cause inflationary pressure on the prices. In the third quarter of 2018, it is shown that the core inflation was 2%, which means that wages and prices have contained well. Therefore, since the Great Recession, the country's inflation rates may have been driven by the people's expectations and the country's economic condition. Economically, this shows a flattening of the Philips Curve because the impacts of economic slack on the inflation rate are generally next to zero. Besides, even if the United States were to experience an unemployment rate of two percent, away from the natural point, its effects would still not cause a significant change in inflation. Since public expectations and economic dynamics solely determine the inflation changes, the short-run Philips Curve may not apply in the United States currently because the curve is associated with unemployment and inflation dynamics (Ball & Mazumder 2019).

Evaluation of the Philips Curve in Resolving Today's Inflation and Unemployment

The Philips curve remains a valid tool for analyzing how an economy, including the U.S., manages its unemployment and inflation. Even though the U.S. inflation dynamics are currently not dependent on the unemployment rates, the relationship between the two macroeconomic elements has been supported by the U.S. data. However, a lot of contention has arisen in the last two decades, questioning the validity of the curve being that the inflation rates have not been very high. For instance, from the data analysis carried out from 1988 to 2018, very little evidence has been shown on the validity of the Philips Curve because both the linear and non-linear slopes are all close to zero. However, this does not necessarily mean that the Philips curve is disappearing or should be forgotten by economists. The reason is, that many researchers continue to explore how unemployment and inflation rates correlate at the state and city levels to understand how the state averages compare with the rate of wage inflation. From the findings, it is important to note that determining the relationship between inflation and unemployment rates at the state and city levels is an essential element that policymakers must consider

Secondly, the current data have shown that the U.S. unemployment rate is becoming very low. This is a warning to the economy at large because the economist cannot predict whether the rates of inflation in the country will rise in the future.