Interplay Between Unemployment and Inflation

DN89...Jybs

16 May 2024

Many might believe there is close to no relationship between unemployment and inflation. However, both unemployment and inflation have their ways of making acquaintance and causing havoc in economies around the world. Traditionally, the relationship between these two macroeconomic variables was thought to be inversely correlated, however, as years passed the relationship between those has been broken down over the course of 50 years. After breaking them down, the new relationship between them looked to be closely related, since they were used as indicators to monitor the health economy, and hence, a positive correlation between inflation and unemployment was recognized.

To understand the relationship between these macroeconomic variables we must have an understanding of the following:

Is Unemployment a Problem?

The moment we hear unemployment rates are high, the first thing our minds relate it to is someone losing their job, which means they have lost their income; which is a bad thing. When people lose their income, it starts off a domino effect, which starts with losses in income and is followed by loss of production. When consumers do not have the capacity to purchase, their demand evidently falls, which leads to a loss in consumption. When people do not consume products, investors will not choose to invest in firms and industries, as a result, production falls, businesses close and workers are let go off, and hence adding fuel to the unemployment rates in the economy. Evidently, the living standard of people in the economy lowers, impacting both the present and future of the economy.

The economy also losses human capital. Human capital simply refers to the skills, knowledge, and experience that an individual possesses. It has been seen that prolonged exposure to unemployment actually damages a person’s job prospects because they lose human capital.

Now let’s look at the demand and supply of labor to understand the depth of unemployment.

Labor Supply and Demand

When unemployment is high, the number of job seekers greatly exceeds the number of available jobs. In other words, the supply of labor is greater than the demand. We take wage inflation, the rate of change in wages, as an indicator of inflation in the economy. With so many workers available, employers do not need to “bid” on employee services by paying them higher wages. In times of high unemployment, wages generally remain stagnant and wage inflation (or wage increases) is non-existent.

In a scenario where unemployment is low, the demand for labor exceeds the supply, resulting in a shortage of labor available in the market. In this kind of market, employers typically need to offer higher pays to attract and retain employees, which ultimately leads to rising in wage inflation. Therefore, over the years, economists have found a relationship between unemployment and wage inflation, and the overall inflation rate.

One of the best ways to understand the correlation between two macroeconomic is through the Phillips curve.

The Phillips Curve

A.W. Phillips was one of the first economists to find an inverse relationship between wage inflation and unemployment. Phillips studied the relationship between unemployment and the rate of change in wages in the UK from 1861 to 1957 and found that the phenomenon of changing wage rate could be explained by two things: the level of unemployment and the rate of change in wages.

When speaking of the level of unemployment in the economy, Phillips made a hypothesis that when demand for labor was high and unemployment was low, employers could bid higher wage rates. But, when the demand for labor is low and unemployment is high, workers are hesitant to accept wages below the prevailing rate and, as a result, wage rates fall very slowly.

The second factor influencing wage rate is the rate of change in unemployment. If the economy is booming or at an expanding stage, employers will make a more spirited supply for workers, which means that the demand for labor is increasing at a rapid rate. For instance, the unemployment rate is falling rapidly, then they would only do so if the demand for labor had not increased, for example, the unemployment rate is unchanged, or is only increasing at a slow pace. Since wages and salaries represent a major input cost for businesses, rising wages are expected to lead to higher prices for goods and services in an economy, which will ultimately push the inflation rate. As a result, Phillips plotted the relationship between general price inflation and unemployment, rather than wage inflation. The graph we can see below is known as the Phillips curve.

Economists soon found that the negative correlation between inflation and unemployment depicted by the Phillips curve worked well only in the short run when inflation rates are constant. However, in the long run, the theory behind the Phillips curve did not hold up since the economy would relapse into the natural state of unemployment as it adjusted with the prevailing inflation rates.

What Would Happen if Inflation and Unemployment are Positively Correlated?

A positive correlation between inflation and unemployment creates a number of challenges for fiscal and monetary policymakers. Policies that work to increase economic output while reducing unemployment, tend to aggravate inflation. On the other hand, policies that curb inflation often constrain the economy and as a result worsen unemployment in an economy. Congressman Pete Sessions has even gone on to quote, “History shows that tax increases during a recession are a recipe for greater unemployment and economic loss.”

A Glimpse into the Past

When we glance into the past, we find that the inverse relationship of unemployment and inflation rates explained through the Phillips curve, failed to hold through. A phenomenon called stagflation occurred in a period in the United States during the 1970s when inflation and unemployment were positively correlated. During this time, the combination of high inflation, high unemployment, and slow economic growth caused stagflation in the US economy. To mitigate the impact on the nation, President Richard Nixon lifted the US dollar off the gold standard. The US dollars instead of being pegged to a commodity with intrinsic value, the currency was set free on a floating exchange rate system, with its value subject to the demand of the market. Nixon also implemented wage and price controls policies, which allowed companies to charge customers. Even though production costs rose under a falling dollar, companies could not raise prices to align revenues with costs. Instead, they were forced to cut costs by reducing the wages of employees to stay profitable, and most employees were also let go. Hence, as the value of the dollar fell, jobs were lost, all of which was the result of a positive correlation between inflation and unemployment.

Federal Reserve Chairman Paul Volcker was determined that the long-term gain justified the short-term pain in attempts to recover from stagflation. Volcker took drastic measures to reduce inflation, by raising interest rates up to 20% all while knowing that these measures would cause a temporary but sharp economic contraction. Evidently, the economy entered a deep recession in the early 1980s, millions of people lost their jobs and the Gross Domestic Product (GDP) declined by more than 6%. However, the recovery was characterized by a vigorous rebound in the gross domestic product, all the lost jobs were recovered.

Recent Times

Through years of experience and analysis of economies around the world, it can be said, positive correlation between inflation and unemployment can also be healthy for an economy as long as both the macroeconomic variables are at low levels. In the times recovering from the Great Depression, the US economy went through a series of ups and downs in the economy, by the end of the 1990s the combination of the macroeconomic variables was: unemployment below 5% and inflation below 2.5%. An economic bubble in the tech sector was largely responsible for the low unemployment rate, while cheap gas during hot global demand helped keep inflation low. By the end of the nineties, in 2000, there was a burst in the tech bubble which caused unemployment to rise and fuel prices began to rise as well as a result. From 2000 to 2020, the relationship between inflation and unemployment again followed the Phillips curve, but the severity was much milder than in the preceding years. Economists have been trying to come up with fewer theories as they believe employment and inflation challenge economies around the globe. Economists have suggested implementing a blend of policies to match the ideal system to the economy.

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