Correlation Between Unemployment And Inflation

Inflation influences economies in different positive and negative ways. The negative impacts of inflation incorporate an expansion in the open door cost of holding money, vulnerability over future inflation which may debilitate investment and reserve funds, and if inflation were sufficiently fast, deficiencies of merchandise as shoppers start storing out of worry that prices will increment later on. Constructive outcomes incorporate diminishing the genuine weight of open and private obligation, keeping ostensible loan costs over zero so national banks can change financing costs to balance out the economy, and lessening unemployment because of ostensible wage inflexibility.

Figure 3.5 illustrates the short run tradeoff between inflation and unemployment observed by New Zealand economist A. W. Phillips in Britain in the 1950s. A government attempting to decrease unemployment to a level below 4%, by an increase in government spending may tradeoff more inflation from 2% to 5% for less unemployment from 4% to 3%. Conversely, a government could cut government spending to tradeoff less inflation from 5%

Inflation in particular is likely to occur when growth is above the long run trend rate and the aggregated demand increases faster than aggregated supply. China and India are two countries where this combination of strong economic growth and rising inflation has been seen in recent years. In 2010, China grew by 9.8% but her inflation rate was 4.9% and rising. India grew by 8.6% but her inflation rate was 8.3%. Persistently higher rates of inflation can then have negative effects on international trade performance, business profits and jobs and ultimately economic growth. When you attempt to control inflation by raising interest rates it may cause the exchange rate to appreciate and this can have a damaging effect on demand in the export industries. Now the conflict between inflation and unemployment is a little different. During a period of strong GDP growth, falling unemployment will create a demand-­‐pull and cost-­‐push inflation leading to a decline in the real purchasing power of money. There are policies designed to control demand-­‐pull or cost-­‐push inflation for example by reducing aggregated demand but may lead to a contraction of output and a rise in unemployment. Similar to how inflation can conflict with unemployment, deflation may also lead to a rise in unemployment.

The first challenge to this theory was by Milton Friedman and Edward Phelps who in individual analysis showed that the Phillips curve could not hold in the long run. Friedman asserted that rational employers pay inflation adjusted wages and this ensures that there is a natural rate of unemployment which is self adjusting in the long run. Therefore the state cannot be able as a matter of policy to regulate inflation by pushing unemployment below the natural rate as it will readjust itself to this rate. In the long run the inverse relationship between unemployment and inflation as posited by Phillips could not hold. His assertion was validated in the 1970’s when there was an increase of inflation from around 2.5% to 7% and the unemployment rate also increased from around 4% to 6%. He therefore contributed to the Phillips theory by creating a distinction between the short run relationship and the long run relationship.

* Adjustment on wages - It is argued a moderate rate of inflation makes it easier to adjust relative wages. If average wages are rising due to moderate inflation, it is easier to increase the wages of productive workers while wages of unproductive workers can be kept frozen – which is effectively a real wage cut. If we had zero inflation, we could end up with more real wage unemployment, with firms unable to cut wages to attract workers.

* Adjustment on wages - It is argued a moderate rate of inflation makes it easier to adjust relative wages. If average wages are rising due to moderate inflation, it is easier to increase the wages of productive workers while wages of unproductive workers can be kept frozen – which is effectively a real wage cut. If we had zero inflation, we could end up with more real wage unemployment, with firms unable to cut wages to attract workers.

Research on the impact of inflation to employment rate is based on Phillips Curve Theori, that said when the unemployment rate is high, the inflation rate is low, and vice versa, if the unemployment rate is low, then the inflation rate is high.

A rise in income will create increased purchasing power. Thus, the demand remains high as it reaches a point where the supply can no longer meet the demand, inflation occurs. However, at the same time, when unemployment is high, workers are unable to ask for better wages. This means that prices can fall, since businesses are not having to pay their employees better wages. Therefore, in many cases, when there is low unemployment, there is high inflation and vice versa. It has been observed that there was a stable and inverse relationship between rate of inflation and the rate of unemployment in an economy. In other words, a lower unemployment rate could be had by tolerating a higher rate of inflation.

Some variables in Economics are very closely related to each other. In many cases, the combination of these variables can have an unexpected effect on the economy. One of these examples can be observed when we compare inflation and unemployment rate. To establish this comparison in a short-run period of time, it will be beneficial to use the Phillip Curve. This curve can be used as a tool to represent the positive relationship between inflation and unemployment in the short-run. In order to comprehend the positive relationship between inflation and unemployment first, we must know what inflation is, how we define unemployment, and how we can use the Phillip Curve to make a functional comparison of these two variables. Moreover, it will be very beneficial to analyze how expansionary fiscal policies affect the relationship between unemployment and inflation. If we understand the meaning of each of these variables in the economy, it will be easier to comprehend the logic of a short-run trade-off between unemployment and inflation.

He argued that, there is a natural rate of unemployment where the real wage rate is in long run equilibrium for employment rate to be below the natural rate, employers and potential employees must be willing to be hired. An employer will engage more employees only if there is an actual decrease in the real wage rate, whereas potential employees, will accept work only if there is an actual or perceived increase in the real wage rate. Hence, any unemployment rate below the natural rate must, in the long run, be a disequilibrium rate. According to Friedman (1977) workers are not likely to suffer from money illusion, as they will not ignore what happens to their real pay in the long run. An initial higher wage will force employers to raise prices in order to afford paying the higher wages, this will still lead to a higher wage demand, which in turn leads to higher prices. Therefore, there is no end to the wage price spiral at any rate of unemployment below the natural rate.

In that way, not only the need of goods will drive the labor force to its pleasant stage, but it will also force prices to escalate simultaneously (Aspromourgos, 2012). Although the Keynesian-economic policy is wrong in the present view, it was not until the 1970s when an unknown phenomenon emerged in the United States that its ineffectiveness was proven; for the surprise of many economists. The phenomenon was defined as “stagflation,” and it consists of a “period [in which both] unemployment and inflation rise at the same time” (Barsky and Kilian, 2004, p.131), and it was caused by primary the combination of shock in oil prices and unsuccessful monetary policies.

Economists have done a lot of work on the study of inflation. The Phillips curve has been the focus and the main line of the macroeconomic debate since the Second World War. The Phillips curve describes the trade-off relationship between inflation and unemployment. According to the rule of substitution between them, the government can implement flexible fiscal and monetary policy to realize the effective intervention and regulation of macroeconomics, i.e. raise the unemployment rate to reduce inflation rate or increase the rate of inflation to reduce the unemployment rate (Trevithick and Mulvey 1975). The Phillips curve has made outstanding contributions to the stable development of the capitalist economy. The traditional Phillips curve model is back-ward looking type model, using output gap and inflation lag to explain current inflation. It shows the relationship between the output gap and inflation, however, it is difficult to be consistent with empirical facts.

The Philip’s curve offers great importance in modern economic analysis. Philip’s curve shows the relationship between the rate of unemployment and the rate of inflation in any given economy. The discovery of Philip’s curve by the great British economist gave room for the analysis of modern macroeconomic policy tools as well as management of different economies around the globe. The curve can be used to analyze the relationships between inflation and unemployment rates affecting modern economies. The curve can be used to address higher rates of inflation by adopting the appropriate fiscal and monetary policies. The same can be done to evaluate and determine possible solutions to higher rates of unemployment.

Inflation is considered to be one of the most “harmful” economic phenomena that manifest in contemporary economies, being considered a chronic disease difficult to control, which can cause recessions (Thornton, 2012, p. 119). Inflation is a serious imbalance in the currently economy and is represented by a generalized increase in prices and a simultaneous decrease in the purchasing power of the national currency. It is a final indicator that shows at the end of a fiscal period if the monetary, fiscal and legal policies were coordinating and were leading to consumer price stability. Deflation is often defined as the opposite of inflation, namely as a situation where there is a general decrease in prices over a long period of time. However,

Have a look on the recession at 2008, the Fed controls the interest rate around 0 to avoid more firms going bankrupt. But after the economy recovery in these 7 years, we can see the drift on both inflation rate and unemployment. The inflation rate keeps reducing trend after 2007 from 4.1% to 0.1% at 2015. For the unemployment rate, it raised up to 10.1% but eventually reduced to 4.6%, which is the half amount