Inflation – Unemployment Relationship

A look at the relationship between inflation and unemployment and whether there is a trade-off as suggested by the Phillips Curve.

phillips-curve2

Phillips curve suggests as unemployment falls and the economy gets closer to full employment – inflation rises.

But, a fall in demand which causes inflation to fall, will cause a rise in the inflation rate.


How would inflation be affecting the recent rise in unemployment?

Usually, a sudden rise in unemployment is due to lower economic growth – or fall in real GDP.

 

fall-in-ad-arrow-ad-as

A fall in AD causes lower economic growth and a rise in unemployment. This is because:

  1. Higher unemployment will make it harder for unions and workers to bargain for higher wages. This is because if they ask for higher wages, employers can turn round and say there are 3 million unemployed people willing to work at lower wages. Therefore, wage inflation is likely to be muted during the period of rising unemployment. This will reduce cost push inflation and demand-pull inflation.
  2. The higher unemployment is also a reflection of the decline in economic output. Therefore, firms are seeing an increase in spare capacity and increase in volume goods not sold. In a recession, there will be greater price competition. Therefore, the lower output will definitely reduce demand-pull inflation in the economy.

Cost-Push Inflation – a worse trade off

SRAS-shift-left

To complicate the issue, inflation can also be caused by cost-push factors. For example, an increase in oil prices could cause a rise in inflation and a rise in unemployment. This is because higher oil prices push up costs and reduce disposable income. Therefore, due to cost push factors, the relationship between inflation and unemployment can break down. For example, in 2011, the UK had CPI inflation of 5%, but unemployment continued to increase.

However, cost-push factors tend to be temporary. There still remains an underlying relationship between unemployment and inflation. What can happen in a period of cost-push inflation is that we get a worse trade-off.

phillips-curve-shift

Empirical evidence of the Relationship between Unemployment and Inflation

inflation

In the early 1980s, the US experienced a high inflation (partly result of oil prices rising). But, then there was a recession – falling output. This caused inflation to fall from over 14% to close to 2%. In this period, unemployment rose from 6% to 11% – a classic example of Phillips curve trade-off. Then economic growth in the 1980s caused a fall in unemployment. Inflation stayed low until the late 1980s, when the economy started to get close to full capacity and inflation started to creep up again.

UK Evidence – Unemployment v Inflation

unemployment-vs-inflation

In 2008, inflation fell because of the recession. This caused a rise in unemployment. Inflation increased in 2010-12 because of cost-push factors.

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By on November 24th, 2013

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