Wednesday, 11 April 2012

Inflation and unemployment

Inflation and Employment
A problem arises when monetary policy is used to reduce inflation. There is a short term trade-off between unemployment and inflation. In 1958, economist A. W. Philips published an article showing that when inflation is high, unemployment is low, and vice versa. This relationship, when graphed, came to be known as the Phillips curve. When monetary policy is used to reduce inflation, either by contracting the money supply or by raising interest rates, this reduces aggregate demand, while aggregate supply remains the same. When aggregate demand decreases, prices decrease, but unemployment rises.

Short-Term Influence of Inflation on Employment — the Phillips Curve

Although the unemployment rate fluctuates, it trends toward a natural equilibrium known as the natural rate of unemployment, which is the unemployment rate that would prevail when there have not been any recent changes to monetary policy.

The natural rate of unemployment cannot be lowered by monetary policy over the long-run, but it can be influenced by other policies, such as minimum wage laws, collective bargaining, unemployment insurance, and job training programs.

It was Milton Friedman and Edmund Phelps who showed that the Phillips relationship between unemployment and inflation was valid over the short run but not over the long run. Over the long run, the natural rate of unemployment would be unaffected by prices. This accords with the principle of monetary neutrality, which simply states that nominal quantities, such as prices, cannot affect real variables, such as output and employment. If prices go up, incomes generally follow.

Hence, the long-run Phillips curve is vertical, which means that it does not depend on money growth or inflation in the long-run.

Graph of both the short-run and long-run Phillips curves, which shows the relationship between the inflation rate and unemployment rate.

Friedman and Phelps concluded that expected inflation is what changed the short-term relationship between unemployment and inflation into the long-term natural rate of unemployment. Expected inflation causes people to demand greater wages so that their incomes will keep pace with inflation. By increasing the cost of labor, the short-term increase in employment is reversed back to the natural rate of unemployment. This relationship is summarized in the natural rate hypothesis, which states that unemployment eventually returns to its normal, or natural, rate, regardless of the inflation rate. The short-term unemployment rate can be approximated by the following equation, where p equals a modifying parameter:

Unemployment Rate = Natural Rate of Unemployment - p x (Actual Inflation - Expected Inflation)

Sometimes the increase in prices results from an increase in the inputs to production, so called supply shocks, such as the increase in the price of oil in 1974, when the Organization of Petroleum Exporting Countries (OPEC) began increasing prices by restricting supply. This increased unemployment by reducing the demand for labor. When prices rise because of the greater cost of the factors of production, it is sometimes referred to as stagflation, since there is inflation even though economic output is falling.

Because inflation is caused by decreasing aggregate supply rather than an increase in aggregate demand, the relationship between unemployment and inflation is reversed in stagflation. Nonetheless, the natural rate of unemployment will prevail over time, under both stagflation and demand inflation.

Sacrifice Ratio

In the early 1980s, Paul Volcker, who was chairman of the Federal Reserve, decided to reduce the money supply to fight inflation, to pursue a policy of disinflation, which is a reduction in the rate of inflation. (Note that this differs from deflation, when prices actually fall.) However, he was uncertain about the consequences on unemployment.

Many economists believed that to reduce inflation, there had to be some unemployment. The number of percentage points of annual output that would be lost in reducing inflation by 1% came to be known as the sacrifice ratio. Many believed that the sacrifice ratio was typically 5. In other words, the central bank would have to accept a 5% reduction in output for each percentage point of inflation, with the resulting increase in the unemployment rate.

Rational Expectations Hypothesis and the Lucas Critique

There were many economists, such as Robert Lucas, Thomas Sargent, and Robert Barro, who believed that the sacrifice ratio would not be that high because people had rational expectations, which could be modified by the government so that the short term trade-off between unemployment and inflation reduction would not be as severe. The rational expectations hypothesis simply states that people will use all of the information they have, including information about government policies, when forecasting the future. Households, firms, and other organizations make decisions based on their future expectations of the economy. Consequently, how soon the unemployment rate would return to its natural rate would depend on how quickly people modify their expectations of future inflation.

Statistical models that were used to forecast the effects of monetary policy changes also had to be modified, since they relied on historical data that only incorporated how the economy responded to monetary policy changes in the past. In what became known as the Lucas critique, incorporating historical information about monetary policy changes and their effects was not enough to predict the consequences of changes to present monetary policy.

Consequently, during the 1970s, Lucas applied the rational expectations hypothesis to econometrics, which is the statistical analysis of economic policy, so that they would be more accurate in predicting the response of the economy to changes in monetary policy.


Volcker succeeded in reducing inflation from 1981 to 1987; however the unemployment rate peaked at 10% in the process of doing so, going from 7% to 10% in 1982 to 1983, then falling back to 7% in 1986 and 6% in 1987.

Even though unemployment did rise under the central bank's contraction of the money supply, the rational expectations hypothesis still had supporters, both because the unemployment did not rise as high as some have predicted and because the public did not believe that Volcker would be successful in reducing the inflation rate. Hence, many economists believed that by having a firm policy of containing inflation, the public will have reduced expectations of future inflation, which would allow a more favorable compromise between unemployment and inflation.

Inflation and unemployment go hand in hand. For every country, maintaining a low unemployment rate is the main objective. It is usually believed that inflation and unemployment are inversely proportional. There are many economists, who hold the opinion that low rate of unemployment together with low inflation rate may be a source of concern. Both low inflation rate and low unemployment rate, may be hypothetical. In real practice, this rarely happens. If a particular country, has full employment, it can be said to have minimum rate of unemployment. If a nation maintains a minimum rate of unemployment in a condition when inflation rate is stable, it is said to follow the natural rate of unemployment. In other words, the natural rate of unemployment is the minimum rate of unemployment, which can be sustained.

Inflation and unemployment- how it works:

If rate of inflation increases suddenly, it temporarily reduces, the rate of increase in the wages. Consequently, unemployment rate decreases. If the workers are able to cope with the increase in inflation, unemployment rate is also less. However, when they do realize that in order to compensate for the increase in price of commodities, the wages ought to be increased, unemployment may rise to a considerable extent. This increase in the demand of wages, has a tendency to reverse the unemployment curve to some extent (unemployment rises). If the rate of inflation is very high, it does not mean that, there will be a permanent decrease in the rate of unemployment. As a rule, rate of inflation and unemployment adjust themselves to attain the equilibrium state, which is known as the natural rate of unemployment state, effortlessly. It just happens.

The Philips Curve:

The Philips Curve, as the name suggests is named after the William Philips, who was a famous economist. He suggested the relationship between inflation and unemployment. The Philips curve shows how inflation and unemployment are related. He suggested that if rate of inflation is high, rate of unemployment is low. On the other hand, if the rate of inflation is low, unemployment rate is high.

Unemployment and inflation are two intricately linked economic concepts. Over the years there have been a number of economists trying to interpret the relationship between the concepts of inflation and unemployment. There are two possible explanations of this relationship – one in the short term and another in the long term. In the short term there is an inverse correlation between the two. As per this relation, when the unemployment is on the higher side, inflation is on the lower side and the inverse is true as well.

This relationship has presented the regulators with a number of problems. The relationship between unemployment and inflation is also known as the Phillips curve. In the short term the Phillips curve happens to be a declining curve. The Phillips curve in the long term is separate from the Phillips curve in the short term. It has been observed by the economists that in the long run the concepts of unemployment and inflation are not related.

As per the classical view of inflation, inflation is caused by the alterations in the supply of money. When the money supply goes up the price level of various commodities goes up as well. The increase in the level of prices is known as inflation. According to the classical economists there is a natural rate of unemployment, which may also be called the equilibrium level of unemployment in a particular economy. This is known as the long term Phillips curve. The long term Phillips curve is basically vertical as inflation is not meant to have any relationship with unemployment in the long term.

It is therefore assumed that unemployment would stay at a fixed point irrespective of the status of inflation. Generally speaking if the rate of unemployment is lower than natural rate, then the rate of inflation exceeds the limits of expectations and in case the unemployment is higher than what is the permissible limit then the rate of inflation would be lower than the expected levels. The Keynesians have a different point of view compared to the Classics.

The Keynesians regard inflation to be an aftermath of money supply that keeps on increasing. They deal primarily with the institutional crises that are encountered by people when they increase their price levels. As per their argument the owners of the companies keep on increasing the salaries of their employees in order to appease them. They make their profit by increasing the prices of the services that are provided by them. This means there has to be an increase in the money supply so that the economy may keep on functioning. In order to meet this demand the government keeps on providing more money so that it can keep up with the rate of inflation.
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