Unemployment and Inflation: The Inverse Correlation

Unemployment and inflation are two significant economic indicators of a country's economy. This study discusses the inverse correlation between unemployment and inflation, the types of unemployment and inflation, and the Phillips Curve. It also talks about the limitations of the short-run Phillips Curve and the importance of maintaining a balance between inflation and unemployment.

MACROECONOMICS

Table of Contents
Introduction......................................................................................................................................2
Literature review..............................................................................................................................2
Relation between Unemployment and Inflation..............................................................................3
Phillips Curve..................................................................................................................................4
The Bottom Line..............................................................................................................................5
Conclusion.......................................................................................................................................5
Reference.........................................................................................................................................6
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Introduction
Unemployment and inflation are the two significant economic indicators of an economy of a
country. As far as the economic development and growth of a specific country is considered,
there should be a low level of unemployment in the economy in order to have a high growth in
future. This inverse correlation between unemployment and the level of inflation introduced by
A.W. Phillips is a major step in macroeconomics. Inflation represents a certain situation in an
economy when the general level of the commodity price is high.
In this study, it will be discussed what exactly the level of unemployment and inflation rate
means and how these two economic indicators are affected by the other economic factors. Then
the relationship between unemployment and inflation and its impact on the growth of an
economy will be discussed.
Literature review
According to Yelwa, David & Awe (2015), there is an inverse relationship between the two main
economic indicators which is inflation and unemployment. At a first glance, the inverse
relationship between inflation and unemployment may look simple. But the inverse correlation
between these two economic indicators is more complicated than it appears to be. In this study, it
will be discussed how the relationship between inflation and unemployment affects the overall
economy of a country in a broader prospect.
According to Sassen (2018), unemployment is one of the biggest problems that the economy of
most of the countries of the world is facing nowadays. The labour force of a country is divided
into two categories which is employed labour force and unemployed labour force. According to
Galí, (2015),the problem of unemployment represents the potential production that the country
could have produced in a specific period of time and that is why the problem of unemployment is
one of the main concerns for the economy of every country. The proper unemployment rate of a
country differs from the official unemployment rate of that country as official unemployment
represents those civilians who are not receiving any wages and exclude those civilians who are
not willing to do any job. There are few different types of Unemployment that exists in an
economy i.e frictional unemployment, cyclical unemployment and structural unemployment.
Frictional unemployment causes when people are in the process of moving from one job to
another. Fresh college graduates are example of this type of unemployment. Frictional
unemployment cannot be fully avoided and does not pose a threat to the economy of a country.
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According to Mueller (2017), cyclical unemployment represents a factor of unemployment,
causes due to the ups and downs of an economy. When the total production from a business
cycle is high, the rate of cyclical unemployment becomes low as the overall production of the
economy is maximized. Structural unemployment causes due to the massive change in the
industry. Structural unemployment occurs when the workers are not qualified enough or due to
technological changes they become inefficient.
According to Galí (2015),inflation represents a certain situation in an economy when the general
level of the commodity price is high. There are two main types of inflation that occurs in an
economy i.e demand pull inflation and cost push inflation. According to Singla, Ahuja & Sethi
(2017), demand pull inflation occurs when there is a high demand of commodities due to the
increased price of the commodities. Demand pull inflation is caused due to many reasons, for
example, expansionary fiscal and monetary policy due to increase in Exports and decrease in
imports. Cost push inflation causes when the production costs of the commodities are much
higher than usual which leads to the increased rate in the general price of those commodities.
Cost push inflation can occur due to many reason for example when the cost of the raw materials
are high, then the producers would obviously increase the price of the commodities in order to
maximize the profit.
Relation between Unemployment and Inflation
According to Keynes, (2018), when the employment rate in an economy increases, the
consumers have increased affordability. This leads to an increased demand for products and
services. And since the supply is not increased in short run, the general price rate of production
services gets higher than usual and causes inflation in the economy. Inflation can also occur due
to the factors on the supply side or more precisely due to the increased cost of the production.
When the oil prices increases overnight, there will be a massive increase in the production cost
of the oil products and the producers would increase the price of those products which may lead
to the decreased demand of those products. Due to the situation of less demand in the market, the
producers would try to cut short the cost of the production which may lead to unemployment.
According to Ho &NjindanIyke,(2018), the inverse relationship between unemployment and
inflation was first introduced by the Economist A.W Phillips. Philips closely monitored the
economic condition of United Kingdom during his time and he discovered that there is a
relationship between unemployment and the rate of change in wages. Philips discovered that the
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rate of change in wages can be defined considering the level of unemployment in the economy
and the changes in the level of unemployment.
According to David,(2015), when the demand for labour in the market is high and there are a few
numbers of unemployed people then the wage rates of the workers would increase. When the
demand for labour in the market is low and the level of employment is high in the market, the
workers would more likely charge less wage rate. Since wage rate is the main input cost of any
production process, when the wage rate is higher, it increases the overall production cost and that
leads to the increased prices of products and services. This situation pushes the overall rate of
inflation higher.
Phillips Curve
According to Rossouwand Marais, (2018), Philips graphed the inverse relationship between the
rate of inflation and the level of unemployment which is called as a Phillips Curve where the rate
of inflation is graphed in vertical axis and the level of unemployment is graphed in horizontal
axis. Philips has drawn two types of curve maintaining the classical theory in economics i.e long
run Phillips curve and short run Phillips curve.
According to Coibion and Gorodnichenko (2015), in case of short run Phillips curve, the rate of
inflation level is expected given the level of unemployment in the market and since in short run
there is money illusion in the market and the wage rates of the workers is not increase in short
run, inflation causes due to an increase in the money supply in the market. But when inflation
rate decreases in short run, the level of unemployment increases as as the real wage of the
workers increases because of the short-run situation.
Every modern Central Bank would try to implement a monetary policy that maintains low
inflation and full employment in the market. For example, the monetary policy of the Federal
Reserve is to maximize level of employment, keeping the level of prices stable and maintaining a
moderate level of interest rate in the market. According to Blanchard,Erceg&Lindé, (2017),as the
Phillips curve shows a specific level of unemployment for a specific level of inflation rate, it is
easier for the government to to reconstruct the monetary and fiscal policy maintaining a balance
between a desired level of inflation and the level of unemployment in the market.
The Bottom Line
During the great recession of 2008, customer price index fell dramatically as the level of
unemployment increased to almost 10 percent in Euro Zone. From 2012 to 2015 the inverse
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correlation between the level of unemployment and the rate of inflation level has been broken
down. Over the past two years the level of unemployment has been decreased and and the the
rate of inflation level is increasing moderately. Central banks r are fine tuning the monetary and
fiscal policy in order to deal with the problem of increasing inflation level.
Conclusion
It can be concluded in the end that the inverse correlation between the inflation and the level of
unemployment is a significant area in order to achieve high growth in the economy of a country
at this current economic situation. Phillips curve is a very important technique in order to
maintain and explicit rate of inflation level for a specific level of unemployment it. Short run
Phillips curve has some limitations and restrictions since there may be some changes in the
wages and money illusion in short run. In order to mitigate the issues caused due to the short-run
Phillips curve, the hypothesis of long run Phillips curve was introduced as it incorporates every
slight change in the wage rate and money illusion to the people. Unemployment and inflation are
the two significant economic indicators of an economy of a country. As far as the economic
development and growth of a specific country is considered, there should be a low level of
unemployment in the economy in order to have a high growth in future. This inverse correlation
between unemployment and the level of inflation introduced by A.W. Phillips is a major step in
macroeconomics.
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Reference
Blanchard, O., Erceg, C. J., & Lindé, J. (2017). Jump-starting the euro-area recovery: would a
rise in core fiscal spending help the periphery?. NBER Macroeconomics Annual, 31(1),
103-182.
Coibion, O., & Gorodnichenko, Y. (2015). Is the Phillips curve alive and well after all? Inflation
expectations and the missing disinflation. American Economic Journal:
Macroeconomics, 7(1), 197-232.
David, H. (2015). Why are there still so many jobs? The history and future of workplace
automation. Journal of Economic Perspectives, 29(3), 3-30.
Galí, J. (2015). Hysteresis and the European unemployment problem revisited (No. w21430).
National Bureau of Economic Research.
Galí, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new
Keynesian framework and its applications. Princeton University Press..
Ho, S. Y., & Njindan Iyke, B. (2018). Unemployment and Inflation: Evidence of a Nonlinear
Phillips Curve in the Eurozone.
Keynes, J. M. (2018). The general theory of employment, interest, and money. Springer.
Mueller, A. I. (2017). Separations, Sorting, and Cyclical Unemployment. American Economic
Review, 107(7), 2081-2107.
Rossouw, J., & Marais, M. (2018). The Phillips Curve Revisited: Implications of an Inaccurate
Urban Legend. Southern African Business Review, 22, 17.
Sassen, S. (2018).Cities in a world economy.Sage Publications.
Singla, A., Ahuja, I. P. S., & Sethi, A. P. S. (2017). The effects of demand pull strategies on
sustainable development in manufacturing industries. International Journal of
Innovations in Engineering and Technology, 8(2), 27-34.
Yelwa, M., David, O. O., & Awe, E. O. (2015). Analysis of the relationship between inflation,
unemployment and economic growth in Nigeria: 1987-2012. Applied Economics and
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