Unemployment and Inflation

Unemployment and Inflation

When it comes to economic indicators, the association between inflation and unemployment has long been studied, debated, and used. As the business cycle progresses, unemployment and inflation will likely fluctuate. Simply put, high inflation and unemployment rates imply that the economy is not producing at its maximum potential. People are saving more, and entrepreneurs operate at total capacity during periods of inflation and unemployment(Kasseh, 2018). This relationship must be fully understood and studied to keep inflation under control and unemployment at a manageable level.

Inflation is a long-term rise in the cost of living in an economy. Essentially, this means that the same goods will cost you more money. Even more apparent is the state of the labour market. People who should be working but are not because of a lack of employment opportunities or low wages are said to be unemployed or underemployed. It is a way of saying that an individual is willing to work but unable to do so(Cottrell,2019). Finally, the unemployment rate, which represents the percentage of available workers who cannot find work, is used to assess the state of the labour market.

Unemployment is an essential indicator of a country’s economic health. The falling unemployment rate is usually accompanied by rising GDP, higher wages, and increased industrial production. It is reasonable to assume that policymakers will aim for a lower unemployment rate by implementing fiscal or monetary policies that are known to reduce unemployment(Lacker and Weinberg, 2006). The association between the underemployment rate and inflation is a factor in policymakers’ apathy.

Research has argued that when the unemployment rate falls below a certain level, it starts as the natural rate. The inflation rate tends to rise and continue to rise till the unemployment rate gets back to its natural rate. TIn other words, when the unemployment rates are high above their natural level, the annual inflation will tend to slow down. Sustainable economic growth is required to maintain the natural rate of unemployment. Wages and prices are likely to rise due to an economy growing faster than it can sustain. Wages and prices fall, leading to lower inflation. Suppose the unemployment rates are high above the natural unemployment rate. In that case, Wages account for a large portion of cost of goods and services, so any increase or decrease in wages impacts the overall cost.

Additionally, the supply of goods is subject to unexpected shifts, which can affect inflation rates. When individuals make price-setting decisions or bargain for wages, they consider their inflation expectations, affecting the actual inflation level. As a result of a change in the prices of goods used as factors of production (e.g., oil), changes in inflation can be expected.

As the economy changes, the natural rate of unemployment shifts as well. For instance, the natural unemployment rate is affected by factors such as inflation. Changes in the workforce’s demographics, education, and experience; programs like apprenticeships and public policies like unemployed benefit programs are examples of institutions. Changes in productivity growth compare the current and previous long-term unemployment rates. Throughout the years following the recession, the actual unemployment rate remained significantly higher than the natural unemployment rate. Natural rate models predicted that the average inflation rate would fall by less than one percentage point during this period. Furthermore, inflation is not showing any signs of picking up as the unemployment rate nears its natural level. As a result, some economists have argued that the concept of the natural unemployment rate should be abandoned in favor of other indicators to explain fluctuations in inflation.

To explain the modest decline in inflation following the recession, some researchers have primarily remained loyal to the natural rate model while taking into account broader economic changes and the specific effects of the downturn. After the financial sector’s collapse, businesses had a limited supply of financing available to them. Also, the Federal Reserve has changed its policies and established an unofficial inflation target, changing how inflation expectations are formed. As a result of long-term unemployment following the recession, the bargaining power of workers was greatly diminished, according to other researchers.

Keynes distinguished three types of unemployment: involuntary, voluntary, and frictional. He believed that while the third unemployment category was consistent with underemployment in the real world, it was inconsistent with classical theory. He did not mean “the simple presence of an endless series capacity to work” when he said “involuntary unemployment.” In light of this definition and his theories regarding the labour market, Keynes believed that employment would rise when prices rose faster than wages(Nitzan, Jonathan, 2022). In terms of monetary policy, Keynes thought that one of the “ultimate predictor factors” in an economy was the “quantity of money as ascertained by the action of the monetary system.”

Additionally, “a change in the quantity of money has a primary effect through its effect on the interest rate on the amount of effective demand.” The financial system can encourage investment and increase effective demand by lowering the interest rate. According to Keynes, “the increase in quantity demanded will, generally, spend itself in raising the level of prices and increasing the quantity of employment.” The use of resources, however, affects this implied trad tradeoff. Keynes declared that it is likely. When there is no unavoidable unemployment and the economy is at full employment, a rise in the money supply results in a thoroughly pro-rata rise in prices and wages without causing a subsequent increase in production. The economy then experiences what Keynes referred to as proper inflation.

However, a decrease in the money supply—and consequently, a reduction in quantity demanded a decrease in employment. The reason, according to Keynes, is that the production’s inputs—particularly the workers—are inclined to resist a decrease in their monetary rewards while being unmotivated to oppose an increase.

The theory of natural rates In 1967, Milton Friedman and Edmund S. Phelps independently developed theories that suggested the Phillips curve would shift over time. Their theories contend that there is no long-term tradeoff between unemployment and inflation. Friedman argued that monetary policy “cannot peg the level of unemployment for more than the minimal person . There is no permanent tradeoff between inflation and unemployment, even though there is “always a tradeoff between the two.

This natural unemployment rate is influenced by several fundamental factors, including “market inefficiencies, stochastic variance in demands and equipment, the cost of accumulating information about job openings and labour availability, the cost of movement, and other factors.” Friedman listed the Walsh-Healy and Davis-Bacon Acts, the size of labour unions, and the minimum legal wage rates as factors influenced by a policy that determines its level. He claimed that he did not use the word “natural” to imply that this unemployment rate was average or desirable but rather to distinguish “real” forces from economic forces. Friedman referred to the market unemployment rate as the actual or reported rate. The amount of money in circulation was thought only to have a fleeting impact on this market rate.

As a result of rising prices, employees are forced to demand higher wages to cover their living expenses. Once the economy slumps, employers may be unable to afford to raise wages or pay employees, which may lead to layoffs. It is up to an unemployed person to choose between working fewer hours, changing careers, waiting for a job opening in their field of expertise, or simply not working at all and trying to get by on unemployment benefits.

Phillips Curve is a major topic of discussion in the inflation-unemployment debate. To put it another way, as unemployment increases, so does inflation, according to the Philips curve. The belief is that the rate of unemployment and inflation are inversely related. There is a tradeoff of both inflation and unemployment, with lower inflation only possible at the expense of higher unemployment. A dual love-hate relationship with the Phillips Curve had evolved in modern macroeconomic theories for unemployment and inflation since the 1960s when the original work by Phillips (1957) was incorporated into macroeconomic models.

As a “menu of choice between various degrees of underemployment and price stability,” Samuelson and Solow proposed the “modified Phillips Curve,” which was roughly approximated on the grounds of 25 years of American data. Because it seemed to be stable, the relationship was regarded as necessary. The tradeoff relationship” implied that the effects of unemployment on inflation (and vice versa) were predestined and that the politician only needed to select the ideal mix that reduced social hardship (Qin, 2020). Although such policy implications dominated later analyses of the Phillips Curve, the change from wage to price inflation initially received much less attention. Samuelson and Solow only hinted at the justification for this transition in their article. Successive interpretations attributed this shift from wages to prices to the presumption of a constant markup. In this later theory, businesses set their unit prices as a constant markup over unit labour costs, resulting in price inflation that was equal to wage inflation less the increase in worker productivity.

Price inflation could be understood as a reasonably stable, linear combination of wage inflation because productivity was generally stable. In other words, you could change the original Phillips-Curve equation to the modified one by simply substituting price inflation for wage inflation on the left side and removing productivity from the right side. Markup pricing was incompatible with a strict competitive market where prices are determined by surplus demand and supply.

Indeed, Samuelson and Solow argued that we must distinguish between the cost-push inflation linked to “market imperfections” and the mechanism of demand-pull inflation, which was driven by competitive forces. The demand-pull theory of inflation was essentially based on the a priori assumption that natural factors (outputs, inputs, and economic variables for goods and services as well as for factors of production) were defined by a set of competitive equations that were “independent of the absolute level of prices,” according to Samuelson and Solow. The latter is influenced by the money supply or, more generally, by the total amount spent. Between both the procedures that determined actual variables as opposed to numeric variables, there was a strict neoclassical “dichotomy,”

In conclusion, There is a general correlation between unemployment and inflation, which means that prices rise faster when fewer people work. When the unemployment rate falls below what economists call the “natural unemployment rate,” tradeoff inflation and unemployment become wildly prominent, it is also possible that if the unemployment rate rises far above the natural rate, the price level will decelerate. The Federal Reserve began implementing expansionary monetary policy in response to the global financial and subsequent recession to stimulate economic growth and improve employment rates

Works Cited

Alisa, Maximova. “The Relationship between Inflation and Unemployment: A Theoretical Discussion about the Philips Curve.” Journal of International Business and Economics, vol. 3, no. 2, 2015, https://doi.org/10.15640/jibe.v3n2a7.

Cottrell, Allin. Economics 207, 2019 Inflation and Unemployment. 2019, users.wfu.edu/cottrell/ecn207/infl_unemp.pdf.

Kasseh, Pa Alieu. “The Relation between Inflation and Unemployment in the Gambia: Analysis of the Philips Curve.” Journal of Global Economics, vol. 06, no. 02, 2018, https://doi.org/10.4172/2375-4389.1000294.

Lacker, Jeffrey M., and John A. Weinberg. “Inflation and Unemployment: A Layperson’s Guide to the Phillips Curve.” Semantic Scholar, 2006, www.semanticscholar.org/paper/Inflation-and-Unemployment%3A-A-Layperson%27s-Guide-to-Lacker-Weinberg/56ccaaf91efbbcf0408619e67ea2dd6b358735e3.

Nitzan, Jonathan. A Service of Zbw Macroeconomic Perspectives on Inflation and Unemployment. 2022, www.econstor.EU/bitstream/10419/157850/1/bna-159_900101N_Macro_perspectives_on_inflation_unemployment.pdf.

Qin, Yizhuo. “The Relationship between Unemployment and Inflation–Evidence from U.S. Economy.” Proceedings of the Fifth International Conference on Economic and Business Management (FEBM 2020), 2020, https://doi.org/10.2991/aebmr.k.201211.029.


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