Inverse relationship of inflation and unemployment

inverse relationship of inflation and unemployment

The relationship between inflation rates and unemployment rates is inverse. Graphically, this means the short-run Phillips curve is L-shaped. A.W. Phillips. William Phillips found an inverse relationship between nominal wage change and unemployment based on historical UK data. It may still be in use in some. Short Run Phillips Curve indicates that there is an inverse relationship between rate of inflation and unemployment. This was a model developed in s but.

Therefore, wage inflation is likely to be muted during the period of rising unemployment. This will reduce cost push inflation and demand-pull inflation. 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 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.

How inflation and unemployment are related?

The stable relationship described by it suggested that policy makers could have a lower rate of unemployment if they could bear with a higher rate of inflation. On the contrary, they could achieve a low rate of inflation only if they were prepared to reconcile with a higher rate of unemployment. But a stable Phillips curve could not hold good during the o seventies and eighties, especially in the United States. Therefore, experience in the two decades has prompted some economists to say that the stable Phillips curve has disappeared.

In these two decades we have periods when rates of both inflation and unemployment increased that is, a high rate of inflation was associated with a high unemployment rate, which shows the absence of trade-off.

We have shown the data of inflation rate and unemployment in case of the United States in Fig. From the data it appears that instead of remaining stable, the Phillips curve shifted to the right in the seventies and early eighties and to the left during the late eighties, see Fig. Causes of Shift in Phillips Curve: Now, what could be the cause of shift in the Phillips curve?

There are two explanations for this. First, according to Keynesians, the occurrence of higher inflation rate along with the increase in unemployment rate witnessed during the seventies and early eighties was due to the adverse supply shocks in the form of fourfold increase in the prices of oil and petroleum products delivered to the American economy first in and then again in The hike in price of oil by OPEC, the cartel of oil producing Middle East countries brought about a rise in the cost of production of several commodities for the production of which oil was used as an energy input.

Further, the oil price hike also raised the transportation costs of all commodities. The increase in cost of production and transportation of commodities caused a shift in the aggregate supply curve upward to the left. This is generally described as adverse supply shock which raised the unit cost at each level of output. It will be seen from Fig.

At the new equilibrium point H, price level has risen to P1 and output has fallen to OY1 which will cause unemployment rate to rise. Thus, we have a higher price level with a higher unemployment rate.

This explains the rise in the price level with the rise in the unemployment rate, the phenomenon which was witnessed during the seventies and early eighties in the developed capitalist countries such as the U. Note that this has been interpreted by some economists as a shift in the Phillips curve and some as demise or collapse of the Phillips curve.

Natural Rate Hypothesis and Adaptive Expectations: A second explanation of occurrence of a higher rate of inflation simultaneously with a higher rate of unemployment was provided by Friedman. He challenged the concept of a stable downward- sloping Phillips curve. According to him, though there is a trade-off between rate of inflation and unemployment in the short run, that is, there exists a short-run downward sloping Phillips curve, but it is not stable and it often shifts both leftward and rightward.

He argued that there is no long-run stable trade-off between rates of inflation and unemployment. His view is that the economy is stable in the long run at the natural rate of unemployment and therefore the long-run Phillips curve is a vertical straight line. He argues that misguided Keynesian expansionary fiscal and monetary policies based on the wrong assumption that a stable Phillips curve exists only result in increasing rate of inflation.

Natural Rate of Unemployment: It is necessary to explain the concept of natural rate of unemployment on which the concept of long-run Phillips curve is based.

The natural rate of unemployment is the rate at which in the labour market the current number of unemployed is equal to the number of jobs available. These unemployed workers are unemployed for the frictional and structural reasons, though the equivalent number of jobs is available for them. For instance, the fresh entrants may spend a good deal of time in searching for the jobs before they are able to find work. Further, some industries may be registering a decline in their production rendering some workers unemployed, while others may be growing creating new jobs for workers.

But the unemployed workers may have to be provided new training and skills before they are deployed in the newly created jobs in the growing industries. Since the equivalent number of jobs is available for them, full employment is said to prevail even in the presence of this natural rate of unemployment.

inverse relationship of inflation and unemployment

It is presently believed that 4 to 5 per cent rate of unemployment represents a natural rate of unemployment in the developed countries. Friedman put forward a theory of adaptive expectations according to which people from their expectations on the basis of previous and present rate of inflation, and change or adapt their expectations only when the actual inflation turns out to be different from their expected rate.

The view of Friedman and his follower monetarists is illustrated in Figure To begin with SPC1 is the short-run Phillips curve and the economy is at point A0, on it corresponding to the natural rate of unemployment equal to 5 per cent of labour force. The location of this point A0 on the short-run Phillips curve depends on the level of aggregate demand. The other assumption we make is that nominal wages have been set on the expectations that 5 per cent rate of inflation will continue in the future.

Now, suppose for some reasons the government adopts expansionary fiscal and monetary policies to raise aggregate demand. The consequent increase in aggregate demand will cause the rate of inflation to rise, say to seven per cent. Given the level of money wage rate which was fixed on the basis that the 5 per cent rate of inflation would continue to occur, the higher price level than expected would raise the profits of the firms which will induce the firms to increase their output and employ more labour.

As a result of the increase in aggregate demand resulting in a higher rate of inflation and more output and employment, the economy will move to point A1 on the short- run Phillips curve SPC1 in Figure It may be noted from Figure Thus, this is in conformity with the concept of Phillips curve explained earlier.

However, the advocates of natural rate theory interpret it in a slightly different way. They think that lower rate of unemployment achieved is only a temporary phenomenon. They think when the actual rate of inflation exceeds the one that is expected, unemployment rate will fall below the natural rate only in the short run. In the long run, the natural rate of unemployment will be restored. This brings us to the concept of long-run Phillips curve, which Friedman and other natural rate theorists have put forward.

According to them, the economy will not remain in a stable equilibrium position at A1. This is because the workers will realize that due to the higher rate of inflation than the expected one, their real wages and incomes have fallen.

The workers will therefore demand higher nominal wages to restore their real income. While for some income earners, income rises more rapidly than prices during inflation, for many others just the opposite is true. Those who have fixed incomes are seriously affected as the real income decline during periods of inflation. Inflation also has an effect on lending and savings.

Inflation benefits the borrowers at the expense of the lenders and savers. It has also adverse effects on foreign trade. The competitiveness of a country may be seriously affected.

How inflation and unemployment are related? - Specialties

Factors affecting the inflation 1. Increase in Money Supply: Inflation is caused by an increase in the supply of money which leads to increase in aggregate demand. The higher the growth rate of the nominal money supply, the higher is the rate of inflation.

Increase in Disposable Income: When the disposable income of the people increases, it raises their demand for goods and services. Disposable income may increase with the rise in national income or reduction in taxes or reduction in the saving of the people. Increase in Public Expenditure: Government activities have been expanding much with the result that government expenditure has also been increasing at a phenomenal rate, thereby raising aggregate demand for goods and services 4.

Inflation – Unemployment Relationship | Economics Help

Increase in Consumer Spending: The demand for goods and services increases when consumer expenditure increases. Consumers may spend more due to conspicuous consumption or demonstration effect. Cheap monetary policy or the policy of credit expansion also leads to increase in the money supply which raises the demand for goods and services in the economy 6. In order to meet its mounting expenses, the government resorts to deficit financing by borrowing from the public and even by printing more notes.

Repayment of Public Debt: Whenever the government repays its past internal debt to the public, it leads to increase in the money supply with the public. The existence of black money in all countries due to corruption, tax evasion etc.

inverse relationship of inflation and unemployment

Shortage of Factors of Production: One of the important causes affecting the supplies of goods is the shortage of such factors as labour, raw materials, power supply, capital, etc. When the country produces more goods for export than for domestic consumption, this creates shortages of goods in the domestic market. This leads to inflation in the economy. Unemployment is a situation in which a person or an individual wants to work at existing or prevailing wage rate but he did not get it.

India is a developing economy mainly based on agriculture but the percentage share of agriculture is declining after independence. Now the dependency is also increasing on others sectors also like service sector and industrial sector. The main causes of unemployment in India are the poor economic condition, corruption and population. Economists general classify unemployment into three types according to the causal factors, namely, frictional unemployment, cyclical unemployment results from business recessions and depressions and structural unemployment mismatch between requirements of the employers and the type of unemployed.

Seasonal and disguised unemployment Disguised unemployment refers to zero or very low productivity level and is most prevalent in Indian agriculture sector are prevalent in India. Unemployment has both economic and social implications for a country like India. Occurrence of unemployment results in the loss of output, loss in revenue of the government and in consequence disastrous effect on developmental works. Unemployment is negatively related to the growth rate of the economy.

It states that there is trade off between real GNP and Unemployment. Unemployment also means loss of self-respect, poverty and frustration. It can even lead to social unrest in the country. The manufacturing sector in India, which provides the bulk of employment to the skilled and semi-skilled labour force, is growing at abysmally low rates of between 2 and 5 per cent. Graphically, this means the short- run Phillips curve is L-shaped This is because: 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.

The Phillips Curve and Keynesian La-La Land: The Alleged Relationship Between Unemployment and...

Therefore, wage inflation is likely to be muted during the period of rising unemployment. This will reduce cost push inflation and demand pull inflation.