The inverse correlation between inflation and unemployment should be intuitively easy to grasp. Based on the fundamental principles of supply and demand, inflation ought to be low when unemployment is high, and vice versa.

However, this relationship is more complicated than it appears at first glance, and has broken down on a number of occasions over the past 45 years. As inflation and (un)employment are two of the most important economic variables that affect us in our daily lives, it is important to gain an understanding of their association.

Supply and Demand of Labor

Let's consider wage inflation, i.e. the rate of change in wages, as a proxy for general inflation in an economy. When unemployment is high, the number of people willing to work significantly exceeds the number of jobs available, which means that the supply of labor is greater than the demand for it.

As a result, there is little need for employers to "bid" for the services of employees by paying higher wages. In this scenario, wages will remain stagnant and wage inflation would be literally non-existent.

Now consider the reverse situation where unemployment is low, which means that the demand for labor (by employers) exceeds supply. In such a tight labor market, employers will not hesitate to offer higher wages to attract employees, leading to rising wage inflation.

Phillips Curve

A.W. Phillips was one of the first economists to present compelling evidence of the inverse relationship between unemployment and wage inflation. Phillips studied the relationship between unemployment and the rate of change of wages in the United Kingdom over a period of almost a full century (1861-1957), and discovered that the latter could be explained by (a) the level of unemployment, and (b) the rate of change of unemployment.

Phillips hypothesized that when demand for labor is high and there are few unemployed workers, employers can be expected to bid wages up quite rapidly. However, when demand for labor is low and unemployment is high, workers are reluctant to accept lower wages than the prevailing rate, and as a result, wage rates fall very slowly.

A  second factor that affects wage rate changes is the rate of change of unemployment. If business is booming, employers will bid more vigorously for workers , which means demand for labor is increasing at a fast pace (i.e. percentage unemployment is decreasing rapidly), than they would if demand for labor is either not increasing (i.e. percentage unemployment is unchanging) or is only increasing at a slow pace.

Phillips' idea that the relationship between unemployment and rate of change of wages was likely to be highly non-linear was proved by scatter diagrams of these two variables, plotted for three separate periods from 1861 to 1957.  (See "Examining the Phillips Curve").The curves depicting the relationship between general price inflation -- rather than wage inflation -- and unemployment came to be known as "Phillips Curves." 

The data supporting wage inflation can easily be extended to general price inflation.Given that the cost of wages and salaries is a major input cost for business, rising wages will lead to higher prices for products and services in an economy, which is the basic definition of inflation.

Implications of the Phillips Curve

Low inflation and full employment are the cornerstones of monetary policy for the modern central bank. For instance, the Federal Reserve's monetary policy objectives are maximum employment, stable prices and moderate long-term interest rates.

The tradeoff between inflation and unemployment led economists to posit that Phillips Curves could be used to fine-tune monetary or fiscal policy options so as to meet desired economic outcomes. Since a Phillips Curve for a specific economy would show an explicit level of inflation for a specific rate of unemployment and vice versa, it should be possible to aim for a balance between desired levels of inflation and unemployment.

Figure 1 shows the U.S. consumer price index (CPI) and unemployment rates in the 1960s. Assuming this relationship held, if the goal was to lower unemployment from 6% to 5%, for example, the concomitant rise in the level of inflation (from monetary or fiscal stimulus required to drive the unemployment rate lower) would not be much. Inflation in this case would probably rise from around 1% to 1.5%, an increase of half a percentage point.

But if the goal was to drive unemployment down from 6% to 4%, inflation would triple to the 3% region, which might be beyond the central bank's comfort zone in terms of the inflation target.

Figure 1: U.S. inflation (CPI) and unemployment rates in the 1960s

Source: U.S. Bureau of Labor Statistics

Monetarists' Rebuttal

The 1960s provided compelling proof of the validity of the Phillips Curve, i.e. that a lower unemployment rate could be maintained indefinitely as long as a higher inflation rate could be tolerated. However, in the late 1960s, a group of economists who were staunch monetarists, led by Milton Friedman and Edmund Phelps, argued that the Phillips Curve does not apply over the long term. Their contention was that over the long run, the economy tends to revert to the natural rate of unemployment as it adjusts to any rate of inflation.

Consider a scenario in which the natural rate of unemployment is prevalent. (The natural rate* is the long-term unemployment rate that is observed once the effect of short-term cyclical factors has dissipated, and wages have adjusted to a level where supply and demand in the labor market is balanced). If workers expect prices to rise, they will demand higher wages so that their real (inflation-adjusted) wages are constant.

Now, if monetary or fiscal policies are adopted to lower unemployment below the natural rate, the resultant increase in demand will encourage firms and producers to raise prices even faster.

As inflation accelerates, workers may supply labor in the short term because of higher wages -- leading to a decline in the unemployment rate -- but over a longer term, when they are fully aware of the loss of their purchasing power in an inflationary environment, their willingness to supply labor diminishes and the unemployment rate rises to the natural rate. However, wage inflation and general price inflation continue to rise.

Therefore, over the long term, higher inflation would not benefit the economy through a lower rate of unemployment; by the same token, a lower rate of inflation should not inflict a cost on the economy through a higher rate of unemployment. Since inflation has no impact on the unemployment rate in the long term, the long-run Phillips curve morphs into a vertical line at the natural rate of unemployment.

Friedman and Phelps' findings gave rise to the distinction between the short-run and long-run Phillips curves. The short-run Phillips curve includes expected inflation as a determinant of the current rate of inflation and hence is known by the formidable moniker "expectations-augmented Phillips Curve."

(* Note that the natural rate of unemployment is not a static number but changes over time due to the influence of a number of factors. These include the impact of technology, changes in minimum wages, and the degree of unionization. In the U.S., the natural rate of unemployment was at 5.3% in 1949, rose steadily until it peaked at 6.3% in 1978-79, and declined thereafter; it is expected to be at 4.8% for a decade starting from 2016).

Breakdown of the Relationship

The monetarists' viewpoint did not gain much traction initially as it was made when the popularity of the Phillips Curve was at its peak. However, unlike the 1960s data, which definitively supported the Phillips Curve premise, the 1970s provided significant confirmation of Friedman and Phelps' theory. In fact, the data at many points over the next three decades do not provide clear evidence of the inverse relationship between unemployment and inflation (Figure 2).

Figure 2: U.S. unemployment rate and PCE inflation rate - 1975 to 2015

Source: St. Louis Fed
 

The 1970s (also see Stagflation, 1970s Style) were a period of both high inflation and high unemployment in the U.S. (consider how high the Misery Index must have been at the time). This was largely the result of two massive supply shocks: the 1973 embargo by Middle East energy producers that caused crude oil prices to quadruple in about a year; and the second oil shock when the Shah of Iran was overthrown in a revolution and the loss of output from Iran caused crude oil prices to double between 1979 and 1980. This development led to the short-run Phillips Curve including supply shocks in addition to expected inflation.

The boom years of the 1990s were a time of low inflation and low unemployment. Economists attribute a number of reasons to this positive confluence of circumstances. These include:

  • Global competition that kept a lid on price increases by U.S. producers
  • Reduced expectations of future inflation as tight monetary policies had led to declining inflation for more than a decade
  • Productivity improvements due to large-scale adoption of technology
  • Demographic changes in the labor force, with more aging baby boomers and fewer teens

In the present decade of the 2010s, U.S. inflation has remained stubbornly low even as the unemployment rate has trended steadily down, from 10% in October 2009 to 4.9% in February 2016. An unusual feature of this environment has been paltry wage gains despite the declining unemployment rate over most of this period, which in turn has kept inflation quiescent.

The Bottom Line

The inverse correlation between inflation and unemployment depicted in the Phillips Curve works well in the short run, especially when inflation is fairly constant as it was in the 1960s. It does not hold up over the long run, since the economy reverts to the natural rate of unemployment as it adjusts to any rate of inflation.

Because it is also more complicated than it appears at first glance, the relationship between inflation and unemployment has broken down in periods like the stagflationary 1970s and the booming 1990s.

Overall, the tradeoff between higher inflation and lower unemployment only works as a temporary measure and is not a universal panacea available to policymakers.

 

 

 

 

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