Inflation is the term used to describe the drop of a currency's purchasing power over time. As such, one unit of currency buys less than it did before inflationary pressures hit the economy. Unemployment is the situation that economists refer to when the number of jobless people who are willing to work exceeds the supply of jobs in the workforce. So what's the relationship between these two economic metrics?
Inflation and unemployment have traditionally had an inverse relationship. When one rises, the other drops and vice versa. Governments typically rely on monetary and fiscal policies in order to keep the economy from overstimulating or from slowing it down too much.
- Monetary policy is enacted when a central bank wants to promote growth by controlling the money supply. More money is injected into the economy by lowering interest rates and printing more currency to spur growth. Rates increase when central banks want to slow down growth.
- Fiscal policy refers to a country's tax and spending policies. Economic growth is encouraged when governments loosen their fiscal policy. They slow down growth when they tighten the reins.
So let's put this all into perspective. Policies that are effective at boosting economic output and bringing down unemployment tend to exacerbate inflation, while policies that rein in inflation frequently constrain the economy and worsen unemployment.
- Economic theory suggests that the rate of inflation rises as unemployment rates fall.
- This has been formalized according to what is known as the Phillips Curve.
- According to the Phillips Curve, lower unemployment means people spend more, leading to more pressure on prices.
- The relationship has broken down over time, which is especially obvious during the period of stagflation in the 1970s when both inflation and unemployment rose.
- The positive correlation between inflation and unemployment may be economically beneficial as long as both levels are low, which was the case in the 1990s.
The Relationship Between Inflation and Unemployment
Inflation and unemployment have historically maintained an inverse relationship, as represented by the Phillips curve. Low levels of unemployment typically corresponded with higher inflation, while high unemployment corresponded with lower inflation and even deflation.
From a logical standpoint, this relationship makes sense. When unemployment is low, the demand for workers exceeds the number available. Put simply, there are more jobs available than people waiting for work. When unemployment rises, on the other hand, the availability of individuals looking for work far exceeds demand. That's because not many employers are hiring even if more people want to get to work.
So how does this play out with inflation? Low unemployment (when more people are working) means more consumers have the discretionary income to purchase goods and the demand for goods rises. When that happens, prices follow. But during periods of high unemployment, though, customers purchase fewer goods, which puts downward pressure on prices and reduces inflation.
The Phillips Curve
The Phillips Curve was developed by A. W. Phillips. This economic concept suggests that inflation and unemployment are inversely related. As such, it states that inflation is ushered into the economy by growth and expansion. According to Phillips' theory, this cuts the unemployment rate since expansion leads to job growth.
This theory worked, to some degree. At least until things got out of control in the 1970s. This period was characterized by high levels of inflation and unemployment, thus disproving the historically contrasting relationship that these two economic metrics had.
The most famous period during which inflation and unemployment were positively correlated in the U.S. was the 1970s. Termed stagflation, the combination of high inflation, high unemployment, and sluggish economic growth that plagued this decade came about for several reasons. President Richard Nixon removed the U.S. dollar from the gold standard, after which its value was left to float rather than be tied to a commodity. The move left it vulnerable to market whims.
Nixon implemented wage and price controls, which mandated the prices businesses could charge customers. Even though production costs increased under a shrinking dollar, businesses could not raise prices to bring revenues in line with costs. Instead, they were forced to cut costs by slashing payrolls to remain profitable. The value of the dollar shrank while jobs were being lost, resulting in a positive correlation between inflation and unemployment.
There was no easy solution for this period of stagflation. The Federal Reserve chair at the time determined that long-term gain justified short-term pain. He took drastic measures to reduce inflation, raising interest rates as high as 20%, knowing these measures would result in temporary but sharp economic contraction.
As expected, the economy entered a deep recession during the early 1980s, with millions of jobs lost and gross domestic product (GDP) contracting by more than 6%. But the recovery featured a robust rebound in GDP. All the lost jobs were regained—and then some.
The national unemployment rate in April 2020—the highest recorded rate between 1948 and 2022. The rate jumped from the previous month, which recorded unemployment at 4.4%, because of the effects of the COVID-19 pandemic.
The positive correlation between inflation and unemployment can also be a good thing, provided both levels are low. The late 1990s featured a combination of unemployment below 5% and inflation below 2.5%. An economic bubble in the tech industry was largely responsible for the low unemployment rate, while cheap gas amid tepid global demand helped keep inflation low. And there were other factors at play that contributed to this relationship during this time, including:
- An increasing number of baby boomers leaving the workforce that wasn't being replaced
- A cap on prices by U.S. producers in the wake of increasing global competition
- An increase in the adoption of technology, which led to higher productivity
The tech bubble burst in 2000, resulting in an unemployment spike. At the same time, consumers say a rise in gas prices, too. From 2000 to 2020, the relationship between inflation and unemployment once again followed the Phillips curve, but to a much lesser degree.
What Is the Relationship Between the Business Cycle, Inflation, and Unemployment?
The business cycle is the term used to describe the rise and fall of the economy. This is marked by expansion, a peak, contraction, and then a trough. Once it hits this point, the cycle starts all over again. When the economy expands, unemployment drops and inflation rises. The reverse is true during a contraction, such that unemployment increases and inflation drops.
How Do Inflation and Unemployment Change During Economic Expansion?
When the economy recovers after a recession and is expanding, inflation often increases. This means that prices rise, giving consumers less power and incentive to spend their money. Unemployment often drops during these times. That's because the demand for products and services rises, leading businesses to increase their output and are generally in need of more workers.
How Does Inflation Affect Unemployment?
Inflation has historically had an inverse relationship with unemployment. This means that when inflation rises, unemployment drops. Higher unemployment, on the other hand, equates to lower inflation. When more people are working, they have the power to spend, which leads to an increase in demand. And prices (inflation) soon follow. The opposite is true when unemployment rises.
Is Inflation More Important Than Unemployment?
On a general scale, unemployment is more important than inflation. That's because it makes more sense to keep people working. As long as they're employed, people have a chance to keep up with inflation, even if prices are higher. By focusing on inflation, regulators and governments omit jobless individuals out of the equation.
The Bottom Line
While the academic arguments and counter arguments rage back and forth, new theories continue to be developed. Outside of academia, the empirical evidence of employment and inflation challenges and confronts economies across the globe, suggesting the proper blend of policies required to create and maintain the ideal economy has not yet been determined.