A positive correlation between inflation and unemployment creates a unique set of challenges for fiscal policymakers. 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.
- According to economic theory, as unemployment rates fall, the rate of inflation rises.
- This has been formalized according to what is known as “the Phillips Curve.”
- Throughout modern history, however, this relationship has broken down—for instance, stagflation in the 1970s, when both inflation and unemployment rose, or the recovery following the Great Recession, when inflation and unemployment both fell.
Historically, inflation and unemployment have maintained an inverse relationship, as represented by the Phillips curve. Low levels of unemployment correspond with higher inflation, while high unemployment corresponds with lower inflation and even deflation. From a logical standpoint, this relationship makes sense. When unemployment is low, more consumers have discretionary income to purchase goods. Demand for goods rises, and when demand rises, prices follow. During periods of high unemployment, customers purchase fewer goods, which puts downward pressure on prices and reduces inflation.
In the United States the most famous period during which inflation and unemployment were positively correlated 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. Instead of being tied to a commodity with intrinsic value, the currency was left to float, its value subject 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 positive correlation between inflation and unemployment.
No easy fix existed for solving the stagflation of the 1970s. Ultimately, Federal Reserve chairman Paul Volcker 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%. The recovery, however, featured a robust rebound in gross domestic product, all the lost jobs regained and then some, and none of the runaway inflation that characterized the preceding decade.
Positive correlation between inflation and unemployment can also be a good thing—as long as 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. In 2000 the tech bubble burst, resulting in an unemployment spike, and gas prices began to climb. From 2000 to 2020, the relationship between inflation and unemployment once again followed the Phillips curve, but far less.
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.