Is there a relationship between Unemployment and Inflation?
The answer is yes. There is an inverse relationship between unemployment rates and inflation rates. This relationship can be modeled using the Phillips curve.
As seen in the diagram above, inflation and unemployment share an inverse relationship. In the diagram’s case study, if unemployment is 6%, then the inflation rate will be valued at 2%. However, if the unemployment rate drops to 3%, then inflation rises to 5%.
The Phillips curve can be better visualized by swapping the inflation rate with the average money wage rate. When the unemployment rate goes up, more people will be looking for a job. This means that businesses will have a larger selection of potential employees to choose from. This allows them to lower their wage rate. Similarly, when the unemployment rate goes down, there will be a smaller selection of workers for businesses to choose from. To attract potential employees to their company, they will set the wage rate higher.
What is Aggregate Supply?
Aggregate Supply is the total number of goods and services which are available in an economy in a given time period.
When Aggregate Supply decreases within an economy, the unemployment rate increases. There is less demand to produce certain goods and, as a result, some workers are no longer required. With a higher unemployment rate, the inflation rate decreases. With fewer goods being produced, the price level decreases, thus decreasing the rate of inflation.
What is Stagflation?
To fight unemployment, governments will intentionally increase the rate of inflation by increasing the supply of money available to the people of their country. However, this can backfire and lead to Stagflation.
Stagflation happens when both the unemployment rate and the inflation rate increase at the same time. The model of Stagflation directly contradicts the Phillips Curve, as the Phillips Curve suggests that inflation and unemployment will not simultaneously worsen. This is one of the weaknesses of the Phillips Curve model.
What is the Long-run Phillips Curve?
LRPC- Long Run Phillips Curve
SRPC- Short Run Phillips Curve
Considering the above diagram,
At point A, the economy is at equilibrium. The unemployment rate is at 5% and the inflation rate is at 2%.
If the government wanted to lower the unemployment rate, a demand for labor would increase. As the demand for labor would increase, so too would the inflation rate.
At this point, the economy moves to point B.
At point B, workers who have taken new jobs and those that are not satisfied with their current wages may decide to leave their current employers. When this happens, the inflation rate remains at 5% rather than going back to 2%.
At this point, prices will continue to rise in intervals of 5% as the economy continues to move to point C. The unemployment rate has now increased as a result of people leaving their employers.
Any attempt to reduce unemployment will result in the economy shifting to point D, which will lead to point E, and so on. This process, when unchecked, leads to Stagflation.
The LRPC is vertically oriented on the diagram, and is centered at the Natural Rate of Unemployment. At certain points in time, there may be compromises between inflation and unemployment, but the economy always returns to the Natural Rate of Unemployment.