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Relationship Between Inflation and Unemployment

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Inflation and unemployment are two key elements when evaluating a whole economy and it is also easy to get those figures from National Bureau of Statistics when you want to evaluate it. However, the relationship between them is a controversial topic, which has been debated by economists for decades. From some famous economists such as Paul Samuelson, Milton Freidman etc to some infamous economists, this topic received a lot of attention. However, it is this debate that makes the thinking about it evolve. In this essay, the controversial topic will be discussed by viewing different economists’ opinions on that according to time sequencing. But before started, it is worthy getting a better understanding of the terms, inflation and unemployment.
Inflation refers to an increase in overall level of prices within an economy. In simple words, it means you have to pay more money to get the same amount of goods or services as you acquired before. By contrast, the term unemployment is easier to understand. Generally, it refers to those people who are available for work but do not find a work. And unemployment rate, which is the percentage of the labour force that is unemployed, is usually used to measure unemployment (Mankiw 1992).

The debate of the relationship between inflation and unemployment is mainly based on the famous “Phillips Curve”. This curve was first discovered by a New Zealand born economist called Allan William Phillips. In 1958, A. W. Phillips published an article “The relationship between unemployment and the rate of change of money wages in the United Kingdom, 1861-1957”, in which he showed a negative correlation between inflation and unemployment (Phillips 1958). As shown in figure 1, when unemployment rate is low, the inflation rate tends to be high, and when unemployment is high, the inflation rate tends to be low, even to be negative.

Figure 1
Phillips Curve

Two years later, economists Paul Samuelson and Robert Solow, who are the most infusive representatives of Keynesian School, also published an article, showing the same negative correlation between inflation and unemployment, based on the United States’ economic data (Samuelson and Solow 1960). Additionally, they also gave an explanation of such a relationship by using the aggregate demand and aggregate supply model. They reasoned that, shown in figure 2, the lower unemployment is associated with a higher output of an economy, which means the aggregate demand is shifting to the right, but with the short-run aggregate supply curve unchanged, the overall price level is pushed to go up. This could be presented in the Phillips Curve, when it is at point A, a higher unemployment but a lower inflation rate. Conversely, when it approaches to point B, the unemployment rate tends to be low, but the price level goes up at the same time.
Figure 2
(A) (B)

According to the explanation, Samuelson and Solow believed that the policy used to intervene economy should be effective, because policymakers can chose a target point on the curve by conducting monetary and fiscal policy, which will be able to influence the aggregate demand. This model could well explain some past economic situations. For example, the US’ Great Depression, from 1929 to 1933, the widely stagnant economy makes the expectation of Americans drop to the lowest. As reported, the unemployment rate of America averaged as high as about 20 percent, whereas the prices of almost everything (farm products, raw materials, industrial goods, stocks) fell dramatically (Samuelson R n.d.). Moreover, the economic situation faced by Western countries in 1950s and 1960s also fitted this model well. Therefore, this explanation did not involve in much debate during that period of time.

However, in 1970s, this was broken by the emergence of Stagflation, which shows a situation where high inflation and high unemployment, compared with historical data, appear simultaneously. From table 1, Real Growth, Inflation, and Nominal Growth in the United States, 1960-1997, it could be viewed that the Great Stagflation had significant impact on the US economy in 1970s. During the period from 1973.4 to 1975.1, the inflation rate was as high as 9.48 percent, whereas the real growth rate was negative 1.84 percent, which implies a significantly high unemployment rate.
Table 1: Real Growth, Inflation, and Nominal Growth in the United States
1960-1997
NBER Business Cycle Dates State of the
Economy Percent Change Per Annum
Real Growth Inflation Nominal Growth
1960.2-1961.1 Contraction - 1.22 + 1.37 + 0.15
1961.1-1969.4 Expansion + 4.62 + 2.58 + 7.20
1969.4-1970.4 Contraction - 0.48 + 5.00 + 4.52
1970.4-1973.4 Expansion + 4.38 + 5.24 + 9.62
1973.4-1975.1 Contraction - 1.84 + 9.48 + 7.64
1975.1-1980.1 Expansion + 3.69 + 7.07 + 10.76
1980.1-1980.2 Contraction - 3.89 + 9.03 + 5.14
1980.2-1981.2 Expansion + 0.30 + 9.32 + 9.62
1981.2-1982.4 Contraction - 1.48 + 6.15 + 4.67
1982.4-1990.2 Expansion + 3.76 + 3.57 + 7.33
1990.2-1991.1 Contraction - 1.72 + 4.54 + 2.82
1991.1-1997.2 Expansion + 2.53 + 2.53 + 5.06

Source: Based on quarterly GDP (GDPQ) and GDP deflator (GDPD) data from DRI for 1960.1-1997.2. The business cycle dates are based on the NBER dating.
Nevertheless, this phenomenon could not be explained by Samuelson’s model. Therefore, a new explanation was suggested by economist Milton Friedman and Edmund Phelps, who are the favourers of Classical principals of Macroeconomics. In their articles, they argued that the relationship between unemployment and inflation would not exist in the long-run. In the long-run, the inflation rate is determined by the money supply, and regardless of inflation rate, the unemployment will also gravitate toward its natural rate. As a result, the long-run Phillips Curve is vertical (Friedman 1968). Friedman and Phelps explained the long-run vertical curve by using the expected inflation. As shown in Figure 3, when people have low expected inflation, the expansionary policy moves the economy up along the curve from A to B. However, in the long-run, people increase their expectation according to empirical experiences. As a result, the short-run curve shifts to the right, and the point B moves to point C.


Figure 3
Long run Phillips Curve

Consequently, this Friedman’s model concludes that in the short-run, government may be able to reduce unemployment at the cost of increasing inflation rate, but in the long-run, the intervention policy is ineffective because Phillips Curve is vertical. This could be used to well explain the 1970s’ stagflation. Some economists even pointed out that it is the inefficiency of policy in the long-run that led to the Great Stagflation.

However, this debate has not ended because the conclusion by Freidman and Phelps has been criticised by Rational Expectation School. Economist Robber Lucas is the representative of this school, he argued that the expectation used by Freidman is adaptive expectation, which is that people simply adjust their expectation according to empirical experiences. However, in real life, people always try to gather as much information as possible to form an expectation, which is called rational expectation and it should be the same as the economic expectation. Based on this, the policy will not work both in the short-run and long-run. Because in the short-run, before the government conduct the expansionary policy, people have adjusted their inflation expectation according to the information they get, and they will request higher wages. As a result, this policy can not change anything but an increasing price level (Lucas 1987, Sargent 1986). Apart from Freidman and Lucas, another economist John Taylor published an article as an extension of this research in 1979, pointing out that in the long run, Phillips Curve is vertical, but there is a long run trade-off between fluctuations in output and fluctuations in inflation (Taylor 1979). Taylor’s model has provided policy makers with a tool to judge and develop monetary policy.

Another school called New Keynesian School, which arose in 1980s, developed a new model to explain the relationship between inflation and unemployment both in the long-run and short-run (Mankiw & Romer 1991). Although the conclusion they come to is the same as Freidman and Phelps’, the explanation they give is different. They suggested that due to the asymmetric information between supply side and demand side in the short-run, there will appear sticky wages in the labour market and sticky prices in the product market, namely, the nominal wages and prices are slow to adjust to changing economic conditions. For example, a year ago, a firm expected the price level to be 100, but it turns out to be 105, which will give the firm incentive to produce more than the natural output because it become more profitable for the firm since the real wage it gives to workers is relatively low. Therefore, by increasing production, more workers are hired and the unemployment goes down. However, in the case of long-run, the wages and prices will adjust to the changing conditions eventually, thus there is no trade-off between inflation and unemployment. So the New Keynesian concludes that governmental policy needs to be done to against the short-run inefficiency of market to increase the employment, whereas in the long-run, the market is effective in adjusting itself. However this model also receives some criticism, Fuhrer (1997), for instance, argued that the New Keynesian model and rational expectation does not fit the US post-war data. Although it is not perfect, in recent years The New Keynesian Sticky price model has been increasingly popular, and it has been widely used by economists to evaluate the contemporary economic policy.

In conclusion, since 1958 when the Phillips Curve was discovered, it has received a lot of attention by economists. Firstly, Paul Samuelsson and Robert Solow discovered the same result from America data and they also suggested government intervening the economy to achieve a target point on the curve. However, the stagflation happened in 1970s made economists to rethink the relationship between inflation and unemployment, finally, Freidman and Phelps raised that the relationship between these two should be viewed in the short-run and long-run. In short-run, they do have such a relation, but in the long-run, there is no trade-off between them. Although it is almost a perfect explanation, critical opinions have been raised by Robber Lucas. Additionally, a different explanation has also been suggested by New Keynesian economists, which is becoming more and more popular nowadays. However, the relationship between inflation and unemployment is still controversial; according to history, it is likely that how the economists’ thinking about the relationship evolves over time will mostly depends on how the economy develops in the future.

Reference:
Friedman, M 1968, “The Role of Monetary Policy,” The American Economic Review, vol.58, pp.1-17.

Fuhrer, J 1997, “Inflation/Output Variance Trade-offs and Optimal Monetary Policy, Journal of Money, Credit, and Banking”, vol.29, pp.214-234.

Lucas, R. E 1987, Models of Business Cycles, Basil Blackwell, Oxford.

Mankiw, N. G 1992, Principals of Macroeconomics, Thomson Education, Singapore.

Mankiw, N. G and Romer D 1991, New Keynesian Economics, MIT press, Massachusetts.

Phillips, A 1958, “The Relations between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”. Economica, vol.11, pp. 283-299.

Samuelson, P and Solow, R 1960, “Analytical Aspects of Anti-Inflation Policy,” American Economic Review, vol.50, pp.177-194.

Samuelson, R. J n.d., Great Depression, The Concise Encyclopedia of Economics, Retrieved April 26th 2008, from http://www.econlib.org/Library/Enc/GreatDepression.html#biography

Sargent, T. J 1986, Rational Expectations and Inflation, Harpercollins College Div, New York.

Taylor, J B. 1979, “Estimation and Control of a Macroeconomic Model with Rational Expectations”, Econometrica, vol.47, pp.1267-86.

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