Relationship Of Inflation And Unemployment

Financial Frictions In The Wake Of Crisis

Alternative explanations for the lack of deflation after the 2007-2009 recession cite the global financial crisis and decreased access to external financing for businesses. Typically, during a recession, as demand for goods and services decreases, the price of those goods and services also tends to decrease. However, some economists have argued that the financial crisis decreased the supply of external financing available for businesses, which increased borrowing costs. In the face of increased borrowing costs, some businesses, especially liquidity constrained businesses with so-called sticky customer bases,30 would have opted to raise prices to remain solvent until the costs of borrowing decreased as the financial sector recovered. Limited empirical work has found evidence of this behavior by businesses during the 2007-2009 recession, and therefore may help to explain the unexpectedly modest decrease in inflation following the recession.31

Shifting The Phillips Curve

The aggregate supply shocks caused by the rising price of oil created simultaneously high unemployment and high inflation. At the time, the dominant school of economic thought believed inflation and unemployment to be mutually exclusive it was not possible to have high levels of both within an economy. Consequently, the Phillips curve could not model this situation. For high levels of unemployment, there were now corresponding levels of inflation that were higher than the Phillips curve predicted the Phillips curve had shifted upwards and to the right. Thus, the Phillips curve no longer represented a predictable trade-off between unemployment and inflation.

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.

Don’t Miss: When Does The Extra Unemployment End

The Exchange Rate Channel Of Monetary Policy

exchange rate

The number of units of home currency that can be exchanged for one unit of foreign currency. For example, the number of Australian dollars needed to buy one US dollar is defined as number of AUD per USD. An increase in this rate is a depreciation of the AUD and a decrease is an appreciation of the AUD.

Monetary policy in the US works mainly through the effect of changes in the interest rate on investment, particularly on new housing and consumer durables. But in many other economies, especially smaller ones, an important channel for monetary policy is through the effect of interest rate changes on the exchange rate and the economys competitiveness in international markets, and hence on net exports.

Why does the interest rate affect the exchange rate? Much of the demand for different countries currencies comes from international investors who want to hold and trade financial assets from around the world. These investors prefer to earn a higher return, so they prefer assets with a high yield, or interest rate. For this reason, if a countrys central bank lowers the interest rate, demand for that countrys bonds declines: international investors are less attracted to their financial assets. With the demand for bonds lower, the demand for the currency to buy those bonds declines. The decline in demand for the currency will lead to depreciation, that is, a decline in its price in terms of other currencies.

Test Result Of Impulse Response Function Analysis

Impulse Response Analysis can use impulse response function . Results of IRF can be seen in the picture. Based on Figure 3, it can be seen that the IRF analysis of variable levels of Inflation and Unemployment levels for the next 10 years are as follows:

Figure 3: Results of Analysis of Impulse Response Function

Inflation rate response to shocks of its own inflation rate in the first year is as high as 12.9, then in the second year it dropped dramatically to – 0.7. However, it fluctuated during the period and reach slightly higher 0 in the end of period.

Inflation rate response to shocks than the unemployment rate in the first year to the second year continued to decline remarkably to -6.6. However in the third year, it rocketed to the highest level in fourth year. Further, in the fifth to eighth response inflation rate to the unemployment rate has fluctuated.

The response rate of unemployment to shocks from the rank of inflation showed an upward trend. in the first year, it was under 0.25 but it rocketed in next four year and reach almost 0.75. However, in the fifth year until the end of period remained stable.

The response rate of unemployment on the unemployment rate experienced a downward trend. In the beginning of period, it was approximately 1.25 and continued to decline dramatically until the sixth year. However, in the seventh to eighth year it had increased slightly and reached almost 0.75 in the end of period.

Don’t Miss: Can Self Employed File For Unemployment

No National Monetary Policy

common currency area

A group of countries that use the same currency. This means there is just one monetary policy for the group. Also known as: currency union.

Monetary policy may not be available to a country. Members of the Eurozone gave up their own monetary policy when they joined the currency union. The Eurozone is called a common currency area because all the members use the euro. This means there is just one monetary policy for the whole of the Eurozone. The European Central Bank in Frankfurt sets the policy interest rate, because it controls the base money used by all banks in the Eurozone. This interest rate may be more appropriate for some members than for others. In particular, after the financial crisis, unemployment was low and falling in Germany but in the southern Eurozone countries such as Spain and Greece, it was high and rising fast. There were many complaints that the ECBs monetary policy remained too restrictive for too long for the needs of the latter countries.

Shifting The Phillips Curve With A Supply Shock

Aggregate supply shocks, such as increases in the costs of resources, can cause the Phillips curve to shift.

learning objectives

• Give examples of aggregate supply shock that shift the Phillips curve

The Phillips curve shows the relationship between inflation and unemployment. In the short-run, inflation and unemployment are inversely related as one quantity increases, the other decreases. In the long-run, there is no trade-off. In the 1960âs, economists believed that the short-run Phillips curve was stable. By the 1970âs, economic events dashed the idea of a predictable Phillips curve. What could have happened in the 1970âs to ruin an entire theory? Stagflation caused by a aggregate supply shock.

Read Also: Can You Receive Unemployment If You Quit

Phillips Curve And The Rational Estimation

The movement of inflation and unemployment rise simultaneously shows the Phillips curve shift that occurred in the United States during 1950 to 1982 . It provided that there is no trade-off between inflation and unemployment. Shifting the Phillips curve in the United States allegedly caused by several factors such as shifts in the demographic composition of the population such as increase in the number of women and children into the labor force. The labor force women and children tend to show the existence of a higher unemployment rate than older men. Therefore, when inflation is at a certain level, unemployment is higher.

Figure 1 depicts about Phillips curve and its estimation. Phillips curve shows in the point of intersection with the horizontal axis. Neither fiscal nor monetary policy cannot lower unemployment below the natural rate of unemployment without having to bear the brunt of inflation. For example, when the government wants to implement an expansionary monetary policy to reduce the level of unemployment U1. This will lead to rise in price as well if not followed by an increase in wages, the real wages will fall. So the demand for labor will increase as seen from the shift from point A to B along the LTO .

Figure 1: Phillips curve and Estimates

How Inflation And Unemployment Are Related

The relationship between inflation and unemployment has traditionally been an inverse correlation. However, this relationship is more complicated than it appears at first glance, and it has broken down on a number of occasions over the past 50 years. Since inflation and employment are some of the most closely monitored economic indicators, we’ll delve into their relationship and how they affect the overall economy.

Also Check: Can You Collect Unemployment If You Are On Workers Comp

How Is The Short Run Phillips Curve Related To Inflation

The curve SRPC 1 is the short run Phillips Curve showing low or zero expected inflation. For obvious reasons, SRPC 3 describes high expected inflation. As peoples expectations regarding future price level changes, short run Phillips Curve shifts upwards showing trade-offs between inflation and unemployment.

The Natural Rate Model And Inflation

The economy’s ability to produce goods and services, or potential output, is dependent on three main factors in the long run: the amount of capital , the number and quality of workers, and the level of technology.10 Although these factors largely govern the economy’s potential output, the economy’s actual output is largely governed by demand for goods and services, which can rise above or below potential output. The economy is most stable when actual output equals potential output the economy is said to be in equilibrium because the demand for goods and services is matched by the economy’s ability to supply those goods and services. In other words, certain characteristics and features of the economy determine how much the economy can sustainably produce at a given time, but demand for goods and services is what actually determines how much is produced in the economy.

As actual output diverges from potential output, inflation will tend to become less stable. All else equal, when actual output exceeds the economy’s potential output, a positive output gap is created, and inflation will tend to accelerate. When actual output is below potential output, a negative output gap is generated, and inflation will tend to decelerate. Within the natural rate model, the natural rate of unemployment is the level of unemployment consistent with actual output equaling potential output, and therefore stable inflation.

Don’t Miss: How To Request Unemployment W2

Inflation And Unemployment: Constraints And Preferences

Phillips original curve, and the model in Figure 15.4d, suggest that there is a lasting trade-off between inflation and unemployment. For example, with the Phillips curve in the figure, if the government is happy to have inflation of 1% each year, then it can support a boom level of aggregate demand with an unemployment rate of 3% year after year.

feasible set

All of the combinations of the things under consideration that a decision-maker could choose given the economic, physical or other constraints that he faces. See also: feasible frontier.

If it prefers stable prices , then it needs to keep aggregate demand at the normal level, with unemployment of 6%. This suggests that the Phillips curve is a feasible set from which the policymaker can select the desired combination of unemployment and inflation. The policymaker prefers low inflation and high employment, and those preferences can be represented in the usual way in the form of indifference curves.

Work through the steps of the analysis in Figure 15.5 to see how the policymakers preferences are described by indifference curves.

The preferred feasible outcome

This is on the Phillips curve at point C.

In this example, the policymaker prefers a combination of unemployment of 3% and inflation of 5% to another feasible combination of unemployment of 6% and a stable price level .

The Shifting Phillips Curve

With low unemployment continuing, workers will be disappointed with the outcome, since they did not achieve their expected real wage. Why not? Workers expected a 2% real wage increase at B from their nominal pay rise of 5% , but they did not get this because firms raised their prices by 5%.

But the story does not end there. We know that both parties cannot be satisfied with the outcome at low unemployment, because their claims add up to more than the size of the pie. Now, we assume that workers expect inflation next year to be equal to inflation last year. So at the next wage-setting round, the human resources department has to take into account the fact that their employees expect prices to rise by 5%. Another interpretation is that HR includes inflation over the past year in the wage settlement, to make up for the shortfall in the real wage that workers experienced because inflation turned out to be higher than expected. So in order to achieve another real wage increase of 2%, the HR department sets a wage increase of 7%. The process continues with the rate of inflation increasing over time.

The table in Figure 15.8 summarizes the situation. We compare the situation over a three-year period with unemployment at two levels: 6% and 3%.

Figure 15.8 Unstable Phillips curves: Expected inflation and the bargaining gap.

We can summarize the causal chain from the last periods inflation rate to this periods inflation rate like this:

To work out the inflation rate:

Don’t Miss: How To Backdate Unemployment Benefits Colorado

A Weakened Relationship Between Inflation And Unemployment

The unexpectedly mild decrease in the rate of inflation following the sustained unemployment gap after the 2007-2009 recession suggested a weakening of the relationship between the unemployment gap and inflation, and evidence of a weakened relationship persists several years into the current economic expansion. Expansionary monetary and fiscal policies have been in place for the better part of a decade. The unemployment rate is approximating estimates of the natural rate of unemployment, and yet the inflation rate has yet to rise to the Federal Reserve’s long-term target of 2% per year. The current state of the economy suggests that either the subdued relationship seen between the unemployment gap and inflation during the depths of the economic downturn appears to be persisting even as economic conditions improve, or the unemployment gap may no longer act as an accurate measure of the output gap.

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.

You May Like: How To File For Unemployment

Alternative Measures Of Economic Slack

Still others have suggested that the failure of natural rate model to accurately estimate inflation following the financial crisis is evidence that the natural rate model may be incorrect or inadequate for forecasting inflation.39 In response to the perceived failure of the model, some researchers are searching for other potential indicators that can better explain and predict changes in inflation.

The unemployment gap is used as a measure of overall economic slack to help explain changes in inflation however, it may not be the best measure currently. One recent article has suggested that an alternative measure of economic slack based on recent minimum unemployment rates may offer an improved measure for forecasting inflation. The new measure consists of the difference between the current unemployment rate and the minimum unemployment rate seen over the current and previous 11 quarters. As the current unemployment rate rises above the minimum unemployment seen in previous quarters, inflation tends to decrease, and vice versa. This relationship appears to be relatively stable over time and, more importantly, improves on some other inflation forecasts for periods during and shortly after the 2007-2009 recession.40

Understand Inflation And How It Affects You

• Social Security: The cost-of-living adjustment, which helps the benefit keep pace with inflation, will be 8.7 percent next year. Here is what that means.
• Budget Surpluses: Up to 20 states are using their excess funds to help taxpayers deal with rising costs. But some economists worry that the payments could fuel inflation.
• Tax Rates: The I.R.S. has made inflation adjustments for 2023, which could push many people into a lower tax bracket and reduce tax bills.
• Your Paycheck: Inflation is taking a bigger and bigger bite out of your wallet. Now, its going to affect the size of your paycheck next year.

Do you think it is possible that the Feds estimates of the lowest sustainable estimates for the unemployment rate may have been too high? Ms. Ocasio-Cortez asked.

Absolutely, Mr. Powell replied. The sustainable unemployment rate now appears to be substantially lower than we thought.

The next day, Mr. Kudlow applauded the congresswomans questioning. Ms. AOC kind of nailed that, he said.

The motives of these unlikely allies are easy to surmise. Ms. Ocasio-Cortez is presumably more concerned about unemployment than about inflation. Mr. Kudlow, who serves a president running for re-election, is undoubtedly praying for a strong economy. Both interests would be served by dovish monetary policy.

You May Like: How To Sign Up For Unemployment In Texas

Describing A Change In Price Level

• Inflation: The price level is rising
• Deflation: The price level is falling
• Disinflation: The inflation rate is falling

We have seen why voters dislike unemployment. But why do voters dislike inflation? For some people in the economy, such as some pensioners, incomes are fixed in nominal terms, meaning that they receive a fixed number of yuan or dollars or euros. If prices rise during the year, these households can buy fewer goods and services at the end of the year than they could at the beginning. They are worse off and will tend to vote against a party they believe will permit higher inflation.

Whether one loses or benefits from inflation also depends on which side of the credit market one is on. Julia the borrower and Marco the lender have a conflict about the interest rate at which Julia borrows. They also have differing interests about inflation, because if prices rise before Julia repays her loan, Marco will find that he can buy less with the repayment than would have been the case if there were zero inflation.

nominal interest rate

The interest rate uncorrected for inflation. It is the interest rate quoted by high-street banks. See also: real interest rate, interest rate.

real interest rate

The interest rate corrected for inflation . It represents how many goods in the future one gets for the goods not consumed now. See also: nominal interest rate, interest rate.

relative price

The price of one good or service compared to another .