Relation between unemployment and inflation

Introduction

Unemployment is one of the major problems across the globe which almost all the countries of the world are facing. Unemployment produces unemployed people. Unemployed people are those people who are without jobs and looking for work. The labor force can be divided into two categories employed people and unemployed people.

Inflation can be defined as increase in the level of prices in any economy. There are various causes of inflation. Both inflation and unemployment are macroeconomic concept. In this article we are going to see what an unemployment means and what exactly is meant by inflation and then we will find out the relationship between unemployment and inflation and accordingly we will conclude whether the relationship between unemployment and inflation holds true or not?

Unemployment

We can define Rate of unemployment of any country through the following formula:

  • Rate of Unemployment of any country = Number of unemployed people in the country
  • Total Labor Force in the country

There are many historical categorizations of unemployment in a country like Demand Deficient Unemployment, Structural Unemployment, Seasonal Unemployment, Classical Unemployment, Technological Unemployment and Frictional Unemployment. (Unemployment)

Demand Deficient Unemployment is mainly caused by lack in aggregate demand in the country. This is simply caused by fluctuations in national output. Actually severe unemployment may be caused by lack in aggregate demand because of the accelerator effect according to which when aggregate demand is decreased, it reduces the national output more than what is expected.

Structural Unemployment is mainly caused by rapidly changing employment industry according to which there can be a mismatch between the knowledge and the skill of the employees and the requirement of the recruiters for job positions.

Seasonal Unemployment is caused to those persons who have knowledge about various works which are restricted to be done at a particular time in a year. For example, Air Cooler Seller.

Classical Unemployment is a concept which was believed by the monetarist economists which is caused by keeping the wage level above the equilibrium level. For example trade union bills or minimum wage legislation.

Technological Unemployment is caused by advancement in the technical aspect of any country because technology is increasing at such a fast rate that it is gulping away job opportunities for lots and lots of people.

Frictional Unemployment is that kind of unemployment in which a person is unemployed because he himself went away from the job or from industry for some time for example a person working in a company chooses to do MBA in between.

Inflation

Inflation is rise in the general level of prices in any economy. Rate of inflation can be defined as changes in general level of prices of commodity. There are mainly two types of inflation that we encounter in the industry, these are demand pull inflation and cost push inflation.

Demand Pull Inflation is that kind of inflation which is caused when there is high demand in the industry because of which prices of the commodity in an economy increases. Increase of aggregate demand may be caused by the following reasons:

  • Increase in the money supply i.e. expansionary monetary policy.
  • Expansionary fiscal policy.
  • Increase in the Net Exports i.e. increase in exports and decrease in imports.
  • Increase in the confidence of any business personality.
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Cost Push Inflation is type of inflation which is caused by increase in the input cost of commodity produced leading to increase in the level of prices. This situation can be explain as let for example there is an increase in the prices of raw material in any industry then definitely the seller will want to take this increase in price from the customers and hence he or she will increase the price. There may be various reasons for cost push inflation like higher import cost and forceful increase in the salaries of the employees without increase in the output. Cost push inflation may occur in the situation when there is an increase in the money supply when there is an increase in the general level of prices.

Relation between Unemployment and Inflation

When we relate this situation with the concept of unemployment then we can say that in case of long run increase in demand will give maximum benefit to the company or the industry when the economy has a starting point when the employment level in the economy is full. This is known as inflationary gap. Inflation is least expected in the deflationary conditions when there is an unemployment equilibrium. Hence inflation may only increase when there is high or full level of employment in the industry. When there is full level of employment in the industry then there is very little chances of increasing money supply to increase the national output. Hence when money supply in increased then there is a modest scenario of inflation.

Phillips Curve is a curve that shows the relationship between inflation and unemployment in which inflation is taken in the vertical axis and unemployment is taken at the horizontal axis. According to the classical theory in economics, there are two types of curves, long run curve and short run curve. Hence Phillips curve consists of two types of curves, Long Run Phillips of Curve and Short Run Phillips Curve. Long Run Phillips curve and Short Run Phillips Curves are shown as follows:

Short Run Phillips Curve indicates that there is an inverse relationship between rate of inflation and unemployment. This was a model developed in 1960s but later on some loop holes were found in this concept there came a situation in which there was high rate of unemployment and high rate of inflation simultaneously. This situation was known as stagflation. Hence in 1970s Long Run Phillips Curve Model was recognized. (Inflation and Phillips Curve)

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There is an appropriate reason that why Long Run Phillips Curve is vertical in nature. In case of long run, there is ignorance to the gain in productivity. Wages and their contracts are renegotiated in long run and there is no money illusion in this scenario. Now let us suppose that there is an increase in the money supply at say x percent then there is an increase in the wages at x percent. Hence there is no chance in the long run for the firms to change the level of output or employment. Hence in the long run, there is no change in the net employment or unemployment of the economy i.e. there is no trade off between inflation and unemployment in case of long run.

In case of Short Run Phillips Curve, there is an expected level of inflation according to given level of unemployment and this curve slopes downwards. Main reason for this curve to be downward sloping is that there is money illusion, in short run wages are not renegotiated which means that there are same wage contracts which is not affected by the increase in the money supply and growth. We can consider a situation in which when there is an increase in the money supply, then there is an increase in inflation rate but increase in wages will be very low because the scenario is of short run. This means that when there is a decrease in inflation rate in short run then the level of unemployment is increased because of the reason that there is an increase in real wages. (Macroeconomics / International Economy)

Hence we can say that Phillips Curve gives an exact relationship between the level of unemployment and rate of inflation through Long Run Phillips Curve (LRPC) and Short Run Phillips Curve (SRPC).

Let us consider a situation when there is a decrease in the long run level of inflation from say 8 percent to 4 percent, we can explore the relationship between unemployment and level very clearly at this point by Phillips Curve.

In the above diagram of Phillips curve, there are three important points. A is the starting point of our consideration according to which there is an equilibrium unemployment and inflation rate, 8% according to intersection of the graph LRPC and SRPC1. This means that there is an increase in the level of wages at the long run is 8%. Now a situation comes when there is a cut down in the rate of growth of money supply is decreased to 4% by the government but still rate of inflation is 8%. This will lead to decrease the real money supply in the economy. Now, when there is a decrease in the real money, this causes interest rate to increase. Hence there will be decrease in investment and consumption of private sector will cause an increase in the unemployment.

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As far as the situation remains when employees of the companies expect money supply to be at 8% till then economy remains at SRPC1, there is very little decrease in wage claims and hence there is a very little in rate of inflation below 8% leading to a very little increase in unemployment. Under such condition inflation goes higher than the money supply which forces money supply to reduce as a result of which money supply and unemployment increases along SRPC1 till point B. Now, according to the self adjusting nature of the economy, it will move to long run equilibrium at point A or point C depending upon workers and government. If there is an increase in the wages by 5%, then there will be an increase in the money supply and hence point will move back to point A because there will be an excessive unemployment which lead to increase of money supply which increases real money supply and decreases unemployment.

In another case, when the government continues to move at 4% of money supply then inflation will come at 4% and hence unemployment will come to the same level but with lower inflation rate via SRPC2 at point C.

Conclusion / Viability of relationship between Inflation and Unemployment

We can conclude in the end that relationship between inflation and level of unemployment is absolutely viable at the present scenario. Phillips Curve is considered to be the best possible technique exploring this important relationship. There had been few changes that we had seen in Phillips curve that earlier there was just a concept of Short Run Phillips Curve but it had few restrictions that there may be increase in wages and money illusion to the people. Hence in order to remove these loopholes, Long Run Phillips Curve was generated which covers the situation of wage increase and money illusion as well. Unemployment and Inflation are two important macroeconomic techniques. In order to have a look the economic situation of any country, it is very much important to look forward rate of inflation of its economy and natural level of unemployment in the country. As far as economic growth of any country is concerned, as level of unemployment in its economy will be low, there will be more growing economic condition in the country. Hence at last we can simply conclude that unemployment and inflation are related and this relationship is explored by Phillips curve which must be considered as one of major victory in terms of macroeconomics.

References

  1. Unemployment. (n.d.). Retrieved on January 31, 2010 from http://www.economywatch.com/unemployment/
  2. Hoover, Kevin. (n.d.). Phillip Curve. Retrieved on January 31, 2010 from http://www.econlib.org/library/Enc/PhillipsCurve.html
  3. Macroeconomics / International Economy. (n.d.). Retrieved on January 31, 2010 from http://tutor2u.net/economics/revision-notes/a2-macro-phillips-curve.html
  4. Inflation and Phillips Curve. (n.d). Retrieved on January 31, 2010 from http://www.economywatch.com/inflation/phillips-curve.html
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