The trade off between unemployment and inflation

Better employability level is always the main concern of any government seeking higher GDP which means economy’s prosperity. If the government is not eligible to provide adequate jobs to claimants this may lead to further consequences, apart from the impact of unemployment on economy it may influence individuals’ attitude in a society which is witnessed in more crimes committed by the unemployed, moreover unemployed people are more likely to suffer depression and mental diseases than employed people, economists realise the significance of unemployment and therefore effective techniques and strategies must be carried out to deal with such problem, overtime countries used a variety of policies to reduce unemployment some of these approaches are assumed to have a negative impact on inflation rate and that is the dilemma. The aim of this research is to reduce unemployment without affecting inflation rate so as to keep the economic balance.

Introduction

Unemployment is one of the most imperative issues that governments must consider in the first place, it means that the economy is not using its full power to achieve prosperity and still there’s a wasted power that can contribute to increase GNP (gross national product), to my mind such threatening issue could influence the economy as a whole and lead to further side effects, as for all individuals basic life requirements are met through employment. However, work does much more than supply the means for meeting physical needs it also can promote self-esteem and provide a chance for achievements and self-realization. Conversely unemployment might be expected produce adverse physical health consequences, researches proved that unemployment has negative effects on mental health and these effects are worse in men than in women, psychological effects include low self-esteem, depression, eating disorders and anxiety.

People suffering unemployment are more likely to addict addictive substances than employed people, it was also claimed that unemployed people make more visits to their doctor, taking more medications and spending more days in bed (Rainer2009). Another analysis shows that unemployment rates and crime rates are positively related (Buchanan & Hartley1996). According to their point of view unemployment is said to be the reason behind a number of committed crimes such as burglary, sexual, administrative crimes and economic crimes of theft.

This project explores a wide range of issues that are relevant to understanding the solutions for high unemployment meanwhile maintaining the economy’s equilibrium without affecting other factors as inflation In order to overcome unemployment governments tend to stimulate expenditures and investments a bid up in prices will take place as money loses its value and consequently higher rate of inflation.

The trade-off between unemployment and inflations reveals how critical the problem is and the main objective of this research is to compel all the techniques together to reduce unemployment and seek better economic potential.

Literature review

Employment zones and job centres proved remarkable effectiveness in UK labour market. Job centres are found to be very practical as it was reported that 40% of the vacancies are filled in one day and 68% of them are filled within two weeks, Job centres have been introduced to provide all services to the unemployed. Personal advisers based in these centres to provide overall guidance and job placement services, based on integration agreements between the employment service and the claimant but unfortunately the employers notified that only one third of the available vacancies are relayed to the job centres as employers think that job centres can only deal effectively with certain jobs , another point in favour is that job centres or government employment offices widely used especially by young people and unmarried females but private agencies are only used by a small minority. Job centres are used mainly by unskilled workers as more skilled workers tend to use newspapers once they gain more skills.

In late 70s and early 80s job centres in UK were not equipped enough to deal with unemployment and that was due to the lack of information transmitted between the provisions of training and unemployment benefits, in an ideal system the following four functions are meant to be carried out together to assist the unemployed: The suitability of an unemployed person to a job vacancy, the length of time that the job will probably last for, the value added to the community of a person being permanently employed or chosen to a training programme and finally the costs that the community is like to afford when a person is permanently employed, but when attempts were made to increase the efficiency of job centres by cutting costs it’s was witnessed that the job centres are more likely to reduce their assistance towards the long-term unemployment and consequently most of these costs were transferred to the DHSS (Department of Health and Social Security).

Unemployment- vacancies (BEVERIDGE) curve is one of the tools used to evaluate the efficiency of job search in job centres, during the 1960s and 1970s it was clear that the relationship between the available job vacancies and unemployment is very much in the balance, but in the following decade the shift seemed to move outwards, once again in the 1990s the curve moved sharply inwards indicating improvements in job search which means that appropriate strategies and actions were taken(Curwen1990).

Now job centres have 750 offices nationwide in UK appointing 78,000 individuals and filling 1.5 million vacancies per year, now job seekers are invited to a one-to-one meeting with advisers to guide them and help them get over any obstacles (Mcatgue2010).

Another key point and according to the survey carried out in June 2002 by Research and Evaluation Services on behalf of The Department for Employment and Learning (DEL)

and the Social Security Agency (SSA) it was found that approximately half of the employers tend to use the job centre to advertise 50% of their job vacancies, the majority of employers were totally satisfied with the service and assistance provided by the job centre, employers scarcely used job centres to advertise for vacancies in managerial/professional/secretarial levels, almost 60% of employers believed that their vacancies were filled with claimants that were qualified enough for these jobs, two thirds of the employers who were likely to recruit within the upcoming 12 months, indicated that they would absolutely use the job centre to recruit which explains how practical the job centre is to polarise and recruit claimants in a short period of time.

The Employment Zones system is one of the policies to improve employment and access to the labour market in UK, these are areas that their ultimate function is to ease restrictions and requirements on government assistance in job acquisition, there are two types of Employment Zones: Single Provider Zones in which one provider is exclusively committed to deliver for job seekers in his area, and Multiple Provider Zones in which one to three providers are holding a fixed market share and clients are assigned to them randomly. This case analysis has three phases. At phase one that lasts for four weeks, the case manager interviews the jobseeker to discuss if there are any obstacles to reintegration and agree on a plan. At phase two, service providers start the employment service for the job seeker for twenty six weeks, including benefit payments, after this period if the job seeker hasn’t been employed then he is entitled to another Employment Zone period from the job centre only after anther eighteen months of unemployment. However, for twenty two weeks after stage two providers can manage with the job seeker and discuss for solutions in the Follow-On period, At phase three if they intend to appoint the job seeker they can determine the outcome fee. The main aim is to provide a clear framework of Personal Job Accounts at a local level for unemployed people. These accounts provides job subsidies along with training initiatives and individual access-to-work measures for a better employment level, the main purpose is to allow all the parts involved(enterprises, trade unions, job centres) to sign an agreement and partnerships in their area(Di Domenico2008).

Equally important with the aforementioned solution is the Education Policy which gives less emphasis to the quantitative link between occupation and formal education and more attention to the structure and content of education, making it more relevant to the environment in which students are going to live and work , this is considered as a key element for reducing unemployment. In USA it was reported in June 2010 that unemployment for those aged between 25 or older with a high school diploma reached 10%. While unemployment among college candidates reached 4.4% (Yandie2010).

According to their point of view the reason why unemployment is high is an education deficit and the economy is in a dire need for a more educated workforce and as a result of this deficit the overall unemployment rate doesn’t seem to descend in the short run, and those who acquired two extra years technical education are more likely to do better in improving employment prospects than those with just a four-year degree, based on the data revealed by labour bureau of statistics employment gains were witnessed in professional and business sectors which require more knowledge than just a four-year degree, now young people can shift their field of study and go towards a competitive education according to the available vacancies and earnings, the wages forgone are the opportunity cost that adults face for continuing their high school education, the 4.4% unemployment rate among the college graduates compared to the 10% unemployment rate among school leavers indicates the precise relationship between unemployment and education level . However tough the message is but it emphasises on the significance of being prepared for the new knowledge economy.

If we are about to compare between unemployment levels in USA and Europe we can notice that this level seems to be shrinking over the last decades as the number of workers in USA with less than a high-school education is going down. And this maybe one of the reasons why unemployment series does not show the same level of persistence as it takes place in Europe. According to statistics it was shown that the labour force share for different educational groups may vary over time as follows: workers with a high school education fell from34.5% in 1971 to only 10.8% in 1996. The share of those with college education rose from 12.3% to 27.8% and the share of those with a college degree rose as well from 14.8% to 28.3 % ( Lazear1989).

A strong relationship between unemployment and education has been found, in a pointing out to different mechanism explaining the dynamics. The probability of long-term unemployment is unequally distributed among various groups in societies with considerable differences depending on educational qualifications, Increased education is likely to make the skills of an individual more valuable in production and consequently, for his/her employability prospects. In addition, it may also increase the efficiency of the matching process as more educated workers are more mobile and have a broader range of search possibilities, thus, decreasing their unemployment probability

The empirical estimates claims that the less educated workers are more likely to quit, after controlling a large set of demographic, labour and job characteristics, a negative gradient was detected between the probability to quit a job and education levels. Workers with O level have the same possibility to quit as workers with no qualification, while workers with A level qualifications have 8-11 percent lower probabilities to quit. This reflects a significant and positive association between the unemployment rate by education group and the quitting probability (McLaughlin1991).

In addition to education there are other factors that determines the possibility of an employee to enter or exit unemployment, working experience is considered a perfect way of accumulating human capital in a successful career, employees with more experience are found to be more attractive to employers as they can probably invest less in their training. The work experience should be true for up to a certain amount and highly sensitive to the educational qualification. In fact, obsolescence of skills can also start to play a role for older workers whose attractiveness to the labour market could decrease with age, especially if they have lower educational qualifications.

The rural development with all its aspects to improve the rural income and provide more job opportunities is believed to be of great effectiveness in reducing the push from the countryside(Ghatak1995), although this may be true but there are some disputes about the efficacy of rural development in reducing the rural-urban migration(Kanbur1981), according to their opinion in the first stages of the development program the policy founders may experience an increased rates of migration, the basic assumption is that a small amount of rural development will not be the perfect incentive for the rural people to stay behind. His study explains that the rural development campaign should be as massive as possible and take time to have a noticeable effect in reducing migration rates.

One of the countries that undertook the development plan is Latvia known as the SAPARD (Special Action Programme for Agriculture and Rural Development). The ultimate objective of the program is to create strong sustainable rural community and employment environment in addition to a diversified employment structure in the rural territory which could be achieved by the following specific objectives of the program:

Increasing competitiveness and farming income level.

Rising up with agriculture enterprises standards.

Improving the rural infrastructure so as to narrow down the difference between the urban and rural infrastructures.

16.6 % of the entire labour force in Latvia was working in agriculture in 1997, which is less than that in Poland (26.7%), Romania (37.3%), Bulgaria (23.4%) or Lithuania (24.0%), the value added per worker employed in agriculture in Latvia is lower than 10% of the standard level in the EU countries. Out – dated machinery, old technologies, insufficient knowledge, small-scale farming are the main reasons behind this, When the reform period commenced in 1998, the agricultural production and food processing export had declined not only relatively but also in terms of volumes, By adjusting production to meet EU hygiene and quality requirements, Latvia is assumed to have a good opportunity in increasing exports of agricultural products to EU and other countries. The income per capita for individuals employed in agriculture has been decreasing since 1995. The imperative factor affecting income was the fluctuating production volumes, influenced by the producer price, which have recently tended to go down, as well as the increase in production input price. In addition, the changes in product prices and production costs have been very disproportional. Consumption of inputs of materials grew by 24% in 1996 and by 10% in 1997, in comparison with the previous year. A comparatively low level of mechanisation, high costs and low income at the agricultural production, limited facilities for attraction of additional funds for the development of farms, relatively bad social and economical conditions for those living in rural territory- are the factors that block any involvement of younger generation into the agriculture. During the next 7 years with the assistance provided by SAPARD Programme, 55.4% of those employed in agriculture, hunting and forestry were full-time workers after it was listed that full-time hunting and forestry labour was 22.4%.

Rural tourism has become a significant sector in the rural development plan. Its economic significance in the rural side has increased as new jobs are about to be created, sale of agricultural products is increased and income of rural entrepreneurs rise. Often tourism could become the only possibility for development to regions, with unfavourable conditions for agriculture, by usefully exploiting spare living area, land unusable in agriculture, and also landscape, which cannot be used for other purposes. Untouched nature, rich cultural and historic heritage and also traditional agriculture and crafts create large opportunity for development of tourism in Latvia. Training of unemployed persons was started in 1992. Currently the state order for training of unemployed persons is managed by the State Service of Employment of the Ministry of Welfare. 60 educational institutions in more than 140 educational programmes trained almost 13 100 unemployed Hand in hand with professional training farmers have the possibility to constantly improve their level of knowledge at the courses organised by the Latvian Agricultural Advisory Centre (henceforth LAAC), Latvia University of Agriculture (LUA) and elsewhere. . The reform of professional training implemented by The Ministry of Agriculture is targeted at provision of high quality agricultural education and promotion of retraining from conventional agricultural professions to alternate professions related to rural entrepreneurship and environment. Since 1998 there have been first level courses organised according to a joint program to obtain the qualification of ‘agriculturist’ for persons involved in agriculture having no agricultural education. . 1900 farmers received Certificates of an Agriculturist in 1998. The second level educational program was elaborated in 1998. This program complies with the EU Green Certificate (document, proving that its owner has acquired the necessary amount of knowledge to work on a farm) requirements. The LAAC has a two-level educational structure with a national centre and 26 district offices employing in total 218 people. Every district bureau employs 4 – 8 employees. They are experts of animal farming, farm accountancy, and tax and farm economy in every bureau. Agricultural educational centres are monitored by LAAC.

Methodology

The relation between unemployment and inflation has grabbed the attention of economists since 1960 as it was believed that there is an inverse relation between the two variables, so that in order to control unemployment for instance we may sacrifice low rate of inflation and vice versa. But the modern notion no longer advocates this idea as many economists debate that full unemployment is the lowest rate of unemployment consistent with a constant rate of inflation. Known as the natural rate of unemployment, some idea of what that rate of unemployment is could be extremely useful to economic policymakers.  Inflation tends to be slow to respond to those changes in policy which affect it, expansionary policies like monetary policy is not assumed to have that rapid impact on inflation in short term, exactly like when a contractionary policy is used to bring down inflation rate, while policies are taken to reduce unemployment it is clear that inflation is going higher, till unemployment reach its minimum rate or natural rate, in this level the existing rate of inflation is meant to be normal and totally predictable in what is called a ‘Healthy Economy’, when the economy is operating with this natural rate of unemployment it is no longer recommended that policymakers do any more attempts to bring it further down as this will definitely lead to an increasing rate of inflation.

To detect the credibility of this theory the following graph determines the U.S unemployment rate and consumer price inflation all together in the 1960s. These statistics assumes that there’s a trade-off between inflation and unemployment

http://www.snpnifty.com/images/philip-curve.jpg

The theoretical explanation for the downward-sloping line describing the trade- off between unemployment and inflation depends on the notion of excess demand. As long as aggregate demand exceeds economic capacity, the unemployment rate will tend to fall, and vice versa.  Similarly, demand in excess of supply will tend to push up both wages and prices, so that rising prices tend to be correlated with falling unemployment. This concept was previously illustrated by ‘Phillips curve’ which explains how policymakers might choose one among several combinations of inflation and unemployment rates that seemed to be most pragmatic and set that as the goal of macroeconomic policy.(Giovanni1997)

On the contrary there was an argument about how monetary and fiscal policies could be manipulated in such a way so as to realize a particular combination of unemployment and inflation in the short run, but that it would only be a temporary accomplishment. This view contended that the trade-off along the Phillips curve was based on the fact that unexpected increases in prices reduced real wages.  A reduction in real wages induces an increase in the demand for labour and the unemployment rate falls.

As a result, a rise in prices would be associated with lower unemployment than under price stability – but only until workers caught on to their loss in buying power. Consequently, there is not just a single Phillips curve, but a Phillips curve for every different possible expectation of inflation. An unexpected increase in the rate of inflation would temporarily reduce the rate of increase in real wages and contribute to a decrease in the unemployment rate.  Again, as long as workers fail to notice the effects of rising prices on their money wages, there is likely to be a drop in unemployment due to a fall in real wages.

  But eventually they will adjust their wage demands to reflect the higher price level, or the higher rate of inflation.  This increase in real wage demands will tend to reverse the drop in the unemployment rate.  In the long run, the unemployment rate tends toward a level that represents equilibrium between the supply of labour and demand for it.  This level is known as the ‘natural rate’, it is the rate of unemployment consistent with a stable rate of inflation. It is the level to which the unemployment rate tends when the public is not fooled by inflation, ‘the non-accelerating inflation rate of unemployment,’ or NAIRU. 

At times, the natural rate is referred to as the full-employment rate of unemployment, Fiscal or monetary policies may shift the economy from one point to another along the original Phillips curve only as long as workers fail to appreciate changes in the price level or the rate of inflation.  A higher rate of inflation would not mean a permanent decline in the unemployment rate.  Eventually, other things being equal, expectations would adjust and the unemployment rate would tend to return to its natural rate, If policy were to push unemployment below the natural rate, the rate of inflation would wind up permanently higher after workers raised their expectation of inflation, and there would be a new Phillips curve describing the trade-off consistent with that higher expected rate of inflation. 

Any short-term trade-off between inflation and unemployment would now involve higher rates of inflation than before.  This process of shifting the trade-off could continue as long as policymakers keep trying to push the unemployment rate below its natural level.

The following figure illustrates that each Phillips curve (PE1 – PE3) is associated with a rate of expected inflation.  Unexpected increases in inflation can result in movement along any one of the Phillips curves

http://www.snpnifty.com/images/i-expect-and-p-curve.jpg

As can be seen and from the aforementioned approaches we can now conclude that unemployment and inflation they are both influencing each others and accordingly governments must choose between the two variables while bearing in mind that both of them will be existing in any economy and can’t be totally controlled or eradicated but the main concern is how to maintain balance between the two variables according to the economy needs using contractionary and expansionary policies without any attempts to bring unemployment down under the ‘natural rate’ as this will lead to a permanent rise in inflation, afterwards unemployment rate tends to increase as a result of decrease in real wages due to price inflation that is accompanied by a demand for higher wages.

Once again equilibrium b which may lead to less employment and inflation as well to reach the same pattern again etween the two variables occurs after an increase in wages for a higher real income.

To come up with a deduction of what happens in the economic cycle, Data was collected from US bureau of labour and statistics to show inflation and unemployment rates over the last 50 years and to notice the fluctuations of the 2 curves overtime, this analysis was a part of a research project analysing the relation between inflation and unemployment and to have a deeper practical vision on how this mechanism can take place in real environment in order to ensure realism and efficiency.

The following tables determine unemployment and inflation rates in USA in the period between 1970 and 2010. According to U.S department of labour: bureau of labour statistics

Year

Unemployment rate

Year

Average Inflation rate

1970

5%

1970

0.35%

1975

9%

1975

0.57%

1980

13%

1980

0.93%

1985

7%

1985

0.33%

1990

5%

1990

0.48%

1995

10%

1995

0.17%

2000

6%

2000

0.27%

2005

9%

2005

0.29%

2010

11%

2010

0.42%

These figures are interpreted in the following graph to show the relation between the two variables.

Now if we are to calculate the ratio between inflation and unemployment in each specific year we can say that unemployment is high when inflation is high too and vice versa but the correlation between them is not constant, in other words if we take a look for instance at year 1970 and 1975 we can say that the rate of increase in unemployment is almost 4%, 5% in 1970 to 9% in 1975 and the rate of increase of inflation is almost 0.22%, 0.35% in 1970 to 0.57% in 1975. As an illustration and to make it simple we can say now that when unemployment rate increased by 4%, Inflation rate was also 0.22% higher.

On the other hand if we take a look at years 1980 and 1985 it’s obvious that unemployment decreased by 6% and accordingly inflation got 0.6% lower, Important to realise also that in years 2000 and 2005 unemployment increased by 3% and inflation increased by 0.02%.

In the final analysis and to monitor the change in both unemployment and inflation we can notice that there is a inverse relation between the two variables but the percentage change in each one of them in accordance to the other is not constant, which may emphasise the idea that unemployment may influence inflation but the elasticity strength between the two variables is not clear enough as some times inflation seems to be perfectly elastic to unemployment and sometimes the elasticity is not that strong.