The Link between Unemployment and Inflation - Essay Example

? Unemployment and Inflation The link between inflation and unemployment has been debated since mid 20th century when AW Phillips published his work, which studied the link between inflation and unemployment in the United Kingdom from 1861 to 1957. In his work, he used a nonlinear function that negatively related unemployment to inflation between 1861 and 1913; he then used this function to explain the relationship between unemployment and inflation for the remaining period of up to 1957. These results were adopted quickly by most of the economists that time since they also partly confirmed the working of the competitive market forces of demand and supply. Most of the economists believe that, this relationship between inflation and unemployment is in the short run, which leads to a trade off between the two undesirables. The trade off, which has been summarised in to the Phillip’s curve shows that since the invention of economics, there has been an inverse relationship between unemployment and inflation where, when inflation is low, the rate of unemployment is high and when the rate of inflation is high, the levels of unemployment are low. Government policies that are designed to lower the levels of unemployment, for instance, during recession will usually lead to increased rates of inflation in the short run while policies that are designed to lower the rates of inflation, especially during the boom cycle will most likely increase the levels of unemployment in the short run. When discussing inflation and the effects that it has in markets, another concept that cannot be ignored is the interest rates, this is because inflation levels in a country are directly determined by the interest rates prevailing in that country. When interest rates in a country are lowered, it encourages businesses to get loans for expansion or to hire more employees; this increases money supply in the economy forcing prices to go up due to the increased demand for products and services hence inflation; however on the positive side is that more people will be employed in the economy. On the other side, if the government increases interest rates, businesses are likely to shy away from getting loans for expansion or to cover other expenses, this has the effect of reducing money supply in the market hence low demand, which in turn leads to low inflation rate. The negative side of this is that the less the amount of money that is available in the market, the higher the levels of unemployment since businesses do not have the money to hire new employees. Phillips curve The above Phillip’s curve shows the inverse relationship between unemployment and inflation. Some economists have argued that this relationship is only applicable in the short run since the in the long run, influence of some other macroeconomic factors may cause inflation and unemployment to move in the same direction or fail to show any influence on each other. Keynes, one of greatest economist of the 20th century have argued that the most important term in economics is the short term since in the long run, we will all be dead. The idea of Phillip’s curve has been criticized especially in relation to the trade off between inflation and unemployment because as data from 1970 in most of the developed countries show, these two economic parameters moved in the same direction, a situation called stagflation. This phenomenon was experienced when in 1970; shocks resulting from fluctuating in oil prices ensure that there were high levels of inflation and at the same time high rates of unemployment. This deviation from the Phillip’s curve is as a result of the fact that workers and employers are likely to take into account the effects of inflation when signing new employment contracts, which would mean employees being paid at rates near the inflation. This would cause the levels of unemployment to rise at the same time meaning that in the long run, there is not trade off between unemployment and inflation. In the current global economy, the Phillips curve is still relevant although not in its original form as it was considered to be too simplistic. The current version of Phillip’s curve that is used takes in to consideration the expectations of inflation and the effect it has on short term and long-term unemployment. The short run Phillips curve, which is also called ‘expectations augmented Phillip’s curve’ shifts up when the levels of inflations are expected to rise, in the long run, this idea implies that the monetary policy that the government adopts will not affect the unemployment levels since it will shift back to its natural state. In the current global economic environment, Phillip’s idea of a trade off between unemployment and inflation in the short run can be seen in United Kingdom where the government has been caught in a dilemma between increasing interest rates to reduce inflation at the expense of increasing levels of unemployment. The monetary policy committee (MPC) is tasked with the responsibility of ensuring that inflation levels do not exceed 2 per cent as measured by consumer price index. In an attempt to recover from the global economic meltdown that faced the country in 2010, the committee had to reduce interest rates to a low level of 0.5 per cent to encourage spending which would stimulate the economy to recover from the recession by creating employment. With the low interest rates, the level of spending increased forcing the price of commodities to go up hence inflation, however, this did not have the desired effects on the levels of unemployment that the country faced since it did not reduce. By early 2011, the levels of inflation had surpassed the standard 2 per cent and rose up to 4 per cent, which required the committee to act to reduce these levels. This put the committee in a dilemma since it had only interest rate as the only tool to reduce inflation while at the same time ensuring adjustments in interest rates do not affect recovery of the economy (Straus, 2013). This problem has persisted up to date with the monetary policy committee and the bank of England executives failing to come with a solid way to reduce the rate of inflation in the country while at the same time maintaining interest rates low to reduce the levels of unemployment. In the recent past, the bank of England and the monetary policy committee has adopted ‘forward guidance’ stance to guide the economy to recovery without necessarily having to face the inflation –unemployment dilemma. The forward guidance statement, made some resolutions on how the economy would be handled, some of these recommendations include the following. The monetary policy committee argued that it intended to leave the interest rates at 0.5% until the rates of unemployment fall below 7.7% as long as it does not pose a great risk to inflation and economic stability. This idea by the monetary policy committee is likely to see the economy recover without making huge tradeoffs between levels of inflation and unemployment since it provides a clear picture on how the economy will recover. In addition, the forward guidance, it has enabled the MPC to test how efficient their policies will be at reducing unemployment without necessarily increasing the levels of inflation. According to Keynesian economics, the trade off between inflation and unemployment is only short term; therefore, the decision by the monetary policy committee to maintain the interest rates at 0.5 per cent despite interest rates surpassing the recommended 2.0 per cent is economically sound in the long run as the rates of inflation are likely to come down. The enactment of forward guidance by the committee also gives it the power to look for other fiscal policies that will reduce the levels of unemployment without affecting the rates of inflation. Due to the unpredictability of the direction that the two parameters will take in case there is a change in interest rates, MPC took the right decision of not lowering or increasing the interest rates from 0.5 per cent as the decision may have had far reaching consequences than they may have anticipated forcing the economy into a crisis. The study of Phillip’s curve has been used by governments in order to determine the optimal trade-off between inflation and unemployment, this is despite criticism from some of economists that the trade-off is not always present and in some cases, unemployment and inflation rise at the same time in the a situation they called stagflation. An example of such a case is in the United Kingdom where the inflations levels have remained high due to low interest rates while at the same time unemployment levels have not dropped. References Straus, R. R. 2013. ‘Rock bottom interest rates are here to stay until unemployment falls below 7%, Bank of England pledges’. Mail Online. 7, August. Viewed 25, Oct 2013. http://www.dailymail.co.uk/money/news/article-2385921/Rock-rates-stay-unemployment-falls-7--Bank-England-pledges.html. Read More