The Correlation between Inflation and Unemployment - Essay Example

The correlation between Inflation and Unemployment al Affiliation The correlation between Inflation and Unemployment The health of any economy in the world can be assessed by measurable indicators. These indicators are referred to as economic variables. Economic variables are very important in the day-to-day running of the economy of a country. They are used by economists, policy makers, employers, and industry captains to determine the position and direction of the economy. These variables include employment, inflation, aggregate demand, and balance of trade. Policy makers usually strive to ensure that these variables are at sustainable levels or at levels that are acceptable. For instance, an unemployment rate of 5% is considered as acceptable in the United States. Almost all economic variables are related to each other. A rise in one consequently causes either a fall or an increase in another. Two variables display this relationship. These are unemployment and inflation. This essay will examine the proposition that there exists this correlation between the rate of inflation and the level of unemployment. Firstly, it will briefly explore the concepts of inflation and unemployment. Secondly, it will examine the relationship between these two variables. Thirdly, it will explain the significance of this correlation and finally give a conclusion. Inflation is, by simple definition, an increase in prices. However, in a more detailed definition, it is the consistent and sustained increase in the general price level of commodities and services. Inflation has an immediate effect on the value of a currency of the country experiencing it. For instance, if the United Kingdom is experiencing inflation in its economy, then the value of a sterling pound reduces. Here the value of a currency denotes its purchasing power or the quantity of real goods that one unit of the currency can purchase. The value of a currency varies with the level of inflation, and is never constant (Mankiw, 2011:43). Where there is an increase in the rate of inflation, the purchasing power of people in an economy declines. The opposite is also true for a decrease in the rate of inflation. Inflation is measured as percentage. Specifically, it is measured as a percentage increase of goods and services in a given year. For instance, if the rate of inflation in a year is 3%, then a commodity that costs 1 sterling pound will cost 1.03 sterling pounds after inflation is factored in. Inflation has three major variations. These are deflation, hyperinflation, and stagflation (Vogt, 2008:37). Deflation refers to a situation in the economy when the general price level of goods and services is falling. This situation is actually the opposite of inflation. Deflation is mostly caused by a sudden burst of an asset bubble causing the prices of that asset to dip. Good examples of deflation include the recent global economic crisis of the year 2006 and the Great Depression of the year 1929. During the Great Depression, the general level of prices fell by 10 percentage points. Deflation, unlike inflation, is considered more difficult to reverse (Gottschalk, 2007:45). Hyperinflation is a rare form of inflation that is actually a detrimental situation. It refers to an unusually increase in the general price level. The increase is very rapid and can result in the disintegration of an economy’s monetary structures and systems. In the year 1923, just 6 years before the Great Depression, Germany experienced a hyperinflation situation whereby the prices of commodities rose by a record level of 2,500 percentage points (Gottschalk, 2007:45). Stagflation, on the other hand, refers to a situation in the economy of a country when economic growth is experiencing stagnation and inflation is present. This situation has been labelled as awkward and even impossible. The cause of disagreement is how economic growth can remain stagnant while the price level is up because of demand. Stagflation has also been defined as a situation where there is economic growth stagnation combined with high levels of unemployment. Stagflation, though a rare and unusual situation, happened in the 1970s when the rising prices of oil led to an increase in the general price level. This was against the backdrop of an ailing economy (Mankiw, 2011:13). It is prudent that we also examine the term unemployment and its effect to economy. Unemployment can be defined in simple terms as lack of employment. In detail, however, it refers to a situation when person who are able and willing to work at the existing wage rate in the economy are unable to secure a job. The person must also be actively searching for a work for the definition to hold. Unemployment, like inflation, has variations. There exists the situation whereby people actively looking for work and are actually available are unable to find a job. However, there is also the concept of voluntary unemployment. This is a situation whereby people who are willing and able to work opt not to work. This is may be because the current wage rate being offered in the market is not attractive given their level of experience and expertise. Voluntary unemployment also occurs when people, mostly undergraduate students, prefer to abandon job search in favour of pursuing higher level of education. This causes unemployment but of a voluntary nature. The third variant of unemployment is referred to as under-employment. This is a situation whereby a person has to settle for job that is part time instead of a full time engagement. This causes some sort of unemployment in the extra hours that person is not working and is unable to find another part time occupation. Unemployment, like inflation, is also measured in percentage. Unemployment usually denotes that the scarce labour that is available is not being fully employed by the economy to produce goods and services that will satisfy aggregate demand. The economy is thus said to be operating at a level below full employment (Gordon, 2004:12). Unemployment has deep-rooted consequences to an economy including social costs. Having discussed the concepts of inflation and unemployment, it is now pertinent that we examine the proposition that there exists a correlation between the two. The relationship between the two economic variables has been a subject of debate for many years. However, A.W. Phillip who came up with the concept of the Phillips curve in the year 1958 has summarized this relationship. Phillips conducted a study on the unemployment situation in the United Kingdom between the years 1861 and 1957 (Vogt, 2008:23). He also studied wage inflation concurrently. In his studies, he observed and found that there existed an inverse relationship between the two. He made an observation that when the rate of unemployment was high, wages or the prices of labour rose slowly. He also found the opposite situation to be true, that when unemployment was low, the price of labour in the economy rose at a faster rate. The below curve shows that the relationship between inflation and unemployment is not linear and represents an L-shape such that when unemployment is on the x-axis, the inflation rate occupies the y-axis To show that inflation and unemployment are related factors, data from the UK shows that a fall in unemployment rate was marked after inflation also dropped. In 2014, the number of people without work dropped by 58,000. The unemployment rate dropped to 5.8 percent. This change was also reflected in inflation because wage growth in the UK contributed to the drop in the inflation rates. In November 2014, for instance, the inflation rates as measured by consumer price index showed that it stood at 1 percent. However, this dropped to 0.5 percent in December coinciding with the fall in unemployment rates in the country (BBC, 2015).. This shows that the two are related. The figure below also shows that the increase in wages affects inflation (United Kingdom) such that when wages increase, inflation drops and vice-versa. The explanation of the relationship between unemployment and inflation is that when there is a low level of unemployment in the labour market, firms respond to this situation by rising the wages they pay out to workers in a bid to attract the available unemployed labour. This causes an increase in wage prices and thus wages inflation. The other explanation offered for the trade-off between the two variables is that when there is unemployment, workers who are available although unemployed are better placed to push for higher wages than what firms are offering (Forder, 201:24). Firms are therefore forced to pass this extra cost on their books to consumers that consequently results in higher prices of goods and services thus inflation. However, this explanation has been disputed by several economists. Milton Friedman argued that workers do not pay attention to nominal wages as the Phillip’s curve theory postulates, but rather to real wages. Real wages, in his view, adjust in such a way that the supply of labour would be equal to the demand for labour. Other economists have also argued that wages are sticky, and firms do not readily increase the wages they pay to workers (Gordon, 2004:26). Despite the criticism levelled against the relationship between unemployment and inflation as explained by Phillip’s curve, there is a strong correlation between the two variables. This correlation is very significant to the economy as it acts as an indicator, which guides policy makers on the appropriate actions to take in the case when the economy is experiencing either a high inflation or unemployment (Vogt, 2008:34). This significance can best be illustrated in a situation when an economy is experiencing inflation. In such a scenario, the Central Bank is obliged to raise the interest rates, which will consequently lower consumer spending, and investments’ resulting to a decline in aggregate demand and therefore inflation is lowered. However, a fall in Gross Domestic Product (GDP) as a consequence of a decline in aggregate demand will cause firms to employ less labour thus unemployment rises again (Forder, 2014:32). This basic explanation shows the magnitude of the significance of the correlation between inflation and unemployment. In conclusion, the economic variables of employment and inflation are used to measure the health of the economy. The Phillips curve highlights the relationship that exists between the two, that when unemployment is high, the wages increase at a slower pace thus inflation arising out of an increase of wages is low. The Philips curve remains relevant and significant to the economy today as it was in the 1960s after its formulation. References BBC., 2015. UK unemployment falls to 1.9 million - BBC News. Retrieved from http://www.bbc.com/news/business-30913960 Forder, J., 2014. Macroeconomics and the Phillips Curve Myth. London: Oxford University Press. Gordon, R., 2004. Productivity Growth, Inflation, and Unemployment: The Collected Essays of Robert J. Gordon. London: Cambridge University Press. Gottschalk, J., 2007. Monetary Policy and the German Unemployment Problem in Macroeconomic Models: Theory and Evidence. New York: Springer Science & Business Media. Mankiw, N., 2011. Brief Principles of Macroeconomics. California: Cengage Learning. Vogt, T., 2008. Inflation and the Phillips curve. Munich: GRIN Verlag. Read More