The Relationship between Inflation and the Rate of Unemployment - Philips - Case Study Example

The Relationship between Inflation and the Rate of Unemployment Name: Institution: Date: The Relationship between Inflation and the Rate of Unemployment Unemployment and inflation represent two of the greatest macroeconomic problems that many governments struggle with. Unemployment is not only a problem in less developing and developing countries but it is also a problem in developed countries (Resurreccion, 2014). Many researchers have attempted to investigate the relationship between unemployment and inflation. For example, Resurreccion (2014) attempted to investigate this relationship in Philippines using Phillips Curve and Okun’s Law. Unemployment represents the condition of an individual with an ability to work having no job despite making attempts to actively search for a job (Rafiq et al., 2010). According to ILO (2010), unemployed population refers to a group of people above a certain specified age and who are available for employment, but have not been able to secure the supply of labor for production of goods and services. Unemployment has a great effect on many economies around the world and it has led to increased rate of poverty in many countries, especially the less developed and developing countries. Therefore, unemployment and inflation cannot be distanced from a market economy. The two have many socioeconomic consequences for the citizens in nations which they occur. Some of the terrible consequences associated with unemployment include declining incomes hence low purchasing power leading to citizens’ inabilities to raise their living standards. On the other hand, inflation is commonly referred to as ‘the enemy of society” because it leads to increasing prices of products and services (Alisa, 2015). Inflation is often considered to be a disaster. Different economists have attempted to analyze the relationship between unemployment and inflation based on Philips curve. These economists usually construct short-term and long-term Philips curves. The present paper is going to investigate the connection between inflation and unemployment based on studies by economists about Philips curve. In 1958, Alban Phillips, then, a Professor in the London school of Economics made a great contribution towards the study of the connection between inflation and unemployment (Alisa, 2015). Phillips came to his conclusion by analyzing statistics for a period exceeding a hundred years. His conclusion was that in a certain level of unemployment (6 to 7 percent), the wage level remains constant with zero increment. The fall of unemployment beyond this level leads to more rapid rise in wages, and vice versa. Figure 1 represents the Phillips curve. Figure 1 Phillips curve Different explanations have been given regarding the existence of inflation-unemployment relationship. A clearer explanation can be provided with the role of labor market flexibility. Since no country has ever achieved full employment, some labor market segments remain unchanged unemployment. However, the situations in other markets have an ability to lead to unsatisfied demand. Such a scenario usually leads to growth in wages and higher costs leading to higher prices. As a result, accelerated inflation is experienced. There are other explanations of the Phillips curve that appear as obvious facts. For example, an explanation that prices and wages are increased with growth in economy. Due to high rates of unemployment, employees find themselves accepting lower wages thus breaking the inflationary spiral (Alisa, 2015). On the contrary, in the absence of full employment, growth for additional factors of production continues to grow. As a result, there is growth in wages to the extent of outstripping the growth in productivity. The resulting effect is the untwisting of the inflationary spiral ‘the salary – the prices.’ This situation leads to accelerating inflation. The analysis of curves of aggregate demand and aggregate supply provided the basis on which the essence of Phillips curve is represented. When the aggregate demand grows, new imbalances are created psychologically increasing limited resources. At this point, it becomes clear that with growth in demand, there is an increase in inflation. With continued increase in aggregate demand and the nearing of realizing full employment, there is an increase in prices. The traditional Keynesian has attempted to interpret the Phillips curve. These traditional Keynesians include Samuelson & Sow (1960) who theoretically justified the connection between inflation and unemployment. As such they argued that there exists some alternative between inflation and unemployment. That is, this curve gets interpreted as a certain dogma or law. When aggregate demand increase, there is an increase in the demand for the factors of production. As a result, the concept of static expectations leads to a decline in unemployment further making the natural level of unemployment to fall further. Thus, there is further increase in inflation. This led economists to establish a negative relationship between the rate of change of wages and unemployment as expressed by equation (1). ………………………………………………..(1) Where ∆W/W represents the rate of change in nominal wages and, U represents the employment rate. Equation 2 represents the last step in formulation of Phillips curve and it represents the situation in which the growth rates of wages change at the inflation rate. ………………………………………………….(2) Where π represents the rate of inflation The evolution of traditional Keynesianism owes the Phillips curve because of the dual role it played. First, the gaps that existed in the construction of Keynesian thought were filled by the Phillips curve. Second, the curve provides individuals responsible for the macroeconomic policies with convenience. Policies made on the basis of Phillips curve show a compromise between unemployment and inflation. Individuals who felt not satisfied with the high level of unemployment can use expansionary policy to satisfy themselves. As a result, there will be an increase in employment; however, this will happen at the cost of having such consequence as inflation. In case of an increase in complains on a rise in the prices of goods and services, the government resorts in restrictive policy. As a result, there is a decrease in inflation rate and an increase in unemployment. According to the interpretation by Neoclassicists and Monetarists, the concept of adaptive expectations is ideal explaining how subjects adjust their expectations by considering the errors of the previous periods (Phelps, 1968; Friedman, 1968). They also consider actions stimulating policy to lead to growth in national income and wages; however, these subjects have to adapt to new conditions thus revising the terms of sale factors as a result. Then, the level of aggregate supply will increase. Finally, the initial value of employment will be realized with an increase in inflation. This only occurs because of the tendency of monetarists to use the hypothesis of adaptive expectations. The resultant rate of inflation becomes one of the functions of past inflation as displayed in equation 3. …………………………………………(3) Where φ represents the adaptation index On the contrary, Neoclassicists were critical of Monetarists’ school approach arguing that the hypothesis of adaptive expectations was incompatible with a fully rational behavior of economic subjects (Lucas, 1973). They followed the concept of rational expectations rather than that one of adaptive expectations. Their believe is that the simultaneous growth of prices and wages leads to cost of production because the economy experiences a situation in which productivity growth lags behind growth of wages. As a result, business slows down, output growth declines, and inflation increases. According to the above discussion, inflation and unemployment have a relationship and the two basic economic issues directing government programs and policies. As a result, the government has to introduce economic reform programs with an objective of addressing these issues so that it can maintain stable price level and a low rate of unemployment (Al-Zeaud, 2014). However, there are still some, such as the Classic states, who disregard this relationship arguing that the economy will only operate under full-employment situation. They further argue that, if the labor market is not interfered with, flexible wages and prices will make it possible for full-employment to be sustained; therefore, unemployment existing in the economy is optional. Classic states continue to argue that if the money in the economy gets increased by a certain fraction, there is a rise in the general level of prices by the same percentage. Therefore, there will not be a resultant increase in employment or output if the economy is operating at full-employment further arguing that there exists a natural rate of unemployment which they commonly refer as the equilibrium level of unemployment (Al-Zeaud, 2014). Their assumption is that, despite the changes in the inflation rate, the long-run unemployment rate stays fixed thus disregarding this relationship in the long-run. On their side, Keynesians were critical of this classic view disregarding the view that the flexibility of prices and wage can eliminate compulsory unemployment. Keynesians championed aggregate demand as the main determinant of the level of unemployment and further argued that the low unemployment rate leads to higher level of prices or inflation. Keynes’s assumption is that, in the case of balance, the aggregate demand and aggregate supply are equal and if the potential output is higher than the actual output, the economy is experiencing unemployment. With an increase in aggregate demand, there will be an increase in the level of price thus, increasing inflation leading to growth in the total output of the economy, thus reducing unemployment. This is an indication that reduced unemployment relates with higher inflation. References Alisa, M. (2015). The Relationship between Inflation and Unemployment: A Theoretical Discussion about the Philips Curve. Journal of International Business and Economics, 3 (2), 89-97. Al-Zeaud, H. (2014). The Trade-Off between Unemployment and Inflation Evidence from Causality Test for Jordan. International Journal of Humanities and Social Science, 4 (4), 103-111. Friedman M. (1968). The Role of Monetary Policy, American Economic Review, 58, 1-17. ILO (2011). Employment and unemployment. Internationl Labor Organization. Retrieved from http://www.ilo.org/global/statistics-and-databases/statistics-overview-and-topics/employment-andunemployment/lang--en/index.htm Lucas R. (1973). Some International Evidence on Output-Inflation Tradeoffs, American Economic Review, 63, 326-334. Phelps E. (1968) .Money Wage Dynamics and Labour Market Equilibrium, Journal of Political Economy, 76, 678-711. Rafiq, M., Ahmad, I., Ullah, A. & Khan, Z. (2010). Determinants of unemployment: A case study of Pakistan economy (1998 - 2008). Abasyn Journal of Social Sciences, 3(1): 17-24. Resurreccion, P. (2014). Linking Unemployment to Inflation and Economic Growth: Toward a Better Understanding of Unemployment in the Philippines. Asian Journal of Economic Modelling, 2(4), 156-168. Samuelson P. & Solow R. (1960). Analytical Aspects of Anti-Inflation Policy, American Economic Review, 50, 177-194. Read More