INTRODUCTION

Inflation seems to be a chronic problem in many parts of the world today and unemployment, a phenomenon, true for Pakistan, and valid for United States and other western economies. Even the fastest growing Chinese economy is not totally immune to it. Thus this research project deals with the analysis of unemployment and inflation in Pakistan. The purpose of this research is to analyze the relationship that exists between these two macroeconomic variables, which affect every nation as well as an individual.

Don't use plagiarized sources. Get Your Custom Essay on

Inflation and Unemployment

Just from $13,9/Page

The Phillips curve shows a historical inverse relation between the rate of unemployment and the rate of inflation in an economy. It is the trade-off between inflation and unemployment (Mankiw, 2002). The lower the unemployment in an economy, the higher the rate of change in wages paid to labor in that economy.

LITERATURE REVIEW

The relationship between unemployment and inflation the two macroeconomic variables is usually summarized by the Phillips curve. Different studies have been conducted related to these variables in order to see whether any relationship between these two macroeconomic variables exists or not.

While analyzing the trade-off between inflation and unemployment in Asia, (Dua 1996), takes inflation as the function of expected inflation, unemployment gap/ output gap, exchange rate, import inflation and oil price inflation. In India and Philippines the tradeoff between inflation and unemployment does not exist, whereas, in Japan, Korea, Singapore, and Hong Kong it does. (Rafael, MacCulloch, & Oswald 2000), on the other hand, suggest that welfare and life satisfaction level is a function of inflation and unemployment and people are happier when rates of both are low. However unemployment in comparison with inflation depresses people more than inflation. Thus while controlling country fixed-effects, year effects, and time trends, it is estimated that people will trade 1% increase in unemployment for 1.7% increase in inflation. A strong positive relation between unemployment rate and inflation rate lagged one or two years is also shown, which is inconsistent with both Philips curve and NAIRU.

In other words the trade-off between inflation and unemployment rate does not exist, except in the same year, and in the long run unemployment is a positive function with inflation (Niskanen 2002). Namibia, using the time series data from 1991-2005, exhibits the presence of stagflation in its economy. In other words he found increase in both inflation and unemployment at the same time, which contradicts the traditional short-run Philips curve (Ogbokor 2005). (Furuoka 2007) using the data of Malaysia from 1975-2004 shows and existence of co-integrated as well as casual relationship between inflation and unemployment. That is the study provides an empirical evidence to support the Philips curve. Likewise, Philips curve also exists in Japan, with negative coefficients of linear link between inflation and unemployment. Also there is a generalized linear and lagged relationship between labor force, unemployment and inflation in Japan, which is confirmed by the fact that the driving force behind unemployment and inflation is the change rate of labor force level (Kitov 2007). In this paper, a Philips curve with linear link will be calculated for Pakistan to see if the negative relationship between the variables exists or not.

Problem Statement:

What is the likely relationship between inflation and unemployment in Pakistan? Hypothesis:

If unemployment increases, then inflation decreases.

Data Source:

Secondary data for the purpose of this research has been obtained from the year 2000-2011. The data on unemployment rate (percentage of total labor force) and inflation rate (general not adjusted for food and energy) for Pakistan, has been taken from the Economic Survey of Pakistan.

Objective

The objective of this research is to determine the relationship between inflation and unemployment for the economy of Pakistan. Philips curve is based on the equation where unemployment is the function of inflation.

METHODOLOGY

Here, a regression is run for inflation rate and unemployment rate for Pakistan. The functional form of the model which is as follows: Y = βο + β1X1 + Є

Substituting the above inflation function in the equation

INFt = βο + β1Ut + Єt

Where U is the unemployment rate and INF is inflation rate for a given time “t”. The Equation obtained after running the OLS model is:

INFt = 30.96981 – 3.306067 Ut

Dependent Variable: INF

Method: Least Squares

Date: 08/01/13 Time: 21:49

Sample: 1 12

Included observations: 12

Variable

Coefficient

Std. Error

t-Statistic

Prob.

C

30.96981

6.078158

5.095263

0.0005

U

-3.306067

0.882942

-3.744377

0.0038

R-squared

0.583686

Mean dependent var

8.549167

Adjusted R-squared

0.542055

S.D. dependent var

5.344512

S.E. of regression

3.616718

Akaike info criterion

5.560023

Sum squared resid

130.8065

Schwarz criterion

5.640841

Log likelihood

-31.36014

Hannan-Quinn criter.

5.530101

F-statistic

14.02036

Durbin-Watson stat

2.038825

Prob(F-statistic)

0.003819

While interpreting the regression line, the negative sign with the coefficient of unemployment shows that in Pakistan Inflation and unemployment are inversely related at “t” period. One percent increase in unemployment in one year will bring a decrease in inflation of 3.306067 percent. Unemployment in this simple regression model is statistically significant as the probability of t-stats is less than 0.05 and so we reject H0. The intercepted value 30.96981 of B0 shows the inflation rate when unemployment is zero. The R2 for this model, which lies between 0 and 1, comes out to be 0.583686 which shows that 58.36 percent of the variation in inflation is explained by unemployment. The adjusted R2 statistics comes out to be 0.542055. The Durbin-Watson d statistics test, which is done for autocorrelation, is 2.038825 for Pakistan, showing that there is no auto or serial correlation. As this is simple regression model multicollinearity is not present. As the probability of F-stat is less than 0.05 we will reject H0 which means that the model is overall statistically significant. The Scatter Plot for Inflation and Unemployment somehow depicts the same relationship as above.

CONCLUSION & RECOMMENDATION

This study is conducted in order to make an analysis of inflation and unemployment in Pakistan from year 2000-2010. It has employed a simple regression analysis technique. The main conclusion derived from this study is that the tradeoff between these two variables, the Philips Curve, is observed in Pakistan. When unemployment is high, the cost of goods will increase during an inflationary period, but firms will be able to hire cheap labor, as labor will be in surplus. Wages will not rise while unemployment remains high. Workers will have to borrow money or reduce the amount of goods they purchase. If workers cannot get loans, firms will have to lower prices to continue to sell products, thus reducing inflation. This study makes the following recommendation in the light of its analysis. Easy fiscal policy can be used to decrease unemployment at the expense of inflation, as mild inflation is desirable in every economy. However in Pakistan the inflation rate is much higher than the unemployment rate. Thus Pakistan has to focus more on policies which lead to reduction in inflation but the Government should also control unemployment at the same time.