Unemployment vs. Inflation

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Inflation vs. Unemployment Inflation and unemployment are two key elements when evaluating the economic well-being of a nation, and their relationship has been debated by economists for decades. Inflation refers to an increase in overall level of prices within an economy; it means you have to pay more money to get the same amount of goods or services as you acquired before and the money becomes devalued. For example 10 dollars seventy years ago had the same buying power that 134 dollars have today (Bureau of Labor Statistics).

This is the result of the government printing more and more money and each individual dollar being worth less and less, comparatively. Unemployment refers to the amount of people that are available or eligible to work, but are unable to find employment. This is measured by the unemployment rate, which is the percentage of the labor force that is unemployed. As inflation rises, unemployment decreases in the short run, but is generally unaffected by inflation in the long run. Unemployment is harmful to both individuals and society as a whole. bviously when an individual is unemployed, he or she is unable to earn money and thereby their standard of living decreases. In terms of the economy as a whole, unemployed workers are seen as wasted production capability. These are people that could be working and contributing to the GDP, but instead are having the opposite effect. Unemployed people also are far less likely to spend money, reducing the overall wellbeing of the economy as well. A certain level of unemployment is normal and natural though. In the past economists used the “Phillips Curve” to show an inverse relationship between inflation and unemployment.

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This curve was based on Economist William Phillips’ findings; when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly… the lower the unemployment rate, the tighter the labor market and, therefore, the faster firms must raise wages to attract scarce labor” (Hoover). By comparing data one can examine the Phillips curve and its effectiveness in predicting unemployment or inflation. The Consumer Price Index, or CPI is most often used to show the effects of inflation by measuring the price of a certain basket of good from year to ear. Unemployment is measured by the unemployment rate. By comparing these figures over time one can see the relationship between the two. From February 2012 to February 2013 the unemployment rate in the United States dropped from 8. 3 to 7. 7. Over that same period of time the CPI increased from 227. 663 to 232. 166. (Bureau of Labor Statistics) This indicates that as unemployment fell, inflation rose, confirming the notion that in the short run the inverse relationship between inflation and unemployment holds true. Not all economists agreed with this theory however.

The Classical school of economists believe that there is a natural rate of unemployment, sort of an equilibrium level of unemployment in the economy. According to this school of thought unemployment will be at a given level no matter what inflation is. Recall the short-term and long-term Phillips Curves. The classical view is that the point where the short-term Phillips curve intersects the long-term Phillips curve marks expected inflation. For any point to the left of this point actual inflation is higher than expected, and for any point to the right, actual inflation is lower than expected.

Unemployment below the natural level of unemployment leads to higher than expected inflation and an unemployment rate above the level of natural unemployment results in lower than expected inflation. In challenge to the Classical School of economic thought, the Keynesian School of Economic Theory makes the argument that it is not changes in money supply that affect inflation, but rather it is inflation that causes change in the money supply. The Keynesians argue that firms raise wages in order to ensure their employees’ happiness. In order for these firms to continue making profit at higher wage rates, prices must be raised.

This causes an increase in both wages and prices, which in turn leads to a governmental increase in the money supply in order to sustain the economy. Milton Friedman and Edmund Phelps both independently challenged the Phillips curve by arguing that the relationship between unemployment and inflation would not exist in the long-run. According to Friedman, in the long-run the inflation rate is determined by the money supply, and regardless of inflation rate, the unemployment will also gravitate toward its natural rate (Friedman). As a result of this the long-run Phillips Curve is vertical.

During the 1970s this Friedman’s theory was confirmed by the emergence of Stagflation, which is when high unemployment and high rates of inflation occur at the same time. From 1970 to 1982 the CPI increased by 57. 7 and the unemployment rate rose by 4. 8 percent (Bureau of Labor Statistics). Numbers like these indicate stagflation and go completely against the Phillips Curve. The ten year period from 2000 to 2010 shows a similar trend. Over this period of time the CPI increases from 172. 2 to 218. 056. According to William Phillips and the Phillips Curve the response to this inflation should be a decrease in unemployment.

The data tells a different story; over this same period of time the unemployment rate shows a dramatic increase from 4. 0 in 2000 to 9. 6 in 2010. (Bureau of Labor Statistics). The original Phillips curve is no longer used today as it is deemed to be too simplistic, and has been replaced with more advanced models, such as the “expectations-augmented Phillips curve”. William Phillips’ contributions to the field of macroeconomics are substantial, as he started the discussion of the relationship between unemployment and inflation in earnest. As Robert Hall says, “Modern unemployment theory has come a long way…

There is far from a complete understanding, however. ” Though there are many different theories out there, both historical and modern, there is no single theory or model that can accurately predict what effect inflation will have on long-run unemployment. There is however much evidence that suggests that while inflation and unemployment are inversely related in the short run, unemployment is generally unaffected by inflation in the long run. Works Cited Friedman, M 1968, “The Role of Monetary Policy,” The American Economic Review, vol. 58, pp. 1-17 Hall, Robert E. Modern Theory of Unemployment Fluctuations:. ” American Economic Association 93. 2: n. pag. Print. Kevin D. Hoover, “Phillips Curve. ” The Concise Encyclopedia of Economics. 2008. Library of Economics and Liberty. 22 March 2013. . United States. Bureau of Labor Statistics. Consumer Price Index – All Urban Consumers. Print. – – -. – – -. Consumer Price Index All Urban Consumers – (CPI-U). Print. – – -. – – -. Employment Situation Summary Table A. Household data, seasonally adjusted. Print. – – -. – – -. Labor Force Statistics from the Current Population Survey. Print.

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