The Relationship Between the Rate of Unemployment and Inflation Rate

The Relationship Between the Rate of Unemployment and Inflation Rate

The relationship between the rate of unemployment and inflation rate is represented on the Phillips curve. The study of Phillip on unemployment and wage inflation was significant in the development of macroeconomics. The findings of Philip were that the two variables had a steady inverse relationship: during high unemployment, there is a slow increase in wages; when there is low unemployment, there is a rapid rise in wages.

Phillips inferred that with lower rate of unemployment, the labour market becomes tighter and, thus the quicker the firms must increase wages in order to attract limited labour. The pressure is abated at higher rates of unemployment. The representation of Phillip’s curve demonstrates an average correlation between wage behaviour and unemployment over the business cycle. The study demonstrates the resultant wage inflation rate suppose a given unemployment level persisted for some time.

In most developed economies, economists estimate the Phillips curve of unemployment in regard to general price inflation but not wage inflation. This implies that a company charges a prices that are closely associated to the wages it pays.

The figure above demonstrates a typical Phillips curve, which is similar to the curve from the 1961-1969 US data. The close similarity between the curve estimated and the data persuaded Robert Solow and Paul Samuelson to treat Phillips curve as a policy options’ menu. This implies that, for example, with a 6 % unemployment rate, the government may stimulate the economy

However, as argued by economists, it is difficult for any government to trade off the higher inflation rates for lower unemployment rates permanently. Suppose the unemployment is at a standard rate. With a constant real wage: labourers who anticipate a certain price inflation rate insist on their wages rise at a similar rate in order for them to maintain their previous purchasing power. The government may decide to employ an expansionary fiscal or monetary policy to lower this rate of unemployment to a level below its standard rate. The resulting demand increases stimulates a firm to increase their prices more rapidly than what the workers anticipated.

Firms will willingly employ more labourers at their old rate of wages and somewhat raise those rates. Workers will suffer from money illusion in a short run as they will willingly increase their labour supply because of money wages’ increase; therefore, the rate of unemployment declines. However, these workers take time to realize that there is a decline in their purchasing power given the rapid price increase as previously anticipated. In the end, workers will expect greater price inflation rates hence cut their labour supply and emphasizing on wage increase to pace up with inflation. This leads to the restoration of the real wage to its old level with the rate of unemployment returning to its standard rate.

Unlike the standard rate NAIRU, (non-accelerating inflation rate of unemployment does not imply that the rate of unemployment is unchanging, social optimal or impervious to policy. The figure shown above is a Phillips curve with expectations-augmented, represented by the straight line (the regression line), which is a summary of the inverse relationship. The hypothesis of rational expectations imply that prices and wages are somewhat sticky. The price and wage inertia result in relative prices and real wages away from their clearing market levels, explaining the huge unemployment fluctuations around NAIRU.

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