The Short-Run and Long-Run Relationship Between Unemployment and Inflation
Evaluate the historical relationship between unemployment and inflation. (hint: You may start from A.W. Phillips’s finding of the relationship between unemployment and inflation.)
Distinguish between the short-run and the long-run in a macroeconomic analysis. Why is the relationship between unemployment and inflation different in the short-run and the long-run?
Assess the recent 20-year U.S. unemployment and inflation data. Do the current U.S. unemployment and inflation data confirm the short-run Phillips curve?
Analyze why the recent 20-year U.S. unemployment and inflation data approves or disproves the short-run Phillips curve.
Evaluate whether the Phillips curve can still validly resolve today’s issue of unemployment and inflation and forecast unemployment and inflation. Why or why not?
Recommend any policy, method, or opinions for the current U.S. unemployment and inflation as a policy maker for either fiscal policy or monetary policy (or both).
The Short-Run and Long-Run Relationship between Unemployment and Inflation
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Introduction
For many decades now, numerous economists have studied both inflation and unemployment, with one of the earliest researchers to study the relationship between the two being Irving Fisher. Nonetheless, the research done by A.W Phillips in 1958 was what brought attention to the assessment of this relationship (Skold & Tesfay, 2020). Phillips would develop the Phillips curve economic concept where he indicated that inflation and unemployment have a stable and inverse relationship. The curve stipulated that economic growth arose from inflation to increase job opportunities and reduce unemployment levels subsequently. Notably, different economists disprove Phillip’s original concept, considering the 1970s stagflation where inflation and unemployment experienced concurrent high levels (Qin, 2020). The inverse relationship and inflation and unemployment would hence hold only over the short run.
This essay seeks to assess the relationship between unemployment and inflation in the short and long run. The discussion will consider the historical context of the relationship between unemployment and inflation and focus on understanding why the relationship between the two is different in the short and long run. An assessment of the United States 20-year unemployment and inflation data will be conducted to determine and analyze whether the data approves or disapproves of the short-run Phillips curve. Also, an Assessment of whether the Phillips curve can still be valid to deal with the prevailing issues of unemployment and inflation and make forecasts. Finally, the discussion provides a recommendation for the present unemployment and inflation rates in the United States.
The Historical Relationship Between Unemployment and Inflation
Historically, a relationship between unemployment and inflation seems to have always existed. In 1958, a British economist named Alban William Housego Phillips published a document titled “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861-1957,” outlining this relationship that would later be called the Phillips curve. Phillips monitored the changes in both wages and unemployment in Great Britain between 1861 to 1957. Following the Phillips Curve, Phillips indicated that inflation and unemployment have a stable and inverse relationship, evident in the data obtained from Great Britain and other industrial nations. The theory stipulated that economic growth happens due to inflation, increasing job opportunities, and reducing unemployment rates. High unemployment rates mean a higher presence of the labor force, but the average wages provided are minimal with no increase (Skold & Tesfay, 2020). This becomes challenging to attract workers to occupy available job opportunities. In low unemployment rates, wages are forced to be increased for workers to be attracted. The rate at which the wages increase is considered inflation in wages which subsequently leads to the inflation in goods and services. Therefore, an average citizen gets a higher monthly payment that can pay more for the average basket of goods and services (Skold & Tesfay, 2020). When there is a low economic rate, the economy grows. This is why Phillips indicated that economic growth comes with greater inflation rates.
Figure 1: The Phillips Curve
Source: (Pettinger, 2021)
Other economists would assert that this relationship does exist. American economists Robert Solow and Paul Samuelson co-authored a report called “Analytics of Anti-Inflation Policy.” This would be an expansion of Phillips’ work as reflected on the relationship between the two.. Considering washes are the most significant component in prices, inflation instead of the change in wages may have an inverse correlation to unemployment. Their study first asserted a correlation between unemployment and inflation in the United States of America. Other economists have stated that the correlation is evident in other countries as well. The research further indicated that the Phillips Curve could be used in federal policy. This curve would provide the possibility of attaining considerable economic policy outcomes that could achieve full employment at the expense of high price levels. In doing so, policymakers can use the Phillips Curve to determine fiscal and monetary policy. They would be able to decide to increase/decrease taxes and adjust government spending. It is said that the Phillips Curve has “flattened.”
However, the correlation between inflation and unemployment has diminished as the Federal Reserve has set fiscal and monetary policies. While it is not an outdated model, it has lost viability over the decades. Economists and policymakers argue that areas with high levels of unemployment have been this way due to “national labor market rigidities and regulatory policies” (Jordan, 2012). The Phillips Curve can still be used to resolve today’s issues with unemployment and inflation, along with other external factors. Policymakers can set a goal that can be forecasted by determining a point on that curve and making necessary changes to reach that point or goal. The fiscal and monetary policies implemented by the Federal Reserve were determined by the Phillips Curve to have both low inflation and low unemployment. The Phillips Curve is a tool to be used and others to determine the best course of action to help the relationship between inflation and unemployment. Ideally, policymakers would prefer that their nation exhibit low unemployment and inflation, but data show that this is not possible.
Why is the Relationship Between Unemployment and Inflation Different in the Short-run and the Long-run?
The Phillips Curve, which suggests that a stable relationship exists between unemployment and inflation, is only valid in the short run before there is an adjustment to inflation expectations. This model could only persist if individuals never changed their inflation expectations which goes against the fundamental economic principle that persons act rationally. Any adjustment to the expectations would prompt the unemployment to be consistent with the natural unemployment rate as a greater inflation rate (Nüß, 2013). Suppose the individuals choose to adjust their inflation expectations. In that case, any measures focused on maintaining the unemployment rate below the natural unemployment rate could lead to a constant increase in inflation instead of a one-time increase in inflation (Labonte, 2016). The rebuttal of the Phillips curve would establish the natural rate model.
In the long run, there can be no trade-off between inflation and unemployment. Therefore, the long-run Phillips curve is a vertical line at the natural unemployment rate to show that the two are unrelated. The ability of an economy to produce goods and services, precisely its potential output, relies on three fundamental elements in the long run (Labonte, 216). These include the amount of capital, labor structure in terms of the numbers and their quality, and finally, the technological level. While the factors largely determine the potential output of an economy, the economy’s actual output heavily relies on the demand for goods and services, which can either be lower or higher than the potential output. A stable economy occurs when the actual output is equivalent to the potential output, considered the equilibrium. At this point, the demand for both goods and services is equivalent to the economy’s capacity to supply the goods and services. Notably, when the actual output is diverging from the potential output, inflation has the tendency to be less stable. With all factors constant, when the actual output is greater than the potential output, it creates a positive output gap, causing inflation acceleration (Labonte, 2016). When the potential output is greater than the actual output, this leads to a negative output gap causing an acceleration in inflation. Following the natural rate model, the natural employment rate is the unemployment level consistent with the actual output being equivalent to the potential output as it attains stable inflation.
Do the Recent 20-Year U.S. Unemployment and Inflation Data Approve Or Disapprove the Short-run Phillips curve?
Figure 2 below demonstrates that the Phillips curve model shifted to become a permanent feature of the country’s economy. From the starting years of the 1990s to late 2007, the country’s economy came into a phase known as the Great Moderation. in this duration, inflation moved following a minimal range between 1.5% to 3.4%. The unemployment rate did follow a similar movement to range between slightly below 4% to slightly above 6%. The economy had moved very close to the objective of concurrent full employment and stability in prices. After the start of the Great Recession in 2007 that deepened dramatically in 2007, the Great Moderation of inflation and unemployment rates ended. Unemployment rates reached monthly peaks of 10% in October 2009. Conversely, inflation remained within a narrow range that was also evident in 2018 and 2019, when the unemployment rate was under 4% for the first time since the 1960s.
Figure 2: United States Inflation Vs. Unemployment 1994-2019
The patterns of inflation and unemployment in the above figure were different such that there was no series of clockwise loops. Its pattern was fundamentally inconsistent with the theory of the Phillips curve that is expected to hold in the short-run (Dolan, 2021). The expected clockwise loops typically entail periods of low unemployment and an acceleration in inflation balanced by durations of higher unemployment and a slow-down in inflation.
Conversely, the economy’s behavior for the last twenty years was a reflection of anchored expectations. During this time, the Fed avoided imposing sudden, unprecedented policy changes and would be very explicit in their decisions. The Fed indicated that it intended to hold inflation at or close to the targeted level of 2% regardless of what was happening in the economy. Therefore, with the expected inflation rate set at 2%, the Phillips curve did not shift, the economy moved within a smaller range of inflation and unemployment (Dolan, 2021). It became evident that the short-run Phillips curve became flattened. Even more significant variation in unemployment, such as those experienced during the Great Recession, did not cause a considerable significant change in inflation. The US economic behavior disapproved of the short-run Phillips curve since the price inflation was less responsive to unemployment changes. The flattening of this curve did imply a change in the dynamic relationship between inflation and unemployment.
Can the Phillips curve still validly resolve today’s issue of unemployment and inflation and forecast unemployment and inflation.
According to Niskanen (2002), the use of annual data from 1960 to 2001 indicated that there is no trade-off between unemployment and inflation except during a similar year. The researcher also indicated that in the long term, the rate of unemployment was a positive function to the rate of inflation; in the 1970s, the two rates increased concurrently since the US was experiencing stagflation. After 2009, unemployment turned sharply lower while inflation remained low. These statistics during the past years have shown that the degree of unemployment is a poor indicator of inflation. From the 1970s, the US economy has undergone different changes such that the duration would be reasonable for the Phillips curve between inflation and unemployment to assert itself. To this effect, the Phillips curve cannot be a considerable tool to solve the current issue of unemployment and inflation.
Regarding forecasting unemployment and inflation, the Phillips curve cannot still be used to provide accurate estimates. Generally, there is a need to update the short-run Phillips curve to consider the changes in slope and, in the time-varying, the Non-Accelerating Inflation Rate of Unemployment (NAIRU) (Dorn, 2020). These two elements cannot be observed in real-time, posing a challenge to policymakers wishing to use them to forecast inflation. It is prudent to acknowledge the fundamental imprecision of the relationship between inflation and unemployment. Therefore, for these difficulties, the short-run Phillips curve needs to be considered a limited tool for forecasting. one may consider it in forecasting the trajectory of change in future inflation but not in predicting the actual magnitude of future inflation.
The Phillips curve has provided a transient and loose relation between inflation and unemployment, which policymakers have hoped that they can use in achieving desired policy goals. The notion that a bit of inflation is desirable for a reduction in the unemployment level could be appealing to the stakeholders who are inclined towards overemphasizing in the short run while discounting the long run. Nonetheless, it is time that policymakers understood that the curve has just been a distraction from finding alternative ideas to conduct monetary policy which would offer a better opportunity to attain long-run price stability while ensuring constant economic growth and stability.,
Recommendations for the Current U.S. Unemployment and Inflation as a Policy Maker
Rather than depending on the flawed Phillips curve in guiding policy, the Fed policymakers need to concentrate on the underlying reasons for the low inflation and the cyclical changes in unemployment (Dorn, 2020). The Fed is obligated to attain maximum employment and price stability which becomes challenging when there is an assumption that the two have a trade-off. This could be replaced by using a single aim, such as keeping the growth of nominal GDP (NGDP) at a level growth trajectory. This would potentially increase the monetary policy’s credibility, mitigate uncertainties, reduce business fluctuations, and keep away from the stop-go monetary policy. According to Niskanen (2008), Congress would be more effective if it instructs the Fed to set up a monetary policy that reflects the concerns towards that one aim. This is considered a feasible strategy since the Phillips curve was not the best in forecasting inflation. The advantages from a nominal income target surpass the inflation target considering that unemployment is a poor indicator for potential inflation.
One advantage of having a rule that will keep nominal income at a steady trajectory is that it moves away from assigning weights to follow the Fed’s mandate of achieving price stability and full employment (Dorn, 2020). What will be required for the growth in nominal spending is the market forces that would determine the natural growth. Furthermore, the ability of the Fed to regulate the NGDP’s growth rate will not rely on keeping the Phillips curve stable. In the current environment, numerous non-monetary forces may also be causing the low rate of unemployment which could cause an overstatement of the actual degree of use of resources in the economy. Focusing on the actual component of growth in GDP protects from the risk of using a policy stance that is improperly restrictive due to the concerns from inflationary pressures that work with the misperceived Phillips curve.
Conclusion
This research analyzed the Phillips curve that has continuously been used as an accepted tool for forecasting inflation. The U.S Economy did disapprove of the stable relationship stipulated by the curve, and it remained evident that changes in unemployment have no considerable effect on inflation. It is hence considerable to look to other strategies in forecasting inflation and unemployment and finding solutions.
References
Dolan, E. (2021, July 6). Is the Phillips curve back? When should we start to worry about inflation? Retrieved from https://www.niskanencenter.org/is-the-phillips-curve-back-when-should-we-start-to-worry-about-inflation/
Dorn, J. A. (2020, February 19). The Phillips curve: A poor guide for monetary policy. Retrieved from https://www.cato.org/cato-journal/winter-2020/phillips-curve-poor-guide-monetary-policy#a-better-framework-for-monetary-policy
Jordan, J. L. (2012) “Friedman and the Phillips Curve.” In Sound Money: Why It Matters, How to Have It, 9–29. Ottawa, Ontario: Macdonald‐Laurier Institute.
Labonte, M. (2016, October 25). Unemployment and inflation: Implications for Policy Making. Retrieved from https://www.everycrsreport.com/reports/R44663.html#_Toc25595663
Nüß, P. (2013). An empirical analysis of the Phillips Curve: A time series exploration of Germany.
Niskanen, W. A. (2002). “On the Death of the Phillips Curve.” Cato Journal 22 (2): 193–98.
Niskanen, W. A. (2008). “Monetary Policy and Financial Regulation.” Cato Handbook for Policymakers, 7th ed., 377–84. Washington: Cato Institute.
Pettinger, T. (2021, May 19). Phillips curve. Retrieved from https://www.economicshelp.org/blog/1364/economics/phillips-curve-explained/
Qin, Y. (2020, December). The Relationship Between Unemployment and Inflation–Evidence From the US Economy. In Fifth International Conference on Economic and Business Management (FEBM 2020) (pp. 157-162). Atlantis Press.
Sköld, E., & Tesfay, K. (2020). The relationship between inflation and unemployment in Sweden.
