Unemployment and Inflation
The relationship between demand for a product and its price is considered basic knowledge in economics. An increase in the demand of a product predictably leads to increase in its price. As more and more people need or want the same product, the sellers are able to raise the price of the product without significant impact on the demand. Suppliers too are willing to supply more when prices are high, and scale down their supplies as prices fall. While such relationships are reasonably straightforward and easy to understand, others are complex and are the hotspots of heated scholarly arguments among theorists. One relationship which has been at the centre of a controversy spanning several decades is the one between unemployment and inflation. This paper explores the dynamic nature of the relationship between these two important economic concepts.
The British economist, A. W. Phillips, theorized that there was a stable inverse relationship between inflation and unemployment, and represented this relationship in the Phillips curve. According to Phillips, any increase in unemployment results in a decrease in the economys inflation rate. The reverse is also true so that as the rate of inflation rose, unemployment declines. Commodity prices therefore remain stable as long as there is some unemployment in the economy (Sennholz, 1986). It could thus be concluded that according to Phillips, inflation is the price that an economy has to pay for providing employment opportunities to its entire workforce. An economy would thus find it unwise or ill-advised to provide employment for its entire work-force as such an effort would occasion very high rates of inflation.
The Phillips curve and the implied inverse relationship between unemployment and inflation were criticized harshly by theorists who argued that it was too simplistic a generalization. Phillips theorized a relationship which was found to go against established economic principles and prevailing realities. However, some scholars have appreciated the existence and strength of this inverse relationship. Most people depend on earnings from the labour market for all or most of their income. This implies that higher rates of unemployment would lead to significant declines in income. With less money to spend, demand for goods and services would predictably decline. In explaining the relationship between unemployment and inflation, these scholars have established that the inverse relationship applies in the short-run, but not in the long run (EconomyWatch, 2009). The implication of the Phillips curve and the stable relationship between inflation and unemployment rates could be of great importance to policy makers.
A permanent and stable relationship between the two implied that policymakers could tolerate high unemployment rates to counter inflation, or tolerate runaway inflation rates as it would lead to lower unemployment rates. Governments could thus use monetary and fiscal policies to stimulate the economy and lower unemployment rates. The cost would come in the form of higher inflation rates. This could apply in the short-term but not in the long-term.
In the long-term, the Philips curve depicts a very different relationship between the rates of unemployment and inflation. Economists established that no real relationship existed between unemployment and inflation rates in the long run, and one could soar independent of the other. Studies conducted for 1963, 1972, and 1974 revealed that although unemployment rates were almost the same, inflation rates hit 1.6 percent, 3.4 percent, and 12.2 percent respectively (Sennholz, 1986). The world witnessed a period of stagflation in the 1970s which was characterized by high rates of unemployment and high rates of inflation. Scholars observed that the Phillips curve gave the wrong picture of what was happening, as there was no trade-off between the sky-rocketing rates of unemployment and inflation (Lacker Weinberg, 2007). Instead of one rising as the other declined, both shot up, thereby creating an economic situation which Phillips had not anticipated. This led the economists Lucas and Sargent to describe the perceived stability as an economic failure on a grand scale (King Watson, 1995).
The instability implies that no credible government can hope to reduce its rates of unemployment by tolerating high rates of inflation. Neither can it check its rates of inflation by tolerating high rates of unemployment. Put simply, the original Phillips curve was shown to be too simplistic to be used to analyse the relationship between inflation and unemployment. Other factors including demographics, productivity and fiscal policy contribute significantly to inflation rates (Berentsen, Menzio Wright, 2008). Since it was originally advanced in 1958, the Phillips curve has been modified to take into account inflationary expectations.
Conclusion
The discussion above shows that the relationship between the rates of inflation and unemployment has been of much scholarly interest for several decades. Although Phillips had argued that there existed a direct and inverse relationship between unemployment and inflation, the events of the 1970s prompted fierce criticisms against the existence of the direct relationship which Phillips had theorised in 1958. Studies established that the Phillips curve held true only in the short-term. In the long term, this paper argues that the two cannot be studied in isolation. Other factors including demographics, monetary and fiscal policy, and productivity must be taken into account.