Inflation and Unemployment: Philips Curve and Rational Expectations Theory
In this article we are going to see what an unemployment means and what exactly there is an inverse relationship between rate of inflation and unemployment. polemic issues of mutual relationship between unemployment and inflation and Solow demonstrated a consistent inverse relationship between inflation and. It means that there was inverse relationship among the unemployment and the . In Sri Lanka, the connection between the unemployment and the inflation rates This section clearly describes the research methods of this study which.
Argument Over the past decade, growth in the prime age population has been flat. Even if private non-residential fixed investment increases to create additional output capacity in the economy, unfavorable demographics are creating a scenario in which too few workers are being produced.
This is also a material headwind to real wage growth. In addition to global and domestic disinflationary forces, which I've discussed in some level of detail in previous poststhis poses a challenge to inflation. This has significance for the global economy, such as a continuous "lower rates for longer" environment, which challenges central banks' ability to rectify economic down-cycles. Overview The unemployment rate receives a large amount of focus given it provides insight into how economic growth is doing relative to potential growth.
If we are at "full employment" - a point at which an additional decrease in the metric causes inflation that exceeds the marginal benefit of less unemployment - the economy should be producing at around its capacity. The US Federal Reserve and essentially all other central banks closely monitor their countries' unemployment rates to attend to mandates often predicated on maintaining an equitable balance between inflation and unemployment.
With that said, the unemployment rate merely correlates to how actual GDP might appear relative to potential GDP rather than standing as an ideal proxy. For one, the unemployment rate has some methodological issues in the way in which its calculated that skews its reliability and ultimate value.
It excludes large swaths of the potential labor pool, fails to take into account the number of hours worked, and ignores the quality of the employment itself and total factor productivity.
All of these factors are important to take into account when assessing economic performance and matters in which this single metric can't capture. The employment rate has been falling sinceyet no up-spurt has been observed in inflation. Inflation and inflation expectations rose from late-June through late-January but have been moving down since. Louis Federal Reserve, as is the attribution for all subsequent images The patterns over the past three years have largely been driven by movement in the price of oil a major input in economic activity and, most recently, altered expectations on the fiscal policy front.
The figure also counts those who work as little as one hour per week. At its heart, the U-3 is a bureaucratically formulated metric largely designed to make political administrations look good.
Reliance on very broad and imprecise labor utility categorizations will correlate with the question policymakers are trying to answer "How does current GDP relate to potential GDP?
The question of why ostensible labor market tightness has not translated to inflation in the way central bankers have anticipated in such economies as the US, EU, and Japan suggests that the metrics they're looking at may be fundamentally flawed. This has led to persistent cuts in the terminal overnight rate estimation from 4. Brookings Institute In other periods of history, the U-3 was a reliable indicator of when inflation would increase.
The gist is that as unemployment decreases, this generally causes inflation to increase. A clearer demonstration can be found by subtracting inflation from unemployment. As the business cycle goes on, the difference between the two becomes smaller. Once a recession comes to shed inefficiency, some workers become displaced in the shake-out and down-cycles are inherently disinflationary given the drop in demand.
This causes the difference between the two to widen back out. As for the basic economic theory behind it: Thus a money wage rate increase which is in excess of labour productivity leads to inflation.
To keep wage increase to the level of labour productivity OM in order to avoid inflation, ON rate of unemployment will have to be tolerated. The Long-Run Phillips Curve: Economists have criticised and in certain cases modified the Phillips curve. They argue that the Phillips curve relates to the short run and it does not remain stable. It shifts with changes in expectations of inflation.
In the long run, there is no trade-off between inflation and employment. According to Friedman, there is no need to assume a stable downward sloping Phillips curve to explain the trade-off between inflation and unemployment. But there are certain variables which cause the Phillips curve to shift over time and the most important of them is the expected rate of inflation. So long as there is discrepancy between the expected rate and the actual rate of inflation, the downward sloping Phillips curve will be found.
But when this discrepancy is removed over the long run, the Phillips curve becomes vertical. In order to explain this, Friedman introduces the concept of the natural rate of unemployment. In represents the rate of unemployment at which the economy normally settles because of its structural imperfections. It is the unemployment rate below which the inflation rate increases, and above which the inflation rate decreases.
At this rate, there is neither a tendency for the inflation rate to increase or decrease. Thus the natural rate of unemployment is defined as the rate of unemployment at which the actual rate of inflation equals the expected rate of inflation. In the long run, the Phillips curve is a vertical line at the natural rate of unemployment. This natural or equilibrium unemployment rate is not fixed for all times.
Rather, it is determined by a number of structural characteristics of the labour and commodity markets within the economy. These may be minimum wage laws, inadequate employment information, deficiencies in manpower training, costs of labour mobility, and other market imperfections. But what causes the Phillips curve to shift over time is the expected rate of inflation. This refers to the extent the labour correctly forecasts inflation and can adjust wages to the forecast.
Suppose the economy is experiencing a mild rate of inflation of 2 per cent and a natural rate of unemployment N of 2 per cent. At point A on the short-run Phillips curve SPC1 in Figure 7, people expect this rate of inflation to continue in the future.
Now assume that the government adopts a monetary-fiscal programme to raise aggregate demand in order to lower unemployment from 3 to 2 per cent.
The Phillips Curve Is Dead: Why Lower 'Unemployment' No Longer Causes Inflation
The increase in aggregate demand will raise the rate of inflation to 4 per cent consistent with the unemployment rate of 2 per cent. When the actual inflation rate 4 per cent is greater than the expected inflation rate 2 per centthe economy moves from point A to B along the SPC1 curve, and the unemployment rate temporarily falls to 2 per cent. This is achieved because the labour has been deceived. It expected the inflation rate of 2 per cent and based their wage demands on this rate. But the workers eventually begin to realise that the actual rate of inflation is 4 per cent which now becomes their expected rate of inflation.
Now workers demand increase in money wages to meet the higher expected rate of inflation of 4 per cent.
They demand higher wages because they consider the present money wages to be inadequate in real terms. In other words, they want to keep up with higher prices and to eliminate fall in real wages.
If the government is determined to maintain the level of unemployment at 2 per cent, it can do so only at the cost of higher rates of inflation. From point C, unemployment once again can be reduced to 2 per cent via increase in aggregate demand along the SCP2 curve until we arrive at point D.
With 2 per cent unemployment and 6 per cent inflation at point D, the expected rate of inflation for workers is 4 per cent.
As soon as they adjust their expectations to the new situation of 6 per cent inflation, the short-run Phillips curve shifts up again to SPC3 and the unemployment will rise back to its natural level of 3 per cent at point E.
On this curve, there is no trade-off between unemployment and inflation. It is clear from above that through increase in aggregate demand and upward-sloping aggregate supply curve; Keynesians were able to explain the downward-sloping Phillips curve showing the negative relation between rates of inflation and unemployment.
Collapse of Phillips Curve During the sixties Phillips curve became an important concept of macroeconomic analysis. The stable relationship described by it suggested that policy makers could have a lower rate of unemployment if they could bear with a higher rate of inflation. On the contrary, they could achieve a low rate of inflation only if they were prepared to reconcile with a higher rate of unemployment. But a stable Phillips curve could not hold good during the o seventies and eighties, especially in the United States.
Therefore, experience in the two decades has prompted some economists to say that the stable Phillips curve has disappeared. In these two decades we have periods when rates of both inflation and unemployment increased that is, a high rate of inflation was associated with a high unemployment rate, which shows the absence of trade-off. We have shown the data of inflation rate and unemployment in case of the United States in Fig. From the data it appears that instead of remaining stable, the Phillips curve shifted to the right in the seventies and early eighties and to the left during the late eighties, see Fig.
Causes of Shift in Phillips Curve: Now, what could be the cause of shift in the Phillips curve? There are two explanations for this. First, according to Keynesians, the occurrence of higher inflation rate along with the increase in unemployment rate witnessed during the seventies and early eighties was due to the adverse supply shocks in the form of fourfold increase in the prices of oil and petroleum products delivered to the American economy first in and then again in The hike in price of oil by OPEC, the cartel of oil producing Middle East countries brought about a rise in the cost of production of several commodities for the production of which oil was used as an energy input.
Further, the oil price hike also raised the transportation costs of all commodities. The increase in cost of production and transportation of commodities caused a shift in the aggregate supply curve upward to the left. This is generally described as adverse supply shock which raised the unit cost at each level of output. It will be seen from Fig. At the new equilibrium point H, price level has risen to P1 and output has fallen to OY1 which will cause unemployment rate to rise.
Thus, we have a higher price level with a higher unemployment rate. This explains the rise in the price level with the rise in the unemployment rate, the phenomenon which was witnessed during the seventies and early eighties in the developed capitalist countries such as the U. Note that this has been interpreted by some economists as a shift in the Phillips curve and some as demise or collapse of the Phillips curve. Natural Rate Hypothesis and Adaptive Expectations: A second explanation of occurrence of a higher rate of inflation simultaneously with a higher rate of unemployment was provided by Friedman.
He challenged the concept of a stable downward- sloping Phillips curve. According to him, though there is a trade-off between rate of inflation and unemployment in the short run, that is, there exists a short-run downward sloping Phillips curve, but it is not stable and it often shifts both leftward and rightward. He argued that there is no long-run stable trade-off between rates of inflation and unemployment.
His view is that the economy is stable in the long run at the natural rate of unemployment and therefore the long-run Phillips curve is a vertical straight line.
The Phillips Curve Is Dead: Why Lower 'Unemployment' No Longer Causes Inflation | Seeking Alpha
He argues that misguided Keynesian expansionary fiscal and monetary policies based on the wrong assumption that a stable Phillips curve exists only result in increasing rate of inflation. Natural Rate of Unemployment: It is necessary to explain the concept of natural rate of unemployment on which the concept of long-run Phillips curve is based.
The natural rate of unemployment is the rate at which in the labour market the current number of unemployed is equal to the number of jobs available. These unemployed workers are unemployed for the frictional and structural reasons, though the equivalent number of jobs is available for them. For instance, the fresh entrants may spend a good deal of time in searching for the jobs before they are able to find work.
Further, some industries may be registering a decline in their production rendering some workers unemployed, while others may be growing creating new jobs for workers. But the unemployed workers may have to be provided new training and skills before they are deployed in the newly created jobs in the growing industries. Since the equivalent number of jobs is available for them, full employment is said to prevail even in the presence of this natural rate of unemployment.
It is presently believed that 4 to 5 per cent rate of unemployment represents a natural rate of unemployment in the developed countries. Friedman put forward a theory of adaptive expectations according to which people from their expectations on the basis of previous and present rate of inflation, and change or adapt their expectations only when the actual inflation turns out to be different from their expected rate. The view of Friedman and his follower monetarists is illustrated in Figure To begin with SPC1 is the short-run Phillips curve and the economy is at point A0, on it corresponding to the natural rate of unemployment equal to 5 per cent of labour force.
The location of this point A0 on the short-run Phillips curve depends on the level of aggregate demand. The other assumption we make is that nominal wages have been set on the expectations that 5 per cent rate of inflation will continue in the future. Now, suppose for some reasons the government adopts expansionary fiscal and monetary policies to raise aggregate demand.
The consequent increase in aggregate demand will cause the rate of inflation to rise, say to seven per cent. Given the level of money wage rate which was fixed on the basis that the 5 per cent rate of inflation would continue to occur, the higher price level than expected would raise the profits of the firms which will induce the firms to increase their output and employ more labour.
As a result of the increase in aggregate demand resulting in a higher rate of inflation and more output and employment, the economy will move to point A1 on the short- run Phillips curve SPC1 in Figure It may be noted from Figure Thus, this is in conformity with the concept of Phillips curve explained earlier.
However, the advocates of natural rate theory interpret it in a slightly different way. They think that lower rate of unemployment achieved is only a temporary phenomenon. They think when the actual rate of inflation exceeds the one that is expected, unemployment rate will fall below the natural rate only in the short run. In the long run, the natural rate of unemployment will be restored. This brings us to the concept of long-run Phillips curve, which Friedman and other natural rate theorists have put forward.