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Unemployment and Inflation – The Philip Curve

The relationship between unemployment and inflation, which is known as Philip Curve, has its critical value in the macroeconomic policies of the country. In this article we are going to discuss this relationship in detail.

Mathematical Derivation

The typical Phillips curve tale begins with a wage Phillips curve, as Phillips himself explains it. The rate of increase in money wages is represented (gW). Operator g here and below is the “the percentage rate of growth of” of the following vector.

gW=gWT-f(U)

This narrative was updated during the 1970s when employees struggled to keep up with inflation (as late Abba Lerner indicated in the 1940s). The equation has modified since the 1970s to incorporate the function of inflationary expectations (or the expected inflation rate, gPex). This results in the Phillips curve, which increases expectations.

gW=gWT-f(U)+ʎ.gPex

Furthermore, the f(U) concept was adjusted to incorporate the notion that the unemployment rate (NAIRU, Non-accelerating inflation rate of unemployment) is non-accelerating, and what is often referred to as the “usual” job or the inflation rate of unemployment.

gW = gWT − f(U − U*) + λ·gPex.           [1]

The NAIRU is U* here. Inflation continues to ramp up, as discussed, if U<U*. Inflation often appears to be sluggish when U > U* is present. F (0) is expected to be 0, and if U = U*, f will be omitted from the equation.

The function of gWT and gPex seems to be obsolete in equation [1] and occupies the same function. Even then, it can be seen that they are not provided that − is equivalent to unity. If the pattern of money wage growth is zero, then where U is equal to U*, gW is equivalent to inflation predicted. In other words, the actual incomes predicted are constant.

Alternatively, the trend rate of monetary growth is comparable to the rate of real labour productivity growth trend (Z). It is what is happening:

gWT = gZT.                           [2]

Assuming [2] that while U is equivalent to U* and T to unity, actual wages will rise with output per worker. This will be in line with an economy where actual incomes are improved as labor productivity rises. True wage patterns can be clarified by contrast to certain other constructs in the model, as distinctive from worker productivity patterns.

The traditional presumption is the abstractly tough competition, with most firms possessing a certain price-setting ability. Thus the analysis implies that, in a common and simplest usage rate (i.e. usage of plants and facilities at 90 percent), the organization sets a selling price (P) as a mark-up (M). Then applies the unit cost of the commodity.

Together all assumptions suggest that only one theoretical unemployment rate occurs in the long term, U* at any given moment. This is why some people call this rate of unemployment “rational.”

History of Philip Curve

The earliest concept regarding the Phillips curve was suggested by economist A.W. in 1958.   In the initial article, Phillips recorded the increases in incomes and unemployment in Britain from 1861 to 1957 and concluded that it compares an inflation rate to the unemployment rate. Claiming that inflation and unemployment appear to have an inverse relationship: when the rate of unemployment falls, inflation rises. However, because of stagflation in the 1970s where both inflation and unemployment were high, the initial term was somewhat empirically contested. The Philips Curve is primarily blamed for the negative correlation between inflation and unemployment. This commercialization, a condition in which the rate of unemployment advances to the balance contributing to NAIRU (Non-accelerating inflation rate of unemployment), persists on the whole (Friedman 1968; Phelps 1968).

Increase in Unemployment and Inflation

When unemployment and inflation both increase at the same time in the economy it is termed as stagflation which presents a dilemma for economic policies but the actions that are intended to lower inflation may exacerbate unemployment. Stagflation results when the economy faces supply shock. Unfavorable conditions if the prices increase and at the same time economic growth slows down by more production cost or less profit. It also occurs in some of the policies made by the government. It was prevalent among the seven major market economies from 1973 to 1982.

Unemployment and Inflation – Short Run Philip Curve

The rate of unemployment isn’t a statistical number but varies considerably due to the impact of a multitude of elements. It includes the effects of technology, which tends to increase wage levels as well as the level of union power.

Adding it all up, the correlation between unemployment and inflation in a prior manner may be inferred. If we want to focus on the economic state of every nation, we need to pay attention ahead to the rate of inflation of the economy as well as the imminent degree of unemployment in that country. As long the economic growth of every country is concerned, as the rate of unemployment in the economy is likely to be low, there will be a growing economic situation in the country. As a result, we may assume that inflation and unemployment are linked and that association is being investigated by the Phillips curve that can be considered among one of the main accomplishments throughout the microeconomic market.

For instance, considering the example, if the unemployment rate is 6%, the resulting inflation rate is 2%. With unemployment dropping to 3%, the inflation rate is rising to 3%. On the other hand, as unemployment rises to 6%, the inflation rate decreases to 2%.

Does Inflation cause Unemployment?

There are indeed a few specific circumstances in which inflation will lead to unemployment. Although, there is no direct connection. We might also see an exchange between inflation and unemployment – e.g. in a time of high economic growth and declining unemployment; inflation is increasing.

It is, therefore, crucial to remember (particularly in the modern global environment) that if the financial sector has deflation or very moderate inflation and the financial institutions seek a moderate rate of inflation, this may significantly boost development and reduce unemployment.

Inflation will cause unemployment unless:

1. The volatility of inflation results in reduced investment and lower economic development in the long run.
2. Paving the way for inflationary growth is unsustainable, contributing to a boost and a downturn economic cycle.
3. Light inflation results in a decrease in productivity and lower capital inflows, leading to unemployment throughout the export market (significantly in a fixed exchange rate).

Does lower Inflation lead to Unemployment?

Low inflation generally has several advantages that tend to boost business growth, including higher investment. Nevertheless, in certain cases holding inflation down might be unfit for the economy. If the country is facing a currency crisis then holding the low inflation in the economy leads to a higher unemployment rate and lower economic growth, which is not in favor of any country. Thus, the government should instead strive for low inflation; instead, have a high level of flexibility if it tends to be insufficient for the present economic situation.

Macroeconomics perspective of Unemployment and Inflation

In some periods of 1990, the unemployment rate reduces and Inflation also remains low which shows that it is possible to decrease unemployment without increasing inflation. It depends on Monetary Policies, if they are done well, they can avoid the boom and bust of economic cycles and also enables sustainable low inflationary growth and help to reduce unemployment. In the long-term high Inflation rate could be non-beneficial to the economy through a low rate of unemployment. By some tokens, low inflation could not inflict a cost on an economy through a high rate of unemployment. But, in long term, inflation has no impact on the unemployment rate.

Limitations of the Philips Curve

The Phillips curve, the relationship between unemployment and inflation, limitations or hindrances typically involve:

1. The correlation among both incomes and prices is bidirectional. The salaries are among the main components of the company’s cost of output that affects consumer prices. Yet price affects the standard of living around that relatively similar period and even the incomes. Phillips curve takes the salaries’ sole influence on markets into account as well as eliminates the income market effects. The rise in inflation results in higher housing costs which then contribute to higher incomes which becomes a restriction.
2. The framework of the Phillips curve suggests that inflation is the internal labor force dilemma of the world, assuming that inflation throughout the current day modern period is connected not just to the country but to a foreign trend, this is not only a nationwide issue.
3. It has been shown that the Philips curve’s effects are only applicable in the short term when stagflation happened during the 19th century since it does not explain that when stagflation happens in the market, namely when both unemployment and inflation are particularly worrisome. Thus, the Phillips curve does not hold in the condition of stagflation evaluation.

Conclusion

William Phillips’s Phillips curve explains that unemployment and inflation are steady and the reverse, meaning that the higher the economic inflation rate, the lower the unemployment rate and vice versa. The Phillips curve hypothesis argues inflation is driving economic growth, which in turn could increase more jobs and decrease unemployment. Inflation also increases with the reliance on declining unemployment.

However, when stagflation took place in the 1970s, the original William Phillips definition was somehow incorrect. The inflation rate and unemployment were also high at the time of stagflation. The Phillips curve thus has short-term effects.