Trade Offs | How Inflation Affects Unemployment

Inflation and employment are two of the most frequently watched economic indicators. Historically, there has been an inverse relationship between unemployment and inflation. Nevertheless, this relationship is more nuanced than it seems. 

Employers need not assume workers' services by offering them higher wages because there are enough of people available. Stated differently, there is a higher supply of labour than there is demand for it. Wages usually stay the same and there is no wage inflation during periods of high unemployment.

As a result, firms usually have to pay higher wages to recruit workers during periods of low unemployment, which eventually raises wage inflation. Employers have a greater need for workers than there is supply. Employers usually have to pay higher wages to recruit workers in such a competitive labour market, which eventually drives up wage inflation. 

One of the first economists to provide convincing proof of the inverse relationship between wage inflation and unemployment was Alban William Housego Phillips. Over the course of nearly a century (1861–1957), Phillips examined the relationship between unemployment and the rate of change in wages in the United Kingdom. He found that the latter could be explained by both the rate of change in wages and the level of unemployment.

According to Phillips' theory, employers should be able to quickly raise wages when there is a high demand for labour and few unemployed workers; conversely, when there is a low demand for labour and a high unemployment rate, workers are hesitant to accept lower wages than the going rate, which causes wage rates to decline very slowly. The rate of change in unemployment is a second element that influences changes in pay rates. Employers will increase wages to attract more workers if the economy is thriving, indicating that the demand for labour is growing quickly, than they would if the demand for labour were either stagnant or just growing slowly.

Raising wages should result in higher prices, which will ultimately raise the total inflation rate because wages and salaries are significant input expenses for businesses. Therefore, instead of graphing pay inflation, Phillips plotted the link between unemployment and general price inflation. 

According to the Phillips curve, an economy's overall inflation rate should rise as a result of growing salaries driving up the cost of goods and services. Because of the trade-off between unemployment and inflation, economists have used the Phillips curve to adjust fiscal or monetary policy. A Phillips curve for a given economy may balance unemployment and inflation since it would explicitly display the level of inflation for a given unemployment rate and vice versa.

Over time, when workers fully understand the loss of their purchasing power in an inflationary environment, their willingness to supply labour decreases and the unemployment rate rises to the natural rate. In the short term, workers may supply labour as inflation accelerates because they are paid more, which would lower the unemployment rate. Nonetheless, both general price inflation and wage inflation are still increasing. 

Therefore, a reduced unemployment rate would not eventually result from increased inflation helping the economy. At the natural rate of unemployment, the long-run Phillips curve turns into a vertical line because inflation has no long-term effect on the unemployment rate.

The natural rate of unemployment is a dynamic figure that fluctuates over time as a result of several causes. These include the degree of unionisation, the impact of technology, and modifications to the minimum wage. In the short term, the Phillips curve's representation of the inverse relationship between unemployment and inflation is effective, particularly when inflation is relatively stable, as it was in the 1960s. However, when the economy adapts to any rate of inflation, it returns to the natural rate of unemployment, therefore it is not sustainable in the long run. 

Bibliography 

How Inflation and Unemployment Are Related https://search.app/fY6RA79oUezw1QXy6 

Trade off between unemployment and inflation - Economics Help https://search.app/SpF69cA3o7CYsr6q8