The two main goals of economic policymakers are low inflation and low unemployment, however often these goals conflict. For instance, if the policymakers decided to use monetary or fiscal policy to expand aggregate demand then this would move the economy along the short-run aggregate supply curve to a point of higher output and a higher price level. The higher output mean lower unemployment as firms would need more workers when they produce more. On the other hand a higher price level, given the previous year’s price level, means higher inflation. Therefore, when policymakers move the economy up along the short-run aggregate supply curve, they reduce the unemployment rate and raise the inflation rate. Similarly, when policymakers contract aggregate demand and move the economy down the short-run aggregate supply curve, unemployment rises and inflation falls.
The trade off between unemployment and inflation is often referred as the Philips curve. The Philips curve is an inverse relationship between the rate of unemployment and the rate of inflation in an economy. In another word, it is a reflection of the short-run aggregate supply curve so as policymakers move the economy along the short-run aggregate supply curve, unemployment and inflation move in opposite direction. The Phillips curve is a useful way to express aggregate supply because unemployment and inflation are such important measures of economic performance. The Phillips curve in its modern form states that the inflation depends on three forces and they are; expected inflation, the deviation of unemployment from the natural rate also known as cyclical unemployment and supply shocks. These three forces can be express in the follow equation:
π = π e – β(u-u n ) + Ê‹
Inflation = Expected Inflation – (β x cyclical unemployment) + supply shock
Where β is a parameter measuring the response of inflation to cyclical unemployment. There is a minus sign before the cyclical unemployment as high unemployment tends to reduce inflation. The equation above basically summarises the link between unemployment and inflation.
The diagram below is an example of a short-run trade off between unemployment and inflation. When unemployment is at its natural rate, inflation depends on expected inflation and the supply shock. The parameter β determines the slope of the trade-off between unemployment and inflation. In the short-run, for a given level of expected inflation, policymakers can manipulate aggregate demand to choose a combination of inflation and unemployment on this curve which is called the short-run Phillips curve. In the short run, inflation and unemployment are negatively related. In the long-run, the Phillips curve is vertical. This is because when actual inflation equals expected inflation, there is no trade-off between inflation and unemployment. In long-term equilibrium the actual rate of inflation must remain equal to the expected rate.
Long-Run Phillips Curve
Short-Run Phillips Curve
There are two main causes of rising and falling inflation; they are demand-pull inflation and cost-push inflation. Demand-pull inflation occurs when aggregate demand in an economy outpaces aggregate supply. This is when the inflation goes up as a result of real GDP rises and unemployment falls which move the economy along the Philips curve. The demand-pull inflation diagram below illustrates that according to Keynesian theory, firms will employ people and the more people are employed, the higher the aggregate demand will become. Greater aggregate demand will lead to firms employing more people in order to meet the higher output. This is when the unemployment falls and the price increases therefore AD0 shifts to AD1. Cost-push inflation occurs when the price of goods or services increases which doesn’t have and close substitutes for example oil. The cost-pull inflation diagram below illustrates that according to Keynesian theory, many prices are sticky downwards, so instead of price falling there would be a supply shock causing a recession. This is when unemployment rises and GDP falls and therefore SRAS0 shifts to SRAS1.
A good example of link between unemployment and inflation can be seen in the United States. The graph below shows the history of unemployment and inflation in the United States since 1961. The four decades of data illustrates some of the causes of rising or falling inflation. As we can see from the graph, during 1960s policymakers were able to reduce unemployment in the short -run, however this caused the inflation to rise high. This was achieved by cutting tax in 1964, together with expansionary monetary policy which expended the aggregate demand and pushed the unemployment rate below 5%. Moreover, due to government spending as a result of Vietnam War, this expansion of aggregate demand continued in the late 1960s. Consequently, unemployment fell lower and inflation rose higher than intended. In 1970s, policymakers started off with trying to lower the high inflation of 1960s. The government imposed temporary controls on wages and prices and the Federal Reserve engineered a recession through reducing monetary policy but the inflation rate only fell slightly. By 1972, unemployment was same as 1962 however the inflation rate was 3 percent higher. At the start of 1973 policymakers had to deal with the large supply shocks caused by the Organization of Petroleum Exporting Countries (OPEC). During mid-1970s, OPEC raised their oil price pushing the inflation rate up to 10 percent. With the supply shock and temporary tight monetary policy, led to recession in 1975. High unemployment during the recession reduced inflation rate however further OPEC price raise pushed inflation back up again in the late 1970s.
During 1980s there was high inflation and high expectation of inflation. So the Federal Reserve was determined to aim monetary policy at reducing inflation. Consequently, in 1982 and 1983 the unemployment rate reached its highest level in 4 decades. Fall in oil price in 1986 has helped reduce the unemployment rate and lowered the inflation rate down from 10 percent to near 3 percent. By 1987, unemployment reached 6 percent which was close to most estimates of the natural rate. The unemployment rate continued to fall throughout the late 1980s and reached to 5.2 percent in 1986 which led to a new round of demand pull inflation. The 1990s began with a recession as a result of contractionary shocks to aggregate demand. However, unlike the recession in 1982, unemployment in 1990 recession wasn’t far above the natural rate therefore the effect on inflation was small. By the end of 1990s, both unemployment and inflation reached their lowest levels in many years. This could be due to a combination of events which helped keep the inflation in check despite low unemployment. However in 2000, inflation rate started to rise up again. The example of United States macroeconomic history displays the many causes of inflation. The two sides of demand pulled inflation can be seen during the 1960s and 1980s. In the 1960s low unemployment pulled inflation up and in the 1980s high unemployment pulled the inflation down. During 1970s the rise in oil price showed the effects of cost push inflation.