Numerous studies focus on unemployment and inflation to measure the economic performance of an economy. Notably, high unemployment and inflation are attributed to an unstable economy. Furthermore, economists hypothesize that there exists a relationship between the two macroeconomic indicators in the short run. Based on compelling evidence from the Phillips Curve, unemployment and inflation have an inverse relationship in the short term, whereby as one increases, the other decreases, and no link in the long run.
Phillips Curve
The Phillips curve, developed by A.W. Phillips, is an economic model that shows the correlation between inflation and unemployment. The concept is based on theories about economic growth, inflation, and unemployment.
The relationship between inflation and unemployment is that of an inverse correlation in the short run. Notably, an increase in the rate of unemployment leads to a decline in the rate of inflation, with the inverse being true as well, as shown in figure 1 (Ademola and Badiru 48). This phenomenon could be explained from a Classical and Keynesian perspective. From a Classical view, a rise in the supply of money causes the price level of goods to go up as well (Ademola and Badiru 48). As such, a decline in the natural rate of unemployment implies that more people are employed, and the money supply in the economy increases. Consequently, the increase in money supply leads to high levels of inflation, with the inverse being true as well.
As observed in figure 1, the unemployment rate decreases as inflation increases.
The phenomenon can also be viewed from a Keynesian perspective, which establishes a connection between prices and inflation. Notably, it is considered that firms make huge profits by increasing prices (Ademola and Badiru 48). As such, when the rate of unemployment is low, it means that more people are employed in firms, and ventures incur high operational costs to pay wages. Consequently, an increase in the cost of salaries translates to a rise in the prices of goods, which eventually leads to inflation.
On the contrary, there lacks a relationship between inflation and unemployment in the long run. Economists argue that in the long term, the Phillips curve is vertical, implying a lack of correlation between the two macroeconomics, as shown in figure 2 (Ademola and Badiru 48). It could be argued that this is brought about by the fact that in the long term, unemployment is at the equilibrium point; thus, inflation cannot occur.
As shown in figure 2, there lacks a correlation between inflation and unemployment in the long-run.
Furthermore, the Phillips curve establishes a connection between wage inflation and unemployment. According to Arnold, there exists a trade-off between wage inflation and unemployment (334). Notably, as wage inflation increases, unemployment decreases. The phenomenon occurs because, during an economic boom, demand for labor is high, and employers are forced to bid for wages. The discrepancy between demand and supply of labor creates a drastic increase in the rate of wages, as employers strive to attract more laborers.
Despite the theory established in Phillip’s curve being seemingly valid and applicable in real-world economies, the relationship depicted in the curve remains highly criticized by scholars. For example, Milton Friedman criticized the short-term trade-off between inflation and unemployment, arguing that unemployment does not arise from inflation per se, but from unanticipated inflation (Omercevic and Nuroglu 2). As such, the economist believed that an increase in money supply could not be used to stimulate employment, as suggested by the Phillips curve.
Works Cited
Ademola, Abdulsalam, and Badiru, Abdullahi. “The Impact of Unemployment and Inflation on Economic Growth in Nigeria (1981-2014).” International Journal of Business and Economic Sciences Applied Research, vol. 9, no. 1, 2016, pp. 47-55.
Arnold, Roger. Macroeconomics. 9th ed., Cengage Learning, 2008.
Omercevic, Edo, and Nuroglu, Elif. “Phillips and Wage Curves: Empirical Evidence from Bosnia and Herzegovina.” Economics Research International, vol. 2014, no. 436527, 2014, pp. 1-8. http://dx.doi.org/10.1155/2014/436527
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