Unemployment and Inflation

Executive Summary

This report has focused on analysing the relationship between unemployment and rate of inflation within an economy with specific focus on United Kingdom. In theoretical terms, the Phillips Curve explains the link between unemployment and inflation. This curve revealed that unemployment and inflation are negatively related with each other. With little unemployment, there would be little rise in prices. However, the report concludes that this theoretical association is no longer valid in modern economies like that of UK. Through independence of the Bank of England, the economy of UK has been able to tolerate lower inflation with lower unemployment rate.

Acknowledgements

I would like to pay gratitude to the Almighty God whose kindness and guidance has been a source of light for me throughout my academic career.

I would like to thank my teachers and fellows who have helped me to accomplish this project in time.

Contents

Report Body

Introduction

Unemployment and inflation represent important indicators of an economy. One of the vital objectives of the macroeconomic policy of a country is to maintain price stability and also economic growth over the long time period. Unemployment refers to the measure of unemployed people within an economy whereas inflation describes the increase in prices of goods and services in an economy (Scarth, 2011). Both these indicators are very critical for an economy, hence understanding relationship between them is very critical for policy makers.

Theoretical Basis

There has been increasing interest of researchers and practitioners to understand association between inflation and unemployment. In the past, it was believed that a trade-off exists between unemployment and inflation that could be capitalised by policy makers (Vera, 205). Alternatively, lower unemployment was believed to be maintained by tolerating higher inflation. However, this view is no more acceptable. As minimal unemployment has been considered as a policy goal for decision makers, while some economists perceive full employment as the situation in which everyone needs the job. On the other hand, many economists argue that full unemployment is a situation that reflects lowest unemployment rate wit stability in inflation rate, and this situation is often termed as ‘natural unemployment rate’ (Scarth, 2011).

From theoretical viewpoint of Friedman (1968), there is no association between demand and inflation in the long run. However, still there is consensus amongst economists that there exists a connection between inflation and demand. Nevertheless, the economic theory does not clarify the exact period for which the term ‘long run’ is applicable. However, for any moment in time, it is usually assumed that level of demand and rate of inflation have certain connection in the economy. This suggests that higher rate of inflation is characteristic of stronger demand in the economy, and the trade-off between the two is termed as ‘Phillips Curve’ (Ormerod, Rosewell and Phelps, 2013).

In macroeconomics, Phillips (1958) made a great contribution by elaborating the association between rate of inflation and unemployment rate. By analysing economic information of more than hundred years, he concluded that at certain rate of unemployment; usually 6-7%, the increment in wage level is zero making it stable (Alisa, 2015). Below this natural level of unemployment, there is rapid increase in wage rate and vice versa. Figure 1 represents the Phillips Curve describing the relationship between inflation and unemployment:

Figure 1: Phillips Curve

Policy makers started to accept the theoretical proposition that trade-off between inflation and unemployment could be exploited. This proposition was of the thought that a more unemployment would bring a less inflation. From 1960s to 1970s, governments had the policy to set a target inflation rate and then contract or expand economy accordingly to achieve that target rate. This was known as the ‘Stop-Go Policy’ (Huang, 2007). Under this policy, banks take decision to put brake on their operations in case of any problem in the economy. However, this policy was criticised by many economists as this policy would solely depend on fiscal measures. Nevertheless, the relationship between inflation and unemployment was accepted by practitioners at that time.

The Phillips Curve has been confirmed by many empirical studies during 1950s to 1960s. Although during this time period, many countries achieved full employment, the adoption phase of policy identified rise in prices when unemployment was aimed to be reduced and vice versa (Alisa, 2015). Alisa (20150 explained the association between unemployment and inflation through flexibility in labour market. She suggested that full employment in an economy has certain segments with unchanged unemployment and unsatisfied demand. This unsatisfied demand may result in higher costs and rise in wages. In macroeconomic terms, this may lead to higher inflation in market. Another explanation of association between inflation and unemployment is that during economic growth period, manufacturers and employees are more likely in position to increase wages and prices (Alisa, 2015). In situation of high unemployment, workers are forced to accept low wages that may lead to lower prices i.e. low inflation. In the opposite situation of full employment, there would be high wages that will ultimately lead to increase in demand of products. The result of this would be higher prices of goods and services.

Although Phillips Curve has been referred by many economists to explain association between inflation and unemployment, others still argue on its applicability. In the recent past decades, knocking down of Phillips Curve has been largely studied by researchers and practitioners. For instance, Ormerod, Rosewell and Phelps (2013) argue that as per reports of International Monetary Fund (IMF), inflation is less susceptible to business cycles in many countries of the world during 1990s. The instability in association between inflation and unemployment has been described in many aspects. Atkeson and Ohanian (2001), for instance, suggested that during 1970-1999, there was no significant association between the unemployment and inflation in US. However, Roberts (2006) reported halving the slop of Phillips Curve for US during 1960-20002. In the same way, King et al (1995) suggested that introduction of time-variance into the model explains negative association between unemployment and inflation in the US. Barkbu et al (2005) suggested that parameter instability exists in the curve during early 1980s in Germany and they also revealed that instability in Phillips Curve was more evident in Germany than US. In the same way, Iakova (2007) also described the knocking down of Phillips Curve in recent times in UK. In the light of these findings, it is imperative to say that instability exists in slop as well as level of Phillips Curve. Many researchers have explained the influence of monetary tactics on alternations of Phillips Curve. Mishkin (2007), for instance, suggested that credible monetary policy can enable central banks to secure expected inflation rate and also to reduce impact on real economic activity on inflation, thus flattens the Phillips Curve. In the same vein, Benati (2007) confirmed instability in trade-off between inflation and output in many countries including Germany, UK, and US.

Case of UK

When it comes to relationship between inflation and unemployment in UK, it is important to note specific country related indicators. Ormerod, Rosewell and Phelps (2013) demonstrated that country-specific variables and structural changes may play their role in altering relationship between inflation and economic growth. For instance, The Bank of England has played critical role in developing credible monetary policy in UK that decides the association between unemployment and inflation.

Figure 2: UK Inflation and Unemployment; Source, Economics online

Data about inflation and unemployment from Office of National Statistics has been plotted in graph from 1993 to 2016. The result has been shown in Figure 2. This graph reveals that trade-off between inflation and unemployment that was valid in the past is no longer functioning. This is more evident from 2011 because both inflation and unemployment show decreasing trend with no trade-off. This has been attributed to supply-side reforms of economy that aimed on expanding economy of UK without inflation. Besides this, flexibility in labour market and higher immigration of labour has also relieved pressures on labour market along with growth.

Within UK, the independence of the Bank of England has been the major contributor in fading the connection between current and future inflation, and thus reducing economic expectations. However, the notable point is that Phillips Curve has not totally become invalid rather it seems functioning during specific economic periods. For instance, from 2007-2009, the economic data shows rise in unemployment and decline in inflation-a characteristic of Phillips Curve. However, from 2011 onwards, this curve has again become invalid as inflation and unemployment both started to fall.

Although practitioners believed that the independence of the Bank of England played important role in easing economic growth, still it is perceived that the Bank of England is the policy maker behind Phillips Curve (Inman, 2016). McCafferty- the member of Monetary Policy Committee (MPC) reasoned that wages will take off that would ultimately raise prices (Inman, 2016). However, central banks can only bash inflation by increasing interest rates. The argument for this is that low unemployment forces employers to increase wage rate not only to attract more talented people but also to retain them for long time period. Consequently the central bank has to increase interest rate to prevent sudden rise in prices and also to reduce demand. Nonetheless, UK is characterised by low unemployment and little pressure on prices making the Phillips Curve invalid for current economy. This signifies that the Phillips Curve has broken in the current economic situation of United Kingdom.

Conclusions

It has been concluded that inflation and unemployment are important indicators of any economy. The inverse relationship between inflation and unemployment is evident in theory whereas this relationship has become invalid in modern economy. It has been concluded that relationship between inflation and unemployment in the economy of UK has been unidirectional i.e. low unemployment and low inflation.

References

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