Relation between Unemployment and Inflation



Relation between Unemployment and Inflation

Introduction

The relation between inflation and employment had held the attention of different economists in different eras. The economists believed that the substitution function between two variables of the macroeconomics could be exploited in order to improve the economic conditions vice versa. High inflation is attributed to lower unemployment rate but this notion is no longer acceptable in the long run. The lowest level of unemployment is desirable by the economists. Full employment level can be defined as the level when individuals are willing to work while few schools of economics believe that the lowest level of unemployment is full employment level because frictional unemployment remains in the economy as individuals are looking for different jobs at given point in times. This rate is known as NAIRU (Non-Accelerating Inflation Rate of Unemployment) or Natural Rate of Unemployment (Trigari, 2009).

The idea of unemployment rates is useful for the policy makers because it helps them in maintaining the employment rate and inflation alongside. The lowest unemployment will yield high inflation and when inflation reducing measures will be adopted the unemployment level will rise as the budgets will be reduced and economy boosting measures will not be adopted. The outcomes of Expansionary or contractionary fiscal and monetary policy might not be evident for some time, however the core objective is to ensure that the economic objectives are achieved without affecting the employment or inflation. However, it is not realistic and pragmatic approach, due to which the Natural rate of unemployment has been, defined which states that the lowest level of natural unemployment is the rate, which is sustainable (Kitov, 2006).

Literature Review

The economists who wish to bring the unemployment level below the natural rate will also have to counter the accelerating inflation. This happens because the inflation responds to changes in macroeconomic variables, which is also a helpful tool to forecast the economic conditions and help economists take relevant decisions regarding macroeconomic policies. Many economists and policy makers have established the fact that NAIRU is a instrument through which the labor markets can be determined which will be leading to the future prediction of inflation. Data collected from 1997 and 2001 showed that unemployment rate was below five percent and inflation maintained an acceptable level. Economists who are evaluating the NAIRU are also examining that whether inflation had been caused by other economic factors or the natural rate of unemployment has declined over the period (Caporale & Skare, 2011).

Philips Curve

A.W. Phillips an economist belonging to UK in 1958 studied the patterns of inflation and unemployment and then suggested the inflation and unemployment have inverse relation. He determined it from the fact the inverse relationship was existent in wages and rate of unemployment. Phillips compared the rates of wages and unemployment in Britain from the period of 1861 - 1957 and found out that as the labor markets squeezes, the unemployment rate declines and wages increase because the demand for labor increases and on the other ...