Inflation and unemployment historically have an inverse relationship. This means that when the inflation rate is high, the unemployment rate is low. In other words, if more individuals who are part of the total labor have jobs, the prices of goods and services tend to be high. However, it is also important to note that this is not always the case.
Explaining the Inverse Relationship Between Inflation and Unemployment: The Philips Curve
New Zealand economist William Philips hypothesized the correlation between a reduction in unemployment and an increase in the rate of wages. His original assumption did not state the relationship between inflation and unemployment.
However, over time, his hypothesis called the Philips Curve has been used as an economic model to illustrate the inverse relationship between the two. This model fundamentally illustrates the short-run tradeoff that exists when the employment rate is high.
Economists have explained that when more people are working, the collective consumers have more money to spend. Demand for goods and services such as basic commodities and utilities increases. A high employment rate essentially results in higher spending.
Higher demand results in supply shortages because there is a limit on how much output firms can produce and provide. Inflation occurs because more people with spending power are chasing the same goods and services resulting in high prices.
On the other hand, a higher unemployment rate results in lower inflation because the collective consumers have less money to spend or, in other words, the demand for goods and services decreases because few people have the means to spend.
The aforesaid inverse relationship between inflation and unemployment might compel others to think which between the two is important. Note that lowering the unemployment rate or increasing the number of people employed is more important.
As long as people have jobs or as long as more people earn money, they have a chance to keep up with inflation. Strategies that focus solely on lowering the inflation rate fundamentally exclude unemployed individuals from the picture.
Issues and Limitations of the Philips Curve: Inflation Can Also Result in High Unemployment Rate
Remember that the Philips Curve illustrates the short-term inverse relationship between inflation and unemployment. Economists such as Milton Friedman predicted the collapse of this model in the 1973-1975 Recession in the Western world.
The inverse relationship explained above has been observed in economies that naturally follow the business cycle that starts from economic expansion and ends with economic recession and trough stages before restarting with economic recovery.
However, there are different scenarios in which inflation can cause unemployment. The oil shock of the 1970s saw inflation rising, specifically as the prices of oil and gas in the global market soared, thus affecting other commodities and end-use goods and services.
Unemployment also increased. Several firms cut down their production capacities and operations to alleviate the rising cost of production inputs. These measures involved reducing the size of their respective workforces, thus increasing the unemployment rate.
It is also important to note that inflation also creates uncertainty and negative sentiments among investors. Some investors are not willing to invest because doing so seemed unprofitable. Poor levels of investment dampen firm activity and economic growth.
Economists and regulators have also noted the inflationary boons signal that an economy is overheating or growing at a rate faster than the long-term trend. The business cycle illustrates that recession often occurs after an economy reaches its maximum growth potential.