Why does unemployment decrease when inflation increases

The Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve argues that unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases.

The relationship, however, is not linear. Graphically, the short-run Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation rate is on the y-axis. Theoretical Phillips Curve : The Phillips curve shows the inverse trade-off between inflation and unemployment. As one increases, the other must decrease. The early idea for the Phillips curve was proposed in by economist A.

In his original paper, Phillips tracked wage changes and unemployment changes in Great Britain from to , and found that there was a stable, inverse relationship between wages and unemployment. This correlation between wage changes and unemployment seemed to hold for Great Britain and for other industrial countries.

In , economists Paul Samuelson and Robert Solow expanded this work to reflect the relationship between inflation and unemployment. Because wages are the largest components of prices, inflation rather than wage changes could be inversely linked to unemployment. The theory of the Phillips curve seemed stable and predictable. The Phillips curve offered potential economic policy outcomes: fiscal and monetary policy could be used to achieve full employment at the cost of higher price levels, or to lower inflation at the cost of lowered employment.

However, when governments attempted to use the Phillips curve to control unemployment and inflation, the relationship fell apart. They do not form the classic L-shape the short-run Phillips curve would predict. Changes in aggregate demand cause movements along the Phillips curve, all other variables held constant.

The Phillips curve shows the inverse trade-off between rates of inflation and rates of unemployment. If unemployment is high, inflation will be low; if unemployment is low, inflation will be high.

The Phillips curve and aggregate demand share similar components. The Phillips curve is the relationship between inflation, which affects the price level aspect of aggregate demand, and unemployment, which is dependent on the real output portion of aggregate demand. Consequently, it is not far-fetched to say that the Phillips curve and aggregate demand are actually closely related. To see the connection more clearly, consider the example illustrated by.

There is an initial equilibrium price level and real GDP output at point A. Now, imagine there are increases in aggregate demand, causing the curve to shift right to curves AD 2 through AD4. As aggregate demand increases, unemployment decreases as more workers are hired, real GDP output increases, and the price level increases; this situation describes a demand-pull inflation scenario. This translates to corresponding movements along the Phillips curve as inflation increases and unemployment decreases.

As more workers are hired, unemployment decreases. Moreover, the price level increases, leading to increases in inflation. These two factors are captured as equivalent movements along the Phillips curve from points A to D.

At the initial equilibrium point A in the aggregate demand and supply graph, there is a corresponding inflation rate and unemployment rate represented by point A in the Phillips curve graph. For every new equilibrium point points B, C, and D in the aggregate graph, there is a corresponding point in the Phillips curve.

This illustrates an important point: changes in aggregate demand cause movements along the Phillips curve. The long-run Phillips curve is a vertical line at the natural rate of unemployment, so inflation and unemployment are unrelated in the long run. The Phillips curve shows the trade-off between inflation and unemployment, but how accurate is this relationship in the long run?

According to economists, there can be no trade-off between inflation and unemployment in the long run. Decreases in unemployment can lead to increases in inflation, but only in the short run. In the long run, inflation and unemployment are unrelated. Graphically, this means the Phillips curve is vertical at the natural rate of unemployment, or the hypothetical unemployment rate if aggregate production is in the long-run level. Attempts to change unemployment rates only serve to move the economy up and down this vertical line.

The natural rate of unemployment theory, also known as the non-accelerating inflation rate of unemployment NAIRU theory, was developed by economists Milton Friedman and Edmund Phelps. According to NAIRU theory, expansionary economic policies will create only temporary decreases in unemployment as the economy will adjust to the natural rate.

Moreover, when unemployment is below the natural rate, inflation will accelerate. When unemployment is above the natural rate, inflation will decelerate. When the unemployment rate is equal to the natural rate, inflation is stable, or non-accelerating.

To get a better sense of the long-run Phillips curve, consider the example shown in. Assume the economy starts at point A and has an initial rate of unemployment and inflation rate. If the government decides to pursue expansionary economic policies, inflation will increase as aggregate demand shifts to the right. This is shown as a movement along the short-run Phillips curve, to point B, which is an unstable equilibrium. As aggregate demand increases, more workers will be hired by firms in order to produce more output to meet rising demand, and unemployment will decrease.

At point C, the rate of unemployment has increased back to its natural rate, but inflation remains higher than its initial level. NAIRU and Phillips Curve : Although the economy starts with an initially low level of inflation at point A, attempts to decrease the unemployment rate are futile and only increase inflation to point C.

The unemployment rate cannot fall below the natural rate of unemployment, or NAIRU, without increasing inflation in the long run. The reason the short-run Phillips curve shifts is due to the changes in inflation expectations.

Workers, who are assumed to be completely rational and informed, will recognize their nominal wages have not kept pace with inflation increases the movement from A to B , so their real wages have been decreased. As such, in the future, they will renegotiate their nominal wages to reflect the higher expected inflation rate, in order to keep their real wages the same.

As nominal wages increase, production costs for the supplier increase, which diminishes profits. As profits decline, suppliers will decrease output and employ fewer workers the movement from B to C. Consequently, an attempt to decrease unemployment at the cost of higher inflation in the short run led to higher inflation and no change in unemployment in the long run.

According to the theory, the simultaneously high rates of unemployment and inflation could be explained because workers changed their inflation expectations, shifting the short-run Phillips curve, and increasing the prevailing rate of inflation in the economy. At the same time, unemployment rates were not affected, leading to high inflation and high unemployment.

The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run.

However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables. As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases. Short-Run Phillips Curve : The short-run Phillips curve shows that in the short-term there is a tradeoff between inflation and unemployment.

Contrast it with the long-run Phillips curve in red , which shows that over the long term, unemployment rate stays more or less steady regardless of inflation rate.

Consider the example shown in. Nowadays, modern economists reject the idea of a stable Phillips curve, but they agree that there is a trade-off between inflation and unemployment in the short-run.

Given a stationary aggregate supply curve, increases in aggregate demand create increases in real output. As output increases, unemployment decreases. Note that this differs from deflation , when prices actually fall. However, he was uncertain about the consequences on unemployment. Many economists believed that to reduce inflation, there had to be some unemployment. Thus, the sacrifice ratio must be at least 2.

There were many economists, such as Robert Lucas, Thomas Sargent, and Robert Barro, who believed that the sacrifice ratio would not be that high because people had rational expectations, which could be modified by the government so that the short term trade-off between unemployment and inflation reduction would not be as severe. The rational expectations hypothesis simply states that people will use all the information they have, including information about government policies, when forecasting the future.

Households, firms, and other organizations make decisions based on their future expectations of the economy. Consequently, how soon the unemployment rate would return to its natural rate would depend on how quickly people modify their expectations of future inflation. Statistical models that were used to forecast the effects of monetary policy changes also had to be modified, since they relied on historical data that only incorporated how the economy responded to monetary policy changes in the past.

In what became known as the Lucas critique , incorporating historical information about monetary policy changes and their effects was not enough to predict the consequences of changes to present monetary policy.

Econometric models must incorporate changes in the behavior and the expectations of economic agents , i. Consequently, during the s, Lucas applied the rational expectations hypothesis to econometrics , which is the statistical analysis of economic policy, to more accurately predict the response of the economy to changes in monetary policy.

Most economists estimated that the reduction in economic output during this time yielded a sacrifice ratio that was at least 2. Even though unemployment did rise under the central bank's contraction of the money supply, the rational expectations hypothesis still had supporters, both because the unemployment did not rise as high as some have predicted and because the public did not believe that Volcker would be successful in reducing the inflation rate, so their expectations of inflation was not reduced as much as desired.

Hence, many economists concluded that by having a firm policy of containing inflation, the public will have reduced expectations of future inflation, which would allow a more favorable compromise between unemployment and inflation. Inflation and Employment Central banks reduce inflation by reducing aggregate demand, either by reducing the money supply or raising interest rates.

Businesses respond by reducing aggregate supply, which increases unemployment. Phillips noted this inverse relationship between unemployment and inflation: when one is high, the other is low. This inverse relationship, when graphed, came to be known as the Phillips curve. Thus, monetary policies that reduce inflation cause higher unemployment.

The unemployment rate tends to a natural equilibrium, known as the natural rate of unemployment, which includes frictional and structural unemployment, but not cyclical unemployment. Frictional unemployment results from workers losing or quitting their jobs, causing their unemployment until they find the next job.

Structural unemployment results from a mismatch of the skills that workers have and the skills that employers want. A portion of this decrease in the s is likely due to baby boomers becoming more experienced and productive workers. The sharp decrease in the s has been largely explained by an increase in the rate of productivity growth in the economy.

Productivity growth, total output per hour of labor, was about 1. Figure 1. Beginning in , the natural rate began to increase sharply, as shown in Figure 1. The rapid increase in the natural rate after can largely be explained by changes in the makeup of the labor force and changes in government policy. Individuals who are unemployed for longer durations tend to have more difficulty finding new jobs, and after the recession, the long-term unemployed made up a significant portion of the labor force, which increased the natural rate of unemployment.

In addition, some research has suggested the extension of unemployment benefits may also increase the natural rate of unemployment. The rate of inflation is not determined exclusively by the unemployment gap. Two prominent factors that also impact the rate of inflation are 1 expected inflation and 2 supply shocks.

Firms will also incorporate inflation expectations when setting prices to keep the real price of their goods constant. An increase in the expected rate of inflation will be translated into an actual increase in the rate of inflation as wages and prices are set by individuals within the economy. Economic events that impact the supply of goods or services within the economy, known as supply shocks, can also impact the rate of inflation.

The classic example of a supply shock is a reduction in the supply of available oil. As the supply of oil decreases, the price of oil, and any good that uses oil in its production process, increases.

This leads to a spike in the overall price level in the economy, namely, inflation. Policymakers generally focus on negative supply shocks, which reduce the supply of a good or service, but positive supply shocks, which increase the supply of a good or service, can also occur.

Positive supply shocks generally reduce inflation. Events following the recession have again called into question how well economists understand the relationship between the unemployment gap and inflation. As a result of the global financial crisis and the U. The natural rate model suggests that this significant and prolonged unemployment gap should have resulted in decelerating inflation during that period. Figure 2. Inflation and Unemployment Rate Post Note: Inflation as measured by core PCE.

Unemployment rate is not seasonally adjusted. Numerous competing hypotheses exist for why a significant decrease in the inflation rate failed to materialize. The following sections describe the prominent hypotheses and discuss the available evidence for these hypotheses. Over the previous several decades, the U. Economists have suggested that as economies increase their openness to the global economy, global economic forces will begin to play a larger role in domestic inflation dynamics. This suggests that inflation may be determined by labor market slack and the output gap the difference between actual output and potential output on a global level rather than a domestic level.

According to the International Monetary Fund, the average output gap following the recession among all advanced economies was smaller than the output gap in the United States, as shown in Table 1. If increased trade openness has subdued the impact of the domestic output gap on inflation in favor of the global output gap, the smaller output gap among other advanced economies may help to explain the unexpectedly modest decrease in inflation after the recession. Table 1. The empirical evidence surrounding the growing impact of the global output gap on domestic inflation, which focused on the time period before the , is mixed.

A number of researchers have found that the global output gap has some impact on domestic inflation dynamics; 27 however, others have found no relationship between the global output gap and domestic inflation.

Researchers who contend that the global output gap is influential with respect to domestic inflation have then attempted to determine if the strength of this influence has grown alongside increases in trade openness. When the global output gap influences domestic inflation, however, the strength of this impact seems to be unrelated to changes in trade openness. Alternative explanations for the lack of deflation after the recession cite the global financial crisis and decreased access to external financing for businesses.

Typically, during a recession, as demand for goods and services decreases, the price of those goods and services also tends to decrease. However, some economists have argued that the financial crisis decreased the supply of external financing i. In the face of increased borrowing costs, some businesses, especially liquidity constrained businesses with so-called sticky customer bases, 30 would have opted to raise prices to remain solvent until the costs of borrowing decreased as the financial sector recovered.

Limited empirical work has found evidence of this behavior by businesses during the recession, and therefore may help to explain the unexpectedly modest decrease in inflation following the recession. Changes in how individuals form inflation expectations, as a result of broad changes in how the Federal Reserve conducts monetary policy, may also help to explain the unexpectedly moderate decrease in the rate of inflation after the recession.

After the high inflation of the late s and s, the Federal Reserve became more concerned with maintaining a stable rate of inflation in the face of economic shocks. Under the previous policy regime, an economic shock that raised inflation would also increase inflation expectations, which would further increase inflation. As seen in Figure 3 , before the s, the fluctuations in inflation were more volatile, with a spread of multiple percentage points from year to year. However, under the new policy regime, economic actors were less likely to shift inflation expectations as a result of an economic shock because they believed the Federal Reserve would stabilize any changes in inflation due to economic shocks.

The decreased volatility can be seen in Figure 3 as the spread seen in core inflation decreases significantly after the early s. Figure 3. Headline and Core Inflation. Core inflation excludes energy and food prices from the measure of inflation. Beginning in the s, the Federal Reserve appeared to make another change in how it was conducting monetary policy.

Not only was the Federal Reserve working to stabilize changes in inflation that resulted from economic shocks, but it appeared to be targeting a specific inflation rate of 2. A number of researchers have found that inflation expectations have indeed become anchored around the Federal Reserve's inflation target, and that the strength of this anchoring effect has increased since the s.

As discussed earlier, actual inflation is heavily influenced by inflation expectations. As inflation expectations become anchored at a specific rate, these expectations place pressure on actual inflation to remain at that specific rate, acting as a positive feedback loop, which pushes actual inflation back to the inflation anchor after any shock pushes actual inflation away from the anchored rate. The increased level of inflation anchoring helps to explain the lack of deflationary pressure after the recession.

An increase in the degree to which inflation becomes anchored may have important implications for future policymaking. As expected inflation becomes more anchored, policymakers may be able to use monetary and fiscal policy more generously without impacting the actual inflation rate.

However, if individuals begin to lose confidence in the Federal Reserve's ability to maintain their target inflation rate because the Federal Reserve pursues policies incompatible with price stability, inflation expectations can become unanchored resulting in a more volatile inflation rate as a result of shifting inflation expectations.

The global financial crisis and subsequent recession in the United States was unique in many ways, including the outsized increase in the proportion of individuals who were unemployed for longer than 26 weeks. The sharp rise of the long-term unemployed has been offered as another potential explanation for the missing deflation after the recession. Figure 4. Long-Term Unemployment Rate. Note: Individuals with unemployment duration longer than 26 weeks are considered long-term unemployed.

Long-term unemployment rate is the number of long-term unemployed as a percentage of total unemployed. Some economists argue that inflation dynamics are driven specifically by the short-term unemployment rate, rather than the total unemployment rate which includes short-term and long-term unemployment.

Employers tend to avoid hiring the long-term unemployed for a number of reasons, as discussed in the " Time Varying Natural Rate of Unemployment " section. Because the long-term unemployed are essentially removed from the labor pool, from the perspective of employers, the numbers of long-term unemployed individuals have very little impact on wage-setting decisions compared with the short-term unemployed.

As a result, the long-term unemployed impact inflation to a lesser degree than the short-term unemployed. Figure 5. Unemployment Rate by Duration. Source: John E. The total unemployment rate remained elevated above estimates of the NAIRU for about seven and a half years following the recession, but this was largely due to the unprecedented increase in the level of long-term unemployed.

The short-term unemployment rate spiked, but fell to pre-recession levels relatively quickly after the end of the recession compared with long-term unemployment, as shown in Figure 5. Compared with the persistent unemployment gap for total unemployment after the recession, the unemployment gap for the short-term unemployed dissipated much faster and therefore would have resulted in a more moderate decrease in the inflation rate.

Using the short-term unemployment gap rather than the total unemployment gap to forecast inflation following the recession, recent research has produced significantly more accurate inflation forecasts and has accounted for much of the missing deflation forecasted by others. Results of this research suggest that when considering the effects of monetary or fiscal policy on inflation, policymakers would benefit from using a measure of the unemployment gap that weights the unemployment rate for the short-term unemployed more heavily than the long-term unemployed.

Still others have suggested that the failure of natural rate model to accurately estimate inflation following the financial crisis is evidence that the natural rate model may be incorrect or inadequate for forecasting inflation.

The unemployment gap is used as a measure of overall economic slack to help explain changes in inflation; however, it may not be the best measure currently. One recent article has suggested that an alternative measure of economic slack based on recent minimum unemployment rates may offer an improved measure for forecasting inflation. The new measure consists of the difference between the current unemployment rate and the minimum unemployment rate seen over the current and previous 11 quarters.

As the current unemployment rate rises above the minimum unemployment seen in previous quarters, inflation tends to decrease, and vice versa. This relationship appears to be relatively stable over time and, more importantly, improves on some other inflation forecasts for periods during and shortly after the recession.

After the recession, actual unemployment rose above CBO's estimated natural rate of unemployment for 31 consecutive quarters. Average core inflation declined, as predicted, but only modestly, from about 2. In response, researchers began investigating potential reasons for the unexpectedly mild decrease in inflation.

A number of explanations have been offered to explain the missing deflation, ranging from increased financing costs due to crippled financial markets following the global financial crisis, to changes in the formation of inflation expectations since the s, to the unprecedented level of long-term unemployment that resulted from the recession.

Researchers have found a degree of empirical evidence to support all of these claims, suggesting it may have been a confluence of factors that resulted in the unexpectedly modest inflation after the recession. The natural rate model has implications for the design and implementation of economic policy, specifically limitations to fiscal and monetary policies and alternative policies to affect economic growth without potentially accelerating inflation.