The Short-Run and Long-Run Relationship Between Unemployment and Inflation

The Short-Run and Long-Run Relationship Between Unemployment and Inflation

While the relationship between unemployment and inflation has traditionally been an inverse correlation, it is more complicated than it appears at first thought and has changed on several occasions over the last 20 years (DiNardo & Moore, 1999). Since unemployment and inflation are the two most closely observed economic indicators, this paper will delve into how they correlate and how they characterize the United States’ economy, both short- and long-term. As unemployment does not lead to inflation at zero frequency of a recursive structure, inflation is ordered first to identify short-term and long-term shock. While the short-term confirms the existence of trade-off induced by transitory stock, in long-term, unemployment, and inflation in the same direction induced by a permanent supply shock.

Historical Relationship

Ideally, the early correlation was proposed by economist A.W. Philips in 1958. In his initial paper, the economist tracked unemployment and wage changes in the United Kingdom between 1861 and 1957 and concluded that there is a stable inverse correlation between unemployment and wages (Ball and Mazumder, 2019). This inverse relationship seemed to hold for the United Kingdom and other industrialized countries. Economists Robert Solow and Paul Samuelson expanded Philips’s work in 1960 to reflect the correlation between unemployment and inflation. They believed that because wages are the main components of prices, instead of wage changes, inflation could inversely be linked to unemployment.

Philips curve theory seemed predictable and stable as data from the 1960s modeled the trade-offs between inflation and unemployment quite well. The curve offered potential economic policy outcomes including monetary and fiscal policies that can be used to attain full employment rate at the expense of higher price levels or lower inflation rate at the expense of lowered employment cost (Ball & Mazumder, 2019). However, when the government attempted to use the curve to regulate inflation and unemployment, the correlation collapsed. From the 1970s onwards, data collected did not match the classical Philips curve trend, and in the subsequent years, both the rate of inflation and the rate of unemployment were more than what Philips curve predicted, a phenomenon referred to as stagflation. Consequently, the use of the Philips curve was proved unstable and thus not usable for policy purposes.

Short Run and Long Run

In the 1960s, the Philips curve was widely accepted because it was viewed to precisely depict the real-word macroeconomics (Russell, 2011). Nonetheless, the stagflation during the 1970s put off any thought that the Philips curve was a predictable and stable policy tool. In the contemporary world, most economics rejects the idea that the Philips curve is a stable policy tool. However, they agree that there are trade-offs between short-run in inflation rates and unemployment levels (Ball & Mazumder, 2019; Leduc & Wilson, 2017). Therefore, given a static aggregate supply curve, increasing aggregate demand will increase the real output. Moreover, an increase in output will decrease unemployment levels. When more individuals are unemployed in an economy, there will be increased spending in the economy, which will lead to demand-pull inflation, rising price levels.

According to Russell, B. (2011), there are two types of equilibriums in macroeconomics, one corresponds to the long run, and the other corresponds to the short run. In microeconomics analysis, the short run is the period in which wages and other prices fail to correspond to changes in economic conditions. In some markets, where there occur changes in economic conditions, prices, including wages, may fail to adjust and maintain equilibrium in those markets (Ball & Mazumder, 2019) quickly. A price that fails to adjust quickly to its equilibrium, thus creating sustained periods of surplus or shortage, is referred to as a sticky price. Prices and wages stickiness prevents the economy from achieving natural unemployment level and its potential output.

On the other hand, the long run is when prices and wages are flexible, which allows employment to move to its natural level and potential output (Ball & Mazumder, 2019). The natural level of employment is achieved when the real wages adjust to the point where the quantity of labor demanded equals the quantity of labor supplied. When the given economy attains its natural level of unemployment, it attains its potential level of output. Therefore, the real GDP ultimately moves to full potential as all prices and wages are believed to be flexible in the long run.

Russell (2011) claims that the inflation rate and the levels of unemployment are different in the short run from long due to the ability of prices to adjust to changes in economic conditions. In the long run, the Philips curve assumes a vertical line, which shows no permanent trade-offs between unemployment and inflation rates. On the other hand, the short-run Philips curve is roughly L-shaped show the initial inverse correlation between two variables. When employment rates increase, there is a decrease in inflation rates, and when employment rates decrease, there is an increase in inflation rates. The short run Philips curve illustrates that there are trade-offs between unemployment and inflation in short terms while the long run Philips curve illustrates that

Assessment of Philips’ Curve in the United States

Short run Philips curve suggests an inverse correlation between the rate of inflation and the level of unemployment (Ball & Mazumder, 2019). There is a trade-off between the level of employment and the rate of inflation. On the other hand, the long run Philips curve suggests there are no trade-offs in the long-term macroeconomics analysis. When inflation increases, the rate of unemployment also increases due to the demand for higher wages. The long run Philips curve depicts a straight line at a natural rate of unemployment. At that point, there is no pressure on the rate of inflation and the level of unemployment. Consequently, when aggregate demand is increased in the long run to decrease unemployment, it will only lead to increased inflation and a higher level of unemployment. Therefore, if the recent twenty years of United States level of employment and the rate of inflation data is accessed, the data shows there is a long run and does not confirm the short run in the Philips curve.

Analysis of Philips’ Curve in the United States

From a microeconomics point of view, the Philips curve was highly applicable in the 1960s. However, stagflation has proved the assumption wrong as it is proved to be unstable and a less useful tool to predict monetary policies (Leduc & Wilson, 2017). The real output increment is caused by an increase in aggregate demand since there is an increase in the levels of unemployment and output. Moreover, Leduc and Wilson (2017) argue that when more individuals get employment, there is no more economical spending. There is no occurrence of demand-pull inflation, which is the inflation caused by high growth in aggregated demand. In turn, this causes the level of wages and other prices to go up. Consequently, it only occurs in the short run, and the recent twenty years of United States data relating to unemployment levels and inflation rate proves it is a recurring issue and cannot apply the concept of the Philips curve for a short-term period.

The validity of Philips Curve in Today’s Issues

Atkeson and Ohanian (2001) claim that the Philips curve cannot be used to solve current issues on inflation and unemployment or be used to forecast the levels of unemployment or inflation. According to Russell (2011), the need to update the short run Philips curve to accommodate the changes in the non-accelerating inflation rate of unemployment poses challenges for anyone who intends to employ the model for forecasting inflation. In light of these challenges, the short run Philips curve is seen as a limited forecasting tool. However, the long run Philips curve can be used in forecasting the direction of change for future inflation instead of forecasting the actual magnitude of future inflation.

The short run in the Philips curve show there is an inverse correlation between the rate of inflation and the levels of unemployment, and thus there is a trade-off between inflation rate and unemployment level in the short run (Ball & Mazumder, 2019). Therefore, there is an increase in the rate of inflation when there is a decrease in unemployment due to the reduction of individuals’ income and increase in individuals’ purchasing power when consumption increases, which forces the aggregate demand to increase, and hence there will be a rise to demand-pull inflation.

Nevertheless, in the long run microeconomics analysis, higher inflation leads to higher unemployment rates. Long run in the Philips curve shows that while there may be a trade-off between inflation rates and unemployment levels in the short run Philips curve, there exist no trade-offs in the long run (Leduc & Wilson, 2017). A straight vertical line represents the long run Philips curve as the natural rate of unemployment. Since there is a very high rate of inflation, employees demand higher wages, thus increasing firms’ costs of production. The firm’s cuts but to employment and hence increasing the rates of unemployment in the long run. In the current state, it is not possible to the rate of natural employment by increasing the aggregate demand in the long run as it will result in higher inflation and thus increase the rate of unemployment.

The probable mechanisms by which American preferences influence the economy is equal to government engagement in social problems, and it is a complex process (Caughey & Warshaw, 2018). Therefore the Philips curve is incapable of adequate and consistent accounting for mood changes in a conservative or liberal government over the last twenty years. In the recent past, more avenues for future exploration have been proposed. Moreover, Caughey and Warshaw (2018) suggest that there is a need for theoretical development. In a point like this when there is a large budget deficit, high growth of national debt, social problems, and their costs which are similarly growing, and a fast-shrinking economy, the need to understand how the economy shapes Americans preferences for the government is more likely to solve economic problems.

Recommendations

According to Nicole et al. (2020), the United States economy has seen the most exceedingly awful downtown budgetary emergency in 2020, with the rate of unemployment flooding over twenty percent due to the coronavirus’s effects. During this period, expansionary fiscal and monetary policies can help the United States recover from this crisis as it was in 2015 when the central bank raised interest rates due to a crisis. As for now, the rate of unemployment in the United States 20%, which is quite high than the employment rate seen before. Economic growth and development are weak, and consumer’s uncertainty is at a raised level.

In light of this situation, the most appropriate in the United States is an expansionary fiscal policy. This fiscal policy includes arrangements for increasing government spending in the economy and increasing social security spending. The motivation behind increased government spending in expansionary fiscal policy is to increase liquid funds on the hands of the household and cushion them from advanced economic turmoil, thus increased the unemployment rate. With reduced economic growth, it is the high time for the federal government to increase government spending and surpluses. Simultaneously, it may bond well with reducing taxes on low paying incomes as it adversely affects consumer spending. Moreover, higher taxes can help in increasing deficit and conceivably reducing government debt.

On the other hand, the central bank can reduce interest rates and the federal fund rates on the monetary strategy front. With the inflation rate reduced and global monetary conditions questionable, the central bank should embrace a pause and watch strategy before any more reduction in interest and federal funds rates. This will be a crucial strategy before further action as a new monetary approach can contrary affect economic growth. Critically, contraction is low, and there should be no worries about an increase in the inflation rate. Therefore, there is a need to build the rates further after the first reduction before observation as the norm can be kept on the financial approach font after expansion arrangements.

Conclusion

Conclusively, the relationship between unemployment levels and inflation rates in the inverse, which graphically shows that the short run Philips curve is L shaped. Philips curve correlates the rate of inflation with the rate of unemployment. Additionally, the Philips curve and aggregate demand share similar components as the rate of inflation and unemployment levels in the Philips curve are also found to the price levels and the real GDP found in aggregate demand. The Philips curve depicts inverse trade-offs between employment levels and inflation rates; if the unemployment levels are high, inflation rates will be below, and if the unemployment levels are low, inflation rates will be high. Moreover, this paper has extensively analyzed the two main types of equilibrium, including the short and long run in microeconomics analysis. The short run is the period in which wages and other prices fail to correspond to the changes in economic conditions, while in the long run, it is the period in which wages and other prices are flexible to the changes in economic conditions.

References

Atkeson, A., & Ohanian, L. E. (2001). Are Phillips curves useful for forecasting inflation?. Federal Reserve bank of Minneapolis quarterly review, 25(1), 2-11.

Ball, L., & Mazumder, S. (2019). A Phillips Curve with Anchored Expectations and Short‐Term Unemployment. Journal of Money, Credit and Banking, 51(1), 111-137.

Caughey, D., & Warshaw, C. (2018). Policy preferences and policy change: Dynamic responsiveness in the American states, 1936–2014.

DiNardo, J., & Moore, M. P. (1999). The Phillips curve is back? Using panel data to analyze the relationship between unemployment and inflation in an open economy (No. w7328). National Bureau of Economic Research.

Leduc, S., & Wilson, D. J. (2017). Has the Wage Phillips Curve Gone Dormant?. FRBSF Economic Letter, 30.

Nicola, M., Alsafi, Z., Sohrabi, C., Kerwan, A., Al-Jabir, A., Iosifidis, C., … & Agha, R. (2020). The socio-economic implications of the Coronavirus and COVID-19 pandemic: A Review. International Journal of Surgery.

Russell, B. (2011). Non-stationary inflation and panel estimates of United States short and long-run Phillips curves. Journal of Macroeconomics, 33(3), 406-419.