Rate of Inflation and Level of Unemployment in Focus

Many Economists believe that a nation's rate of inflation is always associated with its level of unemployment. They all endorse the theory of Phillips curve which upholds that there exists a historical inverse correlation and trade-off between the level of job loss and rate of price increase in an economy. Simply put, the theory emphasizes that if unemployment level goes down, the rate of change in wages paid to labor goes high and if that happens, inflation is also affected.

This chain of events however met various doubts and questions from the other group of Economists. They focus on the theory's regularities when a hypothetical explanation is a must, especially on the context of time frame (long-term and short-term). To others, a correlation does exist but only for a short period of time. They believe that a nation only experiences inflation shock and thus the wave of events but things will be normalized after quite some time. According to Philips Curve, when Inflation shocks occur, laborers are "fooled" into uncomplainingly accepting lower wages because they do not see the collapse of real wages right there and then. On the other hand, companies hire these laborers because they see that inflation allows them higher profits for a given minimal wage. However, once workers discover that real wages have fallen, they push for higher compensation. They tend to reject this theory.

This paper aims to analyze the reason behind these conflicting beliefs. Why do others uphold the Philips Curve while others do not? Where is the catch? These questions we'll try to answer as we on the following pages.

A Little Historical Background

In 1958, an economist born in New Zealand, Alban William Phillips wrote and published in the quarterly journal "Economica" a research paper entitled: "The relationship between unemployment and the rate of change of money wages in the United Kingdom 1861-1957". In his writing, Phillips described how he perceived and detected an inverse relationship between monetary compensation changes and unemployment level in the British economy over a sample period. This pattern was similarly found in other nations' economy as well. Because of this observation, in 1960, economists Paul Samuelson and Robert Solow took after Phillips' study and made a definite and clear correlation between inflation and unemployment; that is, when inflation (price increase rate) was high, unemployment was low, and vice-versa.

Researchers believe however that an American economist Irving Fisher first came up with this kind of Phillips curve correlation in the early 1920s. They contend that the difference is that Phillips' original curve focused on describing the behavior of monetary compensations. These researchers then believe that the Phillips curve should have been called the Fisher curve.

This claim however was ignored by many economists and in the years following Phillips' publication of his inflation-unemployment relationship accounts, the same economists working in the advanced industrial nations believed that the Philip's curve results showed that there was an enduring steady and constant relationship between inflation and unemployment. They see however one connotation of this theory in the existing government policy, which is: that governments could control and manipulate unemployment and inflation within a Keynesian (of or relating to John Maynard Keynes or to his economic theories) policy. One situation is that, the government can endure a reasonably high rate of inflation as long as this would lead to a lower unemployment level. This simply means that in so doing, there would be a trade-off between inflation and unemployment. As an example of this, the following circumstance could happen: Financial policy and/or fiscal policy (deficit spending for instance) could be used to kindle and fire-up the economy, which will in turn raise gross domestic product (GDP) and result to a lower unemployment rate. Adhering to the Phillips curve, by leaning towards the left, this would lead to an elevated inflation rate. This is the cost of enjoying lower unemployment levels that the government is more than willing to take.

The aforementioned manipulation could be seen during the early 1960s wherein a leftward progress along the Phillips curve depicted the path of the United States economy. Others speculated that the government did manipulate the inflation rate with the aid of the Philips curve. The government however defended their side by stating that the circumstances are due to the unplanned side-effects of the Vietnam War.

Analysis

During the onset of the early 1970s, many nations experienced sky-scraping levels of both inflation and unemployment, this condition is also known as stagflation. Economists who follow the theories based on the Phillips curve advocated that this could not happen, and thus the curve was attacked and criticized by a group of economists in the leadership of Milton Friedman. This group argued that the self-evident fiasco of the association demanded a restoration of economic theories to its foundation - a non-interventionist, free market policy. Since then, the idea that there exist a simple, expected, conventional, and constant correlation between inflation and unemployment was discarded by most if not all macro-economists.

However, until now, modified structures of the Phillips Curve that take inflationary probabilities into account remain significant and powerful among economic theories and rationalizations. The difference is that, the theory now goes under several distinctive names, having variation in its details. Yet, all these modern Philips curve versions discern between short-run and long-run effects on unemployment. The long-ago "short-run Phillips curve" is now called the "expectations-augmented Phillips curve", because of the fact that it shifts up when inflationary possibilities rise. In the long run, this circumstance entails that fiscal policy cannot influence unemployment, which will then adjust back to its "natural rate", nowadays called as the "NAIRU" or the "long-run Phillips curve". Nevertheless, this long-run "neutrality" of financial policy does tolerate short run fluctuations and the capacity of the financial authority to momentarily decrease joblessness by escalating inflation, and vice versa.

Further analysis of the Phillips curve produced what is now known as the triangle model. In this model, the actual inflation rate is determined by the sum of the following factors:
1. demand pull or short-term Phillips curve inflation,
2. cost push or supply shocks, and
3. built-in inflation

Built-in inflation manifests inflationary possibilities as well as the price/compensation spiral. Fluctuations in the built-in inflation along with supply shocks are the main reasons why the short-run Philips curve shifts, and thus modifying the trade-off. Under this notion, inflationary possibilities is not the only factor that can cause stagflation, it suggests that other factors such as the steep climb of a commodity price could have the same effect.

Adjustments in built-in inflation adhere to the partial-adjustment reasoning behind most theories of the natural rate theory or the long-run Phillips curve; this can be further demonstrated as follows:

1. Depleted unemployment levels promote high inflation rates, as shown on the simple Phillips curve. However, if unemployment levels stay low and inflation rates stay high for a longer period of time, as what was seen in the late 1960s in the United States, both inflationary possibilities and the price/compensation spiral speed up. This situation will then shift the short-run Phillips curve upward and rightward; meaning, more price increase is seen at any given unemployment level.

2. Soaring unemployment levels promote stumpy inflation rates, again as shown on a simple Phillips curve. However, if unemployment levels stay high and inflation rates remain low for a longer period of time, as what was seen in the early 1980s in the United States, both inflationary possibilities and the price/compensations spiral decelerate. This situation now shifts the short-run Phillips curve downward and leftward; which means fewer price increase is seen at each unemployment level.

Between these two adjustment factors lies the NAIRU or the long-run Philips curve. It is in this level that the Phillips curve does not have any natural or intrinsic inclination to shift, making the inflation rate stable and permanent. Nonetheless, there seems to be a scale in the middle of the curve between "high" and "low" where built-in inflation stays constant. The terminating points of this non-accelerating price increase range of unemployment levels vary over time.

Wage and price inflation stability in many nations might lead many economists to conclude that the level of unemployment adequate to sustain a stable rate of inflation has risen stridently. If this is the case however, policies to incite cumulative demand would only reignite price increase. Some situations nevertheless could be interpreted in a dissimilar manner. If a high level of joblessness continues for long intervals, it may stop to put forth downward demands on the rate of inflation. This could only mean that the Phillips curve correlation between the rate of inflation and level of unemployment would break down. The Phillips curve will seem likely to fade away in exactly this fashion in the United States where, prices went down as unemployment skyrocketed and went up when it fell back. The rate of inflation fluctuations did not persist to fall in response to a ten-year high unemployment status, as the Phillips curve would have advocated. This examination also suggests that cumulative demand increase to reduce unemployment would be unsustainable.

Conclusion

Many economists reject the Philips curve theory because it entails that laborers go through "money illusion". The fact however remains, that in a modern industrial economy, laborers do not stumble upon their employers in an atomized and perfect economy. They maneuver in a composite mixture of imperfect markets, monopolies, labor unions, and other institutions. In more than not situations, they may be short of the bargaining power to act on their potentials, even if they are rational or perceptive or even if they are one of those so-called sufferers of "money illusion". This is not because high inflation causes low unemployment or vice-versa. This is because low unemployment level raises employee bargaining power. This power then allows them to successfully press on for higher nominal compensations. In return, to protect earnings, employers raise prices; this low unemployment status then causes inflation.

References

1. The Unemployment Inflation Trade-Off in the Euro Area - http://papers.ssrn.com/sol3/papers.cfm?abstract_id=775364#PaperDownload

2. Controlling Inflation: Applying Rational Expectations to Latin America - http://org.elon.edu/ipe/Hughart3.pdf

3. The Relevance of Keynes Today: with Particular Reference to Unemployment in Rich and Poor Countries1 - http://www.kent.ac.uk/economics/staff/at4/The%20Relevance%20of%20Keynes%20Today.pdf

4. Inflation, Disinflation and the Natural Rate of Unemployment: A Dynamic Framework for Policy Analysis - http://www.rba.gov.au/publicationsandresearch/Conferences/2000/Leeson.pdf