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Unemployment and Inflation, The Probable Correlation

How do the unemployment rate and consumer price index relate to one another? An observable inverse correlation between unemployment rates and CPI exists that can be best explained by the fundamentals of supply and demand. As the demand for jobs increases, wage inflation will decrease as employers recognize they do not need to offer high pay to attract employees. The opposite is also true. When the job market strengthens, employers will offer higher salaries to incentivize the limited number of prospective employees to come work for them, therefore increasing wage inflation. Wage inflation relates to inflation in general because as businesses pay more for labor, a major input cost, they consequently drive up prices of goods and services leading to inflation.

In the graph above, when the unemployment rate spikes upwards, the median CPI drops, showing the inverse relationship between the two. CPI is essentially a measure of the changes in price of market baskets, including goods and services, purchased by households. Inflation rates are indirectly reflected through this measurement. What is also important to note is that, over time, the two will normalize as unemployment stabilizes relative to the inflation rates.

A.W. Phillips was an economist who was formative in describing the relationship between wages and inflation. He theorized that a this could be represented in a nonlinear fashion if he were to further research the subject. Data he later compiled from studies in the U.K. confirmed his theory, allowing him to introduce the now-famous "Phillips Curve" in 1958.

U.S. inflation (CPI) and unemployment rates in the 1960s

A line drawn through these points would clearly demonstrate the connection between these two economic factors. In this model, as inflation rates decrease, unemployment rates increase. The concept was not immediately well-received in the economic world, especially by monetarists who claim it is only accurate in the short term. They scite economic events, such as those that occurred in the 1970s, as their main evidence to prove that there is not always solidified, long term trade-off between unemployment and inflation. The Prof: The Phillips curve was the received view in the 1960s, we'll examine some of why that changed later - see what Levinson wrote thereon.
  • Why might it be that, given enough time, the curve would eventually level out?
  • Is it theoretically feasible to control unemployment rates using inflation rates?

Nate Abercrombie and Maddox Wilkinson

Works Cited:

  • https://courses.lumenlearning.com/boundless-economics/chapter/the-relationship-between-inflation-and-unemployment/
  • http://www.investopedia.com/articles/markets/081515/how-inflation-and-unemployment-are-related.asp

30 thoughts on “Unemployment and Inflation, The Probable Correlation

  1. lentza20

    Considering that as inflation rates decrease, unemployment rates increase, it is inevitable that the rates and thus the curve will level out. The less inflation there is, the less businesses have to pay and the less they drive up prices in the market as a whole. With wages and wage inflation leveling out, the demand for jobs will level out in conjunction because there will be no more incentive to leave your job for another one, or to leave the work force. But, if prices in the market are low, businesses must do more sales in order to stay afloat. Because markets trend towards equilibrium and efficiency; so eventually this curve would even out as inflation steadies out so will unemployment. Theoretically at least.

  2. perelk20

    To analyze unemployment rates vs. inflation rates in a more simple manner, when more people have jobs and consequently have more money the purchasing power of that money would consequently decrease. Using that logic, to think that we can then control employment rates using inflation seems a little shaky. The same thing vice versa with controlling inflation using employment rates (that simply is not feasible in our economy). I do agree with Annie that markets tend to come to equilibrium based off of their current state, that inflation and unemployment rates will come to a corresponding middle ground.

  3. yuy20

    I think the Philips' Curve is an interesting trend that can be studied but not used as a concept to rely on. There are numerous factors that influence unemployment and attempting to control it with inflation will go on to affect other areas of the economy, not just unemployment. Also, considering the events in the 1970s, we shouldn't be quick to generalize future events based off of the curve even if it seems that the inflation and unemployment may balance out.

    1. mikesmitka

      There are numerous factors, certainly at the "micro" level. Try to give an example of one that would have the economy-wide impact posited in the Philips Curve. [more later this term...]

      1. yuy20

        I think changes in demand for labor also affects employment, definitely the government can stimulate the economy for a short period but believing that they can sustain this change is flawed. Also, wouldn't organizations such as unions affect the ability of workers outside of their group to also look for employment?

  4. hermana20

    The inverse relationship between inflation and unemployment explains why administrations after the end of the Golden Age in November 1973 (following the enactment of an Oil Embargo by OPEC) and the stagflation of the 1980's, were unable to get both inflation and unemployment down at the same time. Administrations had to choose to either focus on lowering inflation or reducing unemployment, not both. In this sense, a little bit of inflation and unemployment will always exist, and this is not necessarily bad. A low inflation rate is natural, and does not cause retirees too much pain by excessively devaluing their money, and some unemployment can be caused by people looking for new jobs that better suit their talents leading to a more efficient allocation of human capital and labor. One exception to the inverse relationship between unemployment and inflation portrayed in the Phillips Curve would be the Stagflation of the 1980's where inflation and unemployment both continued to rise due to stagnant economic growth. At the annual Jackson Hole Economic Policy Symposium, Janet Yellen (chair of FR) and other economists and financial journalists discuss how to balance the goals of low unemployment and price stability (low yet positive inflation rate) knowing that lowering inflation often increases unemployment and vice versa. In this sense, it is possible to control unemployment with inflation rates, but it is a constant trade-off, and really becomes a question of balance.

  5. johnsonj20

    Since the goal of macroeconomic policy is to keep a low but positive rate of inflation, a competent government will inevitably try to curb increasing unemployment, thereby driving up inflation. It could achieve this either by devaluating its currency through measures such as selling its currency and limiting the ability of foreigners to buy its currency, or by funding job training programs and subsidizing employment. In either case, the government would be attempting to decrease the cost of employing a worker in order to increase the demand for labor. However, I agree that attempting to control unemployment rates through inflation rates is risky because it could have unfavorable economic side effects like deterring investment (due to the perception of an unstable currency).

    1. the prof

      "the goal"? "a" goal? your first sentence is not very clear given the rest of what you write.

      can the US govt devaluate its currency? what would it have to do to make that happen?

  6. Juliana Kerper

    It seems that this model could work realistically in the short run. However, a complete leveling off of the curve would imply a trend with zero inflation and an unfeasibly high unemployment rate. We know it is impossible to have zero inflation. In addition, as was mentioned above, the economic bust that occurred after the Golden Age was a prime example that disproved this model's accuracy in the long run. There have been multiple periods of economic stagflation in our history. In the long run, workers and employers may take inflation into account so that employment contracts have pay sums that anticipate inflation. This could cause unemployment to rise back to its previous level, but with higher inflation rates. In the long-run, there might be no-trade off between inflation and unemployment. Thus, it would not be feasible to try to control unemployment rates with inflation rates to make a permanent change.

    1. mikesmitka

      It is very possible to have deflation, that was a major challenge during the Great Depression but also in Japan during the past 20 years. We even had a brief period coming out of the Great Recession.

  7. williamse19

    hermana20 makes a good point. The proposed relationship between inflation and unemployment explains the ineffective manipulations of interest rates after 1973. Nothing would lower inflation while also lowering unemployment. This presents an interesting question: who does inflation benefit or hurt? In other words, is it actually bad? According to a Forbes article by John T. Harvey, it's uneven. Inflation simply shifts buying power to one group or another. Due to their handling of the supply and price of oil, OPEC caused a slew of prices to rise in 1973. Consider for a moment if OPEC were a domestic entity. CPI would have fallen (the same as inflation rising) and unemployment fallen. However, because the fictitious US OPEC resides in the US, wouldn't it then benefit from the inflation? And what effect would this have on CPI as a total? It is my opinion that during the oil crisis, our purchasing power shifted outside the country when typically we do not see a shift in CPI because it is shifting within our domestic economy in reaction to changes in demand and supply. As inflation relates to employment, in my opinion, changes based on who is in higher demand, who is benefited from changes in CPI.

  8. Mac

    After reading this blog post and the article is it based off of, I think that the Phillip Curve is out of date and not an accurate graph for evaluating an economy. Economies are affected by changes in the inflation rate in the short run, as mentioned in the article, but the economy learns to adapt and handle the new inflation rate. Once the economy has stabilized, the unemployment rate will return to its normal rate that is almost constant until the next shift in the inflation rate. This is my reasoning for the curve to level out. The inflation rate does not have complete control over the unemployment rate of an economy. Various other factors influence it such as technology, labor skills, and GDP. The Phillips Curve might be good to graph to begin with, but it is a graph of facile and rudimentary information.

  9. liur20

    We know that CPI is an important measure of the economy as it measures the inflation rate and is closely related with the consumer choices. It is also easy to see why that the inflation rate and unemployment rate are inverse. This phenomenon is due simply because of the supply and demand. As unemployment rates started to go up, the demand for goods will go down as people do not have enough money to spend on goods. In this way making the inflation rate drop. But the effect of high unemployment rate does not only cause the decrease in demand, it will also cause political instability, given the unemployment rate is high enough. If the unemployment rates reachers till a breaking point where there might be a political instability, the government will step in. And I believe this is the cause of the leveling of the inflation rate. Once the government steps in, it will first provide aids and federal jobs for the unemployment people and this will cause the rate of change in the inflation curve to slow down. And if government provide enough jobs, aids, and stimulus to the economy, the rate of change of inflation in respect with the unemployment rate will tend to go to zero as the demand rates went up. This is why the curve would eventually level out.

  10. gutierrezcuadras20

    The curve would most likely level out because markets tend to reach equilibrium. As unemployment rates increase, there develops a high supply of workers. With so many workers readily available, businesses may decide that they don't need to pay high wages. Saving on wages (a large input cost to production, as mentioned), businesses can then lower prices causing inflation to decrease. The same logic can be said for low supply of workers and the consequential high prices. Eventually, markets will reach a point in which prices will reach a level appropriate to the level of workers available.

    1. hartigank20

      I agree with what Sofia is saying about how markets will tend towards equilibrium. In the 1990s, the US had a booming economy where there was low unemployment and low inflation. This period shows that they aren't always inversely related because there are other factors involved including global competition and a changing workforce.
      Also, when people are unemployed, they will be less likely to spend their money on consumer products because they want to save their money. If they are spending less and saving more, inflation will decrease

      http://www.investopedia.com/articles/markets/081515/how-inflation-and-unemployment-are-related.asp

  11. mikesmitka

    We'll get to this topic later in the term, empirically and theoretically. First though we need our supply-side and our demand-side models.

  12. thaia19

    Perhaps the CPI and unemployment rate would eventually reach equilibrium, and would not longer increase and decrease. However, it is unlikely that such a thing would happen for a long period of time, given that the CPI and unemployment rates have been equal 1985, and quickly moved away from equilibrium.

  13. grims20

    The curve will even out because as inflation continues to decrease, unemployment can only increase to a certain extent because of the underlying fact that companies will always need a certain amount of workers. When the demand for jobs is extremely high, companies will be able to pay workers less and therefore decrease wage inflation and inflation as a whole, but they will still need to hire a certain amount of workers so that their company can run efficiently, and therefore even if inflation continues to fall, unemployment can only rise to a certain level.
    No, I do not think that it is feasibly possible to control unemployment rates using inflation. Inflation is hard to control. Also, the increase and decrease of inflation shown here is a result of the unemployment rates, rather than the unemployment rates being a result of the inflation.

  14. patelp20

    Theoretically, I guess it is possible to control unemployment by manipulating the inflation rate. The problem with this is that it is hard to correctly influence inflation. Inflation isn't something that we can directly control like interest rates. If anything, the way to change inflation rates and consequently unemployment rates is through government policy. However this poses another challenge because many people want to see the government play a small role in the economy.

  15. Lukas Campbell

    It may be possible, to some extent, the CPI and unemployment curves will level out as prices of goods and services start to match with current wages. However, the trend the first graph shows is that since 1985, these rates have achieved near equilibrium, but for only a brief period of time before the CPI dipped and unemployment simultaneously rose. It seems to be that when equilibrium is reached, the demand for goods and services becomes stagnant, thus producers will lower their prices in order to incentivize consumption. This, in turn, allows employers to lower wages in an attempt to match the lowering CPI; the lowering of wages can drive employees to leave their current work to look for better opportunities. When wages across the nation decrease, some of the employees looking for better opportunities cannot find one, and may leave the work force, thus driving up unemployment. The process of returning to equilibrium after this seems to take more time than is spent in equilibrium.

  16. Tommy Mottur

    When describing the relationship between the CPI and the unemployment rate, do we run into the problem of Endogeneity? These two variables both have the potential to influence and simultaneously be influenced by the other one. If unemployment drops, wages will rise and input expenses will rise as a result, driving up prices. However, if prices rise, then consumers will run tighter budgets and the economy will weaken as a result, which will eventually lead to the unemployment rate rising again. Using this correlation as a policy tool would entail manually changing one variable to cause a predictable and beneficial change in the other variable, which would be difficult considering that these variables are co-dependent; purposefully changing one variable would lead to unintended changes to both variables in the long run.

  17. Chris Vogel

    The inverse relationship between CPI and unemployment, essentially shows the relationship between inflation and unemployment. Usually, but not always, inflation can decrease unemployment. But, it is important to note that there are many other side effects that arise with inflation, such as decreased investment, reducing of individual's purchasing power, and issue with lenders. Therefore, I believe that governments would never implement policies that would control unemployment with inflation because there are too many potential issues that could arise. There are better ways to try to control unemployment rate, such as creating policies that incentivize and help people to enter the labor force and help.

    1. the prof

      A final note, some of which is semantics: given our definition of "U" what more could be done? Not having a job is surely an incentive, indeed a very powerful one, and "U" reflects the response to that: hunt for a job! So is there anything left on the incentive front? [phrasing: if someone is "U" they are in the labor force]

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