Unemployment and inflation are an economy’s two most important macroeconomic issues. The federal government’s fiscal policy and the Federal Reserve’s monetary policy try to maintain both a low unemployment rate around a natural rate and a low inflation rate around 2%.
*Evaluate the historical relationship between unemployment and inflation. (hint: You may start from A.W. Phillips’s finding of the relationship between unemployment and inflation.)
*Distinguish between the short-run and the long-run in a macroeconomic analysis. Why is the relationship between unemployment and inflation different in the short-run and the long-run?
*Assess the recent 20-year U.S. unemployment and inflation data. Do the current U.S. unemployment and inflation data confirm the short-run Phillips curve?
*Analyze why the recent 20-year U.S. unemployment and inflation data approves or disproves the short-run Phillips curve.
*Evaluate whether the Phillips curve can still validly resolve today’s issue of unemployment and inflation and forecast unemployment and inflation. Why or why not?
*Recommend any policy, method, or opinions for the current U.S. unemployment and inflation as a policymaker for either fiscal policy or monetary policy (or both).
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Inflation and Unemployment
When there is an increase in production cost, the high demand for products would increase the level of inflation and, at times, lead to unemployment as the organization seeks ways of reducing expenditure. In other terms, when, in an organization, the labor supply outweighs its demand, inflation is affected. In the economy, inflation and unemployment have maintained a historically inverse relationship, usually characterized by Philip’s Curve. Unemployment gets connected to inflation. Low levels of unemployment lead to a rise in inflation, while high unemployment levels cause low inflation, leading to deflation. The connection between unemployment and inflation is discussed with the terms between the past 20 years mentioned concerning A.W Philip’s curve.
The theory associated with Philip’s curve, first proposed by A.W Philips, an economist, in 1958, sounded predictable and stable. Initially, he tracked the changes between employee wages and the changes in unemployment rates. Then he explored more to figure out how they interacted with the quality of inflation (Conti, 2020). Through the curve (which is an inverted L), Philip established a significant relationship between unemployment and inflation since wages are the highest price component. At first, the curve was beneficial, and it offered potentially economic policy outcomes. With the curve’s use, it can be discovered that lowered employment echelons could decrease inflation. Additionally, the curve can get used to attain full employment through fiscal and monetary policies.
Fig 1.1: the short-run Philip’s curve retrieved from Conti, 2020.
For the economy to grow much better, the market must increase aggregate demand, which means that the organizations must reduce output in the short run. Through the curve, economies can see how inflation is affected by unemployment and steps towards solving the issue (Moloi & Marshall, 2020). The decision made by many policymakers towards economic development always edged towards output, which puts workers at the risk of losing their jobs. It implies mainly to this era where organizations have turned to computers and robotization for a better outcome. The government has tried repeatedly to make up a situation where the economy experiences low unemployment and inflation rates, an impossible situation.
The Role of Monetary policy, a paper written by economist Milton Friedman, claimed that the monetary policy could not lower unemployment through inflation’s plummeting rates. Being a nominal variable, Friedman believed that the economy’s finances did not influence output or employment because they are real variables. Many other scholars have emerged, proving that there are o long-term connections between price increases and joblessness. The long-run curve, contrary to the short-run curve, settles on the natural redundancy rate. It denotes to the economy’s movements in the long run and how it relates to unemployment rates (Moloi, 2020). As it rests in the natural unemployment rate, it maintains a dynamic concept that allows it to change as time ticks on. However, it is not the level of employment that is socially optimal. Economists argue that there are no trade-offs in the long run between unemployment and inflation.
Fig 2.1: The long-run Philip’s Curve (Moloi, 2020)
During the initial half of the 20th century, people believed that unemployment and inflation were economic problems that act independently. The Philips curve changed people’s mindset when he analyzed the relationship between the gradual increase in people’s wages and inflation, just as explained above. It meant that the more something existed, the lesser its counterpart existed and vice versa. He got this after discovering that the more unemployment persisted in a year, the more inflation went down, and vice versa. These findings were later discovered to only work in the short run because there were no apparent trade-offs among job loss and inflation during the long run.
Short-run in macroeconomics
The short-run is an economic period through which money and wages fail to respond to economic condition changes. Additionally, equilibrium is not usually reached in some markets as prices might fail to adjust fast even as changes in an individual’s economic conditions. The main idea here is that the timespan through which an economy reacts to specific stimuli is dependent on how different the behavior of the economy is. Short-run is not a period that is specific but unique to the economic variable.
With this macroeconomic factor, the central concept is that costs are fixed, and the organizations face variable costs that deny wages and salaries the potential to achieve a new equilibrium. The variance amid the short run and the long run is that in the short run, wage agreements, contracts, and leases limit the ability of the firm to regulate wages or output. The limitation prevents organizations from maintaining a profit (Conti, 2020). For example, if a hospital undergoes lower demand in a given year but still keeps its doctors, nurses, technicians, and subordinate staff for the entire year, there is the possibility that the hospital would have to bear a cut in its profit. The difference is that in the long run, there are organizations that manage to either expand or shrink down their operations to fit the budget. These companies carry out these processes without having to change demand. Short-run does not capitalize on-demand changes while maintaining their flexibility.
Examples include the year 2015 which saw many energy and mining giants going into losses due to the fall in coal, iron ore, copper, etc. Organizations such as Glencore lost over 5 billion dollars while Rio Tinto lost over 800 million dollars. However, the organizations still manage to shake themselves back up and soup up new investments, especially those in Brazil and Australia. Such companies were created at a time when prices of commodities were a bit high in the year 2011. To offset costs that are fixed partially, an organization must understand the economies’ behavior so that they can operate without profit throughout the short run.
The Long-run in Microeconomics
When all the factors and costs of production are at their variable, the time is known as the long run. Firms in this situation can alter the prices contrary to the short run where we saw companies only being able to control the prices through controlling the levels of production. If an organization attains market domination while in the short-run, they are likely to develop competition in the long run (Moloi, 2020). Different from the short-run, in the long-run the company may realize that supply and demand are more flexible in reaction to the price levels.
Based on the organization’s expected profits, businesses can exit the market, cut down on production capacity or expand. The levels of production cannot be altered in this scenario if the firm is intent on attaining a demand and supply equilibrium. All the factors such as contractual wage rates, expectations, and the overall price level fully adjust to the economic state which is different from how the short-run works. This factor offers flexibility in that the organization can easily alter the levels of production without losing profits. Such action is done in response to profits and losses experienced in the firm. The impacts of the short run and the long run concerning inflation and unemployment thus are different and depend on the right choices that a company has to make, not forgetting the profit and loss levels.
20-Year U.S Unemployment and Inflation Rates
Available research depicts that the relationship between unemployment and inflation has been considered to be inversely correlated. In the actual sense, the bond is more complex than it appears. As observed using the Philip Curve though unemployment and inflation are related one doesn’t result in the other. The curve suggests that falling unemployment may result in inflation in some instances (Goldberg, 2018). In American history, the inverse relation of unemployment and inflation was hard to grasp during the 70s when stagflation occurred. In this period both unemployment and inflation were on the rise (Donayre & Panovska, (2018). Some researcher believes that the inverse relationship between inflation and unemployment only occurs as a short-term measure. When experiencing inflation as a result of low-income laborers would be compelled to demand more pay or change employers to earn more money. This phenomenon would lead to an overall increase in wages.
In the long-run other elements will influence the nature of inflation. According to the Phillips Curve when the nominal GDP growth is below the unemployment rate there is no correlation. The Federal Reserve holds that the natural unemployment rate lies between 3.5% and 4.5% and if the rate goes up the economy is experiencing inflation (Goldberg, 2018). In essence, unemployment is an indicator of inflation. After the recession, the economy improves progressively and the unemployment rate may reduce gradually worsen. Companies are hesitant to recruit new employees until there is an assurance of a stable market.
20- year US unemployment and inflation data
Based on the Phillips Curve inflation is inversely rated to unemployment, when unemployment levels are high the rate of inflation is low on the other hand when unemployment levels are low high levels of inflation are experienced. In the last 50 years, we have witnessed a decline in the levels of unemployment while inflation has been low. In the last 20 years, the Federal Reserve has played a vital role in reducing the rate of inflation (Albuquerque & Baumann, 2017). Some experts would suggest the efforts by the Federal Reserve have killed the Phillips Curve. In the current market, the relationship between labor market performance and inflation is very minimal.
There has been debate on the validity of the Phillips Curve as a credible indicator of inflation. Several factors are leading to lower inflation rates and a decline in unemployment rates in the American market. One of the key elements for anomalies in the Phillips Curve is the increase in competition in the United States industries. A competitive market ensures that producers do not overcharge on products unlike in less competitive markets. Another factor that has greatly influenced the rate of inflation in the United States is the monetary policy regime that directs the future of inflation, productivity levels, and demographic changes in the labor force.
The relevance of the Phillips Curve in today`s unemployment and inflation forecast
Movement along the Curve when wages increase than the average level for a particular job during economic expansion indicates that government policy can be used to influence employment rates. The government strives to formulate and implement the right policies to attain a long-lasting balance between inflation and employment to foster prosperity. In an attempt to attain the perfect balance between inflation and employment rates the government stimulates the economy to reduce unemployment.
When the government intervenes in the economy in an attempt to reduce inflation and maintain a stable market it results in higher inflation. The government can rely on fiscal policies to guarantee a decrease in the rate of inflation though it leads to an increase in unemployment. In the modern economy, the Phillips Curve only applies for short-term scenarios hence the government can formulate policies that stabilize the economy temporarily (Geerolf, 2019). Most economists agree with the Phillips Curve but are not convinced that the economy can be pegged on constant unemployment rates. Monopolies and unions contradict the theory by Phillips Curve since workers, in this case, are not consulted in decisions about wages.
Recommendations on policies for U.S unemployment and inflation
The government relies on monetary policy to enact its macroeconomic policies and influence the economy. The monetary policy entails the regulation of the supply of money and interest rates by central banks. To boost economic growth the central banks reduce interest rates driving the borrowing rate up and hence increasing the money supply in the economy. When the economy is growing faster than usual the central bank can impose higher interests and regulate the amount of money in circulation. On the other hand, fiscal policy regulates how the central government gathers money through taxes and its expenditure. The government stimulates economic growth by reducing tax rates and increase expenditure to promote development.
In the United States, the Federal Reserve was established to attain maximum employment and ensure price stability. In most countries, central banks operate as independent agencies with minimal government interference. The Federal Reserve can increase the amount of reserve commercial banks are allowed to retain hence limiting their loan capabilities. The government can also sell its bonds in the open market to help reduce money circulating in the economy. To limit the amount of money in circulation introducing higher interest rates will result in higher borrowing costs thereby reducing the demand for loans. When implementing the monetary policy the government should consider other factors that impact the economy. The government should be careful to regulate restrictive fiscal policy to boost economic growth.
Conclusion
In conclusion, after careful and extensive analysis of the factors influencing unemployment and inflation. For economies experiencing a recession, the government is advised to lower interest rates and to sell bonds in exchange for the new currency. For an economy to thrive low levels of inflation are essential for a growing economy to draw investors and increase wages. Inflation is determined as the general increase in price levels of products in an economy. High-interest rates discourage investors and lead to slow economic growth. Low interests can lead to overborrowing speculative inflation where prices of commodities can increase drastically. In retrospect increasing the volume of money in circulation can also lead to inflation. On the bottom line, the government enforces policies like the monetary and fiscal policy to ensure stable economic growth, low rates of unemployment, and low inflation.
References
Albuquerque, B., & Baumann, U. (2017). Will US inflation awake from the dead? The role of slack and non-linearities in the Phillips curve. Journal of Policy Modeling, 39(2), 247-271.
Conti, A. M. (2020). Resurrecting the Phillips Curve in Low-Inflation Times. Economic Modelling.
Donayre, L., & Panovska, I. (2018). US wage growth and nonlinearities: The roles of inflation and unemployment. Economic Modelling, 68, 273-292.
Geerolf, F. (2019, August). The Phillips Curve: A relation between real exchange rate growth and unemployment. In 2018 Meeting Papers (Vol. 1187).
Goldberg, E. (2018). In Search of a Long-Run Phillips Curve in the US. Available at SSRN 3197176.
Moloi, T., & Marwala, T. (2020). The Phillips Curve. In Artificial Intelligence in Economics and Finance Theories (pp. 53-62). Springer, Cham.
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