UNIT 6 INFLATION AND UNEMPLOYMENT 

Structure
6.0 Objectives
6.1 Introduction
6.2 Types of Unemployment
6.3 Phillips Curve
6.4 Natural Rate of Unemployment
6.5 Expectation-Augmented Phillips Curve
6.5.1 Phillips Curve under Adaptive Expectations
6.5.2 Phillips Curve under Rational Expectations
6.6 Let Us Sum Up
6.7 Answers/ Hints to Check Your Progress Exercises

6.0 OBJECTIVES
After going through this unit you should be able to
 identify various types of unemployment;
 explain the concept of natural rate of unemployment;
 establish a relationship between unemployment and inflation;
 explain how the short-run Phillips curve shifts; and
 reconcile the difference in shape of the Phillips curve in short-run and long-
run.

6.1 INTRODUCTION
In Units 7 and 8 of BECC 103 we gave some preliminary ideas of inflation – its
definition, causes and effects. In this Unit we describe the relationship between
inflation and unemployment. In the process, we discuss various types of
unemployment and its measurement. Recall that classical economists believed in
dichotomy of real and monetary variables. Thus, inflation being a monetary
variable should not have any effect on a real variable such as unemployment.
Keynesian economists, however, believed that change in monetary variables
could affect real variables.
Inflation, as you know, is defined as a persistent rise or, a tendency towards
persistent rise in the general level of prices. As and when there will be


Prof. Kaustuva Barik, Indira Gandhi National Open University, New Delhi and Dr. Tarun
Manjhi, Sri Ram College of Commerce, University of Delhi.
Expectations, Inflation increase in the general price level, purchasing power of households decline.
and Unemployment
Increase in inflation is likely to reduce the value of national currency and it’s vice
versa. Although there are many types of inflation, it can be mainly classified into
three types of inflation- demand pull (caused by increase in demand), cost push
(cause by increase in cost of production) and built-in inflation (mainly caused by
past events). The rate of inflation could vary from a low level to a very high
level. As of 2021, Venezuela for example has an inflation rate of nearly 10,000
per cent per year.
Unemployment is a state in which healthy person fails to get employment at
prevailing wage. It is caused by various factors that are concerned with demand
and supply. There are broadly six types of unemployment- structural (arises due
to change in structure of economy, frictional (arises due to time gap between
changing jobs), cyclical (arises due to change in cycle of economy i.e. boom,
recession, etc.), seasonal (arises due to change in season), disguised
unemployment (it is also called hidden unemployment where marginal product of
labour is very much close to zero) and under employment in which better
qualified person end with low quality, low paid jobs because of excess supply of
labour and lower availability of job opportunity.

6.2 TYPES OF UNEMPLOYMENT

‘Labour force’ as a concept includes all persons in the age group of 16 years to
64 years who are willing to work. Thus it includes both employed and
unemployed persons. The persons not included in the labour force include those
who are retired, too ill to work, keeping the house, or simply not looking for
work.
‘Work force’ as a concept is somewhat narrower – it includes the employed
persons only. Thus the difference between the labour force and the work force
gives us the number of unemployed.
By employed persons we mean those who perform any paid work (thus
homemakers are not included) and those who have jobs. On the other hand, the
unemployed as a category includes people who are not employed but are actively
looking for work. While considering unemployment we do not take into account
those who are not in the labour force. We define unemployment rate as the
number of unemployed divided by the total labour force. You should remember
that the concept of unemployment implies ‘involuntary unemployment’. This
concept implies that a person is willing to work at the prevailing wage rate, but
cannot find work.

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There are three types of unemployment, viz., frictional, structural and cyclical. Inflation and
Unemployment
We explain the differences below.
(i) Frictional unemployment: It takes place because people switch over from one
job to another. In many cases the tenure of job gets over and workers remain
unemployed till they get another job. In other cases workers migrate from one
region to another in search of better jobs or opt to remain out of job for short time
periods. Frictional unemployment takes place because in an economy with
imperfect information, job search and matching is not smooth and there are
frictions in the economy.
(ii) Structural unemployment: It results from the mismatch between supply and
demand for different kinds of jobs. For example, in recent years, the number of
engineers and management professionals looking for jobs in India has been much
higher than available jobs. This has resulted in a number of persons with
technical qualification opting for low qualification jobs. Structural
unemployment takes place largely due to structural shifts in an economy and
adjustments to such shifts take time. A large number of educational institutions in
India have discontinued their engineering education programmes.
(iii) Cyclical unemployment: It arises due to fluctuations in aggregate demand,
which is a part of business cycles. When aggregate demand declines, there is
simultaneous decline in the demand for labour and consequent increase in
unemployment. On the other hand, a general boom in the economy increases the
demand for labour and unemployment decreases. Thus cyclical unemployment is
pro-cyclical in nature.
Empirical data shows that the labour force in an economy is much less than the
total population. Total labour force in India, according to certain sources, is about
50 crores compared to an estimated population of 138 crores in 2020. Persons
above 65 years and children below 15 years of age however should not be taken
into consideration while comparing the size of the labour force to total
population. A relevant ratio in this context is the ‘Labour Force Participation
Rate (LFPR)’. It is defined as follows:
Size of the labour force
LFPR =
Size of population in the age group of 16 − 64 years
The labour force participation rate (LFPR) varies across countries, and over time
for the same country. If we take gender into account, there could be male labour
force participation rate and female labour force participation rate. Usually, there
is a gap between male LFPR and female LFPR. In India, for example, female
LFPR is much lower compared to male LFPR. Further, there is a sharp decline in
female LFPR in recent years. Such a decline could be due to cultural and
structural issues.
The rate of unemployment u is defined as the ratio of unemployed persons to
total labour force. The rate of unemployment varies across countries and for a
country over time.
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Expectations, Inflation
and Unemployment
6.3 PHILLIPS CURVE
The Phillips curve, named after A W Phillips, describes the relationship between
unemployment and inflation. In 1958 Phillips, then professor at London School
of Economics, took time series data on the rate of unemployment and the rate of
increase in nominal wage rate for the United Kingdom for the period 1861-1957
and attempted to establish a relationship. He took a simple linear equation of the
following form:
𝑤̇ = 𝑎 − 𝑏𝑢
where 𝑤̇ is the rate of wage increase, a and b are constants and u is the rate of
unemployment. Phillips found that there exists a stable and inverse relationship
between 𝑤̇ and u, with the implication that lower rate of unemployment is
associated with higher rate of wage increase.
Subsequent to the publication of the results by Phillips, many economists
followed suit and attempted similar exercises for other countries. Subsequently, it
was established that there is a stable relationship between rising wage rate and
rising price level. This led some economists to refine the simple equation
estimated by Phillips and use of inflation (the rate of increase in prices) instead of
wage rate increase. In many cases the scatter of plot of variables appeared to be a
curve, convex to origin. As empirical studies reinforced the inverse relationship
between the rate of inflation and the rate of unemployment the Phillips curve
soon became an important tool of policy analysis.
The policy implication of such a result was astounding – an economy cannot
have both low inflation and low unemployment simultaneously. In order to
contain unemployment an economy has to tolerate a higher rate of wage increase
and vice versa. Thus the Phillips curve justifies the discretionary stabilization
policy of a government.
In Fig. 6.1 we depict a typical Phillips curve. Suppose the economy is operating
at point A with inflation rate of 𝜋 and unemployment rate of u1. If the
government wants to reduce the rate of inflation to u2, the economy has to
tolerate a higher rate of inflation (𝜋 ).

Inflation rate

B
𝜋

𝜋 A

u2 u1 Unemployment rate

Fig. 6.1: Phillips Curve

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During the 1960s and early 1970s the Phillips curve was considered to be an Inflation and
Unemployment
important tool of policy analysis. The prescription was simple and straight
forward: During periods of high unemployment the government could follow an
expansionary monetary policy which leaves more money in the hands of people.
Such a policy may accelerate the rate of inflation while lowering unemployment.
Conversely, during periods of high inflation the government could follow a
contractionary economic policy so as to reduce inflation rate; the cost of such a
policy however was supposed to be higher rate of unemployment. Thus,
economists believed that there was a trade-off between inflation and
unemployment. The government could choose any combination of inflation rate
and unemployment rate depending upon the slope and position of the Phillips
curve.
During the late 1970s and early 1980s, however, such a belief got shattered. The
prescriptions of the Phillips curve did not work at all. Economies suffered from
both high inflation and high unemployment. As unemployment increased, there
was a lower level of output implying stagnation in economic growth. When
governments tried to follow Keynesian policy prescription of higher government
expenditure so as to increase aggregate demand, the rate of inflation accelerated.
Thus, what most countries experienced was ‘stagflation’ – a combination of
stagnation and inflation. The reason for stagflation was found to be supply shocks
due the ‘oil crisis’ of 1973 and 1979 (refer to Unit 6). Stagflation prompted
economists to explore further into the reasons for stagflation.
Check Your Progress 1
1. Write a brief note on the various types of unemployment.
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2. Explain how the Phillips curve could offer policy options before the
government.
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Expectations, Inflation 3. Define the following concepts:
and Unemployment
a) Involuntary Unemployment
b) Natural Rate of Unemployment
c) Labour Force Participation Rate
d) Inflation-Unemployment Trade-Off
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6.4 NATURAL RATE OF UNEMPLOYMENT

You might have come across the term full employment, which implies that all
workers in the economy are employed. Have you ever thought of such a
situation? Can it be attained? When we say that an economy is operating at ‘full
employment’ level, we do not mean that there is zero unemployment. Because of
imperfections in markets, rigidities in wages and prices, and various frictions in
the economy it is not possible to obtain zero unemployment.
For example, at any point of time, some workers are in the transition process
from one job to another (frictional unemployment). Similarly, a fraction of
workers cannot be employed because of mismatch between the skill they possess
and the skill required (structural unemployment).
In view of the above, a new concept termed ‘natural rate of unemployment’ was
introduced in the 1960s independently by Milton Friedman and Edmund Phelps.
Natural rate of unemployment takes into account the frictions and imperfections
in the economy and assumes that it is natural for an economy to have certain
fraction of its labour force unemployed, at any point of time. We observe that any
unemployment that is not natural could be due to business cycle, or policy
related.
For empirical purposes natural rate of unemployment is the total of frictional
unemployment and structural unemployment in an economy.
It varies across countries, and over time for the same country. For the US
economy, for example, natural rate of unemployment is estimated to be between
3.5 per cent and 4.5 per cent. Many countries do not report any estimate of
natural rate of unemployment.
The concept of natural rate of unemployment reshaped macroeconomic analysis
in subsequent years. As we will see later in this Unit, expectations of economic
agents (such as households, firms and government) about future economic
environment play a major role in the shape and position of the Phillips curve.

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6.5 EXPECTATION-AUGMENTED PHILLIPS Inflation and
Unemployment
CURVE
The Phillips curve discussed earlier could not explain stagflation in an economy.
For explaining stagflation we need to bring in expectations into our analysis. In
fact, Phillips curve given in Fig. 6.1 holds true if there is no change in
expectations in the minds of people. In case people perceive that there is a change
in expectations, then the Phillips curve will shift. Both adaptive expectations and
rational expectations have important implications for Phillips curve.
6.5.1 Phillips Curve under Adaptive Expectations
You know from microeconomics that workers and employers take decisions
regarding employment on the basis of real wage; not nominal wage. According to
Friedman and Phelps, expectations do matter. Thus the ‘expected real wage’
should be looked into account for determining equilibrium output and wage rate.
Workers usually enter into a contract with the employer regarding their salary for
certain time period. During contract period, salary cannot be re-negotiated; it can
be changed only after the contract period is over. As the workers are aware of
these conditions, they incorporate expected inflation into the contract. For
example, if the workers expect that inflation rate would be 3 per cent in the
coming year, they will negotiate the wage rate in such a manner that the real
wage rate does not decline due to price increase.
For an expected inflation rate of 𝜋 per cent, suppose the Phillips curve is given
by SRPC1 (see Fig. 6.2). Suppose the economy is at point A. At this point the
expected inflation rate is 𝜋 (say 3 per cent) and unemployment rate is at the
natural rate u* (say 6 per cent). At point A, the workers and firms expect an
inflation rate of 3 per cent and they are getting it. Thus there is no pressure on the
economy for a change.
There is a possibility of trade-off between inflation and unemployment along the
curve SRPC1. If there is higher inflation, then real wage will decline (because
nominal wage cannot be increased due to existing contracts). Consequently, firms
will employ more labour thereby leading to a decline in unemployment.
Suppose the government pursues an expansionist fiscal policy (government
expenditure increases or tax rate decreases), which will boost aggregate demand.
As a result, there is an increase in prices (means higher inflation rate). An
expansionist monetary policy, such as increase in money supply or decrease in
interest rate, will also have the same effect. It will lead to an increase in
investment which will, to some extent, increase the demand for labour also. In
either case, there is an increase in inflation rate to 𝜋 (say 6 per cent). The rate of
unemployment reduces to u2 (below the natural rate). It implies that more
workers are employed, as a result of which output will be higher than potential
output. In Fig. 6.2 we have shown this situation as point B.

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Expectations, Inflation Equilibrium at point B, however, is temporary. Workers very soon realize that
and Unemployment
there is an unexpected increase in inflation rate. In order to compensate for the
price rise, workers will demand a higher wage rate. It will lead to a shift in the
Phillips curve from SRPC1 to SRPC2. Equilibrium in the economy will be at
point C in Fig. 6.2. Consequently, inflation will be at 𝜋 while unemployment
will be at the natural rate, i.e., u*.

LRPC
Interest Rate

𝜋3 C

B
𝜋2
A
SRPC2
𝜋1
SRPC1

u2 u*
Unemployment Rate
Fig. 6.2: Shift in Phillips Curve

Notice that unemployment in the economy is back at the natural rate (6 per cent).
The inflation rate however is much higher ( 𝜋 ). Thus the attempt of the
government to reduce unemployment rate below the natural rate inflation rate,
results in higher and higher inflation. In view of this, the natural rate of inflation
is often termed as the ‘non-accelerating inflation rate of unemployment’
(NAIRU). It means that there is no acceleration in inflation if unemployment is
maintained at this. Further, the term natural rate of unemployment indicates that
it is inflexible, but social optimal. The term NAIRU, on the other hand, does not
indicate any social optimality or desirability.

When unemployment is at the natural rate or NAIRU, there will be stability in the
rate of inflation. When unemployment departs from the natural rate, there is
acceleration or deceleration in inflation rate. Thus if actual unemployment is less
than u*, inflation will continue to accelerate – higher and higher in subsequent
years. The concept of NAIRU and expectations formation explains the
hyperinflation witnessed by many countries. Unless unemployment returns to its
natural rate the inflation spiral will keep on accelerating.

The above analysis brings us to an important conclusion. Under adaptive

expectations, the short run the Phillips curve is downward-sloping. In the long
run however, it is vertical. In Fig. 6.2, the vertical line LRPC depicts the long run
Phillips curve. Thus there is no trade-off between inflation and unemployment in
the long run.
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6.5.2 Phillips Curve under Rational Expectations Inflation and
Unemployment
Under rational expectations economic agents such as firms and households are
forward looking. They take into account all available information – past
experience as well as present and future developments in the economy. There is
no perfect foresight under rational expectations, but the errors cancel out on the
whole.

An implication of the above is that actual inflation rate is equal to expected

inflation rate. Thus workers and firms do not commit any error regarding wage
rate during negotiations. Thus, there is no trade-off between inflation and
unemployment under rational expectations. Unemployment rate in the economy
is at the natural rate.

Suppose unemployment in the economy is at the natural rate. Firms and workers
expect inflation to be at the rate of 𝜋 . Suppose, the government pursues an
expansionary policy as a result of which there is an increase in aggregate
demand. Consequently, there is an increase in the rate inflation. If this policy was
expected by the economic agents, they would have factored in the increase in
inflation rate into their decision-making. If the policy is unexpected, then it
would have the desired effect, that is, reduction in unemployment. This brings us
to an important issue: how effective is government policy under rational
expectations? If government policy is expected, it will not have any impact.
Check Your Progress 2
1. In 2019 the expected rate of inflation was 7 per cent while actual rate of
inflation was 5 per cent. If ʎ = 0.5, find out the expected inflation rate for
2020.
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2. How do you reconcile the vertical long run Phillips curve with the
downward sloping short run Phillips curve? Explain through a diagram.
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Expectations, Inflation 3. Explain the following concepts:
and Unemployment
a) Adaptive Expectations
b) Rational Expectations
c) Non-Accelerating Inflation Rate of Unemployment (NAIRU)
d) Long-Run Phillips Curve
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6.6 LET US SUM UP

Unemployment results in loss of not only potential output at the macro level but
also in income at the individual level. Many a time unemployment culminates
into a crisis situation when there is widespread unemployment in the economy.
The social sigma and psychological trauma associated with unemployment often
compels policy makers to cut down on the rate of unemployment.
The classical economists assumed flexibility in real wage and prices which
ensured full employment in the economy all the time. Keynesian economists,
however, contest such an assumption and speak about rigidities in wage rate and
prices. In case of sticky prices there is a possibility of unemployment as per the
Keynesian model.
Phillips curve describes the inverse relationship between inflation and
unemployment. It shows the possibility that unemployment can be reduced at the
cost of higher inflation.
During the 1970s most economies in the world passed through a phase of
stagflation. The trade-off between inflation and unemployment was proved to be
false. In order to explain such a situation we bring in expectations into our
analysis. There are two models of expectations: adaptive and rational.
According to adaptive expectations, the Phillips curve is stable in the short-run
but in the long run it shifts. The long run Phillips curve is vertical. Thus there
could be some trade-off between inflation and unemployment in the short-run,
but in the long-run there is no trade-off. We explained the process through which
the shift in the Phillips curve takes place. According to rational expectation, there
is no trade-off between inflation and unemployment. Any policy of the
government to reduce unemployment becomes ineffective, as people can forecast
the expected changes correctly.
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6.7 ANSWER/HINTS TO CHECK YOUR PROGRESS Inflation and
Unemployment
EXERCISES
Check Your Progress 1
1. Your answer should include frictional, structural and cyclical
unemployment. Go through Section 6.2 for details.
2. Go through Section 6.3 and refer to Fig. 6.1.
3. These concepts are discussed in Sections 6.2 and 6.3.
Check Your Progress 2
1. Refer to the text in Section 6.5. You should explain Fig. 6.2.
2. These concepts are defined in Sections 6.5.

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