Unemployment and inflation trade-off
One of the key trade-offs that a government always faces is that between unemployment and
inflation. Low unemployment may mean high inflation. This is because the high level of demand
in the economy that helps give everyone a job may also be too much for the capacity of firms to
cope with and they may respond to rising demand by increasing prices. This, as we have already
seen, is called demand-pull inflation.
This trade-off was formalised in research done by Professor A.W.Phillips, and the curve he
derived from his empirical study of unemployment and inflation has since become known as
the Phillips curve.
Phillips Curve
The Phillips Curve is a relationship between unemployment and inflation, discovered by
Professor A.W.Phillips. The relationship was based on observations he made of unemployment
and changes in wage levels from 1861 to 1957. He found that there was a trade-off between
unemployment and inflation, so that any attempt by governments to reduce unemployment
was likely to lead to increased inflation. This relationship was seen by Keynesians as a
justification of their policies.
The curve sloped down from left to right and seemed to offer policy makers with a simple
choice - you have to accept inflation or unemployment. You cannot lower both.
Figure 1 Phillips Curve
For example, when the economy is operating with low unemployment at OU, the inflation rate
is high at OI. However, the higher unemployment rate of OU1 is consistent with a lower
inflation rate of OI1.
Up until the recent 'credit crunch' in 2008, many economies were experiencing both low
inflation and low unemployment. Improvements in technology which have lowered costs, and
globalisation which lowered import prices were two factors thought to be responsible for this.
However, in the 1970s the curve broke down as the economies suffered from
unemployment and inflation rising together (stagflation). This caused governments many
problems and economists struggled to explain the situation. One of the most well-known
explanations came from Milton Friedman - a monetarist economist. He developed a variation
on the original Phillips Curve called the expectations-augmented Phillip's Curve.
If workers see through money illusion and bargain in real terms, the greater the anticipated
rate of inflation, the greater the increase in money wages workers will demand in order to
maintain the value of their real wage.
Figure 1 Expectations-augmented Phillips curve
In Figure 1 above, assume that the actual and expected rate of inflation are zero, that
unemployment is initially at the natural rate U, that there is no change in productivity and that
the three curves indicated represent different expected inflation rates. Also assume that the
government believes a rate of unemployment of U to be too high, and attempts to reduce it to
U1 by expansionary monetary and fiscal policies. The following steps will occur:
Step 1 - the economy now moves to point a, with 5% inflation.
Step 2 - the increase in the price level reduces real wages, making labour more
attractive so firms expand output and employ additional labour and then pass on the
wage increase in the form of higher prices.
Step 3 - as workers experience inflation of 5%, they begin to anticipate inflation of 5%
and the Phillips curve shifts to the right to PC2, which is consistent with 5% inflation.
Step 4 - as workers are assumed to be interested only in the real wage, and this has now
fallen to what it originally was due to inflation, unemployment returns to the natural
rate at point b. Workers leave those jobs where the real wage has not risen and search
for jobs with a higher real wage.
Step 5 - at point b, inflation is 5% and unemployment has returned to OU. If the
government wishes to reduce unemployment again to U1 by increasing government
spending, it will result in a 10% inflation rate at point C and the Phillips curve shifts to
PC3 as workers learn to anticipate the inflation rate.
Step 6 - again the same process is followed with a return to the natural rate at point d,
the same level of unemployment but with an inflation rate of 10%.
So, according to Friedman, the long run Phillips curve is vertical (i.e. UN) at the natural rate of
unemployment. There is no long run trade-off between inflation and unemployment, the
implication being that governments cannot permanently reduce unemployment below the
natural rate by reflationary monetary and fiscal policies.
