The Link Between Inflation and Unemployment

April 22nd, 2008 — lekker

The idea behind the Phillips Curve is that higher inflation is associated with lower unemployment, and vice versa. Intuitively, this seems plausible enough. The stronger the economy, the more business is booming, the more jobs there will be. So we can expect the rate of unemployment to be lower. Indeed, it may fall to a point where shortages of various labor skills begin to emerge. In general, the more the economy is booming, the more likely there are to be shortages and inflationary pressures. By the same token, in a slump, excess labor and excess capacity will reduce inflationary pressures, and may even lead in some areas to price cutting.

So much is common sense; but making it theoretically precise has not been easy. The early Keynesian approach, drawing on institutional studies (Duesenberry, 1958), clarified the intuition but left it very loose. Everything depends on where shortages emerge and what policies there are for dealing with them — the inverse relation between unemployment and inflation was by no means necessary. But the link came to be seen as the way to tie up loose ends and close the model. Rather than leave money wages exogenous, they would be determined by the dynamics of inflation.

BEEPartner SA EconomyThen it became important to have a theory that explained the linkage. The Phelps—Friedman Monetarist approach grounded the unemployment—inflation connection on ad hoc asymmetric expectations, which New Keynesians have tried to bolster and fit better with a framework of rational choice. But the success of this enterprise has been limited. For one thing, it is not clear why the relevant expectations and information should be asymmetric. For another, the argument concerns the labor market; corporate pricing decisions are not examined. Finally, even if passive pricing is accepted, the framework is the labor-market model of marginal productivity, and this is itself seriously questionable, both theoretically and practically.

The evidence for the Phillips Curve is not very strong (Michie, 1987). It is well known that yearly data on the inflation and unemployment rates for the US from 1961-69 trace out a pattern that might reasonably be construed as a Phillips Curve. But after 1969, running on through the end of the 1990s, the points are all over the place. In the 1970s, unemployment and inflation rise together, at times quite strongly; they fall together through the 1990s, again markedly. At other times they appear to have no relationship. Indeed, it has been observed that, by today’s standards, the original econometrics on which the Curve was based, using British data, would not be acceptable (Wulwick, 1989). For one thing, the ‘identification problems’ are too serious and too difficult. (That is, if a new point is not ‘on’ the Curve, does it mean that the previous construction was faulty or incorrect, or has the previous curve, correctly identified, shifted, presumably in response to other variables?) Finally, over the larger part of the second half of the postwar period, there is virtually no evidence of anything resembling a Phillips Curve. If it did exist, where has it gone? What has changed?

An important school of thought holds that the Phillips Curve shows only short-run relationships. An attempt by policy to reduce the level of unemployment will generate an increase in the rate of inflation. But it will only have a temporary effect on unemployment. In the long run, the level of unemployment will move to its ‘natural‘ level.

The Friedman—Phelps critique holds that unemployment depends on real forces, and that output cannot rise for long above its ‘natural‘ level; policy may raise it temporarily above the natural level, but it will return there as business and works adjust their behavior to offset the effects of policy.38 Further, despite policy, inflation will continue. Inflation at any time depends on past inflation through expectations. Hence any given level of inflation will tend to persist, since expectation will generate demands for money and the monetary system will normally accommodate.

The idea of a ‘natural rate‘ rests on the twin foundations of a ‘natural‘ level of output and unemployment, together with the suggestion that inflation is driven by expectations in the environment of an accommodating monetary system. On an intuitive level, the idea underlying the ‘natural rate of unemployment‘ is not that plausible. Supposedly the ‘general equilibrium’ of the economy will generate a certain level of frictional unemployment; supplies and demands will be matched as well as they can be given the practical realities. This will be the ‘natural rate of unemployment.’ At this rate, inflation will be steady; there are no new inflationary pressures, since the labor market will be in equilibrium.

However, if there are expectations of inflation, the monetary system will accommodate them. Agents today will expect prices to behave as they did yesterday, based on the logic that if they rose yesterday, they will do so again today. On this basis they will formulate their plans and make their demands on the banking system. Money will be created accordingly, and credit advanced, so prices will rise today as they did yesterday. (The expectations generate the demand for money; the demand for money is accommodated, and the new money creation causes the price increases. The expectations are self-fulfilling, even though money creation is the ultimate cause of the inflation.) But there will be no additional pressure from the economy. Hence there will be no tendency for inflation to accelerate. So this natural rate will be the `NAIRU,’ the ‘non-accelerating inflation rate of unemployment.’

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