The Short-Run and Long-Run Relationship Between Unemployment and Inflation

Introduction

The intricate relationship between wages, prices, and the currency form one of the pillars of an economy. The rate at which people can access jobs, earn income, and therefore spend it later is directly related to the economic growth in any given country. When the currency loses its power due to economic reasons, crises, or changes, it then naturally affects people’s work as the available job positions may shrink in numbers or grow. Business companies and theorists have long noticed a link between unemployment and inflation factors, but its nature has been uncertain. It was until William Phillips created a concrete concept of the Phillips curve that observes and analyzes the direct connection between unemployment and inflation.

While it has seen a lot of use soon after its conception, many have since rejected it. Nowadays, the theory is considered too simplistic to determine and predict how the economy will react. Nevertheless, despite the concept’s weaknesses when addressing the national or global economy, it can still provide insight into how unemployment and inflation interact, offers some prediction power and has theoretical and practical value.

Unemployment and Inflation: Causation or Correlation

It is necessary to look at unemployment and inflation and see how they might be related to determine if there is a value in the Phillips curve concept. Inflation is when the country’s currency loses its buying and selling power, becoming cheaper for various reasons. The primary reason for many inflation crises in history has been overprinting of the currency. Inflation causes many issues for an average buyer, as their money may lose more than half its previous value. That may affect people’s buying power as customers and thus their choices when it comes to spendings.

Unemployment is defined as people’s lack of a job position, which can happen for many reasons. It may be their inability to find official work, preference to stay at home and be a housekeeper, or lack of organizations providing jobs. With the exception of personal choices or health factors, people mostly rely on businesses and organizations to provide them with work offers and income. While unemployment and inflation mostly happen for different reasons, they can also be born out of the same issue.

The primary root that both unemployment and inflation can share is economic issues and shifts. Various financial crises can negatively impact companies which may, in turn, cut many people out of their jobs or even go completely bankrupt. When it happens, the entire teams lose their job and have to either find a similar position in another company or look for a completely different job. The employment market gains more people to fill positions that may not even exist anymore, especially in a crisis. Inflation can also be pushed forward by an economic crisis in the country. The government may decide to print more money to make up for losses, but that is hardly a solution to the problem and can lead to even more significant issues. Primarily, it leads to the currency losing its value as more of it is used on the market even if the economy is still in the same state.

Jobless people who have no economic stability cannot afford to spend luxury money on anything but bare necessities. Keeping that in mind, it is easy to see how inflation and unemployment might affect each other and how policymakers can use this fact to predict and control the economy’s situation. When Phillips analyzed the historical data of the United Kingdom’s economy, he saw the link between the two. He thus created the curve concept, which he designed to help policymakers see the connection and utilize it. The theory is often criticized for its simplicity: it does not consider the full complexity of the economy and only relies on the relation between unemployment and inflation. While no curve can contain all the potential data, it is still possible to use the Phillips curve to predict future inflation.

Phillips Curve Concept

The Phillips curve is an economic concept developed by William Phillips. The concept revolves around a negative, reverse relationship between economic inflation and the unemployment rate within a country (Quévat and Vignolles, 2018). After studying the long-term historical data that documented the United Kingdom’s economy from 1861 to 1957, Phillips came to the conclusion that there is always a direct correlation between unemployment and inflation in the economy (Quévat and Vignolles, 2018).

He theorized that the unemployment rate stays low when inflation grows, and when inflation shrinks, the opposite applies. He proposed that it was thus possible to predict the future changes in employment and inflation rates or even control them by applying his concept (Freund and Rendahl, 2020). Therefore, policymakers could potentially utilize this knowledge to make policies that would determine how the economy would change in the future. The Phillips curve has been applied in developing and developed countries and was observed to be a stable, constant curve. Despite its early popularity, the concept soon became a target of mass criticism.

The Phillips curve has since been used to forecast the inflation rate, although the theory is not as accepted as it was in the 1960s. The theory was considered universal for a while. It was until the oil price crisis of the 1970s that made many reconsider its utility (Bildirici and Ozaksoy, 2018). The most common criticism that the theory faces is that it is too simplistic and does not cover the relationship between inflation and unemployment entirely, especially in long-term or large-scale scenarios. When he was creating the concept, Phillips relied heavily on the data based on the United Kingdom. It is one of the criticisms that his theory has received.

Although some other countries have demonstrated a similar pattern, many have not. Even the United Kingdom’s economy has gone through economic phases when the Phillips curve concept could not be applied (Bildirici and Ozaksoy, 2018). After the theory was made, the world saw a considerable number of economic crises involving high unemployment numbers and strong inflation. It includes countries such as the USA, the United Kingdom, Japan, and others.

Over time, more examples have demonstrated that the change and relationship between unemployment and inflation keep shifting in manners that ignore or contradict the Phillips curve concept. While a variation of it is still used in some cases, it became clear that the policymakers cannot always utilize it to predict the negative relation between unemployment and inflation for the economy’s benefit. When analyzing long-run and long-term economic changes, the Phillips curve has often failed to prove the connection between inflation and unemployment. The theory has not been completely abandoned and has found supporters that believe in the theory’s application, alas with some changes. It also created the basis for the discussions on how inflation and unemployment can affect one another on the macroeconomic level. That only raises the further question of what may be the reason behind the concept’s inconsistencies.

There are many potential reasons behind the discrepancies, and it is essential to discuss the distinction between the long-run and short-run periods in the economy. On the macroeconomic level, the terms short-run and long-run describe how soon prices and wages adapt to the economic changes (Bildirici and Ozaksoy, 2018). A period when they do not adapt to the changes is referred to as a short-run. The short-run is often influenced by sticky prices and wages: the prices and wages that are naturally resistant to the change.

The opposite of it is a long-run, a period when they do correspond to the economic shift. A country reaches its economic potential within the long run because the market is flexible to the change. Both supporters and opposers of the Phillips curve have noted that the concept proved to be practical when applied to the short-run periods, but not the long-run (André et al., 2012). This further empathizes that the concept has not entirely lost its usage but has seen reduced following.

Fitzgerald et al. (2013), who both criticize and support the concept, concluded that there is another manner in which the Phillips curve falls short. According to their analysis, most of the time, the Phillips curve falls apart when applied to the macroeconomics of the national level (Fitzgerald et al., 2013). In such cases, the relation between unemployment and inflation does not follow the Phillips curve pattern. Fitzgerald et al. (2013) criticize the theory for its weaknesses but do not entirely reject it either. For example, it works well when used on local and regional scale even in long-run multidecade periods. It becomes much more accurate on regional scale and could be utilized to predict and monitor economic events, inflation level, and unemployment rate.

They proposed that although the Phillips curve lacks accuracy in terms of national and global examples, it is still suitable to be applied to smaller-size samples (Fitzgerald et al., 2013). Therefore although the Phillips curve might not have as big of a grasp on the economy as initially intended, it can still be used by the policymakers on a regional level.

Another potential reason Fitzgerald et al. (2013) offer that explains the concept’s failure to predict or influence the market changes is central banks’ insistence on actively trying to achieve specific goals. It can weaken the existing links between the factors due to the prevalent awareness of the policy. If people, companies, and policymakers are aware of it, it can influence the way they react to the implementation (Fitzgerald et al., 2013). Therefore, making policies based on the Phillips curve theory can become self-negating, as it was not designed with this factor in mind.

While it is more of a theory, the possibility makes one question how practical a theory is if its application can negate the effects it is trying to achieve. It further supports the criticism the theory has received over the years. Nevertheless, its true efficiency is determined only when applied to the business world and economy. Over the last 40-50 years since its conception, the economy has shifted and changed drastically in ways that not many could predict. Applying the Phillips curve concept to the modern data is a good way to test the concept in practice.

American unemployment in 2021 is holding on 5-6%, similar to 2001 when it was averaging on 4-6% (U.S. Bureau of Labor Statistics, 2021). Inflation in 2001 was 2.85% while in 2021 it reached whole 5.48% (xxx). Unemployment fell to 3.5% in February 2020 before skyrocketing up to 14.8% in April, a new record for the decade (U.S. Bureau of Labor Statistics, 2021). Inflation during the same period stayed relatively low, going from 1.76% in 2019 to 1.23% in 2020 (xxx). While 1.23% is a low percentage, 2014 and 2015 had an inflation rate of even lower 0.12-1.62% despite a relatively average unemployment level of 5-6.6% (U.S. Bureau of Labor Statistics, 2021).

The data presented sometimes supports the Phillips curve, for example, in 2020 when the unemployment reached a new high the inflation fell down (xxx). Yet although unemployment has been on steady decline from 2010 to 2020, the inflation rate kept going up and down regardless. If the Phillips curve were accurate in its application, then there would be a clear contrast between the inflation and unemployment rate. Yet, the connection is not always observable in the presented data.

The main question remains the same: is Phillips curve as a theory still applicable in real life, or is it an outdated concept? The professional opinions on the concept can be self-contradictory at times. Despite the theory facing various criticisms over the years, there have been many attempts to reinvent the theory without completely abandoning it. Based on the presented analysis, it seems that the Phillips curve can be utilized with a fair trade-off if applied to smaller range or short-run scale. They may be able to form a fiscal policy to influence local businesses that will curb unemployment or damper the inflation depending on their goal. By either keeping it short-run if global or long-run if regional, policymakers can influence the unemployment and inflation factors, which is especially necessary right now due to the pandemic events characterized with economic uncertainty.

Conclusion

Although the Phillips curve concept has faced a lot of criticism, it still is used as the foundation for macroeconomic analysis and to forecast the inflation rate by the business companies. The criticism it has received is fair, but not unanimous as many still keep the Phillips curve concept in mind when analyzing the market. It sparked an idea that there might be a direct relationship between unemployment and inflation that was new at the time. While the majority reject the notion that there is causation between the two, the business community does not entirely ignore the theory.

It is still used to predict and forecast the inflation rates, analyze the unemployment levels, and short and long-run economic changes. Some have tried to adapt the theory to the modern-day business theory to give it higher complexity, others declined it. Most importantly, the Phillips curve concept made people consider that it was possible to use this relation and affect inflation and unemployment directly, trading off some elements to reach a specific economic goal.

References

André, F., Cardenete, M. A., & Lima, M. C. (2012). Using a CGE model to identify the policy trade-off between unemployment and inflation. The efficient Phillips curve. Economic Systems Research, 24(4), 349–369. Web.

Bildirici, M. E., Sonüstün Özaksoy, F. (2018). Backward bending structure of Phillips Curve in Japan, France, Turkey and the U.S.A. Economic Research-Ekonomska Istrazivanja, 31(1), 537-549. Web.

Fitzgerald, T., Holtemeyer, B., & Nicolini, J. P. (2013). Is there a stable Phillips curve after all? Regional analysis suggests a consistent inflation-unemployment trade-off. Economic Policy Papers, 13(6). Web.

Freund, L., & Rendahl, P. (2020). Unexpected effects: Uncertainty, unemployment, and inflation. CEPR Discussion Paper No. DP14690. Web.

Quévat, B., & Vignolles, B. (2018). The relationships between inflation, wages and unemployment have not disappeared. A Comparative Study of the French and American Economies. Conjoncture in France. 19-34. Web.

U.S. Bureau of Labor Statistics. (2021). Graphics for Economic News Releases. Web.

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BusinessEssay. 2022. "The Short-Run and Long-Run Relationship Between Unemployment and Inflation." December 7, 2022. https://business-essay.com/the-short-run-and-long-run-relationship-between-unemployment-and-inflation/.

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