Inflation and Employment
Unemployment rates increase in the short run when monetary policy is used to reduce inflation. This is the short term trade-off between unemployment and inflation. In 1958, economist A. W. Philips published an article showing that when inflation is high, unemployment is low, and vice versa. This relationship, when graphed, came to be known as the Phillips curve. Most inflation is caused by demand-pull inflation, when aggregate demand grows faster than aggregate supply. Consequently, businesses hire more labor to increase supply, thus, reducing the unemployment rate in the short run.
But when monetary policy is used to reduce inflation, either by contracting the money supply or by raising interest rates, this reduces aggregate demand, while aggregate supply remains the same. When aggregate demand decreases, prices decrease, but unemployment rises, since aggregate supply is also subsequently reduced.
Short-Term Influence of Inflation on Employment — the Phillips Curve
Although the unemployment rate fluctuates, it trends toward a natural equilibrium known as the natural rate of unemployment, which is the unemployment rate that would prevail when there have not been any recent changes to monetary policy, when economic output is optimal. The natural rate of unemployment includes frictional unemployment, which is the unemployment that results because it takes time to find another job or a new job, and structural unemployment, which results from a mismatch of the skills that the labor force provides and what the job market demands. The other component of unemployment is cyclical unemployment, which is the unemployment that results when there are fewer jobs than members of the labor force.
Although the natural rate of unemployment cannot be lowered by monetary policy over the long-run, cyclical unemployment can be reduced, at least temporarily, through monetary policy.
It was Milton Friedman and Edmund Phelps who showed that the Phillips relationship between unemployment and inflation was valid over the short run but not over the long run. Over the long run, the natural rate of unemployment would be unaffected by prices. This accords with the principle of monetary neutrality, which simply states that nominal quantities, such as prices, cannot affect real variables, such as output and employment. If prices go up, incomes generally follow.
Hence, the long-run Phillips curve is vertical, meaning the unemployment rate does not depend on money growth or inflation in the long-run; instead, it depends on the natural rate of unemployment, which, itself, can change over time due to changes in minimum wage laws, collective bargaining, unemployment insurance, job training programs, and changes in technology.
Expected inflation causes people to demand greater wages so that their incomes will keep pace with inflation. By increasing the cost of labor, the short-term increase in employment is reversed back to the natural rate of unemployment. This relationship is summarized in the natural rate hypothesis, which states that unemployment eventually returns to its normal, or natural, rate, regardless of the inflation rate.
The short-term unemployment rate can be approximated by the following equation, where p equals a modifying parameter:
Unemployment Rate = Natural Rate of Unemployment − p × (Actual Inflation − Expected Inflation)
Friedman argued that if the actual inflation rate is steady, then expected inflation will equal actual inflation, in which case, the 2nd term of the above equation become 0, so the unemployment rate will simply equal the natural rate of unemployment.
Unemployment Rate = Natural Rate of Unemployment
Sometimes the increase in prices results from an increase in the inputs to production, from so called supply shocks, such as the increase in the price of oil in 1974, when the Organization of Petroleum Exporting Countries (OPEC) began increasing prices by restricting supply. This increased unemployment by reducing supplies, and therefore, the demand for labor. When prices rise because of the greater cost of the factors of production, it is sometimes called stagflation, or cost-push inflation, since there is inflation even though economic output is falling.
Higher prices causes aggregate demand to decline, which, in turn, causes aggregate supply to decline, reducing the demand for labor. Because inflation is caused by decreasing aggregate supply rather than an increase in aggregate demand, both unemployment and inflation are high in stagflation. Nonetheless, the natural rate of unemployment will prevail over time, under both stagflation and demand inflation.
In the early 1980s, Paul Volcker, who was chairman of the Federal Reserve, decided to reduce the money supply to fight inflation, to pursue a policy of disinflation, which is a reduction in the rate of inflation. (Note that this differs from deflation, when prices actually fall.) However, he was uncertain about the consequences on unemployment.
Many economists believed that to reduce inflation, there had to be some unemployment. The number of percentage points of annual output that would be lost in reducing inflation by 1% came to be known as the sacrifice ratio.
Sacrifice Ratio = Percentage Reduction in Economic Output Per 1% Decline in Inflation Rate
Many economists believe that unemployment must rise by 1% for every 1% reduction in the inflation rate. So, according to Okun's law, a 1% increase in the unemployment rate decreases economic output by 2%. Thus, the sacrifice ratio must be at least 2.
Rational Expectations Hypothesis and the Lucas Critique
There were many economists, such as Robert Lucas, Thomas Sargent, and Robert Barro, who believed that the sacrifice ratio would not be that high because people had rational expectations, which could be modified by the government so that the short term trade-off between unemployment and inflation reduction would not be as severe. The rational expectations hypothesis simply states that people will use all the information they have, including information about government policies, when forecasting the future. Households, firms, and other organizations make decisions based on their future expectations of the economy. Consequently, how soon the unemployment rate would return to its natural rate would depend on how quickly people modify their expectations of future inflation.
Statistical models that were used to forecast the effects of monetary policy changes also had to be modified, since they relied on historical data that only incorporated how the economy responded to monetary policy changes in the past. In what became known as the Lucas critique, incorporating historical information about monetary policy changes and their effects was not enough to predict the consequences of changes to present monetary policy. Econometric models must incorporate changes in the behavior and the expectations of economic agents, i.e. consumers and businesses, to changes in the monetary policy.
Consequently, during the 1970s, Lucas applied the rational expectations hypothesis to econometrics, which is the statistical analysis of economic policy, to more accurately predict the response of the economy to changes in monetary policy.
Volcker succeeded in reducing inflation from 1981 to 1987; however the unemployment rate peaked at 10%, rising from 7% in 1982 to 10% to 1983, then falling back to 7% in 1986, then 6% in 1987.
Most economists estimated that the reduction in economic output during this time yielded a sacrifice ratio that was at least 2.5, even though Paul Volcker clearly announced his disinflation policy before implementing it, to reduce the expected inflation rate.
Even though unemployment did rise under the central bank's contraction of the money supply, the rational expectations hypothesis still had supporters, both because the unemployment did not rise as high as some have predicted and because the public did not believe that Volcker would be successful in reducing the inflation rate, so their expectations of inflation was not reduced as much as desired. Hence, many economists concluded that by having a firm policy of containing inflation, the public will have reduced expectations of future inflation, which would allow a more favorable compromise between unemployment and inflation.
Inflation and Employment
- Central banks reduce inflation by reducing aggregate demand, either by reducing the money supply or raising interest rates.
- Businesses respond by reducing aggregate supply, which increases unemployment.
- In 1958, economist A. W. Phillips noted this inverse relationship between unemployment and inflation: when one is high, the other is low. This inverse relationship, when graphed, came to be known as the Phillips curve.
- Thus, monetary policies that reduce inflation cause higher unemployment.
- The unemployment rate tends to a natural equilibrium, known as the natural rate of unemployment, which includes frictional and structural unemployment, but not cyclical unemployment.
- Frictional unemployment results from workers losing or quitting their jobs, causing their unemployment until they find the next job.
- Structural unemployment results from a mismatch of the skills that workers have and the skills that employers want.
- Cyclical unemployment results when there are fewer jobs than there are members of the labor force.
- Monetary policy can be used to mitigate cyclical unemployment, but not frictional or structural unemployment.
- Demand-pull inflation lowers the unemployment rate, but cost-push inflation increases the unemployment rate by reducing aggregate demand.
- Over the long run, unemployment does not depend on money growth or inflation, which is explained by the principle of monetary neutrality: nominal quantities, such as prices, cannot affect real variables, such as output or employment.
- Over the long run, inflation does not affect the employment rate because the economy compensates for current and expected inflation by increasing worker compensation, causing the unemployment rate to move to the natural rate.
- Some reduction in economic output, accompanied by an increase in unemployment, must be tolerated to reduce inflation. The percentage decline in annual output for each 1% decline in the inflation rate is called the sacrifice ratio.
- The trade-off between unemployment and inflation reduction occurs in the short run, but not in the long run, because people need time to adjust to changing inflation rates. The rational expectations hypothesis states that the trade-off between unemployment and inflation could be mitigated if people have better information about future inflation so that they can more quickly compensate for changes in inflation. Since central banks try to control inflation through monetary policies, they can communicate their intentions to the public, thereby reducing the time for the short run, thus shortening the time required for the unemployment rate to reach the natural rate.
- The Lucas critique was a critical assessment of economic models based solely on historical information, which did not account for changes in the behavior of economic agents in response to changes in monetary policy. Incorporating such behavior into economic models would increase their reliability.