Introduction

Unemployment and inflation are two major economic issues, which the government works to control because of their impact on economic growth. U.S government works to maintain 6.5 percent and below the unemployment rate and inflation of 2 percent. They are challenging to control because, when the government increases interest rates to lower inflation, the economic growth slows down. The two have had a history of inverse relationship creating even more challenges when trying to control them. Reducing any of the issues leads to an increase in the other. This study seeks to find out what the relationship the two issues have had both in the short and long run and whether it still holds to give recommendations on how to control them. The study uses US data on inflation and unemployment for the recent 20 years to help evaluate the relationship.

The historical relationship between unemployment and inflation

Unemployment and inflation have had a negative association in the past. An increase in inflation led to a decrease in unemployment. More relationship is studied from research done by Allan William Phillips, an economist to get the relationship between changes in wage and unemployment. The analysis showed that an increase in wages led to a decrease in unemployment. Since wages directly affects prices of products and therefore inflation, Phillips shows that the two were inversely proportional related. Phillips observed that the idea was not only applicable in Great Britain, the area of research but also to other economies like that of the United States.  The research done by Philips dates back form 1861 where the relationship held until 1970.

The historical relationship between the two is represented on a curve known as the Phillips curve, which is L-shaped to show that when inflation increases, unemployment decreases. The connection arises because of an increase in demand for goods without a subsequent increase in supply to offset the deficit. In such a case, prices of products go high raising the inflation rate. Suppliers increase labor to grab the opportunity for high prices as well as cater for the deficit in supply thereby lowering the unemployment rate. The process reverses in that when the supply increases, the prices go down reducing the demand Suppliers lays off the laborers thereby increasing unemployment. At that time, it was easy to use monetary and fiscal policies to ensure low unemployment by increasing the price of goods to raise demand and therefore, need for laborers. Inflation, on the other hand, lowers demand for products since there is no subsequent increase in money supply. Unemployment increase when the demand for goods and services decreases.

Although the two are have shown a negative relationship, there are sometimes when they do not affect each other. When the unemployed workforce is not ready to work at the prevailing conditions, the two have had no relationship. Increase or decrease in inflation late has not shown any effect in unemployment because there are not enough workers in the firms to be laid off. Also, there are no workers ready to join the firms to lower the rate of unemployment.

short-run and the long-run in a macroeconomic analysis

A short run refers to a unique duration of time to a specific industry, economy or a firm where one of its inputs is fixed in supply for example labor. The firm cannot adjust the fixed input even with a decrease in demand. In such a case, the affected firm, industry or economy will have different behavior, which will last depending on the duration of changing the fixed input. The firm at that state incurs both variable and fixed costs because of the agreements on wages leases among other contracts, which cannot change. There are no adjustments like production or wages which it can make to maintain its profit. On the other hand, the Long run is a period specific to a firm, industry or economy where all factors of production are variable. No contracts or agreements are biding any factor of production within such duration. Firms, in the long run, can adjust any factor of production like labor to cater for changes in demand and supply. Firms incur only fixed costs in such duration because they can reduce variable costs depending on the need.

Inflation and unemployment in the Short and long run

In the short run, unemployment and inflation are inversely related in that, an increase in one leads to a decrease in the other. On the other hand, the two do not affect each other in the long run. The reason why the difference arises is that, of the difference in adjustments of factors of production. In the short run, firms cannot adjust some factors of production to cater to the demand changes or achieve equilibrium. Changes in demand will make a firm to change the number of workers to maintain a specific rate of production. Demand is affected by inflation meaning that the two affects each other.

In the long run, firms can bring labor and demand for goods at equilibrium because all factors of production are variable. Labour is, therefore, enough to produce the required products. When demand and labor are at equilibrium, there is a natural rate of unemployment. A natural rate of unemployment is the portion of the unemployed workforce who either, do not want to work at a given wage rate or are not skilled to get the job. Changes in demand due to decrease or increase in inflation, therefore, do not make the unemployed be attracted to work.

20-year U.S. unemployment and inflation data approval on Phillips curve

The current US unemployment and inflation data confirm the short-run Philips curve. According to the Philips curve, an increase or decrease in inflation or unemployment leads to an increase or decrease of the other.   From the data provided in the table below, there are two sections when a change in one of the two variables led to a consistent change in the other in the opposite direction. Tracing the years from 1998 to 2005 a change in inflation led to a negative shift in unemployment apart from the year 2003. There is consistency, which means that a graph of inflation against unemployment from 1998 to 2005 would give a smooth L shaped curve similar to that of Philips. A similar curve will also appear with the use of the data from 1997 to 2016 where the majority of the points, 10 out of 19 will be on the curve. Further proof is seen between the years 2008 and 2009 when there was a significant change between the two. Inflation decreased by 4.2 percent and the unemployment increase by 2.8 percent.

Evaluation of the Philips Curve in solving today’s issue of unemployment and inflation and forecast unemployment and inflation

Phillips curve can still validly resolve today’s issue of unemployment and inflation because the suggested relationship still holds as seen from the US data analysis. One challenge that is faced today in solving the problem between the two is to identify their affiliation. Philips curve solves that problem by showing that they are inversely related. Understanding the link will help to be cautious not to control one of the issues while making the other one worse. Another issue between the two is identifying the best combination that solves a country’s problem of either. From the curve, it is easy to know the extent at which one of the issues will increase when the government reduces the other to ensure that none of them will get beyond the manageable level. The curve provides the optimal level where neither inflation nor unemployment is too high.

The curve can be used to forecast unemployment and inflation even today because the two still relates inversely as it suggests. Through the curve, Philips argued that short-term changes in inflation and unemployment move in opposite directions. In case the unemployment gets above is equilibrium obtained from the curve, it follows that inflation will be low and when it goes below the balance, inflation will be high. Any change in factors, which affects unemployment and inflation, can predict what will happen to the two issues. When wages decreases or minimum qualifications for workers increase, unemployment will increase making a downward movement on the curve. An economist can use such changes occurring in employment contracts to predict that inflation will decrease from the graph. On the other hand, the increase in the price of goods and increased demand will raise the rate of inflation making an upward movement along the curve. Economist again can, therefore, use such changes on price to predict that unemployment will decrease. The curves, thus, can still today, forecast unemployment and inflation.

Recommendation for the Current U.S. unemployment and inflation

The current US inflation late 1.9 percent is below what the government was targeting 2 percent.  That means that it should focus on lowering the unemployment rate which stands at 3.9 percent. One of the monetary policies, which can help to reduce the unemployment rate, is lowering interest rates. The low-interest rate will make loans cheap increasing the money available to the public. When there is too much supply of money, purchasing power is high. People increase demand more so for luxurious goods. Increase in need makes the suppliers add more workers to cater to supply deficit. The state will, therefore, be able to create more jobs by creating demand for goods and services. However, the interest rate should be controlled not to rise to make excess money in supply creating too much demand that will make suppliers increase the price of goods leading to inflation again. The Us Federal reserve should, therefore, lower the interest rates in phases as it checks the effect on demand and prices of goods.

The Federal Reserve can also expand open market operations to make it easy for other businesses to borrow. It will increase the supply of money available to business people to help them improve their operations. When companies have enough money, they can expand their business creating more vacancies for employment. They also increase demand for raw materials, which in return makes the farmers, miners, and other people get back to work of making raw materials for the industries thereby creating employment. Again, the Federal Reserve should also expand the market operations slowly as it watches the effect on inflation to ensure that it does not rise beyond what it targets as decreased unemployment raises the price of goods.

Conclusion

Unemployment and inflation are macroeconomic issues, which are essential to control since they affect economic growth. The two have had a relationship from the past as explained by Philips and represented on Philips curve. In the short run, a change in one of them leads to a change in the other but opposite direction. Philips curve is L-shaped to show the inverse relationship. However, in the long run, the two are not related because the economy is experiencing a natural unemployment rate which change in demand cannot affect.  The relationship holds today as proved by the US inflation and unemployment data for recent years. The data shows that as the US inflation rate increases, unemployment decreases. It is recommended that the Federal Reserve can lower the interest rate and expand open market operations to increase money supply which in turn will increase demand to create more jobs.

United States Department of Labor 2019 Labor Force Statistics from the Current Population Survey

https://data.bls.gov/pdq/SurveyOutputServlet

 
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