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

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

Principles of Macroeconomics ECO203

Instructor Christopher Newcomb

Introduction

The two most critical macroeconomic issues are unemployment and inflation. The history of macroeconomics teaches us about the Phillips curve and how many countries also saw a short-run negative impact between unemployment and wages. This paper will be a highlight of the historical relationship between the two issues, unemployment and inflation, and how they are affected differently between the short-run and the long-run analysis. Accessing twenty years of data, we will look at the U.S. inflation and unemployment graphs and determine if the data confirms a short-run Phillips curve. After we look at the full span of data, we will analyze it in detail to see if it can still be used in today’s economy. Lastly, I will recommend a policy we should use to help maintain the two percent inflation goal the Federal Reserve supports. We must be aware that with any choice we make as policymakers, there is cause and effect for both the short-run and long-run.

Unemployment and Inflation: The History

The historical relationship between unemployment and inflation has been one of the main arguments between economists. Those economists who believe that there is a trade-off between unemployment and inflation have used the Phillips curve. The Phillips curve was in practice between 1861-1913 because the same trade-offs were noticed in other countries as well. An economist named A.W. Phillips published his researching 1958, and in the early ’60s, American economists named the curve “Phillips” after him. One thing all economists can agree on is that the Phillips curve can only be used with accuracy in the short-run. (Schoder, 2018)

The Phillips curve shows the various combinations of inflation and employment that an economy has experienced in a specific period. Early Phillips curves showed a negative relationship, leading economists to view the Phillips curve as a menu of policy choices between inflation and unemployment. The Phillips curve appears to show a trade-off between inflation and unemployment, but the relationship shifted in the 1970s. Experience in the past four decades has led economists to doubt that the Phillips curve offers a stable menu of policy choices. (Amacher, 2019)

The experience since the last four decades is that the Phillips curve’s goal is to show that low unemployment increases the employer’s need to raise employees’ wages due to job market completion. If everyone is already employed, corporations would need to offer better packages and idealistic work environments for other to join their workforce and improve their productivity. Where there is job market coemption, wages are increasing creating a surplus in income to the GDP which can lead to inflation in the long-run. Johannes Schwarzer is quoted that “The discussion is still very active,” this still has economists puzzling at how these two concepts are related. (Schoder, 2018)

Short-Run Versus Long Run

The difference between the short-run and long-run in macroeconomic analysis is the time in which the economy must adjust to the change. As an example, in the short run, there is both a fixed and a variable factor. In the long-run, however, there are not any fixed factors. To be more specific, let’s look at the previously mentioned discussion about the relationship between unemployment and inflation. This discussion is agreed-mutually by economists that the relation can only be predictable using the Phillips curve in the short-run.

The short-run analysis used in macroeconomics shows the relationship between unemployment and inflation as trade-offs because the economy has not had enough time to adjust to the new expectation. An example would be workers who haven’t recognized that their nominal wages have not kept up with the pace of inflation. As wages stay the same, profits for the company will increase.

The long-run analysis used in macroeconomics shows the relationship between unemployment and inflation to be non-existent. An example would be that same worker as above, but they are aware and informed that their wages are not keeping up with inflation. As a result, they will renegotiate their wages to keep up with expectations. As a result, the company will experience profits declined because of an increase in expenditures, but the unemployment will not change in the long run. (Lumen, 2019)

U.S. History and the Phillips Curve

When we access the twenty-year U.S. unemployment and inflation data, the current U.S. unemployment and inflation data don’t confirm the short-rum Phillips curve expectations. “In the last two decades, however, the U.S. inflation rate has not been particularly high, even during periods of low unemployment. The recent data have led many to wonder whether the Phillips curve has weakened or disappeared. However, the Phillips curve is still considered a good indicated of the country’s health and can help detect Inflation from unemployment” (Foy, 2019).

The researchers point out that the relationship between Inflation and the unemployment rate is a crucial input to the design of the monetary policy. They note that the unemployment rate in the U.S. economy is currently near record lows, and they caution that they cannot predict whether Inflation will rise in the coming years. However, they conclude that “Evidence that the price Phillips curve has been dormant for the past several decades does not necessarily mean that it is dead… it could be hibernating, and there is a risk of the Phillips curve waking up, with inflationary pressures rising in the face of an overheating labor market.” (Foy, 2019)

Researchers examined data from 1988 to 2018 and saw a linear slope rather a Phillips curve. The conventional view here is that the curve is now flattening, and we need to view this data differently. The is still a curve when it is describing the wage data, and can be more substantial in today’s market. (Foy, 2019)

When we analyze the recent twenty-year U.S. unemployment and Inflation data, we can see that the Phillips curve is slowly flattening out with the changes in today’s economy. We can take a more in-depth look by using data published by Kimberly Amadeo. During 2001 the Unemployment rate was at 5.7 percent with a national GDP of 1%. The Inflation amount caused by the Bush tax cuts and the 9/11 attacks was 1.6%. Analyzing this data against a decade later in 2010, we can find that the unemployment rate increased by 3.6%, and it is now 9.3%. This alarming rate was due to the Obama administration’s tax cuts. This stimulated a GDP growth of 1.6%, and the Inflation remained the same at around 1.5%. This data shows us that the unemployment and inflation rate are not related to one another using a long-run analysis in macroeconomics. (Amadeo, 2020)

Today’s Use of Phillips Curve

Could today’s issues be evaluated using the Phillips curve? That is the hot question on a lot of other economists’ minds. It seems as though there are two sides to this story. The facts behind the Phillips curve is that he saw that when unemployment went down, wages tended to rise. Inflation tends to increase after an increase in wages, so economists started to use the correlation as what may happen to the economy. This would later help the Central Bank indicate when to raise interest rates and help feed into the economy or retract and monitor inflation. Since the involvement in the economy, it doesn’t allow for a natural order, such as the Phillips curve may indicate. Understanding that the Phillips curve was intended to be an indicator of the connection between unemployment and wages, then we could still use the Phillips curve in today’s economic condition. 

It doesn’t “work” because it’s not a cause-and-effect relationship, to begin with, according to Doug Duncan, Chief Economist at Fannie Mae. “The Phillips Curve is the observation that there is a correlation between employment and inflation. The degree of correlation varies over time. But that does not extend to causation.” So, while rising inflation may sometimes occur during times of falling unemployment, one doesn’t cause the other. (Sellers, 2019)

The Future of Unemployment and Inflation

As a policymaker, the method I would recommend for the current U.S. unemployment and inflation situation would be to improve education for all citizens. This will enhance the knowledge-based decisional everyone would make. If we employ a smarter workforce, we could gain natural productivity that is not manipulated by the government or the Federal Reserve. While our inflation is hovering around 1.9% and just shy of the Federal Reserve goal of 2%, we should invest in educating and building a stronger and more efficient country.

The unemployment rate in 2018 was lower for those with higher levels of educational attainment. For example, the unemployment rate was lowest for those with a bachelor’s or higher degree (2 percent). The unemployment rate was more economical for young adults with some college (5 percent) than for those who had completed high school (6 percent), which was, in turn, lower than the rate for those who had not completed high school (9 percent). The same pattern was observed for young adult males and young adult females, with the exception that there was no measurable difference in unemployment rates between young adult males who had completed high school and those who had not. (Education, 2019)

In an ideal world, employers would like to have a staff of workers who needs less management and who are naturally more productive. This also benefits the worker. If the worker is more productive, the likely hood of them making more wages than someone who is not fruitful is significantly higher. Naturally, humans have a desire for higher knowledge, and the same goes for in the work-place. I know from first-hand experience.

My desire for knowledge only recently awoken. My employer SYKES has a partnership with Ashford University, where I can receive my bachelor’s for free. My employer is investing their most crucial resource, me. While they are encouraging my personal growth, they are also gaining a more educated employee. I will be more cautious with my decisions and thoroughly think about the consequences of my actions. While I am more careful, I am teaching my colleagues’ tricks of the trade as well. I am helping to keep my company alive and healthy. Because I am dedicated to this agreement, my employer rewards my behavior with extra incentives and higher pay.

Conclusion

In conclusion, we learned that the history of the Phillips curve was credited to A.W. Phillips from his published paper in 1958. We know that the argument between all economists is because of this theory between unemployment and inflation. The original author stated that his correlation was based on unemployment and wage changes. This gave a pathway to our now arguments on Classical and Keynesian theorists. The conversation is still an active one and causes debate at the mentioning.

History shows us that a cycle is moderately predictable, and if we are talking about the short-run, then the Phillips curve will serve nicely to show the relation in unemployment and inflation. The long-run analysis will show that employees will notice and negotiate pay base on knowledge of inflation. This will cause the long-run to decrease profits for the company based on an increase in expenses.

In today’s economy, the Phillips curve is proven false and unable to predict the current inflation rates. The ideologist is now noticing the curve is straightening out. We must remain open-minded to new ideas and policies that are different because those could be the ones to change our economy for growth.

References

Diana Schoder, February 23, 2018. Does a Tradeoff Between Inflation and Unemployment Exist? https://www.aeaweb.org/research/inflation-unemployment-retrospectives-milton-friedman-cruel-dilemma

Lumen Learning, 2019. The Relationship Between Inflation and Employment https://courses.lumenlearning.com/boundless-economics/chapter/the-relationship-between-inflation-and-unemployment/

Morgan Foy, 2019. Is the Phillips Curve Still a Useful Guide for Policymakers? https://www.nber.org/digest/sep19/w25792.shtml

Kimberly Amadeo, January 14, 2020. Unemployment Rate by Year Since 1929 Compared to Inflation and GDP https://www.thebalance.com/unemployment-rate-by-year-3305506

Bob Sellers, June 14, 2019. The Famous Phillips Curve to Predict Inflation Isn’t Working Like It Should https://fortune.com/2019/06/14/phillips-curve-unemployment-inflation/

The Condition of Education, May, 2019. Employment and Unemployment Rates by Education Attainment https://nces.ed.gov/programs/coe/indicator_cbc.asp

Amacher, R., & Pate, J. (2019). Principles of macroeconomics (2nd ed.). San Diego, California: Bridgepoint Education.