John E. Marthinsen. "Demystifying Global Macroeconomics", Walter de Gruyter GmbH, 2020 paper text: Running head: 8UNEMPLOYMENT AND INFLATION The Relationship between Unemployment and Inflation 29Student's Name Institutional Affiliation Course Title Date The Relationship between Unemployment and Inflation For many years, economists and other scholars have tried to understand the 8relationship between unemployment and inflation to determine effective ways of controlling the economy. Unemployment refers to a state where individuals cannot find viable and legal income-generating opportunities. Inflation is the 23measure of the rate at which the average prices of certain goods and services increase over a certain period (Ho & Iyke, 2019). Historically, economists have been using Phillip's curve to describe the 26relationship between unemployment and inflation. According to the Philips curve, unemployment and inflation are 30inversely related. Therefore, an increase in inflation causes a decrease in the rate of unemployment. The relationship presented in Phillip's curve is not linear. The subsequent parts of this paper are therefore aimed at analyzing 24the relationship between unemployment and inflation using the Philips curve and identifying the most effective policies that can be used to address the challenge of unemployment in the current century. The Phillips curve is a concept in economics that was developed by A.W. Philips. The concept asserts 21that inflation and unemployment have an inverse and stable relationship. According to the Phillips curve, 27inflation comes with economic growth. Economic growth, in turn, leads to more available jobs within the economy (Dorn, 2020). The abundance of job opportunities means that most people can find employment, thus reduced unemployment rates. Although the Phillips curve has been used for many years, its original concept was disproven in the 1970s due to stagflation. During the period, the United States experienced both high unemployment and inflation levels. The main argument behind the Philips curve states that changes in unemployment within an economy lead to predictable changes in price inflation (Dorn, 2020). Philip's 2curve depicts the inverse relationship between unemployment and inflation as a downward curve slopes downwards. Unemployment is placed 2on the x-axis, while inflation is placed on the y-axis. Therefore, 3an increase in inflation leads to a decrease in unemployment levels within an economy. In the 1960s, most economists believed that any effort 3to increase the overall demand for products and services would result in several effects. For example, there would be 8an increase in the demand for labor. The demand for more labor means that the number of unemployed within a community would decrease. A decrease in the number of people looking for employment in an economy drives up the demand for more labor. As a result, companies increase wages and bonuses, and working conditions to attract more employees. The companies' cost of wage increases is then passed to consumers as price increases. In the 1960s, most countries use a stop-go model to control their economies (Mustafa & Rahman, 2017). For example, the countries would come up with a target rate of inflation and then implement monetary and fiscal strategies to ensure that they reach the target inflation rate. Governments used this model worldwide until in the 1970s, where stagflation questioned the Phillips curve's validity. The figure above shows 15the relationship between unemployment and inflation, according to the Phillips curve concept. From the figure, it is evident that 15the higher the unemployment rate, the lower the rate of inflation. 3For example, when the rate of unemployment rises to 3%, the 32inflation rate is 5%. When the rate of 2unemployment increases to 6%, the rate of inflation drops to 2%. The validity of the Phillips curve was thrown into question in the 1970s by stagflation. Stagflation occurs when the economy stagnates, leading to 22high unemployment and high price inflation. Such a scenario contradicts the Philips curve concept, which states that an increased relationship exists between unemployment and inflation. Before 1973, the United States had not witnessed any stagflation periods (Liu & Xu, 2019). From 1973 to 1975, the U.S. economy experienced a declining GDP, which increased its inflation by more than three years. Short and Long Run Philips Curve 12In the short run, the Phillips curve demonstrates an inverse relationship between unemployment and inflation. Inflation, therefore, increases with decreasing rates of employment. Through inversely related, 9the relationship is not linear. In the short run, the Phillips run traces an L shape with the inflation rate on the y-axis and unemployment rate on the x-axis. In the short run, the 12Phillips curve shows an inverse relationship between unemployment and inflation. An increase in inflation causes decreases in the rates 3of unemployment. The Long Run Phillips Line In the 14long run, the Phillips curve is represented by a vertical line at the natural rate of unemployment. In the long, there is no relationship between unemployment and inflation. Economists have discovered that 2in the long run, there can be no relationship or tradeoff between inflation and unemployment. Therefore, a decrease in unemployment levels cannot have any consequences in the rates of inflation. Both unemployment and inflation can remain the same (Ho & Iyke, 2019). As a result, 18the Phillips curve is graphically represented as a vertical line at the natural rate of unemployment. Any attempts to reduce or increase the rates 3of unemployment in the long run 19only move the economy up and down the vertical line. To further elaborate the long-run Phillips curve, 2economists Milton Friedman and Edmund Phelps with the 17natural rate of unemployment theory. The theory is also referred to as the non-accelerating inflation rate of unemployment (NAIRU) theory (Dorn, 2020). The theory asserts that attempts to expand the economy will only reduce the rates of unemployment temporarily since the economy will readjust to its natural state. Inflation is bound to increase if 4the unemployment rate is below the natural state. The inflation rate will also decelerate if unemployment is above its natural state. Inflation is only stable when the unemployment rate is equal to the natural rate. As the leading economy in the world, the United States presents a perfect opportunity to study the 25relationship between unemployment and inflation and the validity of the Phillips curve. In most instances, unemployment rates increase during recessions and decrease during periods of peace and positive economic growth. Unemployment rates have also declined in almost all the wars that the United States has been involved in in recent times. However, the low unemployment rates experienced during these wars increased during recessions that followed the war. From the analysis of unemployment and inflation figures in the United States, it is evident that the United States experienced the highest unemployment rate in 1933 during the great depression when the unemployment rate stood at 24.9%. Unemployment rates also increased during the great recession of 2009, with rates going as high as 10% (Liu & Xu, 2019). The lowest unemployment rate recorded in the United States was in 1944, when the unemployment rate stood at 1.2%. According to the Federal Reserve, the natural unemployment rate lies from 3.5% to 4.5% (Liu & Xu, 2019). Any figure lower pr higher than the margin provided could force the country to experience too much inflation, which could make it hard for businesses to find good employees to help them expand their operations. 4Unemployment and Inflation Rates in the United States in the Last 10 Years Year Unemployment Rate Inflation 2010 9.3% 1.5% 2011 8.5% 3.0% 2012 7.9% 1.7% 2013 6.7% 1.5% 2014 5.6% 0.8% 2015 5.0% 0.7% 2016 4.7% 2.1% 2017 4.1% 2.1% 2018 3.9% 1.9% 2019 3.5% 2.3% The data presented in the figure above confirm the Phillips curve model. According to the Phillips curve concept, the rate of unemployment is inversely related to inflation rates. Therefore, increases in inflation should result in to decrease in the rates of unemployment within an economy. The analysis of the table reveals that in all the years where the rate of unemployment is high, inflation is lower. For example, in 2010, the unemployment rate was 9.3%, while inflation was 1.5% (Liu & Xu, 2019). The data presented reveal that there was no time when the rate of inflation and unemployment were the same. A decrease follows an increase in the unemployment rate in inflation. While the Phillips curve has been used for many years to predict inflation and unemployment rates, its validity has been questioned in the last few years. The conceptual foundations of the Philip curve model have been under scrutiny from many economists and researchers all over the world. Mustafa and Rahman (2017) state that the validity and applicability of the Phillips curve have been brought into question due to the figures drawn from the U.S. economy in the last two decades. For example, while the United States has maintained a relatively lower inflation rate in the last two years, its unemployment rate has remained almost constant. The Phillips curve asserts that increased inflation should lead to reduced unemployment rates. However, the concept has not been replicated in the united states in the last two decades. Most economists have, therefore, concluded that the Phillips curve has weakened and cannot be used to 8describe the relationship between unemployment and inflation. In a study carried out by Mustafa and Rahman (2017), the researchers investigate inflation in wages and inflation in consumer prices. Using the data on annual costs of goods and services, they investigate the validity and applicability of the Phillips curve. The researchers further accommodate the different types of relationships between unemployment and inflation in slack and tight labor markets. Furthermore, the data from 1961 to 2018 was used through a model that takes a linear relationship between unemployment and inflation. Through the data, researchers observe that a one-point decrease 31in the rate of unemployment corresponded with an increase in inflation by a mere 0.14% (Dorn, 2020). When the researchers change the rate 6of unemployment in slack and tight labor markets, they discover that the estimated effect of a 1% rate of employment 6decline on the rate of inflation is almost -0.32% when the rate of unemployment is one percentage point below the natural rate and -0.12 when it is one percentage point above it. From the analysis of the data from 1988 to 2018, it is evident that the Phillips curve concepts are not reflected. It is observed that the linear and non-linear slopes are almost 0, which is in line with the common perception regarding the flattening of the Phillips curve. Despite the inconsistencies, the Philips curve is still an important economic model applied to select scenarios or instances. Dorn (2020) further states that the Phillips curve is not applicable in the current market environment due to changing forces. From the analysis of the data from the last three decades, including during the period of the great recession in 2009, it is evident that there has been less variability in the national economy as compared to previous years. As a result, it is almost impossible 16to detect the effects of unemployment on inflation. Furthermore, the Federal Reserve has tried to prevent labor market from overheating to stabilize inflation. Additionally, Dorn (2020) states that the relationship between unemployment and inflation is an essential factor in monetary policy design. Currently, the United States is experiencing low unemployment rates. As a result, it is hard for researchers and analysis to predict whether inflation will rise in the future. From the analysis, it is evident that 20the Phillips curve is no longer accurate in predicting the relationship between unemployment and inflation. While most economists call for the application of other models, others claim that the Phillips curve could be hibernating, and there is a possibility that the curve could be used again, especially with the rising pressures in the face of the overheating labor market. Several policies could be implemented in the United States to address the issue of unemployment and inflation. Unemployment is one of the most significant challenges that any country can face, and most of them try to ensure that the unemployment rate is kept at a minimum. High unemployment could lead to social unrest because people will not afford basic things such as food and shelter. Uncontained inflation could also negatively affect the economy by devaluing its currency and increasing the 3prices of goods and services. Fiscal policy is one way that the issue of unemployment can be addressed in the United States. Fiscal policy contributes to reduced unemployment levels by increasing the aggregate demand and the rate of economic growth. Some of the options that could be pursued by the government include lowering taxes and increasing government spending. Lowering taxes increases the amount of money that people have, meaning that they have more disposable incomes (Calcagno & López, 2017). The availability of more disposable incomes allows consumers to consume more products and services, leading to higher aggregate demand (A.D.). 28An increase in A.D. causes an increase in Real GDP. Since more goods are consumed, companies will be forced to expand and produce even more goods, thus requiring more employees (Calcagno & López, 2017). Increased A.D. also means stringer economic growth, which provides a conducive environment for companies to operate. Performing companies are less likely to go bankrupt, but they are more likely to employ more people and reduce unemployment. From the analysis of the Phillips curve, it is evident that it is a significant 5economic model that describes the relationship between unemployment rates and inflation. Although the concept is not applied currently as it was in the past, it can still predict inflation and how to control int. 7References Calcagno, P. T., & López, E., J. (2017). Informal norms trump formal constraints: The evolution of fiscal policy institutions in the United States. Journal of Institutional Economics, 13(1), 211-242. doi:http://dx.doi.org/ 10.1017/S1744137416000321 13Dorn, J. A. (2020). The Phillips curve: a poor guide for monetary policy. Cato Journal, 40(1), 133-151. doi: http://dx.doi .org/ 10.36009/CJ.40.1.8 10Ho, S., & Iyke, B. N. (2019). Unemployment and inflation: evidence of a non-linear Phillips curve in the eurozone. The Journal of Developing Areas, 53(4), 151-163. 11Liu, Z., & Xu, Y. (2019). Technological progress, globalization, and low-inflation: Evidence from the United States. PLoS One, 14(4) doi:http://dx .doi.org/10.1371/journal.pone.0215366 5Mustafa, M., & Rahman, M. (2017). Empirics of the traditional u.s. Phillips curve: evidence from 1930-2016. Journal of Business Strategies, 34(2), 97-110. 1 1THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 2 THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 3 THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 4 THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 5 THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 6 THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 7 THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 8 THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 9 THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 10 THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 11