Inflation And Unemployment
When economists and policymakers talk about the health of the economy, inflation and unemployment are two of the most important economic indicators they follow.
While they’re not directly related, inflation and unemployment can strongly impact each other. For instance, it can be difficult for policymakers to reduce inflation without causing an increase in unemployment.
This is a problem we’re seeing play out right now. In July 2022, the unemployment rate dropped to 3.5%, returning to pre-pandemic levels. However, inflation increased 8.5% over the prior 12 months.
How Does Inflation Impact the Economy?
Inflation is the gradual rise in prices for goods and services throughout the economy.
To measure inflation, economists use yardsticks like the consumer price index (CPI), which measures the prices of goods and services purchased by consumers. The CPI tracks the prices of a basket of goods that includes food, energy, cars, clothing and housing.
A steady, low level of inflation is necessary for economic growth. In fact, the Federal Reserve aims to maintain a 2% annual inflation rate, as measured by the price index for personal consumption expenditures (PCE), a sibling of CPI. But when inflation rises too high, it can negatively affect the economy.
The trouble with inflation is that it erodes purchasing power. As prices go up, you need more money to buy the same goods and services. This is especially difficult for low-income households or those on fixed incomes, such as retirees.
Inflation can also lead to rising interest rates. When the prices of goods and services rise, so does the cost of borrowing money. This change can make it difficult for businesses to expand and hire new workers.
Policies That Affect Inflation
Policymakers find it difficult to manage elevated levels of inflation. If they try to reduce inflation too quickly, it could lead to higher unemployment. But if they allow inflation to get too high, it could harm the economy.
To combat inflation, the government may institute the following measures:
- Rate hikes. The Fed can raise the federal funds rate, making it more expensive to borrow money. Higher interest rates discourage consumer spending and slow economic growth.
- Fiscal policy. The government may increase taxes on businesses and individuals or lower government spending.
- Supply-side policies. To improve the long-term outlook, the government may reduce regulations to increase competition and reduce the cost of business.
How Does Unemployment Impact the Economy?
The unemployment rate measures the percentage of people in the workforce who do not have a job and are actively looking for work. It’s a major indicator of the economy’s strength that’s closely watched by policymakers and economists.
During the Covid-19 economic crisis’s peak, unemployment rates soared 14.7% in April 2020. But as of July 2022, unemployment stands at 3.5%, the lowest level since February 2020.
Why is that significant? When the economy is strong and unemployment is low, this growth can increase inflation as businesses raise wages to attract and retain workers.
On the other hand, when unemployment is high, businesses are typically cutting costs and shedding jobs, and this can add to deflationary pressure as businesses lower prices and cut wages.
Policies That Affect Unemployment
The government may institute policies to address high unemployment rates. For example:
- Relocation subsidies. Some states may offer subsidies or tax incentive programs to encourage workers to relocate to the area.
- Employer subsidies. The government may give businesses subsidies and tax credits to encourage hiring.
- Interest rate reductions. The Fed cuts interest rates during periods of high unemployment, making it cheaper for businesses to borrow money and boost production.
- Fiscal policies. The federal government may adjust fiscal policies to reduce taxes and encourage spending to boost aggregate demand.
What Is the Relationship Between Inflation and Unemployment?
Economists have determined that there may be a relationship between inflation and unemployment, described as the Phillips Curve, in honor of economist A.W. Phillips, who identified the relationship in 1958.
The Phillips Curve hypothesizes that there is a correlation between inflation and unemployment. When inflation is high, unemployment is low. Conversely, when inflation is low, unemployment levels increase.
This connection poses a difficult challenge to policymakers. While low unemployment may sound like a positive for the economy and workers, too low an unemployment rate may drive inflation up. But if the government takes steps to curb inflation, that may chip away at unemployment and trigger a recession.
Is the Phillips Curve Still Accurate?
Economists point out that the inverse relationship between inflation and unemployment was very clear in the 1950s and 1960s. However, the relationship between these two variables has been less clear over the past 20 years.
Between 2012 and 2019, unemployment rates dropped. Inflation remained low, signaling that the relationship between inflation and unemployment, as reflected in the Phillips Curve, may not be as closely tied as previously thought.
Since the Covid-19 pandemic, inflation rates have risen dramatically, while unemployment rates are considerably lower.
Currently, the relationship described in the Phillips Curve seems strong, and economists debate just how much curbing inflation will affect unemployment.
The relationship between inflation and unemployment is complex. Therefore, it’s not always easy for policymakers to determine the best course of action.