Trade-off Between Inflation and Unemployment

Trade-off Between Inflation and Unemployment: Explanation

Inflation and unemployment are among the most crucial economic indicators. Moreover, what makes the two even more important is that they share a relation, which is the inverse correlation. Since both have an inverse correlation, it is possible to trade off between inflation and unemployment.

Over the years, several economists have come up with an explanation for this trade-off between the two parameters. But The Phillips curve is considered to be the best explanation of this trade-off.

In his 1958 research paper, W. Phillips talked about a negative statistical relationship between the rate of change in unemployment and the rate of change in the money wage. Also, the paper talked of a similar negative relationship between the rate of change in unemployment and the rate of change in prices (inflation). The Phillips curve generalizes this relation between the two parameters. 

A Keynesian view also suggests that a trade-off is possible between inflation and demand deficient unemployment. As per the Keynesian view, if the real GDP rises, it would boost the real output and result in the creation of more jobs. And this leads to a drop in unemployment. Also, the rise in aggregate demand results in a rise in the price level (inflation).

Also Read: Inflation

Why trade-off between inflation and unemployment is possible?

The following points will help to explain why a trade-off between inflation and unemployment is possible:

  • A rise in the demand in an economy results in a jump in output.
  • An increase in output encourages businesses to up hiring. This, in turn, reduces unemployment and increases disposable income.
  • More disposable income could result in demand exceeding supply, leading to inflation.
  • So, we can say that with faster economic growth, an economy witnesses a drop in unemployment and a rise in inflation, at least in the short term.

Trade-off Between Inflation and Unemployment: Phillips Curve

In the curve, the x-axis represents unemployment, and the y-axis represents the rate of inflation. 

Philip Curve

As per the curve, a rise in the unemployment level results in a drop in inflation. An economy can achieve a zero inflation rate only if it witnesses a high positive unemployment rate. Or, we can say that an economy can hit the full employment level only at a high inflation level.

Now, let’s talk about the trade-off between inflation and unemployment. As per the curve, the more the inflation rate, the less the unemployment rate and vice versa.

So, the relation that the Phillips Curve shows helps policymakers choose the combination of inflation and unemployment that they are comfortable with. For instance, if their objective is to control the rising level, then they will have to live with a higher unemployment rate. And, if their objective is to reduce the unemployment level, then higher inflation should be acceptable.

For instance, if a nation is witnessing high inflation, then to control it, the Central Bank could up the interest rates. An increase in the interest rate would lower spending and investment. This, in turn, would reduce aggregate demand, leading to a rise in unemployment and, eventually, a drop in inflation.

Let’s see some real-world examples:

  • Between 1979 and 1983, there was a drop in inflation from 15% to 2.5%. Unemployment rose from 5% to 11% during the same period.
  • Similarly, during the late 1980s, there was a drop in inflation from 6.5% to 2.8%. But there was a rise in unemployment from 5% to 8% during the period.
  • Most recently, in 2008, there was a drop in inflation from 5% to 2%. And, there was a rise in unemployment during the same period from 5% to over 10%.

Does Trade-off Between Inflation and Unemployment Always Hold?

Though the Phillips Curve is a good explanation of the trade-off between inflation and unemployment, there are instances when the inverse relationship between the two is proved wrong.

For instance, in the late 1960s, there was a rise in unemployment, wages, as well as prices. Similarly, the Phillips Curve lost relevance in some parts of the 1970s and 1980s. Both inflation and unemployment rose during these periods as well. 

And there were some periods when there was a drop in both inflation and unemployment. For instance, during the 1990s, there was a drop in unemployment, but inflation was also low. It implies that it is possible to lower unemployment without pushing up inflation.

Such scenarios lead to the development of new theories, as well as economic policies. At the time, Milton Friedman, a monetary economist, disputed the trade-off relationship between inflation and unemployment.

Friedman noted that an inverse relation (negative sloping Phillips Curve) between the two could exist in the short-run but not in the long run. As per Friedman, the curve may shift upward or downward in the long run due to the unstable relation between the two factors over a longer period. Thus, there is no trade-off between the two in the long run.

Trade-off Between Inflation and Unemployment in Long Run

Friedman used the inflation expectations theory (theory of adaptive expectations) to explain the no trade-off argument in the long run. As per this theory, people usually have wrong expectations regarding price changes due to the lack of information in the short run. Such behavior makes the trade-off possible.

However, in the long run, the gap between the price change expectations and the actual price change gets thinner. It means that people are generally able to guess the price changes correctly.

What Friedman meant is that tradeoff is possible in the short-run as workers don’t immediately expect prices to go up. But when they actually realize that inflation is occurring, they ask for higher wages to offset the rise in prices. This results in the aggregate supply curve shifting up, leading to higher inflation, but with the same level of unemployment as in the short run. Friedman calls this unemployment as the natural rate of unemployment.

As per Friedman, it is the minimum unemployment rate that is compatible with a stable rate of inflation and that an economy would always return to its natural rate of unemployment.

Thus, expectations significantly impact the relationship between inflation and the unemployment rate. And due to such expectations, it isn’t possible to have a tradeoff between inflation and unemployment in the long run.

Final Words

Yes, a trade-off between inflation and unemployment is possible, but not always. There have been periods when both inflation and unemployment went up, or there was a drop in both. So this means it is possible for a country to reduce unemployment without pushing inflation up too much.

It won’t be wrong to say that it mostly depends on the monetary policies that countries adopt. If the implementation of the monetary policies goes well, then a nation could avoid boom and bust economic cycles to enjoy sustainable low inflationary growth along with reducing unemployment.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

Leave a Comment