Introduction
It is important to understand the economic relationship from a historical and evidence-based perspective. To better understand unemployment and inflation, this paper will focus on four key areas. Understanding the historical background of inflation and unemployment by focusing on the Phillips curve. Determining what short- and long-run are as used in macroeconomics and how they relate to the Phillips curve.
Finding out whether the Phillips curve is still a viable option to be used by economists today. Ultimately, it is essential to understand how fiscal and monetary policies are utilized to manage inflation levels and how these policies can be more effectively formulated. Thus, the general relationship of inverse correlation between the two economic factors is no longer relevant in modern economic conditions.
Overview
Unemployment and inflation are the two primary tools used by economists to gauge the state of a nation’s economy. The former term refers to the number of the employable segment of the population that is unable to secure jobs. This can be caused by several internal and external factors, among them fiscal and monetary policies.
The use of capital-intensive methods of production, personal reasons, and unemployment are generally affected by the labor supply. The latter refers to what people are willing to offer at the prevailing market prices. Inflation, on the other hand, is the general increase in the price of commodities either instantaneously or gradually.
Historical Background
Considering the historical context of inflation and unemployment is crucial for a more comprehensive assessment. In the year 1958, a New Zealand economist by the name of A. W. Phillip noted that whenever wages increased, there was an adjacent increase in the relative prices of goods (Purnomo et al., 2020). This was based on extensive research and study conducted on the relationship between unemployment and inflation in Great Britain between 1861 and 1957 (Jones, 2017).
It was determined that whenever the rate of unemployment increased, the rate of inflation was considerably lower. When the rate of unemployment was reduced, the inflation dropped (Carvalho et al., 2018). This theory held up even during periods of recession and recovery.
During the recession, many people were unable to secure jobs, which led to an increase in the unemployment rate, while the rate of inflation decreased. During the recovery, the population of those who were unemployed decreased significantly, and the unemployment rate dropped. Thus, the rate of inflation skyrocketed whenever the economy underwent recovery. In 1960, American economists Paul Samuelson and Robert Solow expanded on this work, focusing specifically on the relationship between unemployment and inflation (Solow, 2018). They confirmed the inverse relationship between unemployment and inflation.
The Phillips curve was developed as a downward-sloping L-shaped curve, used to predict the relationship between inflation and unemployment rates. It is stated that the model developed by Phillip was adopted by many countries in the 1960s (Jones, 2017). However, when the data from the 1970s was subjected to the model, it could not hold, and the model was later deemed unfit for policy formulation. At this time, the model demonstrated a favorable tradeoff and was utilized to develop viable fiscal and monetary policies that could effectively manage unemployment and inflation.
Short- and Long-Run Phillips Curve
The short run is a situation in which economic conditions have not yet impacted key metrics, such as wages. A good example is when a firm is unable to increase its capital. Therefore, it increases its labor force to maintain or increase production. In macroeconomics, the short run refers to a situation where a short-term increase in the money supply in the economy can lead to short-term increases in output, as workers perceive an increase in real income. The short-run Phillips curve is roughly L-shaped, which depicts a tradeoff between unemployment and inflation. As unemployment increases, the inflation rate tends to decrease, and as unemployment decreases, the inflation rate tends to increase.
In the long run, on the other hand, all the main factors of production are variable, and none is constant. The firm can, therefore, easily adapt to changes in demand. In macroeconomics, the long run refers to the period in which full wage and price flexibility, as well as market adjustment, have been achieved, allowing the economy to reach its natural state of employment and potential output. When there is an increase in an economy’s production capacity, it increases the long-run aggregate supply.
An increase in the money supply causes increased inflation, and so workers realize that their real wages are relatively the same; therefore, output remains the same. According to economists, the tradeoff between unemployment and inflation is not applicable in the long run (Jones, 2017). In the short run, an increase in unemployment leads to reduced inflation. Still, this inverse relationship is not necessarily applicable in the long run. It means that “the Phillips curve is graphically vertical to the rate of unemployment, and any attempt to change the rate of unemployment only moves the economy up and down this line” (Boundless, 2021, p. 115).
This long-run effect will continue until the economy reaches the non-accelerating inflation rate of unemployment (NAIRU). The latter refers to the lowest rate of unemployment that the economy can sustain without triggering inflation and wage rises (The Reserve Bank of Australia, n.d.). Thus, in the long run, inflation and unemployment are not directly related to one another.
U.S. Unemployment and Inflation Data Analysis
Assessing the United States’ rate of unemployment and inflation over the past two decades reveals a significantly different trend compared to the 1960s. The rate of unemployment and inflation in the past two decades has not followed the classical Phillips curve, in which the rate of unemployment and inflation could be easily predicted from the Phillips curve. Over the past two decades, the rate of inflation has not been too steep, even when the unemployment rate was very low. This has caused the graph produced from the data in the recent past to be a downward-sloping curve, unlike the expected L-shaped curve.
Analyzing the unemployment and inflation rates of the past two decades, it is evident that whenever the unemployment rate increases in a given year, there is no corresponding decrease in the inflation rate. The only case where the Phillips curve is a viable mode of analysis is the year of the 2008 financial crisis (U.S. Bureau of Labor Statistics, 2022).
2008 had a record-high unemployment rate of 10% accompanied by a record-low inflation rate of 2%. However, in all other years, there is no major inverse relationship, as unemployment continued to decline, while inflation remained static (U.S. Bureau of Labor Statistics, 2022). The reason for the lack of correlation is that the rate of inflation had remained relatively low even when the rate of unemployment was even lower.
The data on unemployment and inflation from the past twenty years, when plotted in a graph, produce a downward-sloping line that is far from what is expected from the Phillips curve. This, therefore, means that this data disapproves of the short-run Phillips curve. The short-run Phillips curve states that the data should follow the Phillips standard and produce an L-shaped curve, showing a direct inverse relationship between the rate of unemployment and the rate of inflation.
The Invalidity of the Phillips Curve in Today’s Economy
The primary reason for the lack of correlation is the Federal Reserve’s monetary policy. Approximately 80% of all U.S. dollars in existence were printed during the years 2020 and 2021, which is a striking statistic considering the institution was founded in 1913 (Levi, 2022). Despite the various intricacies involved in monetary policy over the past two years, it is undeniable that such an influx of money will have an impact on the natural relationship based on the Phillips curve.
Firstly, there is a shift in the labor market that hinders the correlation between unemployment and inflation, where workers no longer adhere to the pre-pandemic working standards. Secondly, the supply of money at such a rate leads to unavoidable inflation through stimulus checks, which direct the flow along specific economic routes. The general population does not experience an increase in the money supply, but the prices of goods do increase. The result is a disruption in the Phillips curve.
In addition, the rationale for the invalidity of the Phillips curve in today’s economy is rooted in the fact that the pandemic and geopolitical changes no longer adhere to the fundamental assumptions of the framework. Since the 2008 correlational matching, inflation and unemployment have become even more disassociated from each other (Hooper et al., 2020).
In addition, the data from 1961 to 2018 showed that a one percent decrease in the unemployment rate caused a rather insignificant inflation charge of 0.14% (Hooper et al., 2020). The data from 1988 to 2018 showed a less robust Phillips curve. The slopes produced when the data were plotted were very close to zero, indicating that the curve was almost flat (Hooper et al., 2020).
The last two decades, however, have shown reduced variability in the national economy, making it difficult to determine the impact of unemployment and inflation. The Federal Reserve has also played a significant role, reducing inflation rates to a 2% target, despite fluctuating unemployment levels (Hooper et al., 2020). Thus, the Phillips curve in today’s economy is mostly irrelevant.
Several observations can be made by reflecting on the last two decades of the U.S. economy. Firstly, unemployment and inflation are pivotal in the development of financial, monetary, and fiscal policies. Secondly, although the unemployment rate is at a record low, there was no way they could predict any future rise. Thirdly, modern economic dynamics hinder the manifestation of the Phillips curve due to geopolitical trade barriers and other policies. Based on the data, policymakers cannot use the Phillips curve in any way.
Additionally, it cannot be used to forecast future rates of unemployment and inflation, given the current economic conditions. The primary reason is that there is no correlation between unemployment and inflation, as per the framework’s assumptions. The curve fails to consider the impact of prices on wages, which is as relevant as the influence of wages on prices (Hazell et al., 2022). However, the Phillips curve might once again revive its legacy in the not-so-distant future if the economic trend changes.
Recommendation
The key recommendation is to revise the monetary policy of the Federal Reserve, which should aim to minimize its money-printing activities. It will lead to significant interest rate increases. Still, it can be considered as a price for the excessive supply of the U.S. dollar during 2020 and 2021. The government needs to decrease its spending, which implies the halting of its geopolitical ambitions. The need for spending measures and the COVID-19 crisis were the primary drivers of the Federal Reserve’s monetary policy, which is why it is critical to focus on domestic affairs rather than foreign policies.
Essentially, the global market was disrupted by COVID-19, followed by the Russian invasion of Ukraine, which led to an energy crisis in Europe and division in the world. During these stressful periods, the Federal Reserve actively increased the money supply to mitigate the impacts of such disruptions, which caused inflation. The costs of goods increased not only due to inflation but also due to supply chain problems, the global pandemic, and geopolitical conflicts.
The Phillips curve does not account for the influence of price increases on wages; instead, it focuses on the reverse relationship. Therefore, the recommendation is to address the source of the problem, which is the monetary policy of the Federal Reserve. The Phillips curve did not anticipate that there would be a period of two years during which 80% of all U.S. dollars in history would be printed. Modern-day economics, both in the U.S. and globally, does not follow the traditional patterns but rather is in a uniquely complex state.
Conclusion
In conclusion, although the Phillips curve was a useful predictor of the inverse relationship between inflation and unemployment when it was developed in the 1950s, it is now considered unsuitable for economic policy formulation. Its original premise—that the two factors are inversely correlated—is no longer applicable in today’s economy because the curve cannot accurately forecast unemployment rates in response to inflation.
Today’s economists have shifted to relying on monetary and fiscal policies as the primary, if not the only, methods to control the rate of inflation. Monetary policies are those policies employed by central banks, such as the Federal Reserve, to ensure that inflation, the rate of change in commodity prices, remains relatively low. Some of these policies include increasing interest rates on lending to banks, which serves to reduce the amount of money in circulation in the economy.
References
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