Inflation and unemployment are vital factors that can have a huge impact on the economy, and the relationship between these might predict the future of an economy. But are inflation and unemployment inversely proportional?
How Inflation affects Unemployment
According to historical analysis of economic trends, inflation directly impacts unemployment. Many economists argue that inflation has an inverse relationship with unemployment, which means that “when inflation rises, unemployment drops” [Source]. It also denotes how high employment is an accurate indication of lower inflation. Other views on this issue factor in different types of inflation and their effect on unemployment. Demand-pull inflation tends to lower the unemployment rate, but cost-push inflation increases the unemployment rate by reducing aggregate demand [Source].
How Unemployment affects Inflation
High unemployment reduces customers’ purchasing power, thus decreasing demand for products and services. When many people work, the power to spend is enhanced, and they move around buying products and requesting various services. If the unemployment rate is high, the public is robbed of its ability to spend and demand a lot of products and services from service providers or firms. If demand is reduced, supply is also affected, and firms may lose money or incur losses regarding their products expiring. If demand is low, then inflation might not rise since buyers will be incapacitated. In other cases, unemployment lowers inflation because the monetary value is maintained rather than wasted on salaries and wages as most people would not be employed. Starving cash on the market due to many financially unstable people helps keep a consistent market value of the currency.
Are Inflation and Unemployment Inversely Proportional?
The Phillips curve denotes that inflation and employment have always maintained an inverse relationship, so they are inversely proportional. This is evidenced by a trend between these two in which low levels of unemployment indicate high inflation, while high levels of unemployment show that inflation is low. A high rate of unemployment can also be a sign of deflation. Shortfalls of the Phillips curve are that he used historical UK data so that the outcome may differ in another locality. The curve was also a reflection of a developed locality, and the same analysis can produce different results in a developing locality. Others believe that the inverse proportion is not a consistent feature and is prone to change [Source].
How are Inflation and Unemployment related in the Short Run?
The outcome of the short-run between unemployment and inflation is presented as follows: “If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment” [Source]. This is backed up Phillip Curve, which clearly states that a decrease in unemployment leads to a rise in inflation, and vice versa is true.
How are Inflation and Unemployment related in the Long Run?
In the long run, economists note that there is no trade-off between inflation and unemployment. Suppose the relationship is analyzed for a short period. In that case, people might witness a decrease in employment, triggering an increase in inflation. But in the long run, they might see that these two entities are unrelated [Source]. A long-run period is based on Phillips Curve in which there is no relationship between inflation and unemployment. If the economy is analyzed from this perspective, the unemployment rate is independent of inflation. Inflation can be lowered by other factors, which also applies to unemployment.