What Is the Relationship Between Unemployment and Inflation?

Understanding the connection between unemployment and inflation is central to comprehending the health of an economy. Both are regularly cited as indicators of economic performance. While distinct, they are interconnected in intricate ways that economists continuously study to gain deeper insights into economic behavior and trends.

Understanding Unemployment and Inflation

Unemployment occurs when individuals willing and able to work cannot find employment. It is measured by the unemployment rate, the percentage of the labor force that is unemployed. The Bureau of Labor Statistics (BLS) compiles this data monthly through the Current Population Survey (CPS).

Several categories of unemployment exist: frictional, structural, and cyclical. Frictional unemployment involves individuals temporarily between jobs or new entrants to the workforce. Structural unemployment arises from a mismatch between available jobs and workers’ skills. Cyclical unemployment is tied directly to downturns in the business cycle.

Inflation refers to the rate at which the general level of prices for goods and services rises, causing purchasing power to decline. This means a fixed amount of money buys fewer goods and services over time. The most commonly cited measure of inflation in the United States is the Consumer Price Index (CPI), published monthly by the BLS. The CPI tracks the average change in prices paid by urban consumers for a representative “basket” of goods and services.

The Inverse Relationship: The Phillips Curve

Economists observed an inverse relationship between unemployment and inflation, first described by A.W. Phillips. His initial research in 1958 suggested that when unemployment was low, wage growth and inflation tended to be higher, and vice versa.

This relationship, known as the Phillips Curve, posits a short-run trade-off: policies to reduce unemployment typically come at the cost of higher inflation. Conversely, efforts to lower inflation might lead to an increase in unemployment. The intuitive explanation for this trade-off is that when unemployment is low, more people are employed and earning income, leading to increased consumer demand for goods and services. This heightened demand allows businesses to raise prices, contributing to inflation.

Conversely, during periods of high unemployment, consumer demand tends to be weaker. Businesses face less pressure to raise prices, which helps to temper inflationary pressures. This short-run inverse relationship implies that a robust economy with low unemployment might experience inflationary pressures, while a struggling economy with high unemployment could see more stable prices. This trade-off became a central concept for macroeconomic policy.

Factors Affecting the Relationship

The simple inverse relationship of the Phillips Curve does not always hold consistently, as various factors can influence this dynamic. One significant factor is inflation expectations. If consumers and businesses anticipate future price rises, workers demand higher wages to maintain purchasing power. These increased wage demands lead to higher production costs for businesses, which they pass on to consumers, creating a wage-price spiral. This adjustment in expectations shifts the short-run Phillips curve, associating a given unemployment rate with a higher rate of inflation.

Another important influence comes from supply shocks, which are sudden events that disrupt the production or supply of goods and services. Examples include abrupt increases in oil prices or disruptions in global supply chains. These shocks can lead to “cost-push” inflation, where rising input costs force businesses to increase prices, regardless of unemployment. This can result in “stagflation,” an economic condition characterized by stagnant growth, high unemployment, and rising inflation simultaneously, seemingly contradicting the Phillips Curve relationship.

Other structural elements within the economy also affect the relationship between unemployment and inflation. Changes in labor market policies, such as regulations affecting hiring and firing, or technological shifts altering skill demand, can influence the natural rate of unemployment. These factors alter job matching efficiency and labor market dynamics, impacting how unemployment responds to economic shifts and inflationary pressures.

Beyond the Short Run: Long-Term Dynamics

While a short-run trade-off between unemployment and inflation may exist, this relationship typically disappears over the long term. Economists introduce the natural rate of unemployment, also called the Non-Accelerating Inflation Rate of Unemployment (NAIRU). The NAIRU represents the lowest sustainable unemployment rate an economy can achieve without continually accelerating inflation. It accounts for structural and frictional unemployment always present in a dynamic economy.

In the long run, attempts to reduce unemployment below its natural rate through expansionary policies lead only to persistently higher inflation, with unemployment eventually returning to its natural level. This occurs because inflation expectations adjust to higher price levels, and temporary employment gains dissipate. The long-run Phillips Curve is a vertical line at the natural rate of unemployment.

This vertical long-run Phillips Curve signifies no permanent trade-off between inflation and unemployment. Regardless of the inflation rate, the economy gravitates back to its natural rate of unemployment over time. This underscores that monetary and fiscal policies can influence inflation in the long run, but they cannot permanently alter the structural level of unemployment.