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Inflation and Unemployment: What is the Connection?


The relation between unemployment and inflation has long held the attention of economists.  For some time, it was believed that there was a trade-off between the two that policymakers could exploit.  In other words, a lower unemployment rate could be had by tolerating a higher rate of inflation.That notion is no longer widely held, at least as regards the long run.While minimal unemployment might seem a desirable policy goal, few economists would define full employment as employment zor everyone who wants a job.  Instead, many would argue that full employment is the lowest rate of unemployment consistent with a stable rate of inflation. This rate is known as the natural rate of unemployment.

Some idea of what that rate of unemployment is could be extremely useful to economic policymakers.  Inflation tends to be slow to respond to those changes in policy which affect it.  The effects of an expansionary monetary policy on inflation, for example, might not become apparent for some time.  Similarly, at times when the inflation rate is relatively high it is likely to respond only slowly to policies designed to bring it down.  In part because of this characteristic, and because policies aimed at reducing inflation may have short-term economic costs, it seems to be the prevalent view that it would be better to avoid increases in inflation altogether.

Perhaps the key characteristic of the natural rate is that it is the lowest rate of unemployment that is sustainable.  If the natural rate model is correct, policymakers seeking to maintain the actual unemployment below the natural rate would eventually have to contend with an accelerating rate of inflation.

Because inflation tends only gradually to respond to changes in underlying economic conditions, a way of predicting it or of identifying the conditions that are likely to lead to an increase in the inflation rate, would be extremely useful to policymakers.  The natural rate of unemployment has been viewed by many economists as a means of measuring tightness in the labor market and thus the risk of future increases in the inflation rate.1

From the middle of 1997 through September 2001, the civilian unemployment rate was below 5%.  Over that time, the inflation rate remained modest.  Continued low inflation in the face of what appeared to be tight labor markets led to some skepticism about the merits of the natural rate theory altogether.  But many, who still see it as a meaningful way of looking at the world, are unsure whether temporary


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factors may have helped to restrain inflation or if the natural rate itself may have fallen so that an unemployment rate below 5% is a realistic long-run policy goal. This report discusses the evolution of the notion of "full employment" as well as those factors that are believed to determine the level of the natural rate of unemployment.  Recent estimates of it are presented as well as an examination of the current uncertainties.  This report will be updated as economic developments warrant.


The Phillips Curve

In a 1958 article that was to become a frequently cited reference in the economics literature, economist A.W. Phillips reported evidence of an inverse relationship between the rate of increase in wages and the rate of unemployment. Comparing rates of increase in wages with unemployment rates in Britain between 1861 and 1957, Phillips found that as the labor market tightened, and the unemployment rate fell, money wages tended to rise more rapidly.  Because wage increases are closely correlated with price increases, that relationship was widely interpreted as a trade-off between inflation and unemployment.2  The implication was that, given a trade-off between inflation and unemployment, policymakers could "buy" a lower rate of unemployment at the cost of a higher rate of inflation.

The curve describing this trade-off became known as the "Phillips curve."  A stable Phillips curve would mean that policymakers might choose one among several combinations of inflation and unemployment rates that seemed to be most palatable and set that as the goal of macroeconomic policy.  The U.S. experience of the 1960s did little to disprove that view.

Figure 1 plots annual U.S. unemployment rates and consumer price inflation together for the 1960s.  These data suggested that there was a trade-off for the United States similar to the one found by Phillips in Britain, and that policymakers could target among several combinations of unemployment and inflation rates, depending on their relative distastes for those two economic evils.

The theoretical explanation for the downward-sloping line describing the trade- off between unemployment and inflation depends on the notion of excess demand. As long as aggregate demand exceeds economic capacity, the unemployment rate will tend to fall, and vice versa.  Similarly, demand in excess of supply will tend to push up both wages and prices, so that rising prices tend to be correlated with falling unemployment.3
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The Natural Rate Hypothesis

In the late 1960s, in spite of the statistical correlation, two economists suggested that there was more to the Phillips curve  than met the eye.  They predicted a breakdown of the Phillips curve.  They argued that monetary and fiscal policy could be manipulated in such a way as to realize a particular combination of unemployment and inflation in the short run, but that it  would only be a temporary accomplishment.4 This view contended that the trade-off along the Phillips curve was based on the  fact that unexpected increases in prices reduced real wages.  A reduction in real wages induces an increase in the demand for  labor and the unemployment rate falls. As a result, a rise in prices would be associated with lower unemployment than under price stability – but only until workers caught on to their loss in buying power. Consequently, there is not just a single Phillips  curve, but a Phillips curve for every different possible expectation of inflation.


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Similarly, an unexpected increase in the rate of inflation would, temporarily, reduce the rate of increase in real wages and contribute to a decrease in the unemployment rate.  Again, as long as workers fail to notice the effects of rising prices on their money wages, there is likely to be a drop in unemployment due to a fall in real wages.  But eventually they will adjust their wage demands to reflect the higher price level, or the higher rate of inflation.  This increase in real wage demands
will tend to reverse the drop in the unemployment rate.  In the long run, the unemployment rate tends toward a level that represents an equilibrium between the supply of labor and demand for it.  This level was dubbed the "natural" rate, and is the rate of unemployment consistent with a stable rate of inflation.5  It is the level to which the unemployment rate tends when the public is not fooled by inflation.

Some economists prefer a more clinical term, the "non-accelerating inflation rate of unemployment," or NAIRU.  At times, the natural rate is more loosely referred to as the full-employment rate of unemployment.  The term “structural” unemployment is also used to distinguish long-term effects from business cycle and normal turnover variations in the unemployment rate.

With no efforts to manage demand through fiscal or monetary policy, wage adjustments would always be working to move the economy to its natural rate of unemployment – either from a higher rate or a lower one.  If a policy of managing demand is pursued, however, the adjustment to the natural rate can either be assisted or hindered, depending on whether or not the policy is synchronized with those wage adjustments.

Fiscal or monetary policies may shift the economy from one point to another along the original Phillips curve only as long as workers fail to appreciate changes in the price level or the rate of inflation.  A higher rate of inflation would not mean
a permanent decline in the unemployment rate.  Eventually, other things being equal, expectations would adjust and the unemployment rate would tend to return to its natural rate.

If policy were to push unemployment below the natural rate, the rate of inflation would wind up permanently higher after workers raised their expectation of inflation, and there would be a new Phillips curve describing the trade-off consistent with that higher expected rate of inflation.  Any short-term trade-off between inflation and unemployment would now involve higher rates of inflation than before.  This process of shifting the trade-off could continue as long as policymakers keep trying to push the unemployment rate below its natural level.

The implication of a constantly shifting Phillips curve is that in the long run there is no trade-off, and that the long-run Phillips curve is vertical at the natural rate. Policymakers cannot expect to choose a point on any one Phillips curve above, or below, the natural rate of unemployment and stay there


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Figure 2 illustrates this point.  Each Phillips curve (PE1 - PE3) is associated with a rate of expected inflation.  Unexpected  increases in inflation can result in movement along any one of the Phillips curves.  But, unless workers can be perpetually  ‘fooled,’  an increase in expected inflation will result in an upward shift of the entire curve describing the short-term trade-off  between unemployment and inflation.  In the long run, the Phillips curve (PL) is vertical at the natural rate of unemployment,  the only unemployment rate consistent with a stable rate of inflation.