Question

In the past how did economists view the rela tionship between unemployment and inflation? When did economic events begin to change this view?

Short answer

Economists initially viewed the relationship between unemployment and inflation as inverse, represented by the Phillips Curve. However, this view began to change in the 1970s during stagflation when economies experienced both high inflation and unemployment. This led to newer economic theories like the NAIRU and the Long-Run Phillips Curve that suggested no long-run trade-off existed between unemployment and inflation.

Step-by-step solution

Understanding the Phillips Curve

The previous view of the relationship between unemployment and inflation was best surveillanced by the Phillips Curve. This economic model created by economist A.W. Phillips showed an inverse relationship between unemployment and inflation, meaning when inflation was high, unemployment was low, and vice versa. The logic behind this was that when the employment was high (unemployment was low), workers would demand higher wages which would then increase the cost of goods and services leading to inflation.

Stagflation

The economic events that changed this view happened in the 1970s, during a period known as stagflation. During this time, many economies experienced high levels of both inflation and unemployment, which contradicted the Phillips Curve.

New Economic Viewpoint

As a result of stagflation, economists began to change their views. Economist Milton Friedman proposed the idea that in the long run, no trade-off between unemployment and inflation exists, and that the natural rate of unemployment is independent of inflation. This resulted in the development of the theory of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) and the Long-Run Phillips curve which posits that the economy will eventually return to the natural rate of unemployment no matter the inflation rate.

Key concepts

Unemployment

Unemployment refers to the situation where people who are capable of working and are actively seeking employment are unable to find a job. It's an important economic indicator because it reveals the state of the economy.

• High unemployment means many individuals are out of work, which can lead to lower levels of spending and economic stagnation.
• Low unemployment generally signifies that more people are working and earning, which can boost economic growth.

When the Phillips Curve was first introduced, it suggested that there was always a trade-off between unemployment and inflation. The idea was that with lower unemployment, more people had jobs, could spend more, and would demand higher wages. Companies would increase prices (inflation) as a result of increased demand. However, as we will see, this relationship was questioned during the phenomenon known as stagflation.

Inflation

Inflation is the rate at which the general level of prices for goods and services rises, leading to a decrease in purchasing power. It is a significant factor in economic policy and guides decisions across all levels of government and business.

• Inflation can erode purchasing power if wages do not increase at the same rate as prices.
• Moderate inflation can indicate a growing economy, while high inflation can be a sign of overheating.

The original Phillips Curve indicated that inflation and unemployment had an inverse relationship. More jobs meant higher money distribution and increased spending, resulting in inflation. However, the reliability of this relationship was disrupted during periods of stagflation, which saw high inflation occurring alongside high unemployment. This led to a rethink of economic strategies on managing inflation.

Stagflation

Stagflation is an economic anomaly where high inflation and unemployment occur simultaneously. Unlike what the Phillips Curve suggested, stagflation defied the expected norm and posed a significant challenge to policymakers.

• In the 1970s, stagflation hit many economies hard, leading to economic distress as traditional measures struggled to address both issues simultaneously.
• It prompted economists to reconsider the relationship between inflation and unemployment thoroughly.

Stagflation indicated that the simplistic view of an inverse relationship between inflation and unemployment was limited. This period of economic confusion taught valuable lessons, leading to advanced theories like the NAIRU which accounts for other dynamics in economic systems, explaining that inflation and unemployment can coexist unfavorably under certain circumstances.

NAIRU

The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is a concept that emerged from the ashes of the Phillips Curve theory after stagflation. It refers to a level of unemployment that does not cause inflation to accelerate.

• According to NAIRU, if unemployment falls below this level, inflation is likely to increase, as the cost of labor rises when everybody is employed.
• If unemployment is above NAIRU, inflation does not necessarily decrease but stabilizes.

Economist Milton Friedman played a crucial role in shaping the understanding of this concept by asserting that long-term unemployment and inflation are not necessarily inversely related. This led to the realization that the economy self-corrects to a natural rate of unemployment, irrespective of inflationary pressures, thereby redefining economic policies to consider more complex interactions beyond the original Phillips Curve.