Impact of Economic Growth & Inflation on Unemployment

1. ABSTRACT

The present research study empirically analyzed the impact of GDP growth rate
and Inflation on unemployment rate through time series data during the year 2003 to
2008. OLS (Ordinary Least Squares) technique has been used for analysis and Multiple
Linear Regression model has been applied to check the relationship of the data used in
the analysis. The result of the model shows that GDP growth rate and inflation play
sufficient role in affecting unemployment rate. An increase in GDP results in decrease in
Inflation and this also lowers the unemployment percentage of the whole economy and
vice versa.

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Impact of Economic Growth & Inflation on Unemployment

2. INTRODUCTION

The three areas of the economy that the Fed (Federal Reserve System) watches
most diligently are GDP, unemployment and inflation. GDP is the market value of all the
output produced in a nation in one year. Inflation is the increase in general level of prices
for goods and services and Unemployment is the measure of those workers who are
currently not working but are willing and able to work for pay, currently available to
work, and have actively searched for work.

Over time, the growth in GDP causes inflation, and inflation gives rise to
hyperinflation. This causes further increases in GDP in the short term, bringing about
further price increases. When there is inflation in the economy, there is a rise in prices.
Hence, there is a fall in the demand of goods and services, consumer stop buying,
manufacturers stop producing which ultimately results in unemployment. If GDP growth
is high, unemployment should be getting lower (since more GDP implies more jobs to
produce more goods & services).

The more important measure for employment is the difference between real GDP
and a theoretical real GDP which economists use to calculate the maximum output of an
economy. When the gap between real GDP and maximum output GDP is large, the
unemployment rate will be large and vice versa.

The effects of inflation are not linear; 10% inflation is much more than twice as
harmful as 5% inflation. There are those who insist that advanced economies should aim
to have 0% inflation, or in other words, stable prices. In a healthy economy, sometimes
market forces will require that companies reduce real wages or wages after inflation. In a
theoretical world, a 2% wage increase during a year with 4% inflation has the same net
effect to the worker as a 2% wage reduction in periods of zero inflation.

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Impact of Economic Growth & Inflation on Unemployment

3. LITERATURE REVIEW

3.1 Theoretical Background:

Brian W. Cashell (2004) has described the comparison between unemployment

and inflation. He says, Even at times when the inflation rate shows little indication that it
is about to Rise significantly; many economists feel that there is some risk of that
happening as Unemployment rate falls to near 5%. He pointed out the fact that an
economy with both low unemployment and low inflation could be considered a source of
concern. By quoting the example, Brian explained the experience of the United States in
the 1960s suggested that there was a trade-off between the unemployment rate and the
rate of inflation. This trade-off was known as the Phillips curve, and was based on the
fact that unexpected increases in prices reduced real wages, increasing the demand for
labor and reducing unemployment. The trade-off along the Phillips curve was based on
errors in inflation expectations. But, as the price level rises, workers eventually realize
that real wages are falling and adjust their nominal, or money, wage demands to reflect
the higher Level of prices and so preserve their real incomes. The increase in real wage
demands tends to reverse the drop in the unemployment rate.

Mr. Imran Aqil (2008) described the common reason for the unemployment, he
explained that many people end up losing their work or they just can’t find it because by
age or level of education they are unable to adapt new technologies and sectors. Mr. Aqil
suggested that it will be necessary to empower individuals, ensuring that they own the
idea of continuing education, caring for their talents, autonomy in the development of
appropriate training. Important education will be a widespread, but more importantly the
willingness to learn independently throughout your life.

Dr. Rashid described unemployment variations by explaining that

the rise in unemployment rate from around 3 per cent in the early
1990s to around 8 per cent in recent years in a country where few
people can afford not to work for a lack of any effective safety net
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Impact of Economic Growth & Inflation on Unemployment

reflects the emergence of a serious imbalance in the labor market. The

high rates of open unemployment are only partly reflective of the weak
demand for labor in relation to its supply. Pakistan's major employment
challenge is that a large proportion of the labor force earns extremely
low incomes and work in hazardous and poor working conditions. In
addition the labor market suffers from serious gender disparity. Female
unemployment rates are double that of men at around 13 percent in
2003-04 Unemployment among young people in the 15-24 age group
was around 24 per cent in 2003-04 i.e. more than three times the
overall unemployment rate.

3.2 Empirical Studies:

A.W. Phillips (1958) reported evidence of an inverse relationship between the rate
of increase in wages and the rate of unemployment. 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.
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.

David Dollar and Aart Kraay of the World Bank (2000) conducted a study
"Growth is Good for the Poor," The authors, put together data from 80 countries covering
four decades, investigated the relationship between incomes of the poor (the bottom one-
fifth) and overall income (per capita GDP). Their findings are that standard pro-growth
macroeconomic policies are good for the poor as they raise average incomes with little
significant adverse effect on income distribution. In fact, macroeconomic stability
increases incomes of the poor more than average income as it tends to improve income
distribution.
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Impact of Economic Growth & Inflation on Unemployment

A recently conducted survey by the PIDE (2009) on inflation shows that both
demand pull and cost push factors are responsible for current inflation in Pakistan, the
most important being global economic conditions and high food and fuel prices. High
cost of living induce by inflation is now the most important problem in Pakistan. The
survey reveals that the current monetary policy has not been effective in reduction
inflation, highlighting the need for coordinated monetary and fiscal policies to control
inflation. An overwhelming majority of the respondents (71%) expect that the rate of
unemployment will increase in the next six months and this situation is likely to persist in
the next year. Nearly two-third of the respondents expect that the rate of growth will drop
in the next six months.

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Impact of Economic Growth & Inflation on Unemployment

4. MODELING FRAMEWORK

Based on the review of the theoretical and empirical literature, the model to investigate
the interaction of GDP and inflation on unemployment rate is derived using the
regression equation. The general econometric model is

Unemployment= f (GDP, Inflation)

The equation used in empirical estimation is as follows;

Unemployment = α + β 1 (GDP) + β 2 (Inflation) + µ

Where,
GDP = Gross Domestic Product
µ is the error term in the above equation
α is the constant value

The model is estimated using annual data for the period 2003 to 2008. Ordinary least
square (OLS) technique has been used. All the data are obtained from economic survey,
Government of Pakistan.

The hypothesis developed for the analysis is as under;

Null Hypothesis:
HO : Unemployment rate does not depend upon GDP and Inflation

Alternative:
H1 : Unemployment rate depends upon GDP and Inflation

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Impact of Economic Growth & Inflation on Unemployment

5. ESTIMATION AND RESULTS

Model Summary (b)

Adjusted R Std. Error of

Model R R Square Square the Estimate Durbin-Watson
1 .777(a) .604 .340 .006690 2.310

a. Predictors: (Constant), inflation, GDP

b. Dependent Variable: unemployment

Coefficientsa

Unstandardized Standardized
Coefficients Coefficients
Model B Std. Error Beta t Sig.
1 (Constant) -.007 .043 -.173 .874
GDP .584 .469 .719 1.246 .301
inflation .393 .190 1.191 2.063 .131
a. Dependent Variable: unemployment

Unemployment = -0.007 + 0.584 (GDP) + 0.393 (Inflation) + µ

t-values (-0.173) (1.264) (2.063)

R² = 0.604

GDP and inflation have significantly impacts on unemployment rate. GDP and Inflation
affect 60.4% of unemployment. It is proved that there is highly positively relationship
between the GDP, Inflation and unemployment. The estimated equation proved that if
there is an increase in GDP and Inflation then Unemployment rate will also be increased.

At this level of analysis we reject our null hypothesis and accept our alternative
hypothesis that Unemployment rate depends on GDPand Inflation.
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Impact of Economic Growth & Inflation on Unemployment

6. CONCLUSION & POLICY RECOMMENDATIONS

Low level and quality of skills of Pakistan's workforce is been the major reason for the
high density of unemployed. More than half of Pakistan's labor force is illiterate and most
skills have been acquired through on-the-job training in the informal economy.

In examining the employment and poverty challenge facing Pakistan the following
important characteristics of the labor market need to be noted.

- With a labor force growth of around 3 per cent, based on historical trends and a
healthy growth in productivity, Pakistan's economy must grow at a minimum of 6
per cent to absorb the new entrants into the labor force. It needs to grow even
faster if it is to bring down the exceptionally high unemployment rate.

- The slackening in the labor market, as a result of the slowing down in economic
growth, is reflected in movement of real wages where except in the public sector,
between 1996 and 2002 they declined for both salaried and casual workers.

- The agricultural sector and allied industry (livestock, poultry and dairy) still account
for the bulk of the employed labor force with a slight increase in recent years to
around 43 per cent in 2003-04. To reduce pressure on rural to urban migration and
corresponding increases in low productivity informal sector employment in urban
areas the agricultural economy still needs to play an important part in increasing
productivity and incomes while maintaining its labor absorptive capacity.

- Women’s participation rate remains extremely low at 16 per cent in contrast to

men’s participation rate of around 70 per cent. If economic activities are carried
out within house premises is included this rate increases to 39.3 per cent but still
is much less than their male counterparts.

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Impact of Economic Growth & Inflation on Unemployment

7. REFERENCES

http://www.sbp.org.pk/research/bulletin/2005/Article-3.pdf

http://www.thenews.com.pk/daily_detail.asp?id=185626

http://www.pide.org.pk/pdf/reports/inflation_report.pdf

http://www.lahoreschoolofeconomics.edu.pk

http://www.econguru.com/macroeconomic-unemployment-explained/

http://www.investopedia.com/articles/06/gdpinflation.asp?viewed=1

http://www.issues2000.org/Background_Budget_&_Economy.htm

http://www.pakspectator.com/the-rising-spectre-of-unemployment/

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