Unemployment and Inflation

Contents

1. Introduction Page 3

2. Unemployment Page 3

3. Inflation Page 5

4. Philip’s Curve Page 8

5. Modern Phillip’s Curve Page 11

6. Conclusion Page 12

7. References Page 13

1. Introduction
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Unemployment and inflation are two macroeconomic concepts that still pose a
challenge to economies today. Economies aim towards the reduction of
unemployment and inflation rates. Unemployment refers to the individuals who
are seeking for a job but are unable to find one. This, in an economy, has a
debilitating effect. In a similar way, inflation also possesses economic and
social implications. Inflation occurs when there is an increase in the money
supply and price level in an economy causing the value of the money to fall.
Thus, these two are the reasons why economies today strive for fuller
employment and for maintaining a steady low rate of inflation.

2. Unemployment
Individuals are categorized as unemployed when they are actively seeking for a
job and are currently available for it but are unable to get a job or employed.
The unemployment rate depends from one region to another. It can be higher in
some regions and lower in other. High rate of unemployment is both a social as
well as an economic problem. It is a social problem since it causes enormous
suffering as unemployed individuals or workers always struggle with reduced
income. High unemployment leads to economic distress causing a huge effect to
the emotions of individuals and their family lives. Similarly, it is an economic
problem since it symbolizes the waste of valuable resources, talent, skill and
assets.

However, it is important to note that not everyone desires a job. Thus, the
individuals who desire to work and actively seek for a job are seen as “labour
force”. A labour force includes both employed and unemployed individuals
since both the categories are willing to work and are available for it. Thus,
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unemployment is a variable which is measured at a particular point of time and
can be said when the level of unemployed individuals exceeds the number of
people employed in an economy.

As of April 2022, the unemployment rate in India is 8% out of which 8.83%

being in urban areas and 7.61% being the unemployment rate in rural areas.
But the common causes for unemployment can be categorized as frictional,
structural and cyclical unemployment.

1. Frictional Unemployment: Frictional unemployment refers to the short-

term unemployment that is resulted when people or individuals move
regions and places or when they switch occupations. The period between
full-time education and into the labour force is also seen as frictional
unemployment. Thus, newly entering the labour force, re-entering the
labour force, relocation of jobs or voluntarily leaving a job all come
under frictional unemployment.

2. Structural Unemployment: Structural unemployment refers to the

unemployment caused by the decline of an economy with respect to a
region or an existing industry. This is neither short term in nature or
voluntary. The skills of the labour force keep changing and the
individuals seeking for new jobs must adapt to the current demands in
terms of new skills required for a new job. This is when unemployed
individuals find it difficult to find a new job because of the requirement
of new training and skills. Advances in technology or job outsourcing are
common causes of structural unemployment.

3. Cyclical Unemployment: Cyclical Unemployment or commonly known

as demand deficient unemployment, refers to the unemployment caused
primarily due to deficiency or shortfall in the aggregate demand for goods
and services in the economy.

Structural and frictional unemployment can be never be zero in a well-

functioning and dynamic economy, primarily due to the change and
advancements in technology and opportunities. On the other hand, in a well-
functioning economy, cyclical or demand-deficient economy must be zero.
However, the rate of unemployment that is expected to see if there was no
deficiency or shortfall in aggregate demand is what is called the “natural rate of
unemployment”.

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3. Inflation
Inflation in general refers to the increase in price level and circulation of money
in the economy causing money to lose its value. Inflations differs and varies
from currency to currency and year to year.
Initially, the neo-classicals viewed inflation as a monetary phenomenon.
According to Friedman, “Inflation is always and everywhere a monetary
phenomenon and can be produced by a more rapid increase in the quantity of
money than output.” However, many economists today do not agree with the
fact that money itself is a sole cause of inflation. This is why economists define
inflation as a sustained increase in the general level of prices of goods and
services in an economy over a period of time.
Inflation leads to a reduction of purchasing power in the economy per unit of
money. As the price levels increase, the currency can buy or fetch only fewer
goods and services.

There are several theories of inflation put forward by economists that explain
what exactly causes inflation. They can be seen in detail below.

3.1 Demand Side and Supply Side Inflation

1. Demand-pull Inflation Theory:

This is also commonly known as excess demand inflation or demand side

inflation and it refers to the situation wherein aggregate demand is rising
as the available supply of goods is becoming less or reducing. In other
words, this type of inflation is caused due to the increase in prices which
if further due to the increase in the demand for the goods and services in
the economy.

When there is an increase in the supply of money, people possess more

money causing them to increase their purchasing power. Thus, this
implies that there is an increase for goods and services which further
increases the prices. When the prices increase, there is a decrease in the
demand but the profit margin of the business owner increases. For
example, Anthony is selling pens for Rs.2 for each. When he sells 400
pens, his current revenue is Rs.1400. Seeing the increase in demand for
pens, Anthony increases the price of the pens to Rs.4. Due to the increase
in prices, he is now selling 200 pens but is making a revenue of Rs.1600.
Thus, Rs.200 is the increase in revenue for Anthony.
On another note, goods either may be in short supply because the
resources are being fully utilized or possibly because the production
cannot be rapidly increased to match the increasing demand. As a result,
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 the prices begin to increase in response to a situation often described as
“too much money chasing too few goods”. Higher salaries can also
increase the purchasing power of consumers thus leading to increased
demand. Thus, it can be said that the pressure on commodities led to an
increase in the prices of the commodities.

However, a certain damaging form of demand-pull inflation occurs when

governments typically engage in deficit spending and rely on the
monetary printing press to finance their deficits. The huge deficits and the
rapid growth of money increase aggregate demand which in turn
increases the price level.

The graph above depicts the demand-pull inflation. DD represents the aggregate
demand curve and SS represents the aggregate supply curve. It can be seen that
as demand increases from D to D1, the supply remains unchanged at S,
implying that there is no shift in the supply. This led the price to increase from
P to P1.

2. Cost-push Inflation Theory:

This is also commonly known as wage-price spiral inflation or supply

side inflation. This theory of inflation is caused by the increase in wages
due to unions and profit increases by employers. The main cause of cost-
push inflation is the rapid increase in wages more than the productivity of
labour. Cost-push inflation occurs when there is a rise in prices due to
high costs of raw materials and production. This type of inflation is
generally determined or driven by the supply side factors such as higher

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 wages and high oil prices.

In other words, cost-push inflation refers to the situation wherein an

increase in the cost of production of goods and services leads to an
increase in the price of finished goods and services. When there is a
decrease in the supply of goods and services and when the demand
remains the same, then the prices of the goods and services increase.
Thus, when there is an increase in the cost of production of goods and
services, the finished goods and services become expensive and
cannot be sold at lower or same prices as there would be a danger
of incurring losses. Therefore, the businesses increase the price of
the goods and services. The burden because of the increase in cost of
production is shifted to the consumers causing inflation. The cost of
production might increase due to an increase in the prices of raw
materials, increase in taxes like excise duties and VAT, or increase in the
salaries or wages of workers.

In the above graph, DD represents the aggregate demand curve and SS

represents aggregate supply. It can be seen that there is a shift in the aggregate
supply curve from SS to S1 S 1. If aggregate supply falls, the aggregate supply
curve shifts to the lef1t. This causes the price level to increase.

3.2 Measurement of Inflation

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Price indexes are primarily used to calculate and track goods and services which
are categorized as multiple types. The most commonly used price indexes are as
follows,

1. Consumer Price Index (CPI): The consumer price index or CPI is a

common measure for inflation and it refers to the weighted average price
of a category or collection of goods and services that are the primary or
base needs of the consumers. These goods and services may include food,
transportation costs and medicines. From each of these goods and
services, the price changes are taken and then taken as an average on the
basis of their weight in the entire collection of goods and services. Under
this, only the consumer prices are considered. Hence, CPI also acts as an
indicator by indicating the cost of living of the economy.

2. Wholesale Price Index (WPI): The wholesale price index or WPI refers
to the index wherein price changes at the wholesale level are included
instead of the retail level. Unlike the consumer price index, the goods and
services are at business or wholesale level. This may include raw cotton,
cotton clothing etc. Thus, it is usually expressed as a percentage and
includes the price changes of goods considered. Wholesale price index is
an indicator to see a country’s inflation level.

The two indexes mentioned above are used to calculate the inflation value or
rate. The formula for measuring inflation is as follows,

( FinalCPI
Inflation Rate =
Initial CPI Value )
Index Value
× 100

4. Phillips Curve
The Phillips curve was developed and pioneered by William Phillips, a New
Zealand economist, in his book “The Relation between Unemployment and the
Rate of Change of Money Wage rates in the United Kingdom” in 1958. The
Phillips curve depicts the relationship between inflation and unemployment.
This differs in both the short run and long run. However, it is to be noted that an
economy can be at any one of the three places at any given point of time, i.e., at
a recessionary gap, an inflationary gap or at full employment. The Phillips curve
shows exactly that.

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According to the Phillips Curve theory, the lower the unemployment rate, the
higher the rate of inflation, and vice versa. As a result, high levels of
employment can only be achieved when inflation is high. Thus, the Phillips
curve's conclusions strongly influence policies aimed at promoting economic
growth, increased employment, and long-term sustainable development.

The implications of Phillips curve, on the other hand, have only been found to
be valid in the short run. When both inflation and unemployment are
disturbingly high, the Phillips curve fails to support stagflation, which refers to
the period wherein there is a continuous increase in inflation but there is a fall in
output and rising unemployment.

Below is the Phillips curve which depicts the unemployment rate on the X-axis
and the inflation rate on the Y-axis. It is pretty similar to the aggregate demand
and aggregate supply model except the X-axis differs in both the graphs, i.e.,
real GDP in the aggregate demand and aggregate supply model which
corresponds with employment whereas in the Phillips curve it is unemployment.

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In the graph above, point A here represents full employment and point B
represents the recessionary gap wherein there is low inflation and high
unemployment. On the other hand, point C represents the inflationary gap
wherein there is high inflation and low unemployment.

In the short run, the Phillips curve is downwards sloping. It can be seen in the
graph as SRPC which is short run Phillips curve. The SRPC shows the inverse
relationship between the unemployment rate and the inflation rate in the short
run. This implies that when there is an increase in the unemployment rate, then
the rate of inflation will decrease. Similarly, when there is a decrease in the
unemployment rate, then the rate of inflation will increase. The SRPC is the
mirror image of the short run aggregate supply curve as we can see below.

However, in the long run, the Phillips curve is vertical. Unlike short run, there
is no relationship between the inflation rate and the unemployment rate. In the
long run, the economy will find a way to the Natural Rate of Unemployment
(NRU) wherein the inflation rate doesn’t affect it. Thus, in the long run Phillips
curve, LRPC is vertical to the natural rate of unemployment. As the Natural
Rate of Unemployment (NRU) or full employment, is the sum of structural and
frictional unemployment, any change in structural or frictional unemployment
will cause the LRPC to move or shift. A greater natural rate of unemployment
causes the long run Phillips curve to shift to the right, whereas a lower natural
rate of unemployment causes the long run Phillips curve to shift to the left.

The economy, however, is always operating on the SRPC since it depicts

different combinations of inflation and unemployment. The common uses of
this model is to generally represent recession whenever the economy is facing
that or to show expectations of inflation with regard to the unemployment rate if
it’s below the natural rate of unemployment.

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5. Modern Phillips Curve
Now that we’ve seen the Phillips curve in detail, we can now move on to the
next topic, i.e., the modern Phillips curve. The modern Phillips curve, or
otherwise known as augmented Phillips curve, was improved and designed by
Milton Friedman and Edmund Phelps in the late 1960s.

The Phillips curve, however, does not take into consideration the predicted
inflation rates when fixing wages and prices. The Phillips curve simply
emphasized on the inverse relationship between the unemployment rate and the
inflation rate in the short run. We’ve also seen how in the long run, there exists
no relationship between the unemployment rate and the inflation rate.

Friedman and Edmund brought forward an improvement to the Phillips curve

by depicting the relationship between rate of increase in price (inflationary rate)
to the rate of unemployment. The modern Phillips curve depicted that
unemployment does not solely depend on the inflation level but that it also
depends upon the excess of inflation over the anticipated value. Thus, the
modern Phillips curve conveys that unemployment is dependent on the level of
inflation as well as the wage inflation that is higher than predicted inflation.

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The above modern Phillips curve displays three properties and they are,

1. Since the slopes are the same, the short-run trade-off between the rate of
unemployment and the rate of inflation is the same. Expected inflation
(π ¿¿ e)¿accounts for the difference between the two curves.

2. In the modern Phillips curve, the short run Phillips curve of 2006 and
1990 are comparatively flatter.

3. The short run Phillips curve of 1990 lies below the short run Phillips curve
of 2006. This is mainly because of in 1990, the inflation rate was 2%
(π ¿¿ e=2 %) ¿ with full employment whereas in 2006 the rate of inflation was
7% (π ¿¿ e=7 %) ¿with full employment.

Conclusion
This entire report was made solely to understand the relationship between
unemployment and inflation. We have seen unemployment and inflation
individually about what they mean and how they both pose a challenge to
economies till today. To conclude, individuals are said to unemployed if they
are actively seeking for a job but are unable to get one. There are three
causes of unemployment and they can be categorized under cyclical,
structural and frictional. On the other hand, we’ve discussed about inflation
which refers to the increase in the price level and circulation of money in the
economy causing money or the currency to lose its value. We have further
discussed the demand-pull and cost-push inflation. Demand-pull inflation or
demand side inflation is caused due to the increase in prices which if further
due to the increase in the demand for the goods and services in the economy
whereas cost-push inflation or supply side inflation, as the name suggests,
refers to the increase in the cost of production of goods and services which
leads to an increase in the price of finished goods and services. The
relationship between the rate of unemployment and the rate of inflation
could be very well seen in the Phillips curve propounded by William Phillips
in 1958. We could see that only in the short run, there exists an inverse
relationship between the two. However, in the long run, we have seen how
there exists no clear relationship between the rate of inflation to the rate of
unemployment. Milton Friedman and Edmund Phelps in the late 1960s
improved the previous Phillips curve by making it the modern Phillips curve
as we know of it today, which explained the relationship between rate of
inflation, in terms of increase in price, to the rate of unemployment.

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References

1. https://www.rba.gov.au/education/resources/explainers/unemployment-
its-measurement-and-types.html

2. https://www.researchgate.net/publication/
341112807_Inflation_and_unemployment_-
_INTRODUCTION_TO_MACROECONOMICS

3. https://unemploymentinindia.cmie.com

4. http://users.wfu.edu/cottrell/ecn207/infl_unemp.pdf

5. https://www.toppr.com/guides/fundamentals-of-economics-and-
management/money/forms-of-inflation/ (Graphs for inflation taken from
here)

6. https://www.economicshelp.org/blog/2006/economics/cost-push-
inflation-2/

7. https://www.economicshelp.org/blog/27613/inflation/demand-pull-
inflation/

8. https://www.reviewecon.com/phillips-curve4 (graph for Phillips curve

taken from here)

9. https://www.economicsdiscussion.net/phillips-curve/modern-version-of-
phillips-curve-with-diagram/2995 (graph for modern Phillips curve taken
from here)

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