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How Can Low Unemployment Gradually Increase Inflation

The trade-off between inflation and unemployment

The trade-off between inflation and unemployment was first reported by A. W. Phillips in 1958—and so has been christened the Phillips curve. The simple intuition behind this trade-off is that as unemployment falls, workers are empowered to push for higher wages.

Firms try to pass these higher wage costs to consumers, resulting in higher prices and an inflationary build up in the economy. The trade-off suggested by the Phillips curve implies that policymakers can target low inflation rates or low unemployment, but not both. During the 1960s, monetarists emphasized price stability (low inflation), while Keynesians more often emphasized job creation.

Relation between inflation and unemployment
Striking Inflation

Stagflation in the 1970s

The experience of so-called stagflation in the 1970s, with simultaneously high rates of both inflation and unemployment, began to discredit the idea of a stable trade-off between the two. In place of the Phillips curve, many economists began to posit a “natural rate of unemployment”. If unemployment were to fall below this “natural” rate, however slightly, inflation would begin to accelerate.

Under the “natural rate of unemployment “theory (also called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU), instead of choosing between higher unemployment and higher inflation, policymakers were told to focus on ensuring that the economy remained at its “natural” rate: the challenge was to accurately estimate its level and to steer the economy toward growth rates that maintain price stability, no matter what the corresponding level of unemployment.

Pros and Cons of the NAIRU Effect

The NAIRU has been extremely difficult to pin down in practice. Not only are estimates of it notoriously imprecise, the rate itself evidently changes over time. In the United States, estimates of the NAIRU rose from about 4.4% in the 1960s, to 6.2% in the 1970s, and further to 7.2% in the 1980s. This trend reversed itself in the 1990s, as officially reported unemployment fell. In the latter half of the 1990s, U.S. inflation remained nearly dormant at around 3%, while unemployment fell to around 4.6%. In the later Clinton years many economists warned that if unemployment was brought any lower, inflationary pressures might spin out of control. But growth in these years did not spill over into accelerating inflation.

Depicting the inverse relation between inflation and unemployment through the Phillips Curve

The early idea for the Phillips curve was proposed in 1958 by economist A.W. Phillips. In his original paper, Phillips tracked wage changes and unemployment changes in Great Britain from 1861 to 1957, and found that there was a stable, inverse relationship between wages and unemployment. This correlation between wage changes and unemployment seemed to hold for Great Britain and for other industrial countries. In 1960, economists Paul Samuelson and Robert Solow expanded this work to reflect the relationship between inflation and unemployment. Because wages are the largest components of prices, inflation (rather than wage changes) could be inversely linked to unemployment.

The theory of the Phillips curve seemed stable and predictable. Data from the 1960’s modeled the trade-off between unemployment and inflation fairly well. The Phillips curve offered potential economic policy outcomes: fiscal and monetary policy could be used to achieve full employment at the cost of higher price levels, or to lower inflation at the cost of lowered employment. However, when governments attempted to use the Phillips curve to control unemployment and inflation, the relationship fell apart. Data from the 1970’s and onward did not follow the trend of the classic Phillips curve. For many years, both the rate of inflation and the rate of unemployment were higher than the Phillips curve would have predicted, a phenomenon known as “stagflation.” Ultimately, the Phillips curve was proved to be unstable, and therefore, not usable for policy purposes.

Monetarists’ Rebuttal

The 1960s provided compelling proof of the validity of the Phillips Curve, i.e. that a lower unemployment rate could be maintained indefinitely as long as a higher inflation rate could be tolerated. However, in the late 1960s, a group of economists who were staunch monetarists, led by Milton Friedman and Edmund Phelps, argued that the Phillips Curve does not apply over the long term. Their contention was that over the long run, the economy tends to revert to the natural rate of unemployment as it adjusts to any rate of inflation.

Consider a scenario in which the natural rate of unemployment is prevalent. (The natural rate* is the long-term unemployment rate that is observed once the effect of short-term cyclical factors has dissipated, and wages have adjusted to a level where supply and demand in the labor market are balanced). If workers expect prices to rise, they will demand higher wages so that their real (inflation-adjusted) wages are constant.

Now, if monetary or fiscal policies are adopted to lower unemployment below the natural rate, the resultant increase in demand will encourage firms and producers to raise prices even faster. As inflation accelerates, workers may supply labor in the short term because of higher wages — leading to a decline in the unemployment rate — but over a longer term, when they are fully aware of the loss of their purchasing power in an inflationary environment, their willingness to supply labor diminishes and the unemployment rate rises to the natural rate. However, wage inflation and general price inflation continue to rise.

Over longer periods, higher inflation would not benefit the economy through a lower rate of unemployment; by the same token, a lower rate of inflation should not inflict a cost on the economy through a higher rate of unemployment. Since inflation has no impact on the unemployment rate in the long term, the long-run Phillips curve morphs into a vertical line at the natural rate of unemployment. Friedman and Phelps’ findings gave rise to the distinction between the short-run and long-run Phillips curves. The short-run Phillips curve includes expected inflation as a determinant of the current rate of inflation and hence is known by the formidable moniker “expectations-augmented Phillips Curve.”

(* Note that the natural rate of unemployment is not a static number but changes over time due to the influence of a number of factors. These include:

  • The impact of technology,
  • Changes in minimum wages,
  1. The degree of unionization.

In the U.S., the natural rate of unemployment was at 5.3% in 1949, rose steadily until it peaked at 6.3% in 1978-79, and declined thereafter; it is expected to be at 4.8% for a decade starting from 2016).

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  1. I work for a church pre school program and I have lost my job due to coronavirus. When I applied for unemployment in Texas it says that two does not except this employer as my last employer. I’ve been working there for 13 years. What do I do?

  2. Chad ….. how do I get thru when it wont accept my ID or my password. I change it 5 times and it still wont work. Calling is not working at any time when I spend and whole day calling back to back to get thru. why don’t they just help or force the employers ( company) to place they claims in for their workers like GM did……I NEED HELP…PLEASE.

    1. Chad,

      We understand this might be a difficult time for you. We’re anticipating a shortage of staff across unemployment offices due to the massive surge in UI applications considering the pandemic. We advise against calling or visiting the office, as you may not get a response instantly.

      Your state may have activated “Extended Benefits (EB)” authorized by the federal government. We recommend you apply for UI benefits online. For more information, please visit your state’s official Unemployment website.

  3. i live in ga…all the day cares have shut down my wife and i have full time jobs,,,but i have to leave my company which i have been there for over two years,to take care of our child….can i still collect unemployment…this covid virus is why i have to leave my job…

    1. Gary,

      We understand this might be a difficult time for you. We’re anticipating a shortage of staff across unemployment offices due to the massive surge in UI applications considering the pandemic. We advise against calling or visiting the office, as you may not get a response instantly.

      Your state may have activated “Extended Benefits (EB)” authorized by the federal government. We recommend you apply for UI benefits online. For more information, please visit your state’s official Unemployment website.

  4. are you kidding me my son lost his job on 10/17/2020 hes mentally challenged and cant file on his own because he doesn’t know how so I started going to sites trying to file for him and the residence inn Marriott promised to help him and have done zip . ive tried 10 different sites and I keep getting dropped wen I complete forms and push submit. 12 days now n still cant file a claim.

    1. Martin,

      There’s only one website you should be trying from. Please let us know your state and we’ll share the website information.

  5. I have submitted my forms EXACTLY as I was instructed too on line. Even though I have filled out the paperwork correctly I keep getting emails asking for me to fill out the form that I have done multiple times already. Remuneration – Claimant Questionnaire is the issue. I got online and requested a phone call. 3 days ago. I just need to know that you guys received everything and I don’t owe any more information.
    Nobody answers the 617-626-6800 number. Just get directed to the internet. Well, you can’t speak with the internet. I am getting mixed messages and I fret that this will delay any benefits.
    Could someone please give me a call.

    1. James,

      Please try finding answers online since there might be limited phone support due to the shortage of staffing. This is a private forum and we’ll not be able to arrange a callback.

  6. I work for a church that has grown it’s congregation over almost 40 years and we now have 26 mostly full time employees, most being here many years. Will our employees be able to file and receive benefits since we are an EXEMPT from paying unemployment industry? State of Florida

  7. My unemployment benefits ran out 3/1/2020 am I able to file for extended benefits ? I live in California and am 62 years old.

    1. Ariana,

      We understand this might be a difficult time for you. We’re anticipating a shortage of staff across unemployment offices due to the massive surge in UI applications considering the pandemic. We advise against calling or visiting the office, as you may not get a response instantly.

      Your state may have activated “Extended Benefits (EB)” authorized by the federal government. We recommend you apply for UI benefits online. For more information, please visit your state’s official Unemployment website.

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