We know that unemployment and inflation are two of the most important indicators of the health of an economy. The relationship between unemployment and inflation is a complex and often misunderstood one.
These two are inversely related, which means that when unemployment goes down, inflation tends to go up, and when unemployment goes up, inflation tends to go down. This relationship is known as the Phillips Curve, and it has been a topic of much discussion among economists and policymakers.
To understand the relationship between unemployment and inflation, let me first define what these terms mean. Unemployment refers to the number of people who are out of work and actively seeking employment. And inflation refers to the rate at which prices for goods and services are rising.
When inflation is high, it means that the purchasing power of money is decreasing, as it takes more money to buy the same goods and services.
Let me take an example to illustrate the relationship between unemployment and inflation. Imagine that the economy is in a state of full employment, which means that everyone who wants a job has one. In this scenario, businesses have to compete for workers, which drives up wages.
As wages go up the cost of producing goods and services also goes up. This increase in production costs is passed on to consumers in the form of higher prices, which leads to inflation.
Now if there is high unemployment in the economy, businesses have a larger pool of job seekers to choose from. This means that they don't have to compete for workers, which keeps wages low. This results in the cost of producing goods and services also staying low which keeps prices from rising and prevents inflation.
Federal Reserve may want to raise unemployment in order to lower inflation. Even they say this is the only option. The FED is responsible for controlling the money supply and interest rates in the economy. One of its primary goals is to maintain price stability, which means keeping inflation under control.
When inflation starts to rise, the Federal Reserve may choose to raise interest rates in order to slow down the economy and reduce inflation.
This is because higher interest rates make borrowing more expensive, which can slow down consumer spending and investment. However, raising interest rates can also lead to higher unemployment, as businesses may be less likely to invest in new projects and hire new workers when borrowing is more expensive.
If the question comes to our mind, why does the Federal Reserve want to raise unemployment to lower inflation? The answer lies in the tradeoff between inflation and unemployment.
The Phillips Curve suggests that there is an inverse relationship between the two, which means that when unemployment is low, inflation tends to be high, and vice versa. By raising unemployment, the Federal Reserve can reduce the pressure on wages and production costs, which can help to bring inflation under control.
It's worth noting that the relationship between unemployment and inflation is not always straightforward. There are many other factors that can affect both variables, including productivity, technology, and government policies. The Phillips Curve has been criticized for being too simplistic, and many economists argue that it doesn't hold up in the long run.
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The reference book I used for my article is below:
Mankiw, N. G. (2014). Principles of macroeconomics.
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