Determinants of Unemployment and Inflation
Unemployment and inflation are two of the most critical aspects of an economy. This is why many governments put in place monetary and fiscal policies, mostly to handle these two issues. But the main one of unemployment, which even affects inflation.
All countries across the world face this issue. And for many years, especially since the great recession, it has been a consistent problem with both developing and developed nations. Unemployment is a state of having no job or being out of work. It is also the rate at which people are unable to get jobs within a given economy.
The relationship between unemployment and inflation
Before understanding what case these issues, it is critical to first develop a foundation by discussing the relationship between them. There is a reason why they are often discussed together. There has been an inverse correlation, that is mostly understood by most economists, which, however, is more complex than it appears. The main reason they are considered together is that they are the most closely monitors economic indicators. Whenever an economy is doing well, the rate of unemployment and inflation is low. And when things are bad, these rates surge. This is why governments will always keep a close eye on them, ensuring everything is kept under control.
Supply and demand in the labor
One of the main ways to understand this difference is by using wage inflation, or the rate of changes in wages, which is a proxy for inflation in the economy. A high unemployment rate means the number of individuals seeking employment in higher than the openings available. This mean supply for labor is way higher than the demand for it.
When there are so many workers on the market, employers will see little or no need to pay them higher wages.
During these times, wages remain stagnant, leading to wage inflation (rising wages) being non-existent.
The opposite is true. When there is low unemployment, employers' demand for labor is higher than the supply. This causes such a tight market where employers will need to pay higher wages to attract and retain more qualified employees. Hence, there is an increase in wage inflation.
Economists have been trying over the past few decades to define the relation between unemployment and the general inflation rate. For this, there are several ideas that have been used to try and explain this relation.
Rising minimum wage and inflation - history
The first economist to come up with convincing evidence about the unemployment being related to inflation was A. W Philips. He studied how inflation affected unemployment in the United Kingdom over several years, between 1861 and 1957. He found out that a change in wages was affected by the level of unemployment and the rate of change in unemployment.
In his hypothesis, Philips stated that when the demand for labor is high and they are a few unemployed, employers will rapidly increase wages. But if there is low demand in labor, and unemployment high, workers may be reluctant to accept low wages, that the current wages, which leads to a slow but steady fall in the prevailing wage rates.
The change in unemployment also affects wage rate changes. When business is good, employers will look vigorously for workers; in the case, labor demand will keep increasing, when the demand was no increasing, or rising at a slow rate. For companies, wages and salaries are the major input cost. This means, rising wages will lead to higher prices or products within an economy, which increases the overall inflation. Philips used the relation between price inflation and unemployment, in a graph known today as the Philips Curve.
The Philips Curve has several implications for the economy. First, it shows that low inflation and high employment are the foundation of monetary policy in the modern central bank. For instance, in the US, the Federal Reserve's monetary policy is mandated to ensure the maximization of employment, stable prices, and reasonable interest rates. Inflation and unemployment caused economists to use the Phillips Curve to polish monetary or fiscal policy. The curve for a specific economy would indicate an explicit level of inflation for a specific rate of unemployment and more. It may be possible to aim for a balance between desired levels of inflation and unemployment.
In the US, the use of the Consumer Price Index has been pivotal in showing the inflation rate or rising prices in the economy. It indicates that when unemployment was at 6%, monetary and fiscal stimulus, which lowered the rate to 5%. In this case, the impact of inflation is insignificant – a 1% fall would not greatly affect the process. But if unemployment fell to 4%, inflation would then rise to 3%.
Phillips curve was validated and proved in the 1960s, where a low rate of unemployment would be maintained so if the economy could tolerate higher inflation. However, in the late 1960s, a group of economists who staunchly followed the monetary theory argued that Philips Curve would not hold waters in the long run. Led by Milton Friedman and Edmund Phelps, the team debated that economies tend to circle back to the natural rate of unemployment over the long term. If there are the effects of short-term cyclical factors, they can initiate a dive into natural rate observance in the long run.
Over the years, there have been changes in the monetary and fiscal policies that directly touch wages and inflation rates. Since business cycles are inevitable, there is always a chance that inflation and unemployment will continue to be major economic growth issues. Today, there is an unusual economic environment where wage gains despite a decrease in unemployment rates. This effect has been felt since the Great Recession.
This shows that the inverse relationship presented by Philips Curve only works well in the short-run. But in the long run, the economy tends to revert to the natural unemployment state and adjust automatically to inflation rate. It is, however, clear that inflation affects unemployment, just like unemployment affects inflation. And this relationship is more complicated than it seems, which is why it has been divided into periods, like the stagflationary of the 1970s and the booming 1990.
There has been low unemployment, low inflation, and fewer wage gains. But this does not stop economies from trying to keep things under control. When there is an economic crisis, it is the unemployment rate and inflation that gets hit first. When this happens, policymakers need to come up quickly with the means to protect the markets. When markets fail, the supply for commodities increases as supply decreases.
Factor affecting unemployment and inflation
As discussed above, the relation between inflation and unemployment is a complex one. The Phillips Curve, on the one hand, shows the inverse relation, whereas monetarists believe this relation does not hold water. No matter, it is critical to understand that rate of inflation will always affect unemployment. When it begins to rise, the general economy decreases and vice versa. In recent years, debates have increased in this relation, some that establish the truth, while others don't have the basic line.
In addition, here are some issues that determine unemployment and inflation.
Environmental concern is always a threat to the economy. One of the biggest issues in consumer theory is scarcity. This happens because the limited resources available cannot support unlimited consumer demands and needs. To get enough resources, producers have to tap into the environment. If starting or running a certain business puts a high risk on the environment, environmental law may stop such operations. In other words, environmental policy can determine how many firms or particular products should be expected from a particular region. Such issues limit how much firms can expand, and where they are forced to close, they cause loss of jobs, contributing more to unemployment.
It is important to keep the environment clean. However, environmentalists have to put into consideration the potential effects economies will have to suffer. Global warming, for instance, has become a huge concern for everyone across the globe. There are many companies that have been closed due to their impact on the environment. Such actions have a great impact on the economy at large. Since the global economy is collectively determined by many factors, among them environmental concerns, it becomes challenging for policymakers to create a point of consensus – yet very crucial for development purposes.
No one can deny that technology is changing the modern world. On one side, these technologies are good because they make human life much easier. However, there is a certain situation where they threaten the labor force. We have seen many Gen Zees, engage in social media activities like Vlogging and running Instagram marketing account. Many say that they are threatened by the fact that robots may replace their labor market positions. Such things force them to seek alternatives means of making ends meets. However, it is important to note that technology makes production processes more efficient, which may lead to lower inflation rates.
Contribution of women in the labor force
For generations, the role of women in society was insignificant. This is true, especially in the less developed worlds where women are left to look after their homes. Today, however, advocacy for women's rights has led to more opportunities opening up for them. Because of this, they have been able to contribute more to the economy. However, this also means competition for jobs has also increased, yet there are not many openings in the job market. There are more students graduating from colleges than there are positions to accommodate them. As seen above, a high rate of unemployment makes government expenditure to increase, which leads to higher inflation. Besides, companies will not be willing to pay high wages because competition for jobs is high.
There are policies that guide firms on who they should employ. There are companies that only employ workers of a certain age. In case they may not want to accommodate older workers, for instance. If every firm were to behave so, then there would be no employment for the rest of the groups. And in the modern world, these form the largest number of people. Also, there are types of unemployment, like structural unemployment, that is caused by a lack of skills for the expected position.
Economies are never stable. There are economic cycles, whereby at one point, the economy is high, while during the recession, the economy is low, causing unemployment. Such type of unemployment is called cyclical. There is insufficient total spending caused by the recession phase of a business cycle. When there are fewer aggregate demands, firms will respond by producing less, which translates to less output, causing a reduction in employment. This also causes a higher inflation rate because the economy is much slower. If there is a recession that leads to unemployment, it can cause more scarcity. Such is not good for society because economic activities will reduce, increasing the cost of living.
During cyclical unemployment, government policies can be used to shield their impacts. Governments use fiscal and monetary policies to restore collapsed or near-collapse markets. This can help in reducing the rate of unemployment. However, it can also mean injecting more money into an economy, which may restore an economy and increase inflation. Injecting money into an economy reduces the strength of a country's currency. This means it will be much harder to import-export goods.
In developing countries, especially in Africa, there is a lot of rural-urban migration. As more people move into cities in such employment opportunities, the cause congestion, hence higher cost of living. Even those who have jobs do not always have enough to take care of their needs as well as that of their families. This only leads to higher inflation as the consumption rate for locally manufactured goods reduces.
Unemployment and inflation are very critical to economic development. The global economy suffers heat when there is more of this, especially in developed countries. They affect currency strength, which, in turn, impacts the process or trading with other nations.
Author: James Hamilton