Inflation and Unemployment

Read this chapter to examine the relationship between inflation and unemployment. As you will see, while there have been some periods in which a trade-off exists between inflation and unemployment, there are also periods in which such clear-cut negative relationship between these variables falls apart. The chapter offers some explanations for these variable behaviors and the stabilization policies that are used to address undesirable trends in the variables.

1. Relating Inflation and Unemployment

The Short-Run Phillips Curve Goes Awry

The effort to nudge the economy back down the Phillips curve to an unemployment rate closer to the natural level and a lower rate of inflation met with an unhappy surprise in 1970. Unemployment increased as expected. But inflation rose! The inflation rate rose to 5.3% from its 1969 rate of 4.8%.

The tidy relationship between inflation and unemployment that had been suggested by the experience of the 1960s fell apart in the 1970s. Unemployment rose substantially, but inflation remained the same in 1971. In 1972, both rates fell. The economy seemed to fall back into the pattern described by the Phillips curve in 1973, as inflation rose while unemployment fell. But the next two years saw increases in both rates. The negatively sloped Phillips curve relationship between inflation and unemployment that had seemed to hold true in the 1960s no longer prevailed.

Indeed, a look at annual rates of inflation and unemployment since 1961 suggests that the 1960s were quite atypical. Figure 16.3 "Inflation and Unemployment, 1961–2011" shows the two variables over the period from 1961 through 2011. It is hard to see a negatively sloped Phillips curve lurking within that seemingly random scatter of points.

Figure 16.3 Inflation and Unemployment, 1961–2011

Annual observations of inflation and unemployment in the United States from 1961 to 2011 do not seem consistent with a Phillips curve.