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

Inflation and Unemployment Relationships Over Time

Although the points plotted in Figure 16.3 "Inflation and Unemployment, 1961–2011" are not consistent with a negatively sloped, stable Phillips curve, connecting the inflation/unemployment points over time allows us to focus on various ways that these two variables may be related.

In Figure 16.4 "Connecting the Points: Inflation and Unemployment" we draw connecting lines through the sequence of observations. By doing so, we see periods in which inflation and unemployment are inversely related (as in the 1960s, late 1970s, late 1980s, the end of the twentieth century, and the first decade of the 2000s). We refer to a period when inflation and unemployment are inversely related as a Phillips phase.

During other periods, both inflation and unemployment were increasing (as from 1973 to 1975 or 1979 to 1981). A period of rising inflation and unemployment is called a stagflation phase. Finally, a recovery phase is a period in which both unemployment and inflation fall (as from 1975 to 1976, 1982 to 1984, and 1992 to 1998). Figure 16.5 "Inflation – Unemployment Phases" presents a stylized version of these three phases.

Figure 16.4 Connecting the Points: Inflation and Unemployment

Connecting observed values for unemployment and inflation sequentially suggests a cyclical pattern of clockwise loops over the 1961–2002 period, after which we see a series of inverse relationships.

Figure 16.5 Inflation – Unemployment Phases

The figure shows the way an economy may move from a Phillips phase to a stagflation phase and then to a recovery phase.

Trace the path of inflation and unemployment as it unfolds in Figure 16.4 "Connecting the Points: Inflation and Unemployment". Starting with the Phillips phase in the 1960s, we see that the economy went through three clockwise loops, representing a stagflation phase, then a recovery phase, a Phillips phase, and so on. Each took the United States to successively higher rates of inflation and unemployment. Following the stagflation of the late 1970s and early 1980s, however, something quite significant happened. The economy suffered a very high rate of unemployment but also achieved very dramatic gains against inflation. The recovery phase of the 1990s was the longest since the U.S. government began tracking inflation and unemployment. Good luck explains some of that: oil prices fell in the late 1990s, shifting the short-run aggregate supply curve to the right. That boosted real GDP and put downward pressure on the price level. But one cause of that improved performance seemed to be the better understanding economists gained from some policy mistakes of the 1970s.

The 2000s look like a series of Phillips phases. The brief recession in 2001 brought higher unemployment and slightly lower inflation. Unemployment fell from 2003 to 2006 but with slightly higher inflation each year. The Great Recession, which began at the end of 2007, was characterized by higher unemployment and lower inflation. The next section will explain these experiences in a stylized way in terms of the aggregate demand and supply model.