No Such Thing as a Free Lunch: Principles of Economics (Part 144)

The best social program is a good job.

BILL CLINTON

The Labor Market, Unemployment, and Inflation

(Part D)

by

Charles Lamson

The Short-Run Relationship between the Unemployment Rate and Inflation

The relationship between the unemployment rate and inflation---two of the most important variables in macroeconomics---has been the subject of much debate. We now have enough knowledge of the macroeconomy to explore this relationship.

We must begin by considering the relationship between aggregate output (income) (Y) and the unemployment rate (U). An increase in Y means firms are producing more output. To produce more output, more labor is needed in the production process. Therefore, an increase in Y leads to an increase in employment. An increase in employment means more people working (fewer people unemployed) and a lower unemployment rate. An increase in Y corresponds to a decrease in U. Thus U and Y are negatively related:

When Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises.

Next consider an upward-sloping AS curve, as shown in Figure 3. This curve represents the relationship between Y and the overall price level (P). The relationship is a positive one: when Y increases, P increases, and when Y decreases, P decreases.

As you will recall from previous posts, the shape of the AS curve is determined by the behavior of firms and how they react to an increase in demand. If aggregate demand shifts to the right and the economy is operating on the nearly flat part of the AS curve---far from capacity---output will increase but the price level will not change much. However, if the economy is operating on the steep part of the AS curve---close to capacity---an increase in demand will drive up the price level, but output will be constrained by capacity and will not increase much.

Think about what will happen following an event that leads to an increase in aggregate demand. First, firms experience an unanticipated decline in inventories. They respond by increasing output (Y) and hiring workers---the unemployment rate falls. If the economy is not close to capacity, there will be little increase in the price level. If, however, aggregate demand continues to grow, the ability of the economy to increase output will eventually reach its limit. As aggregate demand shifts farther and farther to the right along the AS curve, the price level increases more and more, and output begins to reach its limit. At the point at which the AS curve becomes vertical, output cannot rise any further. If output cannot grow, the unemployment rate cannot be pushed any lower.

There is a negative relationship between the unemployment rate and the price level. As the unemployment rate declines in response to the economy moving closer and closer to capacity output, the overall price level rises more and more, as shown in Figure 4.

The curve in Figure 4 has not been a major focus of attention in macroeconomics. Instead, the curve that has been extensively studied is shown in Figure 5, which plots the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. The inflation rate is the percentage change in the price level, not the price level itself.

Figures 4 and 5 imply different things. Figure 4 shows that the price level remains the same if the unemployment rate remains unchanged. Figure 5 shows that the inflation rate remains the same if the unemployment rate remains unchanged. The curve in Figure 5 is called the Phillips Curve, after A. W. Phillips, who first examined it using data for the United Kingdom. In simplest terms, the Phillips Curve is a graph showing the relationship between the inflation rate and the unemployment rate. 

The next few posts focus on the Phillips Curve in Figure 5 because it is the macroeconomic relationship that has been studied the most. Keep in mind, however, that it is not easy to go from the AS curve to the Phillips Curve. We have moved from graphs in which the price level is on the vertical axis (Figures 3 and 4) to a graph in which the percentage change in the price level is on the vertical axis (Figure 5). Put another way, the theory behind the Phillips Curve is somewhat different from the theory behind the AS curve. Fortunately, most of the insights gained from the AS/AD analysis concerning the behavior of the price level also apply to the behavior of the inflation rate. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 564-565*

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