Inflation, Unemployment & The Phillips Curve

Both the "demand-pull" and "cost-push" theories of inflation are able to be summarized by the Phillips Curve: as unemployment approaches zero, inflation rises. The consequent solutions to the inflation problems differ from demand pull to cost push: "demand-pull" theorists concentrate on bringing down demand by, for example, reducing government expenditure, while "cost-pushers" call for the easing of wage pressure by institutional reform or incomes policies.

"Demand-pull" inflation is generated by the pressures of excess demand as an economy approaches and exceeds the full employment level of output. Output, is generated by aggregate demand for goods therefore, whatever aggregate demand happens to be, aggregate supply will follow suit. However, at full employment output, if aggregate demand rises, output cannot follow because of full employment restrictions. Consequently, the only way to clear the goods market, then, is by raising the money prices for goods, essentially causing inflation. Demand-pull inflation will usually occur along with a booming economy. To avoid demand-pull inflation governments need to try to keep the economy growing at a steady, but not excessive rate.

Cost-push inflation happens when firms' costs go up. To maintain their profits, firms then need to put their prices up. In other words cost increases have pushed inflation up. Inflation is not the workers fault alone: a push for profits by owners will be enough to initiate price-wage inflation. In particular, there might be such a push when the owners' bargaining position seems relatively strong, i.e. when unemployment is high. Consequently, there is the possibility of inflation with high unemployment, i.e. stagflation. Stagflation is the worst of both worlds: inflation and recession, a combination of slow economic growth and rising prices.

Up until the 1970s, it was generally believed that recession and inflation could not occur at the same time. A slowing economy was supposed to bring stable prices, so inflation just could not be a problem when the economy slowed. That fact gave central bankers a sure-fire method for combating high inflation: just use strict financial guidelines until inflation was choked and disappeared. The Oil Crisis of 1973 shattered that myth and resulted in a new word in financial circles: stagflation.

Stagflation is very hard to control, and once it takes hold of an economy, is very hard to correct. ...

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Stagflation is very hard to control, and once it takes hold of an economy, is very hard to correct. Stagflation can cause distortions that put governments in a no-win situation. For instance, one part of the economy can be growing at the same time that another is shrinking. For instance, manufacturing can fall into recession, while the service sector is still growing. This can mean that wages are growing in one sector at that same time they are falling in another. This creates a serious problem for timing any adjustment of the economy. It can even make it difficult for economists to judge what direction the economy is actually going in.

Thinking in terms of supply and demand, price inflation could be caused in one or both of two ways. Prices in general would only rise if, on the average, demand increases or supply decreases. In the first case, when demand increases, resulting in inflation, we describe it as demand pull inflation. On the other hand, when cost increases and this causes supply to decrease in turn, causing inflation, we describe it as cost push inflation. But these two different causes of inflation are not independent. A demand-pull inflation may itself lead to cost increases, which then give rise to further cost-push inflation.

Hyperinflation refers to a very rapid, very large increase in the price level. This has happened in many societies throughout history. For example in Germany after World War 1, the government responded to the poor standing of the economy by printing money to replace the lost revenues. This was the beginning of a vicious circle. Each increase in the quantity of money in circulation brought about a further inflation of prices, reducing the purchasing power of incomes and revenues, and leading to more printing of money. In the extreme, the monetary system simply collapses. One source says that, “People might buy a bottle of wine in the expectation that on the following morning, the empty bottle could be sold for more than it had cost when full.” Another Example was in Hungaria, where hyperinflation after World War II forced the government to print bills for one hundred million trillion pengos (the pengo was the Hungarian currency unit) and bills for one billion trillion pengos were printed but never issued. Essentially, the monetary system can function reasonably well as long as the value of the monetary unit is reasonably stable and predictable, and the high standards of living of modern societies cannot exist without a functioning monetary system.

High unemployment means that costs rise less rapidly than prices when unemployment is high, so that inflation slows down. On the other hand, low enough unemployment will cause costs to rise faster than prices, with the result that inflation speeds up. In between the two extremes is a rate of unemployment just high enough that costs and prices rise at the same level, so there is no tendency for inflation either to speed up or slow down. This unique rate of unemployment is called the NAIRU, short for Non-Accelerating-Inflation Rate of Unemployment.

The main reason for the changes in unemployment statistics is technological progress. Although progress is good and it makes life easier, if every year we produce the same amount of goods with fewer people -- in a few years far less working hours are needed to produce all the goods that are required. The historical trend has been to use less and less working hours per week. If we do not continue this trend, the supply of working hours is greater than the demand. An oversupply of working hours means they are worth less, wages and salaries get reduced. Also many persons are out of work; their working hours are no longer needed. Those that are out of work have no income and therefore the demand for goods goes down. With fewer sales, less gets produced, more persons are laid off. This is a vicious circle that accelerates unemployment.

The definitions of the natural rate of unemployment and expected inflation are nearly circular. The natural rate of unemployment is the rate at which inflation is equal to expected inflation. Expected inflation is the inflation rate that prevails when unemployment is equal to its natural rate. These two characteristics determine the location of the Phillips curve. (The expected rate of inflation and the natural rate of unemployment)

The Phillips curve demonstrates the relationship between Unemployment and Inflation in modern society, and many economists use it to display current unemployment/inflation figures. Whenever unemployment is low, inflation tends to be high. Whenever unemployment is high, inflation tends to be low, essentially creating an inverse relationship.

The Phillips curve must pass through the point on the graph where actual inflation is equal to expected inflation, and where the actual rate of unemployment is equal to the natural rate of unemployment. Any shift in the natural rate of unemployment will shift the Phillips curve to the left or the right. Any shift in expected inflation will shift the Phillips curve up or down.

Bibliography:

Text References:

The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities, Mancur Olson (Paperback - May 1984)
Inflation, Unemployment and Money: Interpretations of the Phillips Curve, Bruno Jossa, et al (Hardcover - December 1998)
Inflation and Unemployment: Causes, Consequences and Cures, Graham Dawson (Paperback - December 1993)

Article/Magazine References:

Inflation and Unemployment: Contributions to a New MacroEconomic Approach (Routlidge Studies in the Modern World Economy), Alvaro Cencini (Editor), Mauro Baranzini (Editor) (Library Binding - September 1996)
The Economist (Magazine) title: American Capitalism Takes a Beating, July 2002. Finance and Economics secton.

Internet Site References: