The Relationship Between Unemployment and Inflation: The Phillips Curve

The English economist Phillips in the late 50s found a relationship between the unemployment rate and wage growth. Analyzing data for more than a hundred years, he came to the conclusion that there is a certain level of unemployment (6-7%), at which the level of wages is constant and its increase is zero. When unemployment falls below this natural level, there is a faster increase in wages, and vice versa. In the future, using the thesis of a strong correlation between wage growth and prices, this pattern was transformed into the relationship between unemployment and the growth rate of prices (inflation).

The appearance of the Phillips curve is shown in Fig. 4.5.

The Phillips curve shows that there is a stable and predictable feedback loop between unemployment and inflation. This confirms the Keynesian thesis that inflation can only be high with a slight level of unemployment, and vice versa. In the economy, there is a level of employment at which prices practically do not grow.

The Phillips curve was well confirmed by empirical studies of statistical indicators of leading countries in the 50-60 years. At this time, full employment was achieved in the economies of many countries. As measures were taken to further increase production and reduce unemployment, price growth accelerated, and vice versa – a decrease in inflation was accompanied by an increase in unemployment.

There are various explanations for the existence of an inverse relationship between inflation and unemployment. This is partly due to the inflexibility of the labour market. The latter is a set of individualized markets that are segmented in nature by the structure of employment, qualifications, location, etc. This circumstance leads to the fact that as the economy moves towards full employment in some segments of the labor market, unemployment will remain virtually unchanged, while in others – unmet demand. In them, there will be an increase in wages, leading to an increase in costs and an increase in prices. The macroeconomic result of this process will be an acceleration of inflation.

Another explanation for the Phillips curve is that it is easier for producers (especially monopolies) to push for higher prices and wages during periods of economic growth. High unemployment forces employees to accept lower wages, which breaks the inflationary wage-price spiral. In addition, poor economic conditions hinder the desire of producers to raise prices. In the opposite situation, as we approach full employment, there is an increase in demand for additional factors of production. The consequence of this is wage growth, overtaking the growth of labor productivity. The inflationary wage-price spiral is unwinding. In addition, in times of economic recovery, it is easier for monopolies to raise prices for products. The result of these processes will be an acceleration of inflation.

The essence of the Phillips curve is clearly represented by analyzing the curves of aggregate supply and demand. The growth of aggregate demand in the economy deepens existing and creates new disproportions in the economy, psychologically increases the limited resources. As a result, with the growth of demand, inflation increases. The greater the increase in aggregate demand and the closer the economy is to the level of full employment, the more prices will rise.

There is a twofold relationship to the Phillips curve. In the first approach, the Phillips curve is treated as an economic law. This means that at the same time there can be no strong inflation and high unemployment in the country. With the help of different combinations of state regulatory instruments, it is possible to achieve any combination of inflation and unemployment levels corresponding to different points in the curve. So, perhaps, free movement up and down the curve. The choice of point is determined by the existing economic situation, as well as the socio-political guidelines of the government.

The second approach to the Phillips curve denies the constancy and stability of the relationship between inflation and unemployment. In the economy, it is possible to achieve the highest level of employment at a given rate of moderate inflation. The conflict of goals – to restrain inflation or unemployment – is overcome if it is possible to shift the Phillips curve left and down.

Analyzing the dynamics of inflation and unemployment of the 70-80s, we can conclude that the relationship between them was very unstable. In times of economic crisis, both prices and unemployment rose simultaneously. This economic situation is called stagflation (economic stagnation with simultaneous inflation), or slampflation (a combination of inflation and a sharp economic downturn). The data obtained at this time on the relationship between inflation and unemployment lead to two conclusions: either the Phillips curve has moved upwards to the right and now each level of inflation corresponds to an increased unemployment rate, or there is no connection between these phenomena.

Economists of the Keynesian school explain the emergence of stagflation by a series of supply disruptions. The previous analysis of the relationship between prices and employment was based on a change in the level of aggregate demand with unchanged supply. A decrease in aggregate supply (shifting the curve to the left) leads to a simultaneous increase in inflation and unemployment rates. As a result, stagflation occurs and a shift in the Phillips curve occurs. The following factors contributed to the increase in unit costs of production and the shift of the aggregate supply curve to the left in the 70-80s:

a fourfold increase in the price of oil and petroleum products; the global food crisis and the subsequent rise in the price of agricultural products; the deterioration of the terms of trade and the resulting inflationary imports; abandonment of the income policy, removal of control over prices and wages; reducing the growth rate of labor productivity at the given growth rates of nominal wages; inflation expectations of workers, causing an increase in nominal wages and specific labor costs.

In another way, representatives of the neoclassical school explain stagflation with the help of theories of adaptive and rational expectations. Both concepts assume that there is a natural level of unemployment in the economy. Having reached it, the economy comes to a stable position. Any deviation from it will generate inflation or deflation.

According to the theory of adaptive expectations, economic entities form their ideas about expected inflation, based on the previous rates of price growth, adjusted for the error of the forecast of the previous period. These expectations are quite stable. In a formalized form, they can be represented in the form of:

Pe1 = Pe0 + a (P0 – Re0),

where Pe1 is the expectation of future inflation made in the current period;

Pe0  – expected rates of price growth in the current period;

P0 – Pe0 – an error in the forecast of price growth in the current period;

a is the correction (adaptation) coefficient, which shows the speed of revision of expectations: 0<a<1.

In the short term, an increase in demand, provided that the actual rate of price growth is higher than expected, will lead to a movement along the Phillips curve and a decrease in unemployment. This is possible due to the fact that wages are set at the expected level, and higher than expected prices for goods increase the profits of producers. The reaction of the business will be to increase output and hire additional workers.

However, the equilibrium achieved is not stable. Over time, wage earners will begin to realize that their real wages have declined. Workers will demand a restoration of the status quo. As a result, there will be an increase in nominal wages and a decrease in profits. There will be no incentives to expand production, the real volume of which will return to the level of the natural rate of unemployment. Inflation generated by rising demand will continue. Its actual and expected level will increase. The short-term Phillips curve rises upwards. Thus, maintaining unemployment below natural levels can be done through expansionary monetary policy, but this causes a continuous increase (acceleration) in inflation rates.

With a new increase in demand in the economy, the action of the mechanism described above will be repeated. At some point in time, price growth reaches such a rate that it becomes impossible to keep inflation at a level higher than expected. Thus, in the long term aspect, there is no choice between inflation or unemployment and the Phillips curve has the form of a vertical straight line passing through the point of the natural unemployment rate. In other words, any given level of inflation in the long run correlates with the natural rate of unemployment. Over long-term time intervals, the aggregate supply curve is a vertical line of natural output. The absolute price level changes in proportion to the growth of the money supply (aggregate demand). This property of money in the long term to influence only the general price level is called the “neutrality” of money.

The relationship between inflation and unemployment in the case of adaptive expectations can be represented as an equation:

Pe1 = Pe0 + b (U – U*),

where Pe0 is the adjusted price level of the previous period, taking into account the error;

U – U* – deviation of actual unemployment from the natural level;

b is the coefficient that determines the reaction of prices to a particular level of unemployment.

The theory of adaptive expectations suggests that economic units cannot accurately account for expected inflation. In contrast, the theory of rational expectations, which is the core of the doctrine of the new classics, assumes that business and household have the necessary information and can draw the right conclusions from its analysis. Expectations are formed not on the basis of past experience, but on the basis of the future economic policy of the state, conjunctural and other forecasts. As a result, wage earners can accurately anticipate price increases and will be able to compensate for it by seeking higher nominal wages. The consequence of this will be the lack of additional profits and incentives to expand production even in the short term. The Phillips curve will take the form of a vertical curve. All the growth in demand will be compensated by rising prices. The equation of the Phillips curve can be represented as:

U = U*+h (P – Pe),

where P is the rate of inflation;

Pe – expected inflation rate;

h is a coefficient showing the reaction of unemployment to an error in the inflation forecast;

U – the level of actual unemployment;

U* – natural unemployment rate.

In this approach, there is no time lag during which the aggregate demand curve will move along the aggregate supply curve. The result of a fully projected expansionary monetary policy will be rising prices. The property of money not to affect the real volume of production in short-term time intervals is called the superneutrality of money.

Important conclusions of the theory of rational expectations are:

First, the growth rates of prices in the previous period are not taken into account future inflation, therefore, there is no inflationary inertia;

secondly, if there are errors in the forecast, the actual inflation is placed higher than expected. In this case, unemployment decreases, and vice versa;

Third, monetary policy will be effective only if it is unpredictable.

To summarize, most economists now recognize in the short term the traditional form of the Phillips curve and the almost complete absence of interconnection in the long-term time interval. The relationship between the rate of inflation and the unemployment rate can be expressed using the equation:

P = D + b (U – U*) + ?AS,

where P is the rate of inflation;

D – expected inflation rate;

U – the level of actual unemployment;

U* – natural unemployment rate;

b is a coefficient ranging from 0 to 2.5, based on A. Okun’s law;

?AS – abrupt changes in supply.

The Belarusian economy for a long time developed on the basis of the priority of industrial sectors, had large volumes of work in progress and was characterized by a high level of monopolization and hidden unemployment, which created the prerequisites for the deployment of powerful inflationary processes in our country in the early 90s. Insufficiently tight financial policy of the state during this period contributed to the strengthening of inflation. Along with the structural features of the economy of Belarus of the post-Soviet period, the causes of inflation in our country can be called:

the crisis in production caused by deficits and chronic non-payments; price liberalization in an environment of high monopoly, which slows down structural adjustment; weak involvement of Belarusian producers in the global division of labor, due to the non-competitiveness of domestic products; increase in prices for imported raw materials and energy carriers.

The combination of these factors has led to the fact that domestic producers raise prices for products in accordance with the world level, taking little into account the fall in demand, compensating for it with a decrease in production volumes.

Since mid-1993, the predominant demand inflation has given way in Belarus to the predominant cost inflation, the main factors of which were a significant increase in costs due to an increase in prices for raw materials, labor, etc. Consumer price indices, prices and tariffs for individual sectors of the Belarusian economy are given in Table 4.2.

Table 4.2.

Price indices for individual sectors of the economy

(December to December of the previous year; in percentage)

Indicators

1995

1996

1999

2000

Consumer price indices for goods and paid services

344,0

139,3

351,2

207,5

Producer price indices of industrial products

221,8

131,4

345,1

268,3

Producer price indices for agricultural products sold

649,01

167,0

499,0

210,0

Indices of goods for freight transportation

291,0

153,9

286,3

420,0

1 Percent to the previous year

Source: Statistical Handbook “Belarus in Figures”. – Mn.: Minstat RB, 2001. p. 82.

In order to prevent inflation or mitigate its consequences, the state pursues an anti-inflationary policy at different stages of the inflationary process. It will be effective only if it affects the causes and mechanism of inflation. From this point of view, the policy of the state, which carries out compensation payments, allowances, administrative control over prices, cannot be fully called anti-inflationary, since it concerns only the consequences of inflation and cannot eliminate its causes.

Throughout the world, a set of measures of anti-inflationary regulation has been developed and tested in practice both for the long term (anti-inflationary strategy) and for a short period of time (anti-inflationary tactics). Successful implementation of a long-term strategy requires a government that enjoys the confidence of the majority of citizens and adheres firmly to the policy of suppressing inflation.

Of great importance for curbing inflation is the correct long-term monetary policy aimed at introducing strict restrictions on the growth of the money supply, regardless of the state of the budget, the level of unemployment, etc. As a rule, when solving this problem, an arsenal of tools at the disposal of the Central (National) Bank is used: changing the interbank loan rate and the required reserve ratio, conducting operations in the securities market with government debt. Obligations. By increasing the interest rate and the rate of required reserves, the Central (National) Bank sets a non-inflationary line of behavior for all parts of the banking system, and, carrying out operations on the open market, it directly affects the state of money circulation. If he sells securities, then this is in line with the policy of “expensive money”, which tames inflation, since money is withdrawn from circulation; if the Central (National) Bank buys securities, it will be a policy of “cheap money”, which stimulates inflation.

Long-term anti-inflationary regulation, based on the rational monetary policy of the Central (National) Bank, should be supported by measures to solve the strategic task – reducing the budget deficit by reducing its expenditure and increasing revenues. The execution of the state budget of the Republic of Belarus suggests that it is not yet “working” to tame the budget: there is a budget deficit, budget expenditures in 1999 amounted to 37.8% of GDP, and revenues – 34.9%. It is clear that these mechanisms are designed for the long term and should be supplemented by methods of short-term anti-inflationary tactics. The maximum effect will be obtained if, firstly, to increase the volume of supply without increasing aggregate demand and, secondly, to reduce the current demand without reducing supply.

To increase the volume of supply, such a method as preferential taxation of enterprises that increase the level of marketability of the national economy, especially in those sectors where market relations are formed, is used. The means of anti-inflationary tactics can be the import of consumer goods and the sale of part of state reserves, reasonably organized privatization of state property.

The purpose of short-term regulation of current demand is to increase the volume of savings and reduce the level of their liquidity. This can be done, for example, by increasing interest on term deposits, temporarily freezing demand deposits, and widespread shareholding. In any case, short-term regulatory measures taken by the government should be combined with a long-term anti-inflationary strategy aimed at establishing a balance between the commodity and money markets.

Thus, the anti-inflationary strategy and tactics in the Republic of Belarus should take into account the peculiarities of the current state of the economy:

the need for structural restructuring of the national economy; delay in the formation of a market economy; the monopolistic nature of the economy; shifting the tax press to the cost of production.

In this regard, in order to implement the anti-inflationary strategy in Belarus, it is necessary to implement the following main activities:

elimination of control over prices and profitability with the exception of over-monopolized industries; effective privatization in order to create a sustainable competitive environment; rejection of the practice of providing loans to unprofitable enterprises, the creation of the institution of bankruptcy; liberal trade policies; implementation of radical agrarian reform, radical improvement of the organization of taxation.