Inflation and Unemployment

Abstract：The relationship between inflation and unemployment has long been debated in economics. The Phillips Curve, proposed by economist A.W. Phillips, initially showed an inverse correlation between unemployment and wage growth, later extended to inflation rates. Early interpretations suggested that moderate inflation could reduce unemployment. However, economists like Milton Friedman and Edmund Phelps argued that in the long term, this inverse relationship breaks down, leading to phenomena like stagflation—simultaneous high inflation and unemployment. Their predictions were validated in the 1970s. Today, most economists agree that the Phillips Curve is vertical in the long term, indicating no stable trade-off between inflation and unemployment.

The relationship between inflation and unemployment is a concept that remains widely discussed. The idea suggests an inverse relationship: when unemployment rates are high, introducing some inflation can reduce it; conversely, lower unemployment often correlates with higher inflation rates. Is there truth to this notion?

Let’s explore how economists view the connection between inflation and unemployment, particularly through the lens of the Phillips Curve.

1. The Original Idea and Origins of the Phillips Curve

What is the Phillips Curve? In 1958, British economist A.W. Phillips (1914–1975) published a paper titled The Relationship between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957. He studied the relationship between two variables: unemployment and the rate of wage changes.

In his paper, Phillips plotted a graph with the rate of wage changes on the vertical axis and unemployment rates on the horizontal axis.

Based on UK data from 1861 to 1957, he identified a trend showing an inverse relationship: as wage rates increased, unemployment decreased, and vice versa. This relationship was logical and easy to understand. When wages rise, more people are willing to work, leading to lower unemployment. Conversely, when wages fall, people are less inclined to take jobs, increasing unemployment.

This inverse relationship between wage changes and unemployment made sense and aligned with common expectations.

2. Why the Phillips Curve Fails in Practice

However, later economists altered a key concept in Phillips’ original work, replacing the rate of wage changes with the inflation rate. They then created a new graph with the same horizontal axis (unemployment rates) but changed the vertical axis to represent inflation rates.

Using this adapted model, economists concluded that there was an inverse relationship between inflation and unemployment: higher inflation correlated with lower unemployment, and higher unemployment correlated with lower inflation.

After the publication of Phillips' paper in 1958, more and more people believed that inflation could be used as a tool to combat unemployment. Governments began implementing inflationary policies, and initially, they observed a decline in unemployment.

Why did this appear to work? Because inflation and its effects take time to spread. During this lag, it misleads individuals and businesses, prompting them to make decisions based on incomplete information.

For example, imagine a restaurant owner experiencing a sudden influx of customers. Initially, they might dismiss this as a one-off event. After several months of consistently high demand, the owner concludes that their business is booming due to excellent management and decides to expand—hiring more staff and opening additional branches.

In this early stage, inflation appears to have a "positive" effect: employers hire more people, incomes rise, and consumption increases, lowering unemployment. However, as inflation spreads throughout the economy, businesses face rising costs—wages, rents, and supplies all increase.

Eventually, business owners realize that the economic environment hasn’t truly improved but was distorted by inflation. Their new investments and hiring decisions may turn out to be misguided. When governments attempt to curb inflation, businesses face a sudden cash crunch, forcing them to halt expansions or lay off staff. The previously observed inverse relationship between inflation and unemployment breaks down.

In summary, as societies improve their ability to anticipate inflation, using inflation to reduce unemployment becomes less effective.

3. The Risk of Stagflation

In 1968, economists Milton Friedman (1912–2006) and Edmund Phelps (1933–) independently published papers arguing that, in the long term, the inverse relationship between inflation and unemployment does not hold. They warned that relying on inflation to reduce unemployment could lead to stagflation—a combination of high inflation and high unemployment.

Their predictions came true.

By the early 1970s, stagflation became a reality in countries like the United States, the United Kingdom, and Canada. The neat downward-sloping Phillips Curve was replaced by erratic, web-like graphs showing no consistent relationship between inflation and unemployment.

Friedman’s accurate prediction of stagflation brought him fame, culminating in his 1976 Nobel Prize in Economics. Meanwhile, Edmund Phelps, who published similar insights around the same time, had to wait until 2006 to receive his Nobel Prize.

4. Modern Consensus: A Vertical Phillips Curve

Today, most economists agree that in the long run, the Phillips Curve is vertical. This means that regardless of the inflation rate, unemployment levels remain relatively stable, determined by structural factors rather than inflation. This consensus underscores the limitations of using inflation as a tool to manage unemployment and highlights the need for more nuanced economic policies.