How Inflation affects Unemployment Level

Various macroeconomic evaluations have attempted to describe the relationship that exists between inflation and unemployment level. For example, the Phillips curve, named after A. W. H. Phillip (1914-1975), envisages an inverse relationship between inflation rate and the employment rate. According to Phillips, decrease in unemployment level is associated with an increase in inflation, partly because of an increase in nominal wages and thus the increase in demand that pushes prices upwards. The increase in nominal wages arises due to the pressure on wages as the economy improves to accommodate more employees. Decreasing unemployment rates imply that firms have to pay higher wages to access the talent they need. In turn, such increased wages increase the firms’ cost of production, which the entities pass on as higher prices and thus increasing the inflation further.  In the short-run, due to the increase in nominal wages, and the concept of money illusion, employees are unlikely to demand further increases in the wages. In the long-term, however, unemployment returns to its natural rate, as a proportion of the GDP. As such, the relationship between inflation and unemployment rate as envisaged in the Phillips curve may not hold in the long –term as evident with periods of simultaneous high inflation and high unemployment.

This paper further explores the relationship between unemployment rate and the inflation rate, explaining the reasons that lead to deviation from the Phillips curve in the long-run. It explains the effect of macroeconomic policies such as monetary and fiscal policies on this relationship.

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