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The macro economic environment is subject to fluctuation in its key variables such as rate of inflation, economic growth, levels of employment, exchange rate, trade cycles and balance of payments. Economists feel that some of these variations interact and a change in one affects the other. One unique interaction has been between unemployment rate and economic growth and the resultant rate of inflation.
Unemployment rate includes those willing and able to take up work but are not able to find any work.
They cannot be absorbed by the economy presently. Policy makers aim to lower unemployment but it is not possible to totally eliminate it as some proportions of the labor force is always between jobs. Inflation on the other hand, describes rise in general price levels. It is measured by various price indices such as CPI and GDP deflator of the economy against a base year. The higher the level of inflation the lower the purchasing power of consumers in the economy and policy makers will try to keep it as low as possible.
To lower unemployment, the government induces economic growth through fiscal and monetary policies. This increases money supply in the economy, which leads to a rise in price levels. This means that when the government undertakes to lower unemployment, inflation rises. A William Phillips first presented this trade off in 1958 when he represented the relationship on a graph, that is, the Philips curve. He plotted annual growth in wages against rate of unemployment in Britain or the period 1861-1913.
The curve is convex to the origin and negatively shaped because of the imperfect inverse relationship between unemployment and inflation. The data for the U.S from inception of the curve to 1969 reflected this relationship. However, the relationship did not hold from then to date. From 1970 inflation went up and so did unemployment thus discounting the Phillips curve.
This phenomenon is known as stagflation. Now theories come up to explain stagflation, a major one being the non-accelerating inflation rate of unemployment (NAIRU). NAIRU states that on short run Phillips curve resembles the traditional Phillips curve. In the long run, unemployment is fixed at natural rate of unemployment and the resultant Phillips curve is vertical line at that rate of unemployment.
The NAIRU states that any government action to lower unemployment below the natural employment rate only reduces unemployment in the short run before it shifts back to the natural rate. Inflation, on the other hand, goes up meaning that the new equilibrium is at a higher inflation and at the same rate of unemployment. This theory now has been discounted when a lower natural rate of unemployment was achieved in the U.S. The curve based on US data from 1960 –1998 is given below.
Inflation can either be demand-pull or cost-push. Key to this analysis is cost-push inflation. Cost-push inflation results from high wages that increase the cost production, which the producer passes on to the consumers inform of high prices of the end product. The high prices reduce the purchasing power of consumers among who are workers. Their real income is depleted by the high prices and through their powerful unions they negotiate a salary raise with the producer. The higher wages again pushes up the cost of production and prices spirals upwards as the cycle is repeated. (Blanchard, Olivier, 1997: 67)
In the unemployment and inflation inverse relationship, a capitalist would prefer that inflation remains low. The capitalist would like to maximize revenue from sales and low prices would lead to higher sales. To keep the inflation rate low, he must ensure that the cost of production is low. In a labor-intensive industry, the capitalist must maintain low wage bill, which will put him on a collision course with the workers.
Low inflation would mean high unemployment rate. High unemployment guarantees an available labor pool at all times. With high unemployment rates, a capitalist will be able to blackmail workers in to accepting low wages which in turn would lead to a lower price levels. If wages were high it would lead to cost push inflation. The capitalist would prefer greater sustainability between labor and capital to ensure low cost of production and hence low cost prices.
The laborers would opt for low unemployment, which would mean high wages. Laborers would be able to negotiate with the producer for higher wages since they would not be easily replaced a jobless labor pool. This would push up the cost of production and lead to cost push inflation. But the effects of the inflation would be mitigated by high wages. If there were high unemployment rates, the laborers would be content with low wages and would absorb such increases in prices. However, for the laborers to be able to negotiate their wages up to match the rise in prices they must be highly unionized and possess unique skills that are not universal. They must also be operating in a laborer-intensive industry where labor is the main cost driver. The labor should not be easily substituted with capital as this lead to layoffs and hence greater unemployment.
The society would prefer low inflation coupled with low unemployment. However, his may not be achievable according to the Phillips curve. The society would be hurt by low inflation, as it would be accompanied by high unemployment. High unemployment leads to many social problems. On the other hand, low unemployment would drive up inflation, which would also hurt the society.
High inflation means high consumer prices, which erode the real wages of the laborers in society. The society will therefore settle for moderate rates of both inflations and unemployment. The optimal levels of both variables will be attained at minimum point of the curve. Unemployment will in the long run be at the natural rate of unemployment. To achieve this optimal level, there must comprise on both the sides of the capitalist and the laborer. Capitalist must absorb part of the increases in wages while laborers absorb part of the increase in cost of production.
The traditional Philips curve has undergone much transformation to reflect the relationship of between inflation and unemployment over time as it continues to loose credibility. Basing the monetary and fiscal policy on the traditional Philips curve would give erroneous results as it has been proved that low unemployment can be accompanied by low inflation.
Based on this curve, capitalists and laborers work at cross-purposes and the society provides the middle ground. However, when a capitalist opts for high unemployment, it also reduces the market available. A laborer opts for higher wages, which reduce the purchasing through higher prices. The Philips curve continues to be popular with economists and financial reporters despite its numerous shortcomings.
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