INFLATION AND UNEMPLOYMENT

When economists look at inflation and unemployment in the short term, they see a rough inverse correlation between the two. When unemployment is high, inflation is low and when inflation is high, unemployment is low. This has presented a problem to regulators who want to limit both. This relationship between inflation and unemployment is the Phillips curve. The short term Phillips curve is a declining one.

Fig 2.4.1-Short term Phillips curve

This is a rough estimation of a short-term Phillips curve. As you can see, inflation is inversely related to unemployment. The long-term Phillips curve, however, is different. Economists have noted that in the long run, there seems to be no correlation between inflation and unemployment.

In the classical view of inflation, the only thing that causes inflation is, in reality, changes in the money supply. Remember the classical quantity theory of money: (money supply) x (velocity) = (price level) x (amount of output). And remember that the classics assume that velocity and output are independent and relatively constant. Thus, as money supply rises, that naturally ups the price level, too, and increase in price level is inflation.

The classical economists believe that there is a natural rate of unemployment, the equilibrium level of unemployment of the economy. That is the long-term Phillips curve. Remember that the long-term Phillips curve is vertical because there inflation is not related to unemployment in the long-term. Unemployment, therefore, will just be at a given level, no matter at what point inflation is at. In the classical view, the point where the short-term Phillips curve intersects the long-term Phillips curve is the expected inflation. To the left side of that point, actual inflation is higher than expected and to the right, actual inflation is lower than expected. Basically, unemployment below natural unemployment leads to inflation higher than expected and unemployment higher than natural unemployment leads to inflation lower than expected.

As opposed to the Classics, who view inflation as a problem of ever-increasing money supply, Keynesians concentrate on the institutional problems of people increasing their price levels. Keynesians argue that firms raise wages to keep their workers happy. Firms then have to pay for that and keep making a profit by subsequently raising the prices. This causes an increase in both wages and prices and demands an increase of money supply to keep the economy running. So, the government then issues more and more money to keep up with inflation. This differs from the classical model. Classics view changing money supply as affecting inflation while Keynesians view inflation as the cause of changing money supply.