Inflation and Unemployment

Inflation and unemployment Opens in new window still preoccupy and perplex economists, statesmen, journalists, housewives, and everyone else.

The connection between them is the principal domestic economic burden of presidents and prime ministers, and the major area of controversy and ignorance in macroeconomics.

Normally inflation should be controlled if it exceeds the desirable limit.

However, by controlling inflation Opens in new window successfully in the first half of the 1980s, most western countries, particularly the US, the UK, West Germany and Italy, experienced a severe recession and growth of unemployment.

For example, the unemployment rate in the US had gone up to 10 percent which was the highest since the Great Depression Opens in new window. This was exactly the dilemma being faced by India in 2008.

The inflation rate had gone up to about 8 percent which was socially and politically unacceptable. But controlling inflation drastically might affect the economic growth adversely and might lower down the 9-percent-growth rate in the year.

Fall in growth rate might aggravate the unemployment problem of the country. This kind of situation creates a dilemma for the policy-makers as to whether or not to control inflation.

The dilemma arises because economists have found that controlling or ignoring inflation, both have the following kinds of undesirable effects on the economy.

  1. Controlling inflation causes unemployment,
  2. Reducing inflation below a certain limit might reduce the growth of GDP, and
  3. Uncontrolled inflation might lead to stagflation.

Therefore, the question “whether inflation should be controlled, and if yes, then to what extent”, has been the foremost concern of the macroeconomists and the policymakers alike, over the past four decades, especially in the industrially advanced countries.

Turning to the problem of inflation and unemployment, because of its policy implications, the relationship between the rate of inflation and the rate of unemployment has received more “attention in contemporary macroeconomics” than any other economic issue.

The reason is that most of the industrialized and developing economies have been plagued, paradoxically though, with the problem of co-existence of unemployment and inflation, though the magnitude of the problem has been different in different countries.

Inflation and the Rate of Unemployment

The relationship between inflation and employment has been a contentious issue. Although the issue was first raised by Irving Fisher in 1920, it was A. W. Philips, a British economist and a Professor at London School of Economics, who brought out an empirical and theoretically sound study in 1958 on the relationship between unemployment and the change in money wage rates in the British economy during the period from 1862 to 1957.

Philips found an inverse relationship between the rate of changes in the money wage rate and the rate of unemployment.

According to this findings, when money wage rate increases, unemployment rate decreases. The rise in money wage rate may be the cause or effect of inflation.

In any case, inflation and unemployment (or employment) are interrelated. It is possibly for this reason that Philips curve logic was extended to construct the theory of relationship between inflation and unemployment.

In fact, Philips’ findings created a flutter and generated a long debate on the relationship between inflation and unemployment and its policy implications.

In the course of the debate, many economists expressed their opinion on and contributed to the analysis of relation between the rate of inflation and the rate of employment (or unemployment). The Philips curve and its theoretical findings is discussed here Opens in new window.