When the terms “inflation” and “unemployment” are mentioned either in newspapers or television, negative thoughts connected with “financial difficulties” comes to a layman’s mind. Questions about what the current inflation and unemployment rates are often indicators of a country’s economic stability or instability. More often, low unemployment rates summon collective jitters as financial analysts try to figure out if the economy will able to sustain without increasing inflation.
Thus, the relationship between inflation and unemployment is always a point of contention among economists, financial market analysts, and policymakers. Arguments about trade-offs between unemployment and inflation are already economic realities in any country’s cycle. However, is there really a trade-off between inflation and unemployment? What does this imply for the role for a nation’s monetary policy? It is well established that any increase of unexpected inflation can lower unemployment, this relationship could be explained visually by the Phillips curve.
In the 1960s, the conventional economic wisdom was that monetary policy could reduce unemployment. The theoretical basis for this was the Phillips curve, named after Bill Phillips, an economist from New Zealand-based at the London School of Economics. Phillips, also a trained engineer, constructed a machine to demonstrate the workings of the economy, using water to represent liquidity. In 1958 he published a study showing that between 1861 and 1957 some kind of trade-off between wage inflation and unemployment seemed to have been operating in Britain: when unemployment was high, inflation was low, and vice versa.
This seemed to suggest that central banks could permanently reduce unemployment by tolerating a bit more inflation (The Economist, 29 September 1999). Debelle and Vickery (1998, p. 384) cited several models of the Phillips curve estimated for Australia during the 1970s. Most of these studies estimated a wage Phillips curve, and generally used a non-linear framework. Nevile (1977) estimated a price inflation Phillips curve using a linear framework, and assumed adaptive inflation expectations. Debelle and Vickery (1998) also made an empirical analysis focusing on the price-inflation version of the Phillips curve.
In estimating wage Phillips curves in Australia, there has been debate over the appropriate way to incorporate the centralized wage-determination system in Australia that existed for most of the sample period (Gregory, 1986). Consequently, a number of specifications have included award wage growth explicitly on the right-hand side of the equation (Mitchell, 1987). However, American economists, Milton Friedman and Edmund Phelps, challenged the theory advanced by what is seen through the Phillips curve.
The trade-off between inflation and unemployment, they argued, was only short-term, because once people came to expect higher inflation, they would demand higher wages, and unemployment would rise back to its “natural rate”, which depended on the efficiency of the labour market. There was no long-term trade-off between inflation and unemployment: in the long run, monetary policy could influence only inflation. If policymakers tried to hold unemployment below its natural rate (also known by an acronym, NAIRU, the non-accelerating inflation rate of unemployment), inflation would be pushed ever higher (The Economist, 29 September 1999).
This brought the development of the “natural rate of unemployment” to be advanced by Friedman and Phelps, which supposed that there is a need for symmetry in the stabilisation policies to thwart the ill effects of unemployment and inflation. Since the natural rate was defined as the rate of unemployment with constant inflation, it could also be identified with a constant real wage since nominal wages and goods prices would rise in the same proportion. At that point, the labour market was in equilibrium. If there were excess supply, there would be falling inflation, but with excess demand there would be rising inflation.
The dangers of trying to reach zero unemployment were now clear: the possibility of hyperinflation and the elimination of money as a medium of exchange (Prachowny, 1994, p. 17). Moreover, the natural rate model implies estimating the inflation--unemployment relation would introduce misspecification error because it would ignore the difference in behaviour when the economy is within the range from when the economy is outside the range. The misspecification error could lead to a false appraisal of the impact of aggregate demand and aggregate supply effects on the rate of unemployment.
For example, estimating the impact of unemployment benefits on the rate of unemployment without allowing for the range of equilibria may give biased estimates because the size of this effect depends on whether the economy is within the range (Lye, Mcdonald & Sibly, 2001, p. 35). In addition, Dillon and Willett (1988, p. 3) mentioned that presently there is a growing recognition that over the long run higher inflation cannot buy lower unemployment. Indeed, typically the reverse holds: higher inflation will contribute to keeping unemployment high.
However, in the short run, a trade-off still does exist. The benefits (expanding employment and rising wages and profits) tend to come first under expansionary economic policies; most of the costs (in terms of rising inflation) come later. With flexible policies, the slump in the economy comes first and the reductions in inflation come later. The effects of monetary policy on interest rates work in the same way. Monetary expansion can hold down interest rates in the short run, but in the longer run they rise with escalating inflationary expectations.
With restrictive monetary policies interest rates rise before they begin to fall. Thus, focusing on short-term effects generates a substantial inflationary bias. For example, monetary policies like the Basic Wage Case in the 1950s in Australia concerning the principles which should guide the setting by the Arbitration Commission of the Basic Wage and, in effect, the rate of increase of the average money-wage in Australia as a whole. Salter provided the statistical data, conceptual analysis and argument, Russell, the theoretical argument and statement of principles.
Between them they not only influenced greatly the setting of the Basic Wage through the 1950s and 1960s but they also sowed the seeds for the principles behind the various Accords which were crucial to advance the policy of the Hawke-Keating ALP government of 1983-96. The fact that the Accords were relatively successful for a number of years, both in reducing inflation and in being associated with rising employment, no doubt there is a positive effect in the feasibility of incomes policies (Michie & Smith, 1997, p. 195).
Thus, it is safe to deem that the Phillips curve ultimately links the domestic rate of inflation to real output, and ultimately to the trade balance through the foreign-trade multiplier. These links provide a stable dynamic mechanism causing domestic rates of inflation to tend to converge toward the average world rate. An interesting implication of this result is that such convergence is not unique to the monetary approach and that evidence on such convergence provides equal support for a “Keynesian-Phillips” view (Branson, 1977, p.66).
The extraordinary combination of low inflation and low unemployment enjoyed in recent years should be mostly transitory. As workers come to realize that productivity is rising faster, they will demand more generous real wage increases. As firms begin to grant these wage increases, their costs will rise. On this view, the short-run Phillips curve tradeoff (between inflation and unemployment) should return to normal as perceptions catch up to reality.
In theory, and in both of the simulation models, the “bliss” is only temporary (Blinder and Yellen, 2001). With this tradeoff as assumed in the Phillips curve, policymakers who benefit from lower unemployment-- such as a sitting administration just before an election-- are always tempted to increase inflation. Policymakers who take a long view-- such as a Federal Reserve Board chairman with a long-term perspective-- would like to build up credibility with the public by keeping price inflation low for years at a time.
This certifies his or her ability to resist the temptation to inflate. In our terms, the policy makers have an incentive to teach the public that inflation will be low in the future. This is because when inflation is high, people find it difficult to distinguish between changes in average prices and changes in relative prices. Inflation also creates uncertainty about the future, which reduces investment.
And lastly, because of the way inflation interacts with tax systems, which are never fully indexed for inflation, it reduces the real return on saving and hence reduces future growth.
Blinder, A. S. & Yellen, J. L. 2001. The Fabulous Decade: Macroeconomic Lessons from the 1990s. New York: Century Foundation Press, 105 pp. Branson, W. H. 1977. A "Keynesian" Approach to Worldwide Inflation. In Worldwide Inflation: Theory and Recent Experience, Krause, L. B. & Salant, W. S. (Eds. ) (pp. 63-106). Washington: Brookings Institute.