What is the Relationship Between Inflation and Unemployment?

The relationship between inflation and unemployment has been a topic of much debate since the mid-20th century. It was initially thought that there was an inverse relationship between the two economic variables—this connection is known as the Phillips curve. The 1970s, however, showed periods of both high inflation and high unemployment. Economists then largely abandoned the Phillips curve, believing there was no long-term link between the two factors. Despite this development, many economists continue to accept a short-term link between unemployment and inflation reminiscent of the Phillips curve.

The first widely-acknowledged research on inflation and unemployment rates was done by New Zealand economist William Phillips in 1958. Phillips examined the economy of the United Kingdom from 1861 to 1957 and concluded that an inverse relationship existed between wage changes—which signify inflation—and the unemployment rate. Others took Phillips’s data and offered an explicit link between unemployment and inflation. This inverse relationship became known as the Phillips curve.

In the 1960s, many economists believed the Phillips curve offered societies a trade off between inflation and unemployment. If a country was willing to tolerate moderate inflation, it could enjoy low unemployment. Likewise, if it desired low inflation, it would have to face higher unemployment. Economic statistics during the ‘60s seemed to confirm the theory.

In 1968, American economist Milton Friedman suggested that there is no long-term link between inflation and unemployment. Three years later, both the inflation and unemployment rate began to rise in industrialized countries. The U.S. economy during 1975 had inflation at 9.3% and unemployment at 8.3%. This data contradicted the predictions of the Phillips curve, which suggested it was impossible to see both rates rise. The phenomenon of high inflation and high unemployment lasted from 1971 to 1984 and has been termed stagflation.

After stagflation, most economists rejected the validity of the Phillips curve. An effect of this paradigm shift was that governments shifted away from directly intervening in their economies through fiscal policy. They now tended to prefer monetary policy to control inflation. The free market was left to adjust to economic disturbances.

Around this time, the idea of a natural rate of unemployment was offered. A natural rate of unemployment essentially means that inflation has no long-term relation to unemployment. A number of reasons for natural unemployment exist, including technological change and voluntary unemployment. While the natural unemployment rate would return in the long-term, many economists continued to advocate the Phillips curve as a short-term economic trade off.