Trade off between inflation and unemployment by Phillips curve

Inflation

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

                        Types of inflation

Demand pull inflation

This occurs when AD increases at a faster rate than AS. Demand pull inflation will typically occur when the economy is growing faster than the long run trend rate of growth. If demand exceeds supply, firms will respond by pushing up prices. The UK experienced demand pull inflation during the Lawson boom of the late 1980s. Fueled by rising house prices, high consumer confidence and tax cuts, the economy was growing by 5% a year, but this caused supply bottlenecks and firms responded by increasing  prices.

This graph shows inflation and economic growth in the UK during the 1980s. High growth in 1987, 1988 of 4-5% caused an increase in the inflation rate. It was only when the economy went into recession in 1990 and 1991, that we saw a fall in the inflation rate

Cost Push Inflation

This occurs when there is an increase in the cost of production for firms causing aggregate supply to shift to the left. Cost push inflation could be caused by rising energy and commodity prices

Example of Cost push inflation in the UK 

In early 2008, the UK economy entered a deep recession(GDP fell 6%). However, at the same time, Uk experienced a rise in inflation. This inflation was definitely not due to demand side factors; it was due to cost push factors, such as rising oil prices, rising taxes and rising import prices (as a result of depreciation in  the Pound) By 2013, cost push factors had mostly disappeared and inflation had fallen back to its target of 2%.

Sometimes cost push inflation is known as the ‘wrong type of inflation‘ because this inflation is associated with falling living standards. It is hard for the Central Bank to deal with cost push inflation because they face both inflation and falling output.

Hyperinflation

Hyperinflation is when the prices skyrocket more than 50% -- a month. It is fortunately very rare. In fact, most examples of hyperinflation have occurred when the government printed money recklessly to pay for war. Examples of hyperinflation include Germany in the 1920's. 

Stagflation

Stagflation is just like its name says: when economic growth is stagnant, but there still is price inflation. This seems contradictory, if not impossible. Why would prices go up when there isn't enough demand to stoke economic growth? It happened in the 1970s when the U.S. went off the gold standard. Once the dollar's value was no longer tied to gold, the number of dollars in circulation skyrocketed. This increase in the money supply was one of the causes of inflation. Stagflation didn't end until then-Federal Reserve Chairman Paul Volcker raised the Feds funds rate to the double-digits and kept it there long enough to dispel expectations of further inflation.

UNEMPLOYMENT

Unemployment is defined as a situation where someone of working age is not able to get a job but would like to be in full time employment..

Here are three primary categories of unemployment that are typically discussed.

Structural unemployment

Structural Unemployment, one of the three types of unemployment, is associated with the mismatch of jobs and workers due to the lack of skills or simply the wrong area desired for work. Structural unemployment depends on the social needs of the economy and dynamic changes in the economy. 

For instance,advances in technology and changes in market conditions often turn many skills obsolete; this typically increases the unemployment rate. For example, laborers who worked on cotton fields found their jobs obsolete with Eli Whitney's patenting of the cotton gin. Similarly, with the rise of computers, many jobs in manual book keeping have been replaced by highly efficient software. Workers who find themselves in this situation find that they need to acquire new skills in order to obtain a new job.

Frictional Unemployment

Frictional Unemployment is always present in the economy, resulting from temporary transitions made by workers and employers or from workers and employers having inconsistent or incomplete information. This type of unemployment is closely related to structural unemployment due to its dependence on the dynamics of the economy. It is caused because unemployed workers may not always take the first job offer they receive because of the wages and necessary skills. This type of unemployment is also caused by failing firms, poor job performance, or obsolete skills.  This may also be caused by workers who will quit their jobs in order to move to different parts of the country.

Frictional unemployment can be seen as a transaction cost of trying to find a new job; it is the result of imperfect information on available jobs. For instance, a case of frictional unemployment would be a college student quitting their fast-food restaurant job to get ready to find a job in their field after graduation. Unlike structural unemployment this process would not be long due to skills the college graduate has to offer a potential firm.

Cyclical unemployment

Unemployment that is attributed to economic contraction is called cyclical unemployment. The economy has the capacity to create jobs which increases economic growth. Therefore, an expanding economy typically has lower levels of unemployment. On the other hand, according to cyclical unemployment an economy that is in a recession faces higher levels of unemployment. When this happens there are more unemployed workers than job openings due to the breakdown of the economy. This type of unemployment is heavily concentrated on the activity in the economy.   

Phillips Curve

The Phillips curve relates the rate of inflation with the rate of unemployment

An economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship.

Short-run Phillips curve

According to the Phillips curve, the lower an economy's rate of unemployment, the more rapidly wages paid to labor increase in that economy.The relationship, however, is not linear. Graphically, the short-run Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation rate is on the y-axis.The Phillips curve show the inverse trade-off between inflation and unemployment .As one increases ,the other must decrease .

The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run. However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables. As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.

Consider the example shown in . When the unemployment rate is 2%, the corresponding inflation rate is 10%. As unemployment decreases to 1%, the inflation rate increases to 15%. On the other hand, when unemployment increases to 6%, the inflation rate drops to 2%.

The short-run Phillips curve shows the trade-off between inflation and unemployment.
 

Long-run Phillips curve

According to economists, there can be no trade-off between inflation and unemployment in the long run. Decreases in unemployment can lead to increases in inflation, but only in the short run. In the long run, inflation and unemployment are unrelated. Graphically, this means the Phillips curve is vertical at the natural rate of unemployment, or the hypothetical unemployment rate if aggregate production is in the long-run level. Attempts to change unemployment rates only serve to move the economy up and down this vertical line.here

Although the economy starts with an initially low level of inflation at point A, attempts to decrease the unemployment rate are futile and only increase inflation to point C. The unemployment rate cannot fall below the natural rate of unemployment, or NAIRU, without increasing inflation in the long run.

Natural Rate Hypothesis

The natural rate of unemployment theory, also known as the non-accelerating inflation rate of unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund Phelps. According to NAIRU theory, expansionary economic policies will create only temporary decreases in unemployment as the economy will adjust to the natural rate. Moreover, when unemployment is below the natural rate, inflation will accelerate. When unemployment is above the natural rate, inflation will decelerate. When the unemployment rate is equal to the natural rate, inflation is stable, or non-accelerating.