Revision - Inflation and unemployment

Inflation and unemployment

Economists have long studied the relation ship between inflation and unemployment, The two are key parts of macroeconomic stability. Historically this relationship was described by the Philips curve.

The original Philips curve(1958)

Inverse relationship between wage inflation and unemployment in uk data

Why

• when unemployment is low, labour markets are tight

• Worker have more bargaining power, pushing wages up

• Higher wages - higher production cost - firm raise prices - inflation

This suggested a trade off policy makers could chose between inflation aor more unemployment

The expectations agmented Philips curve |(1970)

In 1960-1970 the simple trade off broke down we got

High inflation and high unemployment (stagflation)

The model was updated

Key idea - people adjust their behaviour based on what they expect inflation to be.

So inflation = expected inflation + natural unemployment - actual unemployment)

Where if unemployment is below its natural rate infaltion accelerates, but over time people adjust their expectations and the trade off disappears

This leads to the long run Philips curve being vertical at the natural rate of unemployment.

So in the long run their is no trade off you get higher inflation without lower unemployment.

Inflation targeting; A new framework

After the infaltion disasters of the 70s, central banks shifted to inflation targeting

What is inflation targeting?

A policy framework where the central bank

• announces a numerical inflation goal

• Uses interest rate policies (monetary policies) top keep inflation near that target

• Is transparent and predicatable

What changed?

• central banks anchored inflation expectations

• This flattened the Philips curve; infaltion became more stable even with changes in unemployment

• The public trusted that inflation would stay low - inflationary spirals became less likely

• So better creditability = weaker inflation/unemployment trade off

Why did inflation return Post 2020

After decades of low and stable infaltion it roared back in 2021-2022 why

1. Covid 19 shocks - supply chain disruptions, stimulus fuelled demand surge, labour shortages in key sectors

2. War in Ukraine - spiked energy and food prices

3. Monetray and fiscal expansion - central banks kept rates low for too long, massive government spending

4. Expectations may have started to shift - for the first time in decades, inflation expectations rose, making it harder to control inflation without a recession

📉 The Re-Emphasis on the Trade-Off

With inflation rising again:

Central banks raised rates aggressively (2022–2023)

This cooled inflation, but raised unemployment risks

The short-run trade-off between inflation and unemployment came back into focus

Even though the long-run Phillips Curve is still vertical, in the short run, we do face difficult choices again.