Unemployment and Inflation: Two Macroeconomic Evils on the Phillips Curve

1. Unemployment

Unemployment is a key macroeconomic indicator reflecting the health of the labor market. It affects income, production, and overall economic stability.

• Leads to lost incomes and production.

• Interrupts human capital accumulation (on-the-job training, learning by doing).

• Prolonged unemployment harms future job prospects and discourages workers.

• Some unemployment is inevitable, even in full-employment economies.

• Economic growth involves creative destruction, requiring the reallocation of workers between industries and regions.

Population and Labor Force Categories

• Civilian working-age population: People aged 16+ not in military service or institutional care (prisons, hospitals, nursing homes).

• Excludes: under 16, active military, incarcerated, or institutionalized individuals.

• Working-age population is divided into:

  • In the labor force

  • Out of the labor force

• Labor force = Employed + Unemployed

Definition of Unemployed Workers

• Without work but have actively looked for work within the past 4 weeks, or

• Waiting to be recalled to a job after layoff, or

• Scheduled to start a new job within 30 days.

Key Labor Market Indicators

• Unemployment rate:

  • Rises in recessions.

  • Can increase during recovery when discouraged workers return.

• Labor force participation rate:

• Employment-to-population ratio:

  • Falls during recessions.

Other Definitions of Unemployment

• U3: Headline unemployment rate (official BLS measure).

• U1–U6: Broader measures of unemployment and underemployment.

  • U1 = narrowest, counts long-term unemployed.

  • U6 = broadest, includes discouraged workers and involuntary part-time workers.

Types of Unemployment

• Frictional Unemployment

  • Normal labor market turnover.

  • Results from career changes, relocation, family changes, or life events.

  • Driven by technological progress and industry shifts.

  • Exists even at full employment.

  • Contributes to the natural rate of unemployment (NAIRU).

• Structural Unemployment

  • Results from skill mismatches or geographic relocation of jobs.

  • Lasts longer than frictional unemployment.

  • Example: Michigan auto industry decline in the 1980s.

  • Raises the natural rate of unemployment.

• Cyclical Unemployment

  • Caused by business cycle fluctuations.

  • Rises in recessions when GDP < potential GDP (output gap).

  • Can be negative in overheating economies when GDP > potential GDP, driving unemployment below the natural rate and increasing inflation.

  • Natural rate is also referred to as NAIRU: Non-Accelerating Inflation Rate of Unemployment.

2. Inflation

Inflation is the sustained increase in the general price level of goods and services in an economy over time.

Rising Prices: Inflation

• Defined as an increase in the general price level.

• Problems caused by inflation:

  • Acts like a regressive tax, hurting the poor most.

  • Disrupts credit markets, discouraging long-term lending.

  • Consumes resources as households and firms try to protect wealth.

• Hyperinflation: Extremely rapid inflation, often defined as 500%–1000% annual inflation.

  • Historical examples: Zimbabwe (2007–08), Yugoslavia (1992–93), Germany (1921–23).

Falling Prices: Deflation

• Defined as a general decrease in the price level.

• Considered highly damaging (downward spiral).

• Historical examples:

  • Great Depression (1930s)

  • Japan’s “lost decade” (1990s)

• Problems caused by deflation:

  • Consumers delay spending, reducing demand and income.

  • Firms suffer declining revenues, causing bankruptcies and financial crises.

  • Central banks (Federal Reserve, ECB, Bank of Japan) actively try to avoid deflation.

Consumer Price Index (CPI)

• CPI measures the average level of prices paid by consumers.

• Reference base period: 1982–1984 = 100.

Steps in Constructing CPI

1. Select the basket of goods (based on Consumer Expenditure Survey).

2. Conduct monthly price surveys.

3. Calculate the CPI.

Example Calculation

• Base year basket (2021): 10 oranges ($1 each) + 5 haircuts ($8 each) = $50.

• Current year basket (2022): 10 oranges ($2 each) + 5 haircuts ($10 each) = $70.

• Inflation rate = 40%.

Biases in the CPI

• Substitution bias (consumers switch to cheaper goods).

• New goods bias (new items not included immediately).

• Quality change bias.

• Overstates inflation, affecting cost-of-living adjustments in programs like Social Security.

• Core inflation: inflation without food and energy. An economic measure that removes food and energy prices from a standard inflation index to show the underlying, long-term price trend in the economy.

Interest Rates and Inflation

• Nominal interest rate: Return in dollar terms.

• Real interest rate: Nominal rate adjusted for inflation.

• Formula:

• Example: 5% nominal interest rate with 5% inflation → 0% real return.

3. The Phillips Curve

The Phillips curve describes an inverse relationship between unemployment and inflation, suggesting that lower unemployment is associated with higher inflation and vice versa.

• Evidence:

  • Strong negative relationship in the 1950s–1970s.

  • Less clear after 1970 due to oil shocks, globalization, and policy changes.

  • Some argued the Phillips curve "died," while others believed it was distorted by external factors.

• Recent evidence: The burst of inflation after 2021 suggests the Phillips curve may still hold relevance.

Additional info: NAIRU stands for Non-Accelerating Inflation Rate of Unemployment, representing the lowest unemployment rate that does not cause rising inflation. The Phillips curve is a foundational concept in macroeconomics, though its empirical validity has been debated in recent decades.