Can low unemployment lead to inflation?

Sungwon Park

“People are classified as unemployed if they do not have a job, have actively looked for work in the prior four weeks, and are currently available for work.” (Hayes, 2022) The drastically high inflation was gradually subsiding as supply chain disruptions were waning along with the easing of interest rates at 15-year highs. Recently, there have been concerns that the tight labour market may lead to inflation. On the 29th of January, the Federal Reserve System has been debating whether the employment rate would lead to inflation (Timiraos, 2023)

When a market is in full employment or when the unemployment rate is low, productivity would increase since it would increase efficiency as there are more people in the workforce As people would gain higher disposable income with greater purchasing power, workers are now able to be more actively involved in economic activities, for instance, through increased consumption and investment. As consumption and investment are the AD components, an increase in these factors leads to an increase in aggregate demand, shifting the AD curve to the right from AD1 to AD2. This may promote demand-pull inflation since the price level may rise from P1 to P2, as shown by the diagram on the right Thus, this emphasises the inability of avoiding the trade-off between unemployment and inflation.

This theory of the low unemployment rate being the cause of inflation was proven by the Phillips curve by New Zealand economist William Phillips in 1958. (Krugman, 2022) The Phillips curve is a graph, in which William plotted the unemployment and wages from 1861 to 1957 in the UK after examining the correlation between the two variables. From the data he looked at, he was able to discover the inverse relationship between the unemployment rate and the inflation rate (Engemann, 2020)

From the diagram below, we can see that at point A, the inflation rate is at Ia and the unemployment rate is at Ua. At point B, the inflation rate is at Ib and the unemployment rate is at Ub. As indicated by the diagram, we can see that when the unemployment rate is low, the inflation rate is high and vice versa

On the other hand, during the pandemic era, it was the opposite of this theory. Due to the sudden spread of an unknown disease, many regulations were set by the government, which shrunk the size of many businesses. To minimise the loss, firms fired many people and did not hire new people as much as before. This resulted in a decrease in demand for labour, increasing the unemployment rate (Anon , 2021)

In the early stages when COVID-19 was out, many consumers’ main expenditure was on food and masks Panic buying was common in the fear of possible lockdowns Food is one of the most common necessities, which is a type of normal good whose demand is inelastic in income. (Nasrudin, 2020) Although masks were not a necessity pre-COVID-19, they soon became a necessity owing to coronavirus being a severe acute respiratory syndrome. (시사상식사전, 2022)

When the price level is high, people are usually reluctant to buy goods However, food being a necessity and the anxiety among people that the lockdown might last a long time caused people to bulk buy, despite the sudden drive in demand for food and masks igniting inflation around the world. (O'Connell et al., 2020)

Therefore, the Phillips curve was proven wrong during the COVID-19 era. However, this does not adjudicate that the Phillips curve is wrong since economics is a social science, and the theories may not always be the case in the real world.

Bibliography

Hayes, A. (2022, December 8). What is unemployment? understanding causes, types, measurement Investopedia Retrieved February 22, 2023, from https://www investopedia com/terms/u/unemployment asp Timiraos, N. (2023, January 29). Fed debates whether wages or employment rate will drive inflation mint Retrieved February 23, 2023, from https://www.livemint.com/economy/fed-debateswhether-wages-or-employment-rate-will-drive-inflation11674994322127 html

Krugman, P. (2022, September 1). Phillips Curve Guide: Definition and History of the Phillips Curve MasterClass Retrieved February 22, 2023, from https://www masterclass com/articles/phillips-curve-explained Engemann, K. M. (2020, January 14). What Is the Phillips Curve (and Why Has It Flattened)? Saint Louis Fed Eagle. Retrieved February 23, 2023, from https://www stlouisfed org/openvault/2020/january/what-is-phillips-curve-whyflattened#:~:text=The%20Phillips%20curve%20is%20named, (i.e.%2C%20wage%20inflation).

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Nasrudin, A. (2020, March 26). Necessities: Meaning, elasticity. Penpoin Retrieved February 23, 2023, from https://penpoin.com/necessities/

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O'Connell, M., Smith, K., & Paula, A. de. (2020, November 4). Spending Dynamics and panic buying during the COVID-19 first wave. CEPR. Retrieved February 23, 2023, from https://cepr.org/voxeu/columns/spending-dynamics-and-panicbuying-during-covid-19-first-wave