Relationship Between Inflation and Unemployment

In the first half of the twentieth century, economists generally believed that inflation and unemployment were independent problems in an economy. Then, in 1958, British economist A.W. Phillips challenged this assumption when he analyzed the relationship between wage inflation (increase over time in wages paid) and unemployment in the United Kingdom. He observed that there was a clear inverse relationship between wage inflation and unemployment. An inverse relationship between two quantities means that the more of one that exists the less of the other exists, and vice versa. Phillips observed that years with low unemployment tended to have high inflation, and years with high unemployment tended to have low inflation. Economists proceeded to analyze wage and unemployment data for other developed economies, often substituting price inflation (the increase in price, over time, of a product or service) for wage inflation, and observed the same behavior. The graph of the inverse relationship between inflation and unemployment is known as the Phillips curve. According to the Phillips curve, policymakers cannot influence either unemployment or inflation without affecting the other. Instead, there would be a trade-off, where a small decrease in unemployment would be accompanied by a small increase in inflation. In principle, the Phillips curve would give a deterministic relationship between unemployment and inflation, meaning that the amount that exists of one quantity depends entirely upon the amount that exists of the other quantity. Thus, policymakers cannot simultaneously control inflation and unemployment.

In the 1970s economists began to question the assumptions behind the Phillips curve. They began to see that the one-to-one relationship between unemployment and inflation no longer existed. American economists Edmund Phelps and Milton Friedman asserted that the trade-off between inflation and unemployment only occurs in the short run. In the long run, regardless of the inflation rate, the unemployment rate gravitates toward the natural rate of unemployment, which is the amount of unemployment that occurs when the economy is producing at potential output. The conclusion of this assertion is that there are multiple Phillips curves, and the relationship between unemployment and inflation depends on the natural rate of unemployment, the aggregate supply (the total supply of final goods and services in an economy at a given time), and whether the economy has adjusted to reach the natural state of unemployment.