Can a reduction in employment in the economy actually make our goods and services more expensive ?
This thought originated from the Phillips Curve, which was formulated by Alban William Housego Phillips in 1958. This curve demonstrates a negative relationship between unemployment and inflation for the short term. At its core, as unemployment decreases inflation tends to increase and vice versa.
During his investigation A.W.H. Phillips studied almost a century of UK data (1861-1957) and observed this relationship. The image given below shows his data for his assumption.
Figure 1 Source: Alberto Americo, ResearchGate
When unemployment is low, firms compete in order to hire workers. Therefore, they raise wages to attract employers. On the other hand, high unemployment means there is excess labour supply in the economy, so firms can employ workers without raising wages. As a result, inflation remains low.
Furthermore, two types of curve can be plotted for the Phillips Curve. First one is Short-Run Phillips Curve which demonstrates the trade-off between unemployment and inflation for short term as the data above. However, in the long run,workers and firms adjust their inflation expectations. Once they figure out, unemployment returns into its natural rate while inflation remains higher. Therefore, Long-Run Phillips Curve represented by a vertical line (NRU) which means there is no trade-off between these two elements anymore.
Figure 2 Source: tutor2u
Real World Example: US 1960s economic growth
During the 1960s, expansionary policies in the US lowered unemployment for a period of time. Due to the scarcity of workers, businesses competed for them which gave a rise to increase in wage thus inflation.
The reason for this is that as wages increase, demand for goods and services also accelerates. There are fewer products with regards to the demand so producers raise prices in order to determine equilibrium in the market.
Over time, workers realized the fact that their purchasing power did not increase as they expected as a result of higher inflation. Therefore, workers negotiated for higher wages,firms avoided hiring more staff. Overall, rate of employment returned back to its original rate.
In summary, the short-run Phillips Curve illustrates temporary interaction between unemployment and inflation. Nevertheless, in the long run workers adjust their inflation expectations and the unemployment rate goes back into its original position regardless of price changes.
Figure 3 Source: Kristie M. Engemann, ST. Louis Fed
Bibliography
- https://www.researchgate.net/publication/304249086_The_Phillips_curve_a_macroeconomics_lynchpin
- https://www.tutor2u.net/economics/reference/macro-policy-conflicts?srsltid=AfmBOopOrEeeHXTxAZW7p4DoSWZNUvuuz3Q9hX2BKFLGcBjbu-QzDN-i
- https://www.stlouisfed.org/open-vault/2020/january/what-is-phillips-curve-why-flattened