Adapting to Shifts in the Labor Market When the number of persons actively seeking work far exceeds the number of available jobs, we observe persistently high unemployment rates. This indicates a more excellent supply of workers than demand for their services.

Consider salary growth as a proxy for inflation. As a result, businesses are not compelled to "bid" for employees by offering more excellent wages . However, wage inflation — when wages rise steadily over time — is typically nonexistent or low during high unemployment.

As the unemployment rate drops, businesses struggle to find enough labor. The tight labor market is causing wage inflation as companies have to pay more to attract and retain workers.

Numerous studies have investigated the role of unemployment and pay inflation in driving up the overall inflation rate.

A.W. Phillips was one of the earliest economists to show the link between high unemployment and rising wages. After studying the relationship between unemployment and wage growth in the U.K. for over a century (1861-1957), Phillips found that the unemployment rate and its rate of change predicted wage growth.

Numerous factors cause the natural unemployment rate to change over time, making it impossible to pinpoint an exact figure. Developments in technology, alterations in salary expectations, and rates of unionization are all contributors. Starting at 5.3% in 1949, the U.S. natural unemployment rate rose steadily to a peak of 6.2% in 1978-79 before beginning a gradual decline. Predictions put it at around 4.5 percent for the remainder of the 2020s decade.

Adapting to Shifts in the Labor Market

According to Phillips, companies will immediately increase wages to compete for talent when there is a high demand for workers but a low unemployment rate. Workers' reluctance to accept pay cuts causes wage rates to fall more slowly during periods of low demand for labor and high unemployment.

Changes in the unemployment rate are another factor that can affect salary levels. If the economy thrives, companies will have to compete with more challenging to attract and retain qualified employees (and a correspondingly low unemployment rate).

Since salaries are a substantial part of a company's operating costs, wage hikes should lead to higher consumer prices and inflation rates. Phillips's curve demonstrates the overall relationship between inflation and unemployment rather than pay inflation.

The Phillips Curve's Repercussions

Maintaining price stability and full employment should be the primary focus of any contemporary central bank. The U.S. Federal Reserve, for instance, aims for full employment, price stability, and low, sustainable long-term interest rates.

According to the Phillips Curve, there is a tradeoff between inflation and unemployment, and economists utilize this to adjust monetary or fiscal policy. Finding a middle ground between inflation and unemployment should be attainable. A Phillips Curve calibrated for a specific economy would show an inflation rate equal to a certain unemployment rate.

The Consumer Price Index is a good measure of general price increases in the United States and thus inflation. Both the Consumer Price Index and the Unemployment Rate soared in the 1960s. Reducing unemployment from 6% to 5% by monetary and fiscal stimulus has a negligible impact on inflation. For example, if unemployment rates fell by one percentage point, consumers may expect very modest price rises.

Splitting Up and Getting Divorced

In the short run, the unemployment rate might go down because more people are willing to put in fewer hours for higher pay as inflation picks up steam. The result is a rise in both pay and general price inflation.

As a result, higher inflation wouldn't boost the economy by lowering unemployment. Similarly, a drop in inflation shouldn't result in a rise in the unemployment rate. As inflation has no lasting impact on the jobless rate, the long-run Phillips curve flattens to a vertical line at the natural unemployment rate.

The work of Friedman and Phelps led to the discovery of two distinct Phillips curves, one for the short run and one for the long run. Considering future inflation expectations, the short-run Phillips curve (also known as the "predictions-augmented Phillips Curve") calculates the present inflation rate.

The monetarists' theory did not get much early traction because it was offered during the Phillips Curve's heyday.

Evidence from the 1960s supported the Phillips Curve hypothesis, while data from the 1970s mainly supported Friedman and Phelps' theory. The data show a shaky anti-correlation between unemployment and inflation over the next three decades at varying points.