During September, the unemployment rate was 5.2%, which is still considerably higher than the pre-pandemic level of 3.5%. In such time the inflation rate (CPI) reached the 13 years high of 5.4%. Is this high inflation rate unfavorable for the economy? Or is there any relation between inflation and unemployment? Let’s take a dip into it.

Unemployment and inflation are two economic determinants that indicate adverse economic conditions. Economy analysts use these rates or values to analyze the strength of an economy. The relationship between inflation and unemployment has traditionally been an inverse correlation. However, this relationship is more complicated than it appears at first glance.

What is an Unemployment rate?

The unemployment rate is the percentage of employable people in a country’s workforce. The term employable refers to workers who are over the age of 16; they should have either lost their jobs or have unsuccessfully sought out jobs in the last month and must be still actively seeking work.

What does Inflation mean? 

Inflation can be defined simply as the rate of increase in prices for goods and services. We use different measures to calculate inflation. Currently, the most used indicators are CPI (Consumer price index) and RPI (Retail price index).

There are two types of inflation. The first one is Cost-push inflation which occurs when there is a price rise of raw materials, higher taxes, etc. The other is Demand-pull inflation which occurs when an economy quickly grows, leading to more demand than supply.

Employment Supply and Demand

A.W. Phillips was one of the first economists to present compelling evidence of the inverse relationship between unemployment and wage inflation. This relationship is called the “Phillips Curve”. In simple terms, he proposed the following theory-

When unemployment is high, the number of people looking for work exceeds the number of jobs available. In other words, the supply of labor is greater than the demand for it. With so many workers available, there is little need for employers to “bid” for the services of employees by paying them higher wages. In times of high unemployment, wages typically remain stagnant, and wage inflation (or rising wages) is non-existent.

In contrast, during low unemployment time, the demand for labor by employers exceeds the supply. In such a tight labor market, employers typically need to pay higher wages to attract employees, ultimately leading to rising wage inflation.

Exceptions…

There are a couple of exceptions to this theory. For example, before the pandemic, we experienced a long period of low unemployment, low inflation rate, and negligible wage growth. However, after the pandemic theory seems to hold its ground and thus we are seeing an increase in the inflation rate when the unemployment rate is approaching to pre-pandemic level.