What Happens When Inflation and Unemployment Are Positively Correlated?

Inflation measures how quickly prices rise over time, and unemployment is the number of people looking for work. Conventional economic thinking predicts that they have an inverse relationship: Low unemployment leads to higher prices, and vice versa.

But in some circumstances, both measures can rise at the same time. What happens when unemployment and inflation become positively correlated?

Typically Inverse Relationship

Inflation and unemployment have traditionally had an inverse relationship. When one rises, the other drops and vice versa. Governments and central banks rely on monetary and fiscal policies to keep the economy from growing too quickly or too slowly.

• Monetary policy is enacted when a central bank wants to manage growth by controlling the money supply. More money is injected into the economy by lowering interest rates and printing more currency to spur growth. Rates increase when central banks want to slow down growth.
• Fiscal policy refers to a country’s tax and spending policies. When governments lower taxes or increase spending, they promote economic growth. They slow down growth when they tighten the reins.

So let’s put this all into perspective. Policies that are effective at boosting economic output and bringing down unemployment tend to exacerbate inflation, while policies that rein in inflation frequently constrain the economy and worsen unemployment.

The Relationship Between Inflation and Unemployment

Inflation and unemployment have historically maintained an inverse relationship, as represented by the Phillips curve. Low levels of unemployment typically corresponded with higher inflation, while high unemployment corresponded with lower inflation and even deflation.

From a logical standpoint, this relationship makes sense. When unemployment is low, the demand for workers exceeds the number available. Put simply, there are more jobs available than people looking for work. When unemployment rises, the number of individuals looking for work far exceeds demand. That’s because not many employers are hiring even if more people want to get to work.

So how does this play out with inflation? Low unemployment (when more people are working) means more consumers have the discretionary income to purchase goods, and the demand for goods rises. Workers can also bargain for higher wages, which are passed on to consumers in the form of higher prices. But when unemployment is high, customers purchase fewer goods, which puts downward pressure on prices and reduces inflation.

The Phillips Curve

The Phillips Curve was developed by A. W. Phillips. This economic concept suggests that inflation and unemployment are inversely related. As such, it states that inflation is ushered into the economy by growth and expansion. According to Phillips’ theory, this cuts the unemployment rate since expansion leads to job growth.

This theory worked, to some degree. At least until things got out of control in the 1970s. This period was characterized by high levels of inflation and unemployment, contradicting the historical relationship between these two economic metrics.

Stagflation

The most famous time when inflation and unemployment were positively correlated in the U.S. was in the 1970s. Termed stagflation, the combination of high inflation, high unemployment, and sluggish economic growth plagued the decade for several reasons. President Richard Nixon removed the U.S. from the gold standard, allowing the dollar’s value to float rather than be tied to a commodity. The move left it vulnerable to market whims.

Nixon implemented wage and price controls, which fixed the prices businesses could charge customers. Even though production costs increased under a shrinking dollar, businesses could not raise prices to bring revenues in line with costs. Instead, they were forced to cut costs by slashing payrolls to remain profitable. The value of the dollar shrank while jobs were being lost, resulting in a positive correlation between inflation and unemployment.

There was no easy solution for this period of stagflation. The Federal Reserve chair at the time determined that long-term gain justified short-term pain. He took drastic measures to reduce inflation, raising interest rates as high as 20%, knowing these measures would result in temporary but sharp economic contraction.

As expected, the economy entered a deep recession during the early 1980s, with millions of jobs lost and gross domestic product (GDP) contracting by more than 6%. But the recovery featured a robust rebound in GDP. All the lost jobs were regained—and then some.

Recent Trends

The positive correlation between inflation and unemployment can also be a good thing, provided both levels are low. The late 1990s featured a combination of unemployment below 5% and inflation below 2.5%. An economic bubble in the tech industry was largely responsible for the low unemployment rate, while cheap gas amid tepid global demand helped keep inflation low. And there were other factors at play that contributed to this relationship during this time, including:

• An increasing number of baby boomers leaving the workforce without being replaced
• A cap on prices by U.S. producers in the wake of increasing global competition
• An increase in the adoption of technology, which led to higher productivity

The tech bubble burst in 2000, resulting in an unemployment spike. At the same time, consumers saw a rise in gas prices, too. From 2000 to 2020, the relationship between inflation and unemployment once again followed the Phillips curve, but to a much lesser degree.

Explain Like I’m Five

Economists usually expect unemployment and inflation to move in opposite directions. Low unemployment leads to higher prices, and high unemployment leads to lower prices. This relationship is predicted by the Phillips curve.

In some circumstances, prices and unemployment can move in the same direction. During the 1970s, unemployment was high but prices were also high, due to some poorly-executed government policies. In the 1990s, there was a period of low unemployment but also low prices. This positive relationship can be good for consumers, so long as both unemployment and inflation stay low.

The Bottom Line

While the academic arguments and counter arguments rage back and forth, new theories continue to be developed. Outside of academia, the empirical evidence of employment and inflation challenges and confronts economies across the globe, suggesting the proper blend of policies required to create and maintain the ideal economy has not yet been determined.