Implementation of expansionary fiscal policy can have both positive and negative consequences for the economy. It can be an effective tool in reducing the unemployment rate and boosting business investment. However, it is also associated with certain macroeconomic risks, most notably inflation. The correlation of inflation and unemployment rates is best described using the Phillips curve. This economic model states that these two factors are mutually negatively dependent. However, this concept is frequently challenged, and while many economists nowadays still believe that this relationship exists, they admit that its dynamics have changed.
Phillips’ study was published in the late 1950s and described the connection between unemployment and inflation. According to his theory, low unemployment would lead to high inflation and vice versa (Gagnon & Coolins, 2019). Philipps (1958) states that when the economy is close to full employment, high demand for the labor force leads to a rapid increase in wages. Higher wages lead to increases in production costs and higher prices as a result. Later, other researchers modified his theory, establishing that the changes in the unemployment rate had only a short-term influence on inflation (Stamatiou & Dritsaki, 2019). While this model predicted the outcomes correctly in some cases, the scholars note that the curve has significantly flattened in recent decades. For instance, after the financial crisis of 2008, the high unemployment rate in the developed countries did not result in significant deflation (Gagnon & Coolins, 2019). Blanchard (2016) states that “as the level of inflation has decreased, wages and prices are changed less often, leading to a smaller response of inflation to labor market conditions” (p. 32). Hence, Phillips curve is applicable to modern economies only with significant adjustments.
While increasing employment can lead to higher inflation in the short term, most economists believe that the trade-off is worth it, especially for countries with a low inflation rate. Blanchard (2016) found that in the US, “a 1 percent decrease in unemployment for one quarter increases inflation, measured at an annual rate, by 0.2 percent” (p. 33). In Poland, researchers reported similar results—0.3 percent increase in inflation for a 1 percent decrease in unemployment (Stamatiou & Dritsaki, 2019). These studies illustrate the potential benefits of the flattened Phillips curve for the countries working on reducing unemployment.
The latest research shows that countries with a high unemployment rate and liberal markets can benefit from decreasing unemployment with no major inflation-related consequences. In a European study, researchers discovered that the correlation between inflation and unemployment was statistically significant only when unemployment was below 6,54% (Ho & Iyke, 2019). This finding correlates with Friedman’s concept of Non-Accelerating Inflation Rate of Employment (NAIRU), which states that inflation rises only when the level of unemployment is insignificant (Stamatiou & Dritsaki, 2019). Hence, in a country with a high level of unemployment, the efforts to reduce it might not result in any trade-off at all. Bhattarai (2016) adds that in countries with flexible markets, such as the UK or Germany, significant reductions in unemployment rates also do not lead to significantly increased inflation. On the other hand, countries with rigid markets can experience more noticeable deviations in inflation rates (Bhattarai, 2016). Overall, most studies show that even when a correlation between inflation and unemployment is present in the short term, the benefits of reducing unemployment significantly outweigh the negatives.
References
Bhattarai. K. (2016). Unemployment–inflation trade-offs in OECD countries. Economic Modelling, 58, 93-103. Web.
Blanchard, O. (2016). The Phillips curve: Back to the ’60s? American Economic Review, 106 (5), 31-34. Web.
Gagnon, J., & Collins, C. G. (2019). Low inflation bends the Phillips curve (Working Paper No. 19-6). Web.
Ho, Sin-Yu, & Iyke B. N. (2018). Unemployment and inflation: Evidence of a nonlinear Phillips curve in the Eurozone. Journal of Developing Areas, 53(4), 151-163. Web.
Phillips, A. W. (1958). The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957. Economica, 25(100), 283-299. Web.
Stamatiou, P., & Dritsaki, C. (2019). The Phillips Curve: Unemployment dynamics and NAIRU estimates of Poland’s economy. International Economics, 72(3), 281-312. Web.