Inflation and Unemployment: What is the Connection? (CRS Report for Congress)
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| Release Date |
April 8, 2004 |
| Report Number |
RL30391 |
| Report Type |
Report |
| Authors |
Brian W. Cashell, Government and Finance Division |
| Source Agency |
Congressional Research Service |
Summary:
Even at times when the inflation rate shows little indication that it is about to rise significantly,
many
economists feel that there is some risk of that happening as unemployment rate falls to near 5%.
There are those who consider an unemployment rate below 5% to be unsustainable, or at least
incompatible with continued low rates of inflation. It might seem strange that an economy with both
low unemployment and low inflation could be considered a source of concern. But, many
economists believe that it may not be possible to keep them both low for very long.
The experience of the United States in the 1960s suggested that there was a trade-off between
the unemployment rate and the rate of inflation. This trade-off was known as the Phillips curve, and
was based on the fact that unexpected increases in prices reduced real wages, increasing the demand
for labor and reducing unemployment.
But, any trade-off that may have existed in the 1960s disappeared in subsequent years.
Moreover, that the failure of the trade-off to persist had been predicted contributed to the wide
acceptance of what is now known as the natural rate hypothesis.
The trade-off along the Phillips curve was based on errors in inflation expectations. But, as the
price level rises, workers eventually realize that real wages are falling and adjust their nominal, or
money, wage demands to reflect the higher level of prices and so preserve their real incomes. The
increase in real wage demands tends to reverse the drop in the unemployment rate. In the long run,
the unemployment rate tends toward a level that is consistent with a stable rate of inflation. This has
been dubbed the "natural" rate.
Most current point estimates of the natural rate of unemployment fall between 5% and 6%.
During the 1990s, the unemployment rate was at or below those levels for some time, which led
many economists to expect signs of an accelerating in the rate of inflation. But, the expected rise
in inflation failed to materialize. In fact, perhaps to the surprise of many, the inflation rate fell.
Although the inflation rate failed to increase at a time when the actual unemployment rate was
well below most estimates of the natural rate, not all adherents of the natural rate model have
rejected it. It may be that a number of temporary factors, including an acceleration in productivity
growth which was not yet reflected in wage demands, or falling prices for oil (in 1997 and 1998) and
imported goods and services (from 1995 to 1998) muted the inflation response to tight labor markets.
