what’s the relationship between inflation and unemployment
Elvis Picardo
2015-08-15
<div><div>
<p>
The relationship between inflation and unemployment has traditionally been an <a href="https://www.investopedia.com/ask/answers/040915/what-difference-between-positive-correlation-and-inverse-correlation.asp">inverse correlation</a>. However, this relationship is more complicated than it appears at first glance, and it has broken down on a number of occasions over the past 50 years.
</p>
<p>
Since inflation and employment (and unemployment) are some of the most closely monitored economic indicators, we'll delve into their relationship and how they affect the overall economy.
</p>
<div>
<h3>
Key Takeaways</h3>
<div>
<ul><li>Inflation and unemployment typically have an inverse correlation but the relationship is a complex one.</li><li>In times of high unemployment, wages typically remain stagnant, and wage inflation (or rising wages) is non-existent.</li><li>In times of low unemployment, employers typically need to pay higher wages to attract employees, ultimately leading to rising wage inflation.</li><li>The Phillips Curve believes that rising wages should lead to higher prices for products and services in an economy, ultimately pushing the overall inflation rate higher.</li><li>Monetarists argue against the Phillips Curve, stating that over the long run, the economy tends to revert to the natural rate of unemployment as it adjusts to any rate of inflation.<br/></li></ul></div>
</div>
<h2> </h2>
<p>
When <a href="https://www.investopedia.com/financial-edge/0811/the-cost-of-unemployment-to-the-economy.aspx">unemployment is high</a>, the number of people looking for work significantly exceeds the number of jobs available. In other words, the supply of labor is greater than the demand for it.
</p>
<p>
Let's take <a href="https://www.investopedia.com/terms/w/wage-push-inflation.asp">wage inflation</a>—the rate of change in wages—as a proxy for inflation in the economy. With so many workers available, there's 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.
</p>
<p>
In times of <a href="https://www.investopedia.com/insights/downside-low-unemployment/">low unemployment</a>, 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.
</p>
<p>
Over the years, economists have studied the relationship between unemployment and wage inflation, as well as the overall inflation rate.
</p>
<h2> </h2>
<p>
A.W. Phillips was one of the first economists to present compelling evidence of the inverse relationship between unemployment and wage inflation. Phillips studied the relationship between unemployment and the rate of change of wages in the United Kingdom over a period of almost a full century (from 1861 to 1957), and he discovered that the latter could be explained by two things: the level of unemployment and the rate of change of unemployment.
</p>
<p>
Phillips hypothesized that when demand for labor is high and there are few unemployed workers, employers can be expected to bid wages up quite rapidly; however, when demand for labor is low, and unemployment is high, workers are reluctant to accept lower wages than the prevailing rate, and as a result, wage rates fall very slowly.
</p>
<div>
<p>The Federal Reserve Bank of the U.S. targets an inflation rate of 2%.</p>
</div>
<p>
A second factor that affects wage rate changes is the rate of change in unemployment. If the economy is booming, employers will bid more vigorously for workers—which means that demand for labor is increasing at a fast pace (i.e., the percentage of unemployment is decreasing rapidly)—than they would if the demand for labor were either not increasing (e.g., percentage unemployment is unchanging) or only increasing at a slow pace.
</p>
<p>
Since wages and salaries are major input costs for companies, rising wages should lead to higher prices for products and services in an economy, ultimately pushing the overall inflation rate higher. As a result, Phillips graphed the relationship between general price inflation and unemployment, rather than wage inflation. The graph is known today as the <a href="https://www.investopedia.com/terms/p/phillipscurve.asp">Phillips Curve.</a>
</p>
<h2> </h2>
<p>
Low inflation and full employment are the cornerstones of <a href="https://www.investopedia.com/terms/m/monetarypolicy.asp">monetary policy</a> for the modern central bank. For instance, the U.S. Federal Reserve's monetary policy objectives are maximum employment, stable prices, and moderate long-term interest rates.
</p>
<p>
The tradeoff between inflation and unemployment led economists to use the Phillips Curve to fine-tune monetary or fiscal policy. Since a Phillips Curve for a specific economy would show an explicit level of inflation for a specific rate of unemployment and vice versa, it should be possible to aim for a balance between desired levels of inflation and unemployment.
</p>
<p>
The rate of change of the <a href="https://www.investopedia.com/terms/c/consumerpriceindex.asp">Consumer Price Index or CPI</a> is the rate of inflation or an indicator of rising prices in the U.S. economy.
</p>
<p>
<em>Figure 1</em> shows the rate of change of the CPI and unemployment rates in the 1960s.
</p>
<p>
If unemployment was 6%—and through <a href="https://www.investopedia.com/ask/answers/100314/whats-difference-between-monetary-policy-and-fiscal-policy.asp">monetary and fiscal stimulus</a>, the rate was lowered to 5%—the impact on inflation would be negligible. In other words, with a 1% fall in unemployment, prices would not rise by much.
</p>
<p>
If instead, unemployment fell to 4% from 6%, we can see on the left axis that the corresponding inflation rate would rise to 3% from 1%.
</p>
<p>
<strong><em>Figure 1:</em> U.S. inflation (CPI) and unemployment rates in the 1960s</strong>
</p>
<figure>
<figcaption>
</figcaption>
</figure>
<h2> </h2>
<p>
The 1960s provided compelling proof of the validity of the Phillips Curve, such that a lower unemployment rate could be maintained indefinitely as long as a higher inflation rate could be tolerated.
</p>
<p>
However, in the late 1960s, a group of economists who were staunch <a href="https://www.investopedia.com/terms/m/monetarist.asp">monetarists</a>, led by <a href="https://www.investopedia.com/terms/m/milton-friedman.asp">Milton Friedman</a> and <a href="https://www.investopedia.com/terms/e/edmund-s-phelps.asp">Edmund Phelps</a>, argued that the Phillips Curve does not apply over the long term. They contended that over the long run, the economy tends to revert to the natural rate of unemployment as it adjusts to any rate of inflation.
</p>
<p>
The <a href="https://www.investopedia.com/terms/n/naturalunemployment.asp">natural rate</a> is the long-term unemployment rate that is observed once the effect of short-term cyclical factors has dissipated and wages have adjusted to a level where supply and demand in the labor market are balanced. If workers expect prices to rise, they will demand higher wages so that their real (inflation-adjusted) wages are constant.
</p>
<p>
In a scenario wherein monetary or fiscal policies are adopted to lower unemployment below the natural rate, the resultant increase in demand will encourage firms and producers to raise prices even faster.
</p>
<div>
<h3>
3.8%</h3>
<p>The U.S. unemployment rate as of Aug. 2023.</p>
</div>
<p>
As inflation accelerates, workers may supply labor in the short term because of higher wages—leading to a decline in the unemployment rate; however, over the long haul, when workers are fully aware of the <a href="https://www.investopedia.com/insights/downside-low-unemployment/">loss of their purchasing power</a> in an inflationary environment, their willingness to supply labor diminishes and the unemployment rate rises to the natural rate. However, wage inflation and general price inflation continue to rise.
</p>
<p>
Therefore, over the duration, higher inflation would not benefit the economy through a lower rate of unemployment. By the same token, a lower rate of inflation should not inflict a cost on the economy through a higher rate of unemployment. Since inflation has no impact on the unemployment rate in the long term, the long-run Phillips curve morphs into a vertical line at the natural rate of unemployment.
</p>
<p>
Friedman's and Phelps's findings gave rise to the distinction between the short-run and long-run Phillips curves. The short-run Phillips curve includes expected inflation as a determinant of the current rate of inflation and hence is known by the formidable moniker "expectations-augmented Phillips Curve."
</p>
<p>
The natural rate of unemployment is not a static number but changes over time due to the influence of a number of factors. These include the impact of technology, changes in minimum wages, and the degree of unionization. In the U.S., the natural rate of unemployment was at 5.3% in 1949; it rose steadily until it peaked at 6.2% in 1978-79, and then declined afterward. It is expected to be around 4.5% for the remainder of the 2020 decade.
</p>
<h2> </h2>
<h3> </h3>
<p>
The monetarists' viewpoint did not gain much traction initially as it was made when the popularity of the Phillips Curve was at its peak. However, unlike the data from the 1960s, which definitively supported the Phillips Curve premise, the 1970s provided significant confirmation of Friedman's and Phelps' theory.
</p>
<p>
In fact, the data at many points over the next three decades do not provide clear evidence of the inverse relationship between unemployment and inflation.
</p>
<p>
The 1970s were a period of both high inflation and high unemployment in the U.S. due to two massive oil supply shocks. The first oil shock was from the 1973 embargo by Middle East energy producers that caused crude oil prices to quadruple in about a year.
</p>
<p>
The second oil shock occurred when the Shah of Iran was overthrown in a revolution and the loss of output from Iran caused crude oil prices to double between 1979 and 1980. This development led to both high unemployment and high inflation. 
</p>
<h3> </h3>
<p>
The boom years of the 1990s were a time of low inflation and low unemployment. Economists attribute a number of reasons for this positive confluence of circumstances. These include:
</p>
<ul>
<li>The global competition that kept a lid on price increases by U.S. producers</li><li>Reduced expectations of future inflation as tight monetary policies had led to declining inflation for more than a decade</li><li>Productivity improvements due to the large-scale adoption of technology</li><li>Demographic changes in the labor force, with more aging baby boomers and fewer teens working</li>
</ul>
<h2> </h2>
<p>
In the graphs below, we can see the inverse correlation between inflation—as measured by the rate of change of the CPI—and unemployment reassert itself, only to break down at times. 
</p>
<ul>
<li>In 2001, the mild recession as a result of 9/11 pushed unemployment higher to roughly 6% while inflation fell below 2.5%.</li>
<li>In the mid-2000s, as unemployment fell, inflation was steady around 1% to 2.5%.</li>
<li>During the <a href="https://www.investopedia.com/terms/g/great-recession.asp">Great Recession</a>, the rate of change of the CPI fell dramatically as unemployment soared to almost 10%.</li>
<li>From 2012 to 2015, we can see that the inverse correlation broke down where inflation and unemployment moved in tandem.</li>
<li>From 2016 to 2019, unemployment steadily declined to 50-year lows (before the onset of COVID-19 at the end of 2019), while inflation remained around 2%. In other words, the inverse correlation between the two indicators wasn't as strong as it was in prior years.</li>
<li>In 2020, unemployment soared to almost 15% (in April 2020) as a result of the economic impacts of the global pandemic caused by COVID-19 but decreased steadily through Jan. 2021.</li>
<li>In Jan. 2021, the unemployment rate fell by 0.4 percentage points, to 6.3%. Although this measure is lower than the high reached in April 2020, it remained well above pre-pandemic levels (3.5%) in Feb. 2020. During this time, inflation remained relatively unaffected, although prices began to rise sharply starting in Feb. of 2021. These price rises were primarily due to the simultaneous supply shocks to the global economy, although likely increased as a result of the shortage of labor in essential industries.</li>
<li>In 2022, inflation continued to soar and unemployment continued to drop, until reaching a stable level of approximately 3.5%, where it remained for the rest of 2022 and most of 2023. In the middle of 2022, inflation started to slow after the Fed's interest rate hikes.</li>
</ul>
<h2> </h2>
<p>
Before the Covid pandemic and the ensuing high inflationary environment, an unusual feature of today's economic environment has been the paltry wage gains despite high corporate profits and declining unemployment since the Great Recession.
</p>
<ul>
<li>In the first graph below, the annual percentage change in wages (red dotted line) for the private sector has barely nudged higher since 2015.</li><li>In the second graph below, you can see that once the economy was hit with high inflation in 2022, constant dollar wages and salaries significantly dropped. They started to climb in 2022, but have not been raised enough to match pre-inflationary levels.</li>
</ul>
<figure>
</figure>
<figure>
</figure>
<div>
<h2>What Are the Main Causes of Unemployment?</h2>
<p>There are many causes for unemployment, including general seasonal and cyclical factors, recessions, depressions, technological advancements replacing workers, and job outsourcing.</p>
</div>
<div>
<h2>Does Inflation Lead to a Recession?</h2>
<p>Inflation can lead to a recession. If prices are too high due to inflation and wages have not increased accordingly, this can cause consumers to slow down or stop spending. When this happens, businesses start to lose money, which would lead to them laying off employees, increasing unemployment, and increasing the number of people willing to spend less money, repeating the cycle and further slowing the economy.</p>
</div>
<div>
<h2>Who Benefits From Inflation?</h2>
<p>Generally, debtors benefit from inflation because they are repaying their loans with money that is less valuable than the money they borrowed initially. Banks can also benefit from inflation because when inflation is high, central banks increase interest rates to combat inflation. Banks make more money with higher interest rates.</p>
</div>
<h2> </h2>
<p>
The inverse correlation between inflation and unemployment depicted in the Phillips Curve works well in the short run, especially when inflation is fairly constant as it was in the 1960s. It does not hold up over the long term since the economy reverts to the natural rate of unemployment as it adjusts to any rate of inflation.
</p>
<p>
Because it's also more complicated than it appears at first glance, the <a href="https://www.investopedia.com/ask/answers/040715/what-happens-when-inflation-and-unemployment-are-positively-correlated.asp">relationship between inflation and unemployment</a> has broken down in periods like the <a href="https://www.investopedia.com/terms/s/stagflation.asp">stagflationary</a> 1970s and the booming 1990s.
</p>
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 Table of Contents
 Expand
 Table of Contents
 * Labor Supply and Demand
 * The Phillips Curve
 * Phillips Curve Implications
 * Monetarist Rebuttal
 * Relationship Breakdown
 * CPI vs. Unemployment
 * Current Environment Wages
 * FAQs
 * The Bottom Line
 * Economics
 * Macroeconomics

 How Inflation and Unemployment Are Related

 By
 Elvis Picardo
 Full Bio
 * 
 Elvis Picardo is a regular contributor to Investopedia and has 25+ years of experience as a portfolio manager with diverse capital markets experience.
 Learn about our editorial policies
 Updated October 04, 2023
 Reviewed by
 Robert C. Kelly
 Reviewed by Robert C. Kelly
 Full Bio
 Robert Kelly is managing director of XTS Energy LLC, and has more than three decades of experience as a business executive. He is a professor of economics and has raised more than $4.5 billion in investment capital.
 Learn about our Financial Review Board

 The relationship between inflation and unemployment has traditionally been an inverse correlation. However, this relationship is more complicated than it appears at first glance, and it has broken down on a number of occasions over the past 50 years.

 Since inflation and employment (and unemployment) are some of the most closely monitored economic indicators, we'll delve into their relationship and how they affect the overall economy.

 Key Takeaways

 * Inflation and unemployment typically have an inverse correlation but the relationship is a complex one.
 * In times of high unemployment, wages typically remain stagnant, and wage inflation (or rising wages) is non-existent.
 * In times of low unemployment, employers typically need to pay higher wages to attract employees, ultimately leading to rising wage inflation.
 * The Phillips Curve believes that rising wages should lead to higher prices for products and services in an economy, ultimately pushing the overall inflation rate higher.
 * Monetarists argue against the Phillips Curve, stating that over the long run, the economy tends to revert to the natural rate of unemployment as it adjusts to any rate of inflation.

 Labor Supply and Demand

 When unemployment is high, the number of people looking for work significantly exceeds the number of jobs available. In other words, the supply of labor is greater than the demand for it.

 Let's take wage inflation—the rate of change in wages—as a proxy for inflation in the economy. With so many workers available, there's 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 times of low unemployment, 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.

 Over the years, economists have studied the relationship between unemployment and wage inflation, as well as the overall inflation rate.

 The Phillips Curve

 A.W. Phillips was one of the first economists to present compelling evidence of the inverse relationship between unemployment and wage inflation. Phillips studied the relationship between unemployment and the rate of change of wages in the United Kingdom over a period of almost a full century (from 1861 to 1957), and he discovered that the latter could be explained by two things: the level of unemployment and the rate of change of unemployment.

 Phillips hypothesized that when demand for labor is high and there are few unemployed workers, employers can be expected to bid wages up quite rapidly; however, when demand for labor is low, and unemployment is high, workers are reluctant to accept lower wages than the prevailing rate, and as a result, wage rates fall very slowly.

 The Federal Reserve Bank of the U.S. targets an inflation rate of 2%.

 A second factor that affects wage rate changes is the rate of change in unemployment. If the economy is booming, employers will bid more vigorously for workers—which means that demand for labor is increasing at a fast pace (i.e., the percentage of unemployment is decreasing rapidly)—than they would if the demand for labor were either not increasing (e.g., percentage unemployment is unchanging) or only increasing at a slow pace.

 Since wages and salaries are major input costs for companies, rising wages should lead to higher prices for products and services in an economy, ultimately pushing the overall inflation rate higher. As a result, Phillips graphed the relationship between general price inflation and unemployment, rather than wage inflation. The graph is known today as the Phillips Curve.

 Phillips Curve Implications

 Low inflation and full employment are the cornerstones of monetary policy for the modern central bank. For instance, the U.S. Federal Reserve's monetary policy objectives are maximum employment, stable prices, and moderate long-term interest rates.

 The tradeoff between inflation and unemployment led economists to use the Phillips Curve to fine-tune monetary or fiscal policy. Since a Phillips Curve for a specific economy would show an explicit level of inflation for a specific rate of unemployment and vice versa, it should be possible to aim for a balance between desired levels of inflation and unemployment.

 The rate of change of the Consumer Price Index or CPI is the rate of inflation or an indicator of rising prices in the U.S. economy.

 Figure 1 shows the rate of change of the CPI and unemployment rates in the 1960s.

 If unemployment was 6%—and through monetary and fiscal stimulus, the rate was lowered to 5%—the impact on inflation would be negligible. In other words, with a 1% fall in unemployment, prices would not rise by much.

 If instead, unemployment fell to 4% from 6%, we can see on the left axis that the corresponding inflation rate would rise to 3% from 1%.

 Figure 1: U.S. inflation (CPI) and unemployment rates in the 1960s

 U.S. Bureau of Labor Statistics

 Monetarist Rebuttal

 The 1960s provided compelling proof of the validity of the Phillips Curve, such that a lower unemployment rate could be maintained indefinitely as long as a higher inflation rate could be tolerated.

 However, in the late 1960s, a group of economists who were staunch monetarists, led by Milton Friedman and Edmund Phelps, argued that the Phillips Curve does not apply over the long term. They contended that over the long run, the economy tends to revert to the natural rate of unemployment as it adjusts to any rate of inflation.

 The natural rate is the long-term unemployment rate that is observed once the effect of short-term cyclical factors has dissipated and wages have adjusted to a level where supply and demand in the labor market are balanced. If workers expect prices to rise, they will demand higher wages so that their real (inflation-adjusted) wages are constant.

 In a scenario wherein monetary or fiscal policies are adopted to lower unemployment below the natural rate, the resultant increase in demand will encourage firms and producers to raise prices even faster.

 3.8%

 The U.S. unemployment rate as of Aug. 2023.

 As inflation accelerates, workers may supply labor in the short term because of higher wages—leading to a decline in the unemployment rate; however, over the long haul, when workers are fully aware of the loss of their purchasing power in an inflationary environment, their willingness to supply labor diminishes and the unemployment rate rises to the natural rate. However, wage inflation and general price inflation continue to rise.

 Therefore, over the duration, higher inflation would not benefit the economy through a lower rate of unemployment. By the same token, a lower rate of inflation should not inflict a cost on the economy through a higher rate of unemployment. Since inflation has no impact on the unemployment rate in the long term, the long-run Phillips curve morphs into a vertical line at the natural rate of unemployment.

 Friedman's and Phelps's findings gave rise to the distinction between the short-run and long-run Phillips curves. The short-run Phillips curve includes expected inflation as a determinant of the current rate of inflation and hence is known by the formidable moniker "expectations-augmented Phillips Curve."

 The natural rate of unemployment is not a static number but changes over time due to the influence of a number of factors. These include the impact of technology, changes in minimum wages, and the degree of unionization. In the U.S., the natural rate of unemployment was at 5.3% in 1949; it rose steadily until it peaked at 6.2% in 1978-79, and then declined afterward. It is expected to be around 4.5% for the remainder of the 2020 decade.

 Relationship Breakdown

 The 1970s

 The monetarists' viewpoint did not gain much traction initially as it was made when the popularity of the Phillips Curve was at its peak. However, unlike the data from the 1960s, which definitively supported the Phillips Curve premise, the 1970s provided significant confirmation of Friedman's and Phelps' theory.

 In fact, the data at many points over the next three decades do not provide clear evidence of the inverse relationship between unemployment and inflation.

 The 1970s were a period of both high inflation and high unemployment in the U.S. due to two massive oil supply shocks. The first oil shock was from the 1973 embargo by Middle East energy producers that caused crude oil prices to quadruple in about a year.

 The second oil shock occurred when the Shah of Iran was overthrown in a revolution and the loss of output from Iran caused crude oil prices to double between 1979 and 1980. This development led to both high unemployment and high inflation.

 The 1990s

 The boom years of the 1990s were a time of low inflation and low unemployment. Economists attribute a number of reasons for this positive confluence of circumstances. These include:

 * The global competition that kept a lid on price increases by U.S. producers
 * Reduced expectations of future inflation as tight monetary policies had led to declining inflation for more than a decade
 * Productivity improvements due to the large-scale adoption of technology
 * Demographic changes in the labor force, with more aging baby boomers and fewer teens working

 CPI vs. Unemployment

 In the graphs below, we can see the inverse correlation between inflation—as measured by the rate of change of the CPI—and unemployment reassert itself, only to break down at times.

 * In 2001, the mild recession as a result of 9/11 pushed unemployment higher to roughly 6% while inflation fell below 2.5%.
 * In the mid-2000s, as unemployment fell, inflation was steady around 1% to 2.5%.
 * During the Great Recession, the rate of change of the CPI fell dramatically as unemployment soared to almost 10%.
 * From 2012 to 2015, we can see that the inverse correlation broke down where inflation and unemployment moved in tandem.
 * From 2016 to 2019, unemployment steadily declined to 50-year lows (before the onset of COVID-19 at the end of 2019), while inflation remained around 2%. In other words, the inverse correlation between the two indicators wasn't as strong as it was in prior years.
 * In 2020, unemployment soared to almost 15% (in April 2020) as a result of the economic impacts of the global pandemic caused by COVID-19 but decreased steadily through Jan. 2021.
 * In Jan. 2021, the unemployment rate fell by 0.4 percentage points, to 6.3%. Although this measure is lower than the high reached in April 2020, it remained well above pre-pandemic levels (3.5%) in Feb. 2020. During this time, inflation remained relatively unaffected, although prices began to rise sharply starting in Feb. of 2021. These price rises were primarily due to the simultaneous supply shocks to the global economy, although likely increased as a result of the shortage of labor in essential industries.
 * In 2022, inflation continued to soar and unemployment continued to drop, until reaching a stable level of approximately 3.5%, where it remained for the rest of 2022 and most of 2023. In the middle of 2022, inflation started to slow after the Fed's interest rate hikes.

 Current Environment Wages

 Before the Covid pandemic and the ensuing high inflationary environment, an unusual feature of today's economic environment has been the paltry wage gains despite high corporate profits and declining unemployment since the Great Recession.

 * In the first graph below, the annual percentage change in wages (red dotted line) for the private sector has barely nudged higher since 2015.
 * In the second graph below, you can see that once the economy was hit with high inflation in 2022, constant dollar wages and salaries significantly dropped. They started to climb in 2022, but have not been raised enough to match pre-inflationary levels.

 What Are the Main Causes of Unemployment?

 There are many causes for unemployment, including general seasonal and cyclical factors, recessions, depressions, technological advancements replacing workers, and job outsourcing.

 Does Inflation Lead to a Recession?

 Inflation can lead to a recession. If prices are too high due to inflation and wages have not increased accordingly, this can cause consumers to slow down or stop spending. When this happens, businesses start to lose money, which would lead to them laying off employees, increasing unemployment, and increasing the number of people willing to spend less money, repeating the cycle and further slowing the economy.

 Who Benefits From Inflation?

 Generally, debtors benefit from inflation because they are repaying their loans with money that is less valuable than the money they borrowed initially. Banks can also benefit from inflation because when inflation is high, central banks increase interest rates to combat inflation. Banks make more money with higher interest rates.

 The Bottom Line

 The inverse correlation between inflation and unemployment depicted in the Phillips Curve works well in the short run, especially when inflation is fairly constant as it was in the 1960s. It does not hold up over the long term since the economy reverts to the natural rate of unemployment as it adjusts to any rate of inflation.

 Because it's also more complicated than it appears at first glance, the relationship between inflation and unemployment has broken down in periods like the stagflationary 1970s and the booming 1990s.

 Article Sources
 Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

 1. International Monetary Fund. "Unemployment: The Curse of Joblessness."

 2. Economic Policy Institute. "Causes of Wage Stagnation."

 3. Economic Policy Institute. "A Long Spell of Very Low Unemployment Would Raise Wages—Even in the Face of Employers’ Monopsony Power."

 4. University of Miami. "The Phillips Curve," Page 56.

 5. Brookings Institution. "The Hutchins Center Explains: The Phillips Curve."

 6. Board of Governors of the Federal Reserve System. "Why Does the Federal Reserve Aim for Inflation of 2% Over the Longer Run?"

 7. Wiley Online Library. "The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957."

 8. Federal Reserve Bank of Richmond. "The Federal Reserve's "Dual Mandate": The Evolution of an Idea."

 9. U.S. Bureau of Labor Statistics. "Consumer Price Index."

 10. U.S. Bureau of Labor Statistics. "The Employment Situation."

 11. Federal Reserve Bank of San Francisco. "Dr. Econ, What Is the Relevance of the Phillips Curve to Modern Economies?"

 12. The Nobel Prize. "Edmund S. Phelps."

 13. St. Louis Fed, FRED. "Noncyclical Rate of Unemployment."

 14. Federal Reserve Bank of San Francisco. "The Natural Rate of Unemployment Over the Past 100 Years."

 15. Encyclopedia Brittanica. "Arab Oil Embargo."

 16. Brookings Institution. "What Iran’s 1979 Revolution Meant for US and Global Oil Markets."

 17. Yale University. "The Oil Shocks of the 1970s."

 18. University of Richmond. "Low Inflation: The Surprise of the 1990s," Page 9.

 19. Federal Reserve Bank of Dallas. "The 1990s Inflation Puzzle," Page 9.

 20. University of Richmond. "Low Inflation: The Surprise of the 1990s," Pages 5-7.

 21. University of Chicago. "Why Is the U.S. Unemployment Rate So Much Lower?" Pages 1-2.

 22. U.S. Bureau of Labor Statistics. "Job Market Remains Tight in 2019, as the Unemployment Rate Falls to its Lowest Level Since 1969."

 23. U.S. Bureau of Labor Statistics. "Consumer Price Index: 2020 in Review."

 24. St. Louis Fed, FRED. "Unemployment Rate."

 25. St. Louis Fed, FRED. "Unemployment Rate vs. Consumer Price Index."

 26. U.S. Bureau of Labor Statistics. "Employment Cost Index," Page 2.

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 * Okun’s Law: Economic Growth and Unemployment
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 * What Can Policymakers Do To Decrease Cyclical Unemployment?
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 Related Articles
 Edmund S. Phelps: Life, Career, Contributions
 The Downside of Low Unemployment
 What Causes Inflation?
 The Importance of Inflation and Gross Domestic Product (GDP)
 Stagflation in the 1970s
 Inflation vs. Stagflation: What's the Difference?
 Partner Links
 Related Terms
 Edmund S. Phelps: Life, Career, Contributions
 Edmund Phelps is an American professor of political economy at Columbia University and winner of the 2006 Nobel Prize in Economics.
 more
 The Phillips Curve Economic Theory Explained
 The Phillips curve is an economic theory that inflation and unemployment have a stable and inverse relationship.
 more
 Non-Accelerating Inflation Rate of Unemployment (NAIRU)
 The non-accelerating inflation rate of unemployment (NAIRU) is the lowest level of unemployment that can exist in the economy before inflation starts to increase.
 more
 Inflation: What It Is, How It Can Be Controlled, and Extreme Examples
 Inflation is a decrease in the purchasing power of money, reflected in a general increase in the prices of goods and services in an economy.
 more
 Pigou Effect: Definition, History and Examples
 Pigou effect is a term in economics referring to the relationship between consumption, wealth, employment, and output during periods of deflation.
 more
 Consumer Price Index (CPI) Explained: What It Is and How It's Used
 The Consumer Price Index (CPI) measures change over time in the prices paid by consumers for a representative basket of goods and services.
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How Inflation and Unemployment Are Related
https://www.investopedia.com/articles/markets/081515/how-inflation-and-unemployment-are-related.asp
Full Bio
2024-01-02T16:38:08-05:00
<div><div><h2> <span> What Is the Wage-Price Spiral? </span> </h2>
<p> The wage-price spiral is a macroeconomic theory explaining the cause-and-effect relationship between rising wages and prices, or inflation. As rising wages increase <a href="https://www.investopedia.com/terms/d/disposableincome.asp">disposable income</a>, demand for goods rises, triggering prices for goods to move higher.
</p>

<p> Rising prices then increase demand for higher wages, which leads to higher production costs and further upward pressure on prices, creating a conceptual spiral.
</p>

<div><h3>Key Takeaways</h3>
<div><ul><li>The wage-price spiral describes a perpetual cycle whereby rising wages create rising prices and vice versa.</li><li>Central banks use monetary policy, the interest rate, reserve requirements, and open market operations to curb the wage-price spiral.</li><li>Inflation targeting is a monetary policy to achieve and sustain a set interest rate.</li></ul></div></div>
<h2> <span> Inflation </span> </h2>
<p> The wage-price spiral describes the phenomenon of price increases as a result of higher wages. When workers receive a wage hike, they demand more goods and services, and this, in turn, causes prices to rise.
</p>

<p> The wage increase effectively increases general <a href="https://www.investopedia.com/terms/b/businessexpenses.asp">business expenses</a> that are passed on to the consumer as higher prices. A perpetual loop or cycle of consistent price increases is created. The wage-price spiral reflects the causes and consequences of inflation, and it is, therefore, characteristic of Keynesian economic theory.
</p>


<h2> <span> How a Spiral Begins </span> </h2>
<p> A wage-price spiral is caused by the effect of supply and demand on aggregate prices. People who earn more than the <a href="https://www.investopedia.com/terms/c/cost-of-living.asp">cost of living</a> select an allocation mix between savings and consumer spending. As wages increase, so does a consumer's propensity to both save and consume.
</p>

<p> If the minimum wage increases, consumers within the economy will purchase more products, which would increase demand. The rise in <a href="https://www.investopedia.com/terms/a/aggregatedemand.asp">aggregate demand</a> and the increased wage burden cause businesses to increase the prices of products and services.
</p>

<div>
<p>In Jan. 2024, 22 states increased their minimum wage. States with hourly rates that match or exceed $15 per hour include Maryland, New Jersey, New York, California, Connecticut, Massachusetts, and Washington.<span></span></p></div>
<p> Although wages are higher, increasing prices causes workers to demand higher salaries. If higher wages are granted, a spiral where prices increase may occur, repeating the cycle until wage levels can no longer be supported.
</p>

<h2> <span> Stopping a Wage-Price Spiral </span> </h2>
<p> A wage-price spiral often makes inflation higher than is ideal. The Federal Reserve in the U.S. aims to sustain an inflation rate of 2%.<span></span> Governments tackle an inflationary environment through the actions of the Federal Reserve or a <a href="https://www.investopedia.com/terms/c/centralbank.asp">central bank</a>. A country's central bank can use <a href="https://www.investopedia.com/terms/m/monetarypolicy.asp">monetary policy</a>, the interest rate, reserve requirements, or open-market operations to curb the wage-price spiral.
</p>

<p> The United States has used monetary policy to curb inflation but sometimes triggered <a href="https://www.investopedia.com/terms/r/recession.asp">recession</a>. The 1970s were a time of oil price increases by OPEC that resulted in increased domestic inflation. The Federal Reserve responded by raising interest rates to control inflation, stopping the spiral in the short term but acting as the catalyst for a recession in the early 1980s.
</p>

<p> Inflation targeting is a strategy for a monetary policy whereby the central bank sets a target inflation rate over a period and makes adjustments to achieve and maintain that rate. In 2018, Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen argued in <em>Inflation Targeting: Lessons from the International Experience,</em> the advantages and disadvantages of inflation targeting and concluded that governments should use their discretion based on the circumstances when deciding to use inflation targeting as a tool to control the economy.<span></span>
</p>

<div><h2>What Is Monetary Policy?</h2>
<p>Monetary policy is a set of tools a nation's central bank has available to promote economic growth by controlling the overall supply of money available to the nation's banks, consumers, and businesses. The U.S. Treasury Department can create money, but the Federal Reserve influences the supply in the economy through open market operations (OMO) by buying financial securities when easing monetary policy and selling financial securities when tightening monetary policy. The central bank may increase interest rates on borrowing to discourage spending or force down interest rates to inspire more borrowing and spending.</p>
</div>

<div><h2>What Is the Difference Between the U.S. Treasury and the Federal Reserve?</h2>
<p>The U.S. Treasury and the Federal Reserve are separate entities. The Treasury manages the money coming into and out of the government. The Federal Reserve's primary responsibility is to keep the economy stable by managing the supply of money in circulation. The Department of <a href="https://www.investopedia.com/terms/u/ustreasury.asp">the Treasury</a> manages federal spending. It collects the government's tax revenues, distributes its budget, issues its bonds, bills, and notes, and prints money. The Federal Reserve is the central banking system of the United States and is run by a board of governors that oversees 12 regional Federal Reserve Banks.</p>
</div>

<div><h2>What Is Inflation Targeting?</h2>
<p>Inflation targeting is a central banking policy that adjusts monetary policy to achieve a specified annual inflation rate. The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.</p>
</div>

<h2> <span> The Bottom Line </span> </h2>
<p> The wage-price spiral is a perpetual cycle where rising wages create rising prices and vice versa. To target inflation, central banks use monetary policy, the interest rate, reserve requirements, and open market operations to curb the wage-price spiral.
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            Table of Contents
              Expand
            Table of Contents
              * What Is the Wage-Price Spiral?
              * Inflation
              * How a Spiral Begins
              * Stopping a Wage-Price Spiral
              * FAQs
              * The Bottom Line
    * Economics
    * Macroeconomics

  Wage-Price Spiral: What It Is and How It’s Controlled

          By
            Caroline Banton
                Full Bio
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                    * 
                  Caroline Banton has 6+ years of experience as a freelance writer of business and finance articles. She also writes biographies for Story Terrace.
                Learn about our editorial policies
          Updated January 02, 2024
          Reviewed by
            Robert C. Kelly
                  Reviewed by Robert C. Kelly
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                  Robert Kelly is managing director of XTS Energy LLC, and has more than three decades of experience as a business executive. He is a professor of economics and has raised more than $4.5 billion in investment capital.
                Learn about our Financial Review Board
          Fact checked by Marcus Reeves
          Part of the Series
          Inflation
        Understanding Inflation
       1. Inflation: What It Is, How It Can Be Controlled, and Extreme Examples
       2. 9 Common Effects of Inflation
       3. How to Profit From Inflation
       4. When Is Inflation Good for the Economy?
       5. How Does Current Cost of Living Compare to 20 Years Ago?
       6. Why Are P/E Ratios Higher When Inflation Is Low?
       7. What Causes Inflation and Who Profits From It?
        Types of Inflation
       1. Understand the Different Types of Inflation
       2. Wage Push Inflation
       3. Cost-Push Inflation
       4. Cost-Push Inflation vs. Demand-Pull Inflation: What's the Difference?
       5. Inflation vs. Stagflation: What's the difference?
        What Does Inflation Impact?
       1. What is the Relationship Between Inflation and Interest Rates?
       2. Inflation's Impact on Stock Returns
       3. How Does Inflation Affect Fixed-Income Investments?
       4. How Inflation Affects Your Cost of Living
       5. How Inflation Impacts Your Savings
       6. How Inflation Eats Away at Your Retirement Income
       7. What Impact Does Inflation Have on the Dollar Value Today?
       8. Inflation and Economic Recovery
        Understanding Hyperinflation
       1. Hyperinflation
       2. Why Didn't Quantitative Easing Lead to Hyperinflation?
       3. Worst Cases of Hyperinflation in History
       4. How the Great Inflation of the 1970s Happened
       5. Stagflation
        Understanding CPI
       1. Purchasing Power
       2. Consumer Price Index (CPI)
       3. Why Is the Consumer Price Index Controversial?
       4. Core Inflation
       5. Headline Inflation
        Related Terms (A-I)
       1. GDP Price Deflator
       2. Indexation
       3. Inflation Accounting
       4. Inflation-Adjusted Return
       5. Inflation Targeting
        Related Terms (J-Z)
       1. Real Economic Growth Rate
       2. Real Gross Domestic Product (GDP)
       3. Real Income
       4. Real Interest Rate
       5. Real Rate of Return
       6. Wage-Price Spiral
            CURRENT ARTICLE

  Investopedia / Julie Bang

      Close

      What Is the Wage-Price Spiral?

      The wage-price spiral is a macroeconomic theory explaining the cause-and-effect relationship between rising wages and prices, or inflation. As rising wages increase disposable income, demand for goods rises, triggering prices for goods to move higher.

      Rising prices then increase demand for higher wages, which leads to higher production costs and further upward pressure on prices, creating a conceptual spiral.

          Key Takeaways

              * The wage-price spiral describes a perpetual cycle whereby rising wages create rising prices and vice versa.
              * Central banks use monetary policy, the interest rate, reserve requirements, and open market operations to curb the wage-price spiral.
              * Inflation targeting is a monetary policy to achieve and sustain a set interest rate.

      Inflation

      The wage-price spiral describes the phenomenon of price increases as a result of higher wages. When workers receive a wage hike, they demand more goods and services, and this, in turn, causes prices to rise.

      The wage increase effectively increases general business expenses that are passed on to the consumer as higher prices. A perpetual loop or cycle of consistent price increases is created. The wage-price spiral reflects the causes and consequences of inflation, and it is, therefore, characteristic of Keynesian economic theory.

            The wage-price spiral is also known as the cost-push origin of inflation.

      How a Spiral Begins

      A wage-price spiral is caused by the effect of supply and demand on aggregate prices. People who earn more than the cost of living select an allocation mix between savings and consumer spending. As wages increase, so does a consumer's propensity to both save and consume.

      If the minimum wage increases, consumers within the economy will purchase more products, which would increase demand. The rise in aggregate demand and the increased wage burden cause businesses to increase the prices of products and services.

            In Jan. 2024, 22 states increased their minimum wage. States with hourly rates that match or exceed $15 per hour include Maryland, New Jersey, New York, California, Connecticut, Massachusetts, and Washington.

      Although wages are higher, increasing prices causes workers to demand higher salaries. If higher wages are granted, a spiral where prices increase may occur, repeating the cycle until wage levels can no longer be supported.

      Stopping a Wage-Price Spiral

      A wage-price spiral often makes inflation higher than is ideal. The Federal Reserve in the U.S. aims to sustain an inflation rate of 2%. Governments tackle an inflationary environment through the actions of the Federal Reserve or a central bank. A country's central bank can use monetary policy, the interest rate, reserve requirements, or open-market operations to curb the wage-price spiral.

      The United States has used monetary policy to curb inflation but sometimes triggered recession. The 1970s were a time of oil price increases by OPEC that resulted in increased domestic inflation. The Federal Reserve responded by raising interest rates to control inflation, stopping the spiral in the short term but acting as the catalyst for a recession in the early 1980s.

      Inflation targeting is a strategy for a monetary policy whereby the central bank sets a target inflation rate over a period and makes adjustments to achieve and maintain that rate. In 2018, Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen argued in Inflation Targeting: Lessons from the International Experience, the advantages and disadvantages of inflation targeting and concluded that governments should use their discretion based on the circumstances when deciding to use inflation targeting as a tool to control the economy.

        What Is Monetary Policy?

          Monetary policy is a set of tools a nation's central bank has available to promote economic growth by controlling the overall supply of money available to the nation's banks, consumers, and businesses. The U.S. Treasury Department can create money, but the Federal Reserve influences the supply in the economy through open market operations (OMO) by buying financial securities when easing monetary policy and selling financial securities when tightening monetary policy. The central bank may increase interest rates on borrowing to discourage spending or force down interest rates to inspire more borrowing and spending.

        What Is the Difference Between the U.S. Treasury and the Federal Reserve?

          The U.S. Treasury and the Federal Reserve are separate entities. The Treasury manages the money coming into and out of the government. The Federal Reserve's primary responsibility is to keep the economy stable by managing the supply of money in circulation. The Department of the Treasury manages federal spending. It collects the government's tax revenues, distributes its budget, issues its bonds, bills, and notes, and prints money. The Federal Reserve is the central banking system of the United States and is run by a board of governors that oversees 12 regional Federal Reserve Banks.

        What Is Inflation Targeting?

          Inflation targeting is a central banking policy that adjusts monetary policy to achieve a specified annual inflation rate. The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.

      The Bottom Line

      The wage-price spiral is a perpetual cycle where rising wages create rising prices and vice versa. To target inflation, central banks use monetary policy, the interest rate, reserve requirements, and open market operations to curb the wage-price spiral.

          Article Sources
        Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

         1. Economic Policy Institute. "Twenty-Two States Will Increase Their Minimum Wages on January 1, Raising Pay for Nearly 10 Million Workers."

         2. Board of Governors of the Federal Reserve System. "Why Does the Federal Reserve Aim for Inflation of 2 Percent Over the Longer Run?"

         3. Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen, via Google Books. "Inflation Targeting: Lessons from the International Experience." Princeton University Press, 1999.

          Open a New Bank Account
          Advertiser Disclosure
              ×
              The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
          Part of the Series
          Inflation
        Understanding Inflation
       1. Inflation: What It Is, How It Can Be Controlled, and Extreme Examples
       2. 9 Common Effects of Inflation
       3. How to Profit From Inflation
       4. When Is Inflation Good for the Economy?
       5. How Does Current Cost of Living Compare to 20 Years Ago?
       6. Why Are P/E Ratios Higher When Inflation Is Low?
       7. What Causes Inflation and Who Profits From It?
        Types of Inflation
       1. Understand the Different Types of Inflation
       2. Wage Push Inflation
       3. Cost-Push Inflation
       4. Cost-Push Inflation vs. Demand-Pull Inflation: What's the Difference?
       5. Inflation vs. Stagflation: What's the difference?
        What Does Inflation Impact?
       1. What is the Relationship Between Inflation and Interest Rates?
       2. Inflation's Impact on Stock Returns
       3. How Does Inflation Affect Fixed-Income Investments?
       4. How Inflation Affects Your Cost of Living
       5. How Inflation Impacts Your Savings
       6. How Inflation Eats Away at Your Retirement Income
       7. What Impact Does Inflation Have on the Dollar Value Today?
       8. Inflation and Economic Recovery
        Understanding Hyperinflation
       1. Hyperinflation
       2. Why Didn't Quantitative Easing Lead to Hyperinflation?
       3. Worst Cases of Hyperinflation in History
       4. How the Great Inflation of the 1970s Happened
       5. Stagflation
        Understanding CPI
       1. Purchasing Power
       2. Consumer Price Index (CPI)
       3. Why Is the Consumer Price Index Controversial?
       4. Core Inflation
       5. Headline Inflation
        Related Terms (A-I)
       1. GDP Price Deflator
       2. Indexation
       3. Inflation Accounting
       4. Inflation-Adjusted Return
       5. Inflation Targeting
        Related Terms (J-Z)
       1. Real Economic Growth Rate
       2. Real Gross Domestic Product (GDP)
       3. Real Income
       4. Real Interest Rate
       5. Real Rate of Return
       6. Wage-Price Spiral
            CURRENT ARTICLE
        Related Terms
          What Is Inflation Targeting, and How Does It Work?
            Inflation targeting is a central banking policy that revolves around meeting preset, publicly displayed targets for the annual rate of inflation.
          more
          Biflation: Definition, Causes, and Example
            Biflation describes the simultaneous occurrence of inflation, price rises, and deflation, price falls, in different parts of the economy.
          more
          Soft Landing: Definition and History in Economics
            A soft landing, in economics, is a cyclical slowdown that comes to an end without a recession phase.
          more
          Inflation: What It Is, How It Can Be Controlled, and Extreme Examples
            Inflation is a decrease in the purchasing power of money, reflected in a general increase in the prices of goods and services in an economy.
          more
          Cost-Push Inflation: When It Occurs, Definition, and Causes
            Cost-push inflation occurs when overall prices rise (inflation) due to increases in production costs such as wages and raw materials.
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          What Is Monetarism? Theory, Formula, and Comparison to Keynesian Economics
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Wage-Price Spiral: What It Is and How It’s Controlled
https://www.investopedia.com/terms/w/wage-price-spiral.asp