Can Inflation Help Determine How Fast Labor Markets Recover from Recession

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Can inflation help determine how fast labor markets recover from recession

1. Introduction

There is an article published on The Economist entitled “The price of getting back to work”. This article, by analyzing the GDP and employment of UK and U.S. from 2007 to 2013 and comparing the data of output per worker as well as average weekly earnings between UK and U.S. during the same period, has found that with similar recovering speed from the financial crisis of 2008, UK, on the strength of its higher inflation than U.S., enjoyed faster recovery of labor markets than U.S.(The Economist). Thus, this article has concluded that during the economic recession, maintaining higher inflation is conducive to the recovery of labor markets. This essay basically agrees with the viewpoint, however, also has different perspective and will then explain reasons as following by analyzing the trade-off between inflation and unemployment with combination of theoretical analysis and practical analysis.

1. Discussion

The trade-off between inflation and unemployment is a fundamental question in macroeconomics (Katria et al. 3). Phillips curve can describe the trade-off between inflation and unemployment in a most direct way. It is a curve originally proposed by Phillips to describe the substitutional relation between unemployment and the rate of change of money wage rates after his studying of the statistic data of unemployment and the rate of change of money wage rates from 1861 to 1957 in UK (283). Later, Samuelson & Solow had transformed the original Phillips curve into a curve to describe the relationship between inflation and unemployment and indicated that higher unemployment rate results in low inflation and vice versa. What’s more, due to that wages are sticky, namely it’s easier for wages to go up instead of going down; firms will become more sensitive to the wages with other conditions unchanged. If real wages go up, firms will lay off employees or improve techniques to lower the costs, among which the job cut has more direct effect on the lowering of costs. In this connection, lower inflation will lead to the rise of unemployment rate by increasing the real wages (177). Marcellino and Mizon had built a modeling framework to show the relationship among real earnings, productivity, unemployment, and inflation and concluded that there exists a negative relationship between inflation and unemployment, which is a steep Phillips curve (387). Calvo et al. used 116 recession episodes as the sample in developed and emerging market economies and divided labor-market recovery as “jobless recovery (higher unemployment)” associated with lower inflation ( below 30% annually) or “wageless recovery (lower real wage)” associated with higher inflation (Jobless and Wageless Recoveries 2). Calvo et al. had discussed three policy tools that can mitigate jobless recoveries during the recession and held that higher inflation during the recession can help unemployment rate to get back to its pre-crisis level (Is Inflation the Way Out 23).

Misery index is founded as the sum of unemployment rate and inflation rate. Both unemployment and inflation, as factors of social unrest, will bring miseries to people and cause losses to the society. Due to the substitutional relation between unemployment and inflation described in Phillips curve, a question can be raised that how to balance the substitution between unemployment and inflation. Obviously, both of them need to be controlled under the range that the society can afford with minimum damages. If unemployment and inflation both exist, the costs of them shall be weighed respectively. The most ideal condition lies in the achievement of full employment with moderate inflation (Welsch 237). Under such condition, examples can be found in the recovery of labor markets of UK and U.S. as mentioned above.

At present, the unemployment rate of UK and U.S. has basically fallen down to around 5%, while Canada still traps in a high unemployment rate. After the outbreak of financial crisis of 2008, Canada, as the neighboring country of U.S., suffered severe economic losses with its GDP decreasing from 1542.56 billion dollars to 1370.84 billion dollars and unemployment rate over 8.5%. In addition, its inflation had even decreased to a negative level (refer to Figure 1), directly resulting in the sharp rise of unemployment rate (refer to Figure 2). Entering into the recovery period, Canada had inflation rate back to previous level prior to the financial crisis with unemployment rate fallen to 7.5%. Since then, its inflation maintained at a relatively low level (around 1% from 2012 to 2014 in Canada, 2% to 4% in UK and 1% to 2% in U.S.), as a result, its unemployment rate had a slow decline (Trading Economic).

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Fig. 1: Inflation rate of Canada (2006-2016). Source: (Trading Economic)

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Fig. 2: Unemployment rate of Canada (2006-2016). Source: (Trading Economic)

However, Phillips curve, as a theoretical hypothesis formed by historical experiences of economic development among western developed capitalist countries, has specific assumptions for its formation and develops continuously with the change of those assumptions. Those assumptions mainly include perfect market economy, basically accomplished industrialization and uncontrolled fluctuations of market price. As for some developing countries like the South Africa, they are not fully conform to the assumptions of Phillips curve (Temple 461), that is to say, they may not enjoy a better recovery of labor markets for higher inflation.    

South Africa, as a developing country, only had its GDP reached 286.77 billion dollars in 2008. In such a country with small economy, the low annual growth rate of GDP can not help produce sufficient jobs for people, leading to the extremely high level of unemployment rate. Resulted from the outbreak of financial crisis of 2008, South Africa achieved a negative growth of GDP and its inflation rate exceeded 10%, an all-time high. With such a high inflation rate (refer to Figure 3), numerous jobs were created and unemployment rate went down for a time (refer to Figure 4) (Trading Economic). However, maintaining such a high inflation rate to reduce unemployment is not sustainable. Even though South Africa maintained an inflation rate of 5% later (exceeding its economic growth rate), its unemployment rate still stayed at a high level. Thus, it’s not a proper way for South Africa, a country with high inflation rate and high unemployment rate, to recover its labor markets by appropriately increasing inflation rate. Similarly, it’s also not a proper way for a planned economy like the North Korea to do so.