Question

The jobless claims in both the United States (US) and Europe have hit more than 30 million each due to Coronavirus, which is expected to rise further in the coming weeks. This implies an unprecedented slowdown in two of the world's largest economies and thus a lower consumer demand.

Question: How this rise in unemployment would affect the inflation and interest rates in these regions (US and Europe)? Provide the reasons for your answer as well.

Answer 1

Unemployment indicates when we have more labour than we need for our operation. In the present situation, global operations have taken a massive hit because of lockdowns. So companies result in less opportunities, less operation and lower demand than before. Because labour supply is higher than demand, in order to survive for long-term, companies lay off people. When people are out of their job, their purchasing power reduces and they start consuming less. So production of goods, services also gets affected and their demand reduces. In order to sell their products, they have to reduce prices or provide offers and discounts. Hence it becomes a case of deflation. So with increase in unemployment, we face deflation or decreased inflation.

When people lose their purchasing power, central banks notice that there is cash need in the public. Hence to increase money supply, interest rates are reduced. As a result people can lend money easily to fulfill their needs and result in more investment as well. As demand for products and services again rise up, the economy starts reviving.

As per Philips Theory, unemployment is inversely related to Inflation and Interest rates in the short term. But in the long run they are unrelated, as it's predicted that the government will expand its economic policies, new opportunities will be found and there will be more demand for labour.