Question

Explain unemployment and inflation from 2000-2010 in relation to output and growth.

Answer 1

The unemployment rate is a vital measure of economic performance. A falling unemployment rate generally occurs alongside rising gross domestic product (GDP), higher wages, and higher industrial production. The government can generally achieve a lower unemployment rate using expansionary fiscal or monetary policy, so it might be assumed that policymakers would consistently target a lower unemployment rate using these policies. Part of the reason policymakers do not revolves around the relationship between the unemployment rate and the inflation rate.

In general, economists have found that when the unemployment rate drops below a certain level, referred to as the natural rate, the inflation rate will tend to increase and continue to rise until the unemployment rate returns to its natural rate. Alternatively, when the unemployment rate rises above the natural rate, the inflation rate will tend to decelerate. The natural rate of unemployment is the level of unemployment consistent with sustainable economic growth. An unemployment rate below the natural rate suggests that the economy is growing faster than its maximum sustainable rate, which places upward pressure on wages and prices in general leading to increased inflation. The opposite is true if the unemployment rate rises above the natural rate, downward pressure is placed on wages and prices in general leading to decreased inflation. Wages make up a significant portion of the costs of goods and services, therefore upward or downward pressure on wages pushes average prices in the same direction.

Two other sources of variation in the rate of inflation are inflation expectations and unexpected changes in the supply of goods and services. Inflation expectations play a significant role in the actual level of inflation, because individuals incorporate their inflation expectations when making price-setting decisions or when bargaining for wages. A change in the availability of goods and services used as inputs in the production process (e.g., oil) generally impacts the final price of goods and services in the economy, and therefore changing the rate of inflation.

Following the 2007-2009 recession, the actual unemployment rate remained significantly elevated compared with estimates of the natural rate of unemployment for multiple years. However, the average inflation rate decreased by less than one percentage point during this period despite predictions of negative inflation rates based on the natural rate model. Likewise, inflation has recently shown no sign of accelerating as unemployment has approached the natural rate. Some economists have used this as evidence to abandon the concept of a natural rate of unemployment in favor of other alternative indicators to explain fluctuations in inflation.

Some researchers have largely upheld the natural rate model while looking at broader changes in the economy and the specific consequences of the 2007-2009 recession to explain the modest decrease in inflation after the recession. One potential explanation involves the limited supply of financing available to businesses after the breakdown of the financial sector. Another explanation cites changes in how inflation expectations are formed following changes in how the Federal Reserve responds to economic shocks and the establishment of an unofficial inflation target. Others researchers have cited the unprecedented increase in long-term unemployment that followed the recession, which significantly decreased bargaining power among workers.

In general, economists have observed an inverse relationship between the unemployment rate and the inflation rate, i.e., the rate at which prices rise. This trade-off between unemployment and inflation become particularly pronounced (i.e., small changes in unemployment result in relatively large price swings) when the unemployment rate drops below a certain level, referred to by economists as the "natural unemployment rate." Alternatively, when the unemployment rate rises above the natural rate, inflation will tend to decelerate. In response to the financial crisis and subsequent recession, the Federal Reserve began employing expansionary monetary policy to spur economic growth and improve labor market conditions. Recently, the unemployment rate has fallen to a level consistent with many estimates of the natural rate of unemployment, between 4.6% and 5.0%. If the unemployment rate were to continue falling, it would likely fall below the natural rate of unemployment and cause accelerating inflation, violating the Federal Reserve's mandate of stable prices.

Events following the 2007-2009 recession have again called into question how well economists understand the relationship between the unemployment gap and inflation. As a result of the global financial crisis and the U.S. 2007-2009 recession, the unemployment rate rose above 10% and remained significantly elevated compared with estimates of the natural rate of unemployment for multiple years The natural rate model suggests that this significant and prolonged unemployment gap should have resulted in decelerating inflation during that period. Actual inflation did decline modestly during that period, decreasing from an average rate of about 2% between 2003 and 2007 to about 1.4% on average between 2008 and mid-2015.However, based on previous experience with unemployment gaps of this size and inflation forecasts based on the natural rate model, many economists anticipated a more drastic decrease in the inflation rate, with some predicting negative inflation (or deflation) rates reaching 4% during that period

Over the previous several decades, the U.S. economy has become more integrated with the global economy as trade has become a larger portion of economic activity. Economists have suggested that as economies increase their openness to the global economy, global economic forces will begin to play a larger role in domestic inflation dynamics. This suggests that inflation may be determined by labor market slack and the output gap (the difference between actual output and potential output) on a global level rather than a domestic level. Since the 1980s, trade (as measured by the sum of imports and exports) has expanded significantly in the United States, increasing from less than 20% of GDP to more than 30% of GDP between 2011 and 2013.