Relationship Between Inflation And Unemployment

There had been many studies that there is a short run tradeoff between inflation and unemployment. Though the rate of inflation and unemployment are the major goals. It is not possible to achieve both low inflation and low unemployment at the same time. Since inflation is the function of monetary policy while unemployment is the function of fiscal policy. The aim of implementing monetary policy is to sustain the level of inflation by sacrificing its employment. On the other hand, the goal of fiscal policy is to lower the unemployment rate in the economy at any rate of inflation. Therefore, the coordination among these policies is very important in order to maintain the level of optimality of tradeoff between inflation and unemployment, which

The relationship between inflation and unemployment is mainly represented by the Phillips curve. The Phillips curve shows that a change on the rate of wage inflation will result to changes in unemployment over time (Hoover, 2008). A decrease in the unemployment rates would lead to an increase in wage, which would then lead to an increase in the cost to produce a good or service. The rise in the prices of goods and services would then be reflected as an increase in the inflation. Since inflation responds to a sudden change in economic conditions, a way of predicting or identifying the causes that will likely lead to the increase of inflation rate will be extremely useful for policymakers. The natural rate of unemployment has been viewed as a means of measuring tightness in the labor market and thus causing the risk of future increase in inflation

For example, between 1979 and 1983, we can see that inflation fell from 15 percent to 2.5 percent. During that same period we can see that there is an increase in unemployment from 5 percent to 11 percent.

H. Vector Autoregression (VAR)

VAR has become a very popular tool for describing the dynamics of monetary transmission, and they are considered to be a natural benchmark for model evaluation. According to Rudebusch & Svensson (1999), most models employed by central banks for monetary policy analysis usually has three common characteristics with respect to its structure:

1. The model contains variable for short-term interest rate as the policy instrument with no direct role for monetary aggregates

2. The model is specified in terms of output gaps from trend instead of output growth rates

3. The model includes a variable to represent the Phillips curve with adaptive or autoregressive expectations that is consistent with the natural rate