Relationship between Inflation, GDP and Employment

Unemployment and Inflation:

The link between unemployment and inflation1 has historically been inverse. One causes the other
to fall when it rises and vice versa. To prevent overstimulating or excessive slowdown of the
economy, governments often depend on monetary and fiscal policy.

Monetary Policy - When a central bank seeks to encourage growth by regulating the money
supply, monetary policy is implemented. To encourage growth, interest rates are lowered and more
money is printed and poured into the economy. When central banks try to stifle growth, rates rise.

Fiscal Policy - Tax and expenditure policies are referred to as a nation's fiscal policy. The
promotion of economic growth occurs when governments relax their fiscal restrictions. When the
reins are pulled tighter, growth is slowed.

Gross Domestic Product is always adjusted for inflation. The growth of unadjusted GDP2 means
an economy has experienced one of five scenarios:

• Produced more at the same prices

• Produced the same amount at higher prices
• Produced more at higher prices
• Produced much more at lower prices
• Produced less at much higher prices

Inflation indicates that prices have risen. The buying power of money falls with an increase in
inflation, which reduces consumption and lowers GDP. Because it raises future uncertainty, high
inflation might make investments less appealing. It can also have an impact on the balance of
payments because exports become more expensive. As a result, GDP continues to decline.
Therefore, it would seem that GDP and inflation are inversely connected. Studies, however,
suggest that there could also be a favorable association. For instance, the Phillips curve
demonstrates that high inflation is associated with low unemployment rates, suggesting that there
is a beneficial effect on economic growth.

1- Inflation simply means either an increase in the money supply or an increase in price levels.
Inflation is often assessed using the core Consumer Price Index (CPI), which is the common
method used in all major economies
2- Gross Domestic Product (GDP) is an economic indicator of the total market value of all the final
products and services it generated within a certain time frame
Inflation and GDP:

Inflation and economic output (GDP) interact in a rather complex way. An important factor for
stock market investors is annual GDP growth. Most businesses won't be able to improve their
earnings if general economic activity is dropping or even holding steady (which is the primary
driver of stock performance). However, excessive GDP growth is also risky since it almost
certainly accompanies a rise in inflation, which reduces the purchasing power of our money and
reduces future corporate earnings. The majority of analysts currently concur that 2.5 to 3.5% GDP
growth annually is the maximum that our economy can sustain without having unfavourable
repercussions.

Fig. 2: Actual Trend of Real GDP Growth and Inflation in India (Mar-1998 to Dec-2010)
Source: Reserve Bank of India

Unemployment and GDP:

By using Okun's Law, it is possible to see the connection between GDP and unemployment rates.
The principles established by this law state that for every established one percent gain in GDP,
there is a matching two percent increase in employment. The justification for this law is rather
straightforward. According to this, demand and supply laws determine GDP levels, hence an
increase in demand will result in an increase in GDP. To keep up with the demand, a demand rise
of this magnitude requires an increase in both productivity and employment.
Phillip’s Curve:

A.W. Phillips was one of the first economists to present compelling evidence of the inverse
relationship between unemployment and wage inflation. Phillips proposed the idea that
companies should anticipate raising salaries relatively quickly when there is a large demand for
labour and a small number of unemployed employees. However, employees are hesitant to
accept lower salaries than the going rate when labour demand is low and unemployment is high,
and as a result, wage rates decline relatively slowly. The rate at which unemployment is
changing has an impact on pay rate fluctuations as well. Employers will bid more aggressively
for workers if the economy is booming than they would if demand for labour were either not
increasing (e.g., percentage unemployment is unchanging) or only increasing at a slow rate. This
indicates that the demand for labour is increasing at a fast pace (i.e., percentage unemployment is
rapidly decreasing).

The trade-off between unemployment and inflation prompted economists to fine-tune monetary
or fiscal policy using the Phillips Curve. It should be able to seek for a balance between desired
levels of inflation and unemployment since a Phillips Curve for a certain economy would
demonstrate an explicit amount of inflation for a specific rate of unemployment and vice versa.

Conclusion:

While GDP increases as a result of inflation, this indicator does not account for genuine
economic growth. Therefore, the GDP must be divided by the inflation rate in order to determine
the rise in real GDP. However, there has been a negative relationship between unemployment
and inflation. This suggests that as inflation rises, unemployment declines. Conversely, lower
inflation is brought on by higher unemployment. As more people find employment, their
discretionary money increases, driving up demand.
References:

• https://www.investopedia.com/ask/answers/040715/what-happens-when-inflation-and-
unemployment-are-positively-correlated.asp
• https://www.researchgate.net/publication/346401181_The_Relationship_between_Inflati
on_and_Employment_in_the_Low_Profit_Rate_Mode#:~:text=Unlike%20what%20Phill
ips%20curve%20shows,rate%20which%20is%20determined%20exogenously.
• https://www.investopedia.com/ask/answers/112814/why-does-inflation-increase-gdp-
growth.asp
• https://www.rbi.org.in/scripts/PublicationsView.aspx?id=13838
• https://www.ivoryresearch.com/samples/the-relationship-between-inflation-and-
economic-growth-gdp-an-empirical-analysis/
• https://www.federalreserve.gov/newsevents/speech/yellen20170926a.htm
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