Unemployment & Inflation

Types of Unemployment

Looking at unemployment and inflation, from the employment difficulties of the 1930s to the stagflation of the 1970s, economists have refined how they categorize job losses, learned to measure price increases, and found the Phillips curve relationship between the two.

Economists divide unemployment into three categories, and it's important to know which one a person falls into when deciding on a solution. A stimulus check won't solve structural unemployment.

Frictional unemployment is the easiest to understand. A student who just finished an accounting degree at the University of Georgia and is applying for jobs, and a marketing manager at Coca-Cola who resigned in February 2024 to begin a new job at PepsiCo in six weeks are both examples. Both have the skills employers want, the jobs are available, it just takes time to connect the two, even in a good economy.

Structural unemployment is very different. Between 2011 and 2020, jobs in U.S. coal mining dropped around 40%, and miners in McDowell County, West Virginia weren't just between jobs, they were without any viable employment. The General Motors factory in Lordstown, Ohio closed in 2019 and those workers on the assembly line couldn't instantly become computer programmers. Their skills, where they lived, or both were no longer what employers needed, and even if retraining works (which is often not the case) it takes many months or years. It's expensive to move, and entire towns can become empty.

Cyclical unemployment is directly tied to recessions. When overall demand falls dramatically, companies cut jobs and these layoffs spread throughout many industries. The financial crisis of 2008-2009 and the very beginning of the COVID pandemic in 2020 are good examples. When GDP gets back to its potential level, cyclical unemployment disappears.

The natural rate of unemployment is frictional plus structural. In other words, it's the unemployment rate when the economy is at potential GDP and cyclical unemployment is zero. The Congressional Budget Office estimated this to be around 4.4% for 2024. This number will never be zero because people will always be changing jobs and some skills will always be in less demand than others.

Measuring Unemployment

Each month, the Bureau of Labor Statistics releases unemployment figures, but their definition of "unemployed" is much more limited than most people think. The "labor force" includes all individuals age sixteen and over who are employed or actively seeking employment. Retirement, full-time study without a job search, being a stay-at-home mom or dad, or simply stopping your job hunt, all mean you're not considered part of the labor force.

The unemployment rate is calculated as (number of unemployed / size of the labor force) multiplied by 100. To be counted as unemployed you need to be without a job and be actively looking for one. This creates two significant weaknesses in the data, and both frequently appear on AP exams.

"Discouraged workers" have stopped looking for work because they believe there are no jobs available for them. Once they stop looking, they disappear from the labor force entirely; the official unemployment rate goes down, even though the job situation hasn't improved at all. The BLS simply stops including them in their calculations. From 2009 to 2010, this made the recession seem not as bad as it really was. The standard U-3 unemployment rate peaked at 10.0% in October 2009, but more inclusive measures which do include discouraged workers indicated the true impact was closer to 17%.

Another issue is "underemployment". A software engineer, unable to find a tech job, taking a part-time barista position at Starbucks, is officially "employed". The BLS does publish the U-6 figure, which includes discouraged workers and those who are forced to work part-time, but U-6 rarely makes the news. On the AP exam, a person working part-time but needing full-time work is an example of underemployment, and the U-3 rate doesn't reflect this.

The Consumer Price Index

Regarding inflation and the CPI, in June 2022 gasoline reached $5.02 per gallon (AAA's highest national average ever), and food costs rose around 10% compared to the previous year. The government summarizes all these price changes into one figure, the Consumer Price Index (CPI) which tracks how the cost of a typical "basket" of goods and services purchased by a normal household in a city changes.

The BLS has been publishing the CPI since 1913, making it a very long-running set of economic data. They decide what goes in the basket (things like housing, food, transport, healthcare, and education) and give each item a weighting based on how much of a typical household budget it takes up (housing uses about a third of most budgets). They then compare the cost of the basket now with the cost in a base year, multiply the result by 100, and that's the CPI.

The formula for calculating inflation from two CPI values is simple:

Inflation Rate = ((New CPI - Old CPI) / Old CPI) x 100

The CPI does have some known issues which cause it to show a higher inflation rate than the actual increase in living costs; the 1996 Boskin Commission identified all of them.

"Substitution bias" happens when the price of beef increases so people buy chicken instead, but the CPI's fixed basket assumes everyone continued to buy beef at the higher price.

"New product bias" is that the CPI is slow to include new, cheaper or better goods (smartphones weren't originally included).

"Quality change bias" means a $900 laptop today is far superior to a $900 laptop last year, so it's not a true "unchanged price".

The Boskin Commission believed these biases increase the measured inflation by about 0.8 to 1.1% each year, and this is important for things like Social Security's Cost of Living Adjustment (COLA) which is directly linked to the CPI.

The Phillips Curve

In 1958, A.W. Phillips published a paper based on almost a hundred years of British pay and unemployment figures (from 1861 to 1957) and found a pretty consistent relationship. When unemployment was low, wages and prices tended to go up, and when unemployment was high, inflation was low.

The short-run Phillips Curve (SRPC) shows this as a downward slope with unemployment on the horizontal axis and inflation on the vertical one. Lower unemployment and higher inflation are up and to the left, and the opposite is down and to the right. Lyndon Johnson inadvertently showed how this worked in the late 1960s. He paid for both the Vietnam War and the Great Society programs at the same time; unemployment dropped below 4%, and inflation rose above 5%.

The long run is completely different, and it's where students often get confused. Milton Friedman and Edmund Phelps (working independently in the late 1960s) both said this balance wouldn't last forever. The long-run Phillips Curve (LRPC) is a straight, vertical line at the 'natural' unemployment rate. Their reasoning was that eventually workers and companies will factor in what they expect inflation to be, so a central bank continually trying to get unemployment below this natural rate by constantly creating more money will only get ever-increasing inflation with no lasting gains in employment. The 1970s showed them to be right, and quite dramatically. Paul Volcker at the Federal Reserve finally stopped the increasing inflation in 1981-1982 by increasing the federal funds rate to over 20% - this caused a severe recession (unemployment reached 10.8%) but it did end the spiral.

What causes the SRPC to move? Primarily expectations about inflation. If people start to anticipate higher inflation, either because they're experiencing it, or because the Fed suggests they're being looser with money policy, the entire curve shifts upwards, meaning at any given unemployment level, actual inflation will be higher. When expectations fall, the curve goes down. After Volcker, keeping inflation expectations stable became pretty much the central aim of central banks everywhere.

Stagflation and Supply Shocks

Then, on October 17, 1973, the Organization of Arab Petroleum Exporting Countries imposed an oil embargo on countries supporting Israel during the Yom Kippur War. Within months, oil prices increased four times over. Inflation rose, unemployment rose… both at the same time.

The Phillips Curve suggested this shouldn't be happening.

Economists coined the word 'stagflation' (stagnation plus inflation), and the typical Keynesian approach - the idea that governments could always choose a point on a nice, clear inflation-unemployment trade off - largely collapsed. What really occurred was a negative supply shock: the massive increase in oil prices increased production costs for almost all industries at once. Companies reduced production, laid off employees, and at the same time increased prices to cover the increased costs. On a Phillips Curve graph, a negative supply shock moves the SRPC up and to the right, so at every unemployment level, inflation is higher.

The dilemma for policy makers was truly bad. Tightening policy to fight inflation would worsen unemployment. Loosening policy to fight unemployment would worsen inflation. Arthur Burns was in charge of the Fed for most of the 1970s and attempted a bit of both. It didn't succeed. Inflation was still close to 13% when Volcker took over from him in August 1979.

Favorable supply shocks have the opposite effect. The late 1990s tech boom alongside cheaper energy pushed the SRPC down and to the left, giving us something unusual: lower inflation and lower unemployment at the same time. In 2000 the U.S. got unemployment down to 3.9% while keeping inflation under 3.5%. That doesn't happen just from managing demand; it needs the supply side to help too.

Worked Example

For an example, the Consumer Price Index (CPI) was 248 last year and 255 this year. So the inflation rate is (255 - 248) / 248 x 100 = 7 / 248 x 100 = 2.8%.

The workforce has 160 million people, and 6.4 million of them are out of a job. Unemployment at 6.4 out of 160, expressed as a percentage, is 4.0%.

Thinking about the Phillips curve with this in mind: if the "natural" rate of unemployment is 5.0%, and unemployment is currently 4.0%, the economy is operating below where it should be. On the short-run Phillips curve this means you're in the upper left portion, experiencing unemployment lower than the natural rate, and prices are increasing. The usual solution to this would be to use a policy that restricts the economy a little, bringing unemployment back to around 5.0% and slowing down inflation. The United States was in roughly this position in late 2021, and then the big increase in inflation in 2022 forced the Federal Reserve to raise interest rates very quickly - in fact, it was the most aggressive series of rate increases since the Volcker years.

But what if a sudden issue with supply pushes unemployment up to 7.0% at the same time that inflation goes to 5.0%? That's stagflation, and the short-run Phillips curve moves upwards and to the right. No policy that affects demand can solve both of these problems at the same time. Increasing the money supply (expansionary policy) would lower unemployment, but would make inflation even worse. Decreasing the money supply (contractionary policy) would reduce inflation, but would make the unemployment situation even more serious. The whole 1970s were a difficult example of this exact issue, and the AP exam frequently asks about it on the free-response section.