Inflation and Unemployment
The key to find the location of the PO is in the relation between unemployment and inflation. Remember, there are reasons why inflation doesn't go away:
- In Keynesian terms, there is the "inflationary spiral," in which a rise in costs causes prices to go up, which in turn raises costs, which again rises prices, and so on.
- Wage costs are among the costs that rise in response to higher prices. When unemployment is low, employees can hold out for full compensation for the higher prices, and raises above that. When unemployment is high, however, the employees will have to settle for less, and so costs do not rise as fast as prices when unemployment is high.
- In New Classical terms, there are "inflationary expectations." When people expect prices to go up, they sign contracts and make long-term plans based on higher prices in the future. These contracts and plans may make it necessary for them to raise their own prices.
- Unusually high unemployment is a sign that employees have mis-estimated the value of their labor. However, as time goes on and they get more information, they will learn what they can get for their work, and then wage costs will moderate, and so costs do not rise as fast as prices.
From either point of view, then, high unemployment means that costs rise less rapidly than prices when unemployment is high, so that inflation slows down. On the other hand, low enough unemployment will cause costs to rise faster than prices, with the result that inflation speeds up. In between the two extremes is a rate of unemployment just high enough that costs and prices rise at the same level, so there is no tendency for inflation either to speed up or slow down. This unique rate of unemployment is called the NAIRU, short for non-accelerating-inflation rate of unemployment.
- NAIRU
- The rate of unemployment at which inflation neither speeds up nor slows down.
NAIRU