Inflation and unemployment have an inverse relationship, so an increase in unemployment will reduce the inflation rate. It is possible for a nation to have high unemployment and high inflation at the same time because of factors such as oil prices, which is a situation known as stagflation. Central banks set an acceptable level of inflation. To reduce inflation, they will reduce the amount of money available for businesses to borrow if the unemployment rate gets too low.
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Inflation increases the cost of all items sold on the market, including the cost of hiring an additional worker. When inflation increases, workers demand higher wages from employers. The employer will have to meet these expectations and raise wages if unemployment is low. Additionally, he must increase product costs to cover these rising expenses. This situation creates a self-reinforcing inflationary spiral where store prices lead to wage increases, and wage increases lead to higher store prices.
When unemployment is high, the cost of goods at the store will still increase during an inflationary period, but the employer will be able to hire cheaper workers if the current workers complain. Wages will not rise while unemployment remains high. Workers will have to borrow money or reduce the amount of goods they purchase. If workers cannot get loans, stores will have to lower prices to continue to sell products, reducing inflation.
The cost of imported goods affects the inflation rate. If a country imports oil and oil prices are low, it can have low inflation while having low unemployment. Dependence on energy imports is risky, because a decline in the value of a nation's currency will increase its energy costs, and the exporting nation may decide to sell to other markets instead of lowering energy prices. According to Northwestern University, low oil prices allowed the United States to have 4 per cent unemployment along with low inflation during the late 1990s.
Central Bank Policy
A central bank has conflicting objectives. The bank must try to keep inflation from making goods too expensive, while also ensuring that citizens of a country can find jobs. If the bank focuses on unemployment alone, inflation will rise. According to the Federal Reserve, a policy only designed to reduce inflation can create long-term unemployment, and prices will be higher in the future because workers who lack skills because of long-term unemployment will be less productive.
Central banks plan for a small amount of inflation. According to the Federal Reserve, an inflation rate of 2 per cent per year is helpful because it reduces the risk of deflation. With deflation, wages will drop in the future, creating a strong incentive for employers not to hire workers, because they can hire them for lower wages next year and their current inventory will sell for lower prices.
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