In general, in economic cycles where there are low rates of unemployment, there is greater economic activity, stronger demand for workers and a higher demand for goods and services. Workers tend to earn higher wages and gain more economic power. They also have more taxable income, which means more revenue for state and federal governments. However, inversely, low unemployment can often lead to higher inflation rates.
In 1962, economist Arthur Okun put forward his theory, known as "Okun's Law," which attempted to prove a relationship between lower unemployment and higher growth in gross domestic product, the primary measure of a country's economic output. Okun's theory is based on the concept that more labour is needed to produce more goods and services, and that higher unemployment is associated with idle resources.
While low unemployment may mean more people working, a popular economic theory known as NAIRU, or Non-Accelerating Rate of Unemployment, holds that when unemployment drops below a certain rate, possibly around 4.3 per cent, that leads to higher inflation. This is why the U.S. Federal Reserve will consider raising interest rates during periods of low unemployment to stave off inflation.
Low unemployment does not always equal higher inflation. In November of 1997, the U.S. had a national unemployment rate of 4.6 per cent, which was the lowest level in 30 years, yet the rate of inflation actually fell, reports a writer on the Industrial Relations Counselors, Inc. website.