An economy does well when there is money circulating. When people and businesses can afford to buy goods and services, people can make a living selling them. Both inflation and unemployment have negative effects on an economy, but to some extent they push in opposition directions, and, therefore, can serve to moderate each other. Too much of either, however, will tilt an economy into a catastrophic downward spiral.
Inflation Devalues Money
Inflation operates like a tax on savings. As the value of a dollar declines, the purchasing power of the money in a savings account declines. In other words, you won’t be able to buy what you used to be able to with the same amount of money. The actions of the Federal Reserve, which expands the money supply, seeks to maintain a constant rate of inflation that is just enough to discourage savings and encourage investment in the economy. Whereas the interest paid on a savings account is usually less than the rate of inflation, return on investment in things like stocks and bonds often exceeds inflation.
Unemployment Makes Money Scarce
While there are disputes as to who should be counted as unemployed, the effects of joblessness are less controversial. People who don’t have jobs can’t spend money because they don’t have the money to spend. Persistently high levels of unemployment can cause stagnation or actually erode the wages of those who have jobs because there is increased competition for jobs. When cash is hard to get, it gets more valuable. Thus, in limited amounts, unemployment can work as something of a check on inflation.
Velocity of Money
The connection between inflation and unemployment is something called the velocity of money. The amount of money in circulation is not the only factor that affects its value. The frequency with which the money is spent has a major impact on inflation. The increase in the velocity of money is why rapidly growing economies tend to generate more inflation than declining economies. In normal times, the Federal Reserve raises interest rates in an attempt to slow the rate of economic growth and inflation.
The worst of all possible worlds, however, occurs when unemployment remains stubbornly high while the supply of money increases significantly. In such circumstances, a central bank would be hesitant to raise interest rates and make economic growth harder to initiate. At the same time, the artificially low interest rates create runaway inflation that crushes the value of the currency and undoes any benefit of the low interest rates. A hyper-inflationary spiral, in which prices rise hundreds or a thousand percent or more in a short time, result in crushing poverty as even the wages of the employed fail to keep up the devaluation of the currency.