The relationship between inflation and unemployment can vary greatly depending on the underlying causes of inflation. Both high economic growth and large government budget deficits can lead to inflationary pressures on the economy. While rampant economic growth results in low unemployment rates, a big deficit means fewer jobs and high rates of unemployment.
Inflation is defined as a broad rise in price levels. It is measured by tracking the change in prices for a broad range of goods and calculating an average change. Two types of inflation rates are calculated and made public. In addition to the consumer price index, or CPI, the producer price index, or PPI, is also widely followed by economists. While the former is a measure of how much more expensive the goods purchased by consumer have become, the later tracks prices paid by manufacturers for such things as steel, cement and wood. It is generally assumed that an increase in PPI results in an eventual increase in the CPI, because sooner or later manufacturers must pass on higher input prices to consumers.
Excess growth in an economy can lead to inflationary pressures over the long run. As consumers demand more goods and services, producers will inevitably begin charging higher prices. Not only is it easy to ask for higher prices if demand is strong, but manufacturing higher and higher quantities results in bigger manufacturing costs as well. Labor costs, in particular, will increase as manufacturers will have to pay overtime rates, which tends to be more costly, to increase output. This higher cost will naturally be passed on to consumers and result in higher consumer price inflation. Therefore, if the inflation is due to excess consumer demand, it will tend to result in plenty of jobs and low unemployment rates.
High rates of inflation can also result from excessive government spending and extreme deficits. When the government spends more than it can collect in tax revenue, it must borrow to finance the shortfall. This borrowing is almost entirely done through the sale of government bonds. When the government needs to borrow excessive amounts, it must offer high rates of interest to entice sufficient numbers of investors. Such high interest rates lead to increasing prices as well, because the borrowing cost of manufacturers also increases. When investors can lend to the government at high rates of interest, they demand even higher rates of return when lending to private corporations, which carry far higher repayment risk. Such circumstances lead to both higher inflation and high rates of unemployment, as manufacturers must often lay off workers in response to increased borrowing costs.
The causes and effects of inflation, unemployment, economic growth and government deficits can be highly complex. Every macroeconomic picture must therefore be analyzed individually, and such things as the savings rate, the qualifications of the work force and other factors also considered. A high deficit and resulting need for heavy borrowing may not result in high inflation, if, for instance, most of the households in an economy save a great deal of their income and buy government bonds with their savings. Due to such demand, the government may not need to offer very high interest rates to elicit sufficient demand for bonds. Similarly, certain countries rely heavily on robots and other machine-intensive manufacturing techniques and may not need to pay a great deal in overtime wages to ramp up production levels.