Unemployment vs. Inflation: Which is Worse? Part I

Macro economic policy making is often characterized as a trade-off between achieving full employment vs. achieving stable money (no significant inflation). This relationship or trade-off,to the extent it exists, is called the Phillips Curve.  [note: the stability and existence of a long-run trade-off is highly contested by some]. In this post, I want to look at the costs of missing our objectives on either.

In my macro classes I like to emphasize that an economy, any economy, wants to achieve at least 4 major objectives through policy:

  1. Overall growth (long run trend growth in GDP)
  2. Short- and Medium-run stability of growth (minimize the business cycle)
  3. Stable monetary and financial system (no significant inflation, no deflation, no financial crises)
  4. Full employment

Of these, it is often perceived that achieving both #3 and #4 may be problematic since the easy policies to achieve either run the risk  of making the other worse.  It is possible to achieve both, but it’s more tricky and requires more accurate policy moves. That brings us to the question of which way is the more serious error?  Not all dilemmas are symmetrical.  In other words, if we’re likely to make an error, which error should we prefer?  Yes, we may be stuck “between a rock and a hard place”, but if the hard place is material that’s likely to absorb some impact and let us survive with injuries, while hitting the rock represents certain death, I would definitely prefer policies that, if they are wrong, they tend to lead to the hard place over the rock.

So which is worse?  The rock of high unemployment?  Or the hard place of inflation?  In this post, I’ll offer some evidence for why high unemployment is the more costly problem.  In a later post, I’ll look at the costs of inflation.  For now let’s look at the costs of high unemployment below the fold:

Costs of  Unemployment

Unemployment costs both society and the individuals involved in several ways.

  1. First, unemployment kills.  It’s unhealthy.
  2. The longer a person is unemployed, the more difficult it is for that person to obtain new employment.  Recessions raise the time it takes to find new employment.
  3. Society loses the potential output of the unemployed workers.  This loss of output is permanent.  If we don’t use the unemployed workers this week, then we have permanently lost that output.  Labor cannot be stored up unused and employed later.

For some supporting evidence, I turn to Menzie Chinn of Econbrowser who, in turn, quotes Dao and Loungani in an IMF/ILO paper:

From the introduction to a paper presented at the joint ILO-IMF conference on Growth, Employment and Social Cohesion, entitled The Human Cost of Recessions: Assessing It, Reducing It, by Mai Dao and Prakash Loungani.

Recessions leave scars on the labour market; the Great Recession of 2007-09 has left gaping wounds. Over 200 million people across the globe are estimated to be unemployed at present. Among countries with unemployment data in the IMF’s World Economic Outlook (WEO) database, there has been an increase of over 20 million unemployed people since 2007. The ILO estimates that globally the increase is over 30 million. As shown in the left panel of Figure 1, three-fourths of this increase in the number of unemployed people has occurred in the ‘advanced’ economies (the term used in the WEO to denote high per capita income countries) and the remainder among emerging market economies. The unemployment rate has increased by 3 percentage points in advanced countries since 2007 and by 0.25 percentage points in emerging markets…

The paper documents a wide variety of effects, but one striking implication is the impact on mortality, as shown in this graph:

Figure 5 from Dao and Loungani (2010). Notes: Marginal effect of displacement on odds of mortality, with 2 SE bands. Source: Sullivan and von Wachter (QJE, 2009).

In terms of implications for macroeconomic policy, I thought this graph was of relevant. It shows that the longer the duration of unemployment, the lower the probability of employment in the next period. Depending upon the interpretation of this correlation, there are important public policy implications. If the extended duration of unemployment implies depreciation of skills relevant to the labor market, then this implies short term (cyclical) and long term (structural) unemployment are related phenomenon.

Figure 5 from Dao and Loungani (2010).

One thought on “Unemployment vs. Inflation: Which is Worse? Part I

  1. Pingback: Just What Is Inflation? Is A Monster Just Around The Corner? « EconProph

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