Wednesday, April 29, 2015

Inflation and Unemployment in Canada

Inflation is believed to be negatively correlated with unemployment, at least in the short-run. An increase in prices (inflation) resulting from an increase in the demand of goods and services will raise gross domestic product (GDP) and reduce unemployment.  

In the long-run, inflation and unemployment are said to be either not at all correlated or positively correlated. Thus in a state of full employment, an increase in the demand of goods and services will cause inflation but will leave unchanged both GDP and unemployment.  The situation where inflation and unemployment are positively correlated is called stagflation. It can occur when a negative shock reduces the supply of goods and services. This will increase inflation, reduce GDP, and raise unemployment.

Canada experienced stagflation in the early 1980s. In 1980, the Bank of Canada’s key interest rate, the discount rate, became again floating. Anticipating inflation, the discount rate reached a historically high level in 1981 causing a recession that lasted till the end of 1982.  In 1982, both inflation and unemployment were high as a result of the tightening monetary policy conducted by the Bank of Canada   [here]. Another case of stagflation occurred in January 1991. Monthly inflation reached the historical high of 2.7 % whereas unemployment rate was at 9.8 %.

How likely is it that the rate of inflation has some effect on unemployment?  

Non-parametric Joint Density of Inflation and Unemployment, Canada, 1979:M1-2015:M3

Non-parametric Joint Density of Inflation and Unemployment, Canada, 1979:M1-2015:M3 (Another Phillips  Curve)
  • The probability of having simultaneously an extremely high level of inflation and unemployment is almost nil.
  • On the other hand, having a low inflation rate along with a low unemployment rate is likely.
  • So is having a low inflation rate and a high unemployment rate.  
  • The most likely occurrence is around the sample averages: .26% for the inflation rate and 8.42% for the unemployment rate.