A Two-year Forecast of Unemployment based on Inflation Rates

CANDICE AMMONS

College of Business

Western Carolina University

Abstract

U.S. unemployment is forecast to increase in 2000 and it increased slightly in 2001. The New Classical School interpretation of the Phillips curve is the approach used in the forecast. U.S. monthly inflation and unemployment rates from January 1978 through December 1999 were used to forecast unemployment. The forecast implies that unemployment will increase in 2000 and 2001. Average unemployment of 4.55% is forecast for 2000, with 4.6% in 2001. (JEL:E130)

Part 1. Introduction

This paper forecasts U.S. unemployment based on inflation rates in the years 2000 and 2001. The explanatory variable is the seasonally adjusted unemployment rate. The approach that is going to be used is the New Classical School interpretation of the Phillips Curve. This particular approach is used because there is a short-run trade-off between inflation and unemployment. Whenever unemployment is low, inflation tends to be high and whenever unemployment is high, inflation tends to be low. The New Classical School interpretation is based on a reasoning that assumed almost full employment was the normal state of the economy. If employment were reduced, self-adjusting forces would tend to bring the economy back to a state of equilibrium at full employment (Kristensen 1981, p. 67). Members of this school of thought believe that the economy has a powerful self-correcting mechanism. They believe that deviations from the natural, or full employment, output level set up forces which eventually return the economy to full employment (Thomas 1997, p. 622).

Inflation rates and unemployment rates are important because they are related to the Government and to the general public. Unemployment is a big problem for the economy. Not only are the unemployed not working, and not contributing to the economy, but they will also be claiming benefits and costing the government money. The aim should be to keep unemployment as low as possible.

The rest of this paper is organized as follows: Part 2. presents the data used to forecast unemployment rates; Part 3. presents the theoretical basis for the approach adopted in forecasting unemployment rates; Part 4. presents forecasts of unemployment rates for 2000 and 2001; Part 5. evaluates the importance of the forecast for the economy; and Part 6. discusses conclusions for economic policy.

Part 2. Data

The first variable is inflation. The rates used for the sample period were expected rates for each month from 1978 to 1999. They came from the University of Michigan Inflation Expectation. The second variable is unemployment. These rates came from the Federal Reserve Bank of St. Louis Federal Reserve Economic Data (FRED). The FRED descriptor is UNRATE. The rates taken for the sample period were from every month from years 1978 to 1999. The forecast horizon is for two years into the future. This data was used because it is easily available over the Internet.

Part. 3 The New Classical Phillips Curve as a Forecasting Instrument

The New Classical School interpretation of the Phillips Curve is going to be used because of the relationship between inflation and unemployment. Unemployment is considered low or high relative to the so-called natural rate of unemployment. Inflation is considered low or high relative to the expected rate of inflation. In the long-run, the Phillips Curve is vertical. In the short-run, the Phillips Curve is upward sloping, which is determined by what people expect the inflation rate will be in the future. The short-run Phillips Curve intersects the long-run Phillips Curve at the expected inflation rate. Unemployment is a function of inflation in the Phillips Curve:

u=f (i),

where i = inflation and u = unemployment. Solving for inflation, the equation is written as:

inf_t = f(inf_t-2, u_t-2).

Part 4. A Forecast of Unemployment

Inflation was lagged twenty-four months to forecast unemployment. The R-square is 0.711899, indicating that 71% of the variation in unemployment is explained by variation in inflation from 2 years prior. The following equation is for the forecast of unemployment which was lagged two years into the future:

1.256785 + 0.507156 (inf_t-2) + 0.462418(u_t-2)

This equation is an example of how the unemployment was computed for each month in 2000 and 2001. Forecast unemployment rates are given in Table 1.

Table 1 Forecast of Unemployment Rates for Years 2000 and 2001
Months in 2000	Forecast Unemployment	Months in 2001	Forecast Unemployment
January	4%	4.6%	January
February	4.6%	4.6%	February
March	4.7%	4.6%	March
April	4.5%	4.6%	April
May	4.6%	4.6%	May
June	4.7%	4.5%	June
July	4.7%	4.6%	July
August	4.6%	4.6%	August
September	4.5%	4.6%	September
October	4.6%	4.6%	October
November	4.5%	4.6%	November
December	4.6%	4.7%	December

This forecast predicts higher than current unemployment. The current unemployment rate is 4%. As you can see, the unemployment rate will increase to about 4.6% and it will stay there for the next two years. If unemployment increases over the next two years, then inflation will decrease over the next two years.

Part 5. Steady as She Goes

The results of the forecast are believable, but not quite accurate. The inflation rates that were used were expected inflation rates and not the actual inflation rates. The unemployment rate in December 1999 was 4.1% and the inflation rate was 2.8%. The inflation rate is expected to go down, which would cause unemployment to go up. The average unemployment rate for 2000 and 2001 are 4.55% and 4.6%. Employers will have a little bit more difficulty filling jobs and keeping help due to the increase in the unemployment rate. As a result of a decrease in inflation, prices will go down.

Part 6. Policy Conclusions

In 2000 and 2001, the unemployment rate will rise by, at the most 0.4% in 2000 and 0.5% in 2001. “Unemployment deprives families of the chief source of income, triggers a host of social problems such as increased incidence of crime and mental illness, and impacts most heavily on the disadvantaged and those at the lower end of the income scale. Increased unemployment reduces the nation’s level of output and income as well as tax revenues at all levels of government, thereby impairing such public services as roads, police protection, and education” (Thomas 1997, p.442). The government should be concerned about the increase in the unemployment rate because the whole economy suffers from people being unemployed.

References

Federal Reserve Bank of St. Louis, Federal Reserve Economic Data (FRED), http://www.stls.frb.org/fred/ (2-28-00).

Kristensen, Thorkil, Inflation and Unemployment, New York: Praeger Publishers, 1981, pp.67.

Thomas, Lloyd B, Money, Banking, and Financial Markets, New York: McGraw-Hill, 1999, pp.442, and 622.