Unemployment & Inflation

Types of Unemployment

Zero unemployment has never existed in any market economy, and it never will. The reasons why tell you everything about the three categories economists have distinguished since the mid-20th century.

A recent college graduate sending out resumes, or a marketing manager who quit in January 2024 to chase a better role at a competing firm, is experiencing frictional unemployment. Both have usable skills. Jobs exist for people like them. The search simply takes time. Frictional unemployment persists even in a roaring economy.

Structural unemployment runs deeper. When the U.S. coal industry shed roughly 40% of its workforce between 2011 and 2020, a miner in McDowell County, West Virginia could not walk down the street and find a similar job. Neither could assembly-line workers at the Lordstown, Ohio General Motors plant after it closed in 2019. Their skills or locations no longer matched what employers needed. Retraining takes months or years, and geographic relocation is expensive.

Cyclical unemployment tracks the business cycle directly. When recession hits, aggregate demand collapses, firms slash payrolls, and layoffs spike across entire sectors. The 2008-2009 financial crisis and the early 2020 COVID shutdown are textbook cases. Once GDP returns to potential, cyclical unemployment vanishes.

The natural rate of unemployment equals frictional plus structural. It prevails when the economy produces at potential GDP and cyclical unemployment is zero. The Congressional Budget Office estimated the U.S. natural rate at roughly 4.4% in 2024. That number is never zero, because job searching and skills mismatches are permanent features of any dynamic economy.

Measuring Unemployment

The Bureau of Labor Statistics has published monthly unemployment data since 1940, and the definition of "unemployed" is narrower than most people assume. The gaps matter for policy.

The labor force includes everyone 16 and older who is either working or actively searching for work. Retirees, full-time students not seeking employment, stay-at-home parents, and anyone who has stopped looking are excluded entirely.

Unemployment rate = (Unemployed / Labor Force) x 100

You must be jobless *and* actively searching to count as unemployed. That requirement creates two major blind spots in the official data.

Discouraged workers have given up looking because they believe no work is available. When they stop searching, they exit the labor force. The measured unemployment rate actually falls — even though the job market has not improved. The statistic simply stopped counting them. During 2009-2010, this effect masked how severe the labor crisis really was; the official U-3 rate peaked at 10.0% in October 2009, but broader measures suggested the real figure was closer to 17%.

Underemployment is the other gap. A software engineer pulling espresso shots part-time at Starbucks because nobody in her field is hiring registers as "employed." The headline U-3 rate misses this slack entirely. The BLS publishes a broader U-6 measure that captures discouraged workers and the involuntarily part-time, but U-6 rarely makes front-page headlines.

Inflation and the CPI

In June 2022, the average price of a gallon of regular gasoline in the United States hit $5.02 — the highest ever recorded by AAA. Grocery bills climbed 10% year-over-year. The government compresses all of that into a single number using the Consumer Price Index (CPI), which tracks the cost of a fixed market basket of goods and services purchased by a typical urban household.

The Bureau of Labor Statistics has been publishing the CPI since 1913, making it one of the longest-running economic data series in the country. The BLS selects the basket — housing, food, transportation, medical care, education, and more — weighting each item by its share of a typical budget, with housing dominating at roughly one-third. The CPI compares the basket's cost in the current period to a base year, then multiplies by 100.

Given two CPI values, the inflation rate calculation is straightforward:

Inflation rate = ((CPI_new - CPI_old) / CPI_old) x 100

The CPI has known biases that push it above the true cost-of-living increase, all identified by the 1996 Boskin Commission. Substitution bias: beef prices spike and consumers switch to chicken, but the fixed basket assumes they kept buying beef. New product bias: the basket updates slowly and misses cheaper or better products entering the market (smartphones did not exist in the original basket). Quality change bias: a laptop priced the same as last year's model but running twice as fast has not really held its price in any meaningful sense. All three mean the CPI overstates actual inflation by an estimated 0.8-1.1 percentage points per year, according to the Boskin Commission's findings.

The Phillips Curve

In 1958, A.W. Phillips published a study examining nearly a century of British wage and unemployment data, from 1861 to 1957. The pattern he found was striking: when unemployment fell, wages — and by extension, prices — rose. When unemployment climbed, inflation cooled. The Phillips curve was born.

The short-run Phillips curve (SRPC) slopes downward with unemployment on the x-axis and inflation on the y-axis. Move up and left for lower unemployment with higher inflation. Move down and right for the reverse. The late 1960s demonstrated this tradeoff vividly, as Lyndon Johnson's simultaneous spending on Vietnam and Great Society programs pushed unemployment below 4% while inflation crept above 5%.

The long-run story is different. Milton Friedman and Edmund Phelps, working independently in the late 1960s, predicted that the tradeoff was temporary. The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment. Workers and firms eventually adjust their inflation expectations, and a central bank trying to hold unemployment permanently below the natural rate through relentless money creation just produces accelerating inflation with no lasting employment gain. The 1970s proved Friedman right. Paul Volcker's Federal Reserve finally crushed the inflationary cycle in 1981-1982 by pushing the federal funds rate above 20% — triggering a severe recession but breaking the spiral.

What shifts the SRPC? Expected inflation. When people expect higher inflation, the entire curve shifts upward: at every unemployment rate, actual inflation is higher. When expectations cool, the curve shifts back down. The anchoring of inflation expectations became the central preoccupation of central banking after the Volcker era.

Stagflation and Supply Shocks

On October 17, 1973, the Organization of Arab Petroleum Exporting Countries announced an oil embargo against nations that had supported Israel in the Yom Kippur War. Within months, oil prices quadrupled. Inflation soared. Unemployment soared. Both at once.

The standard Phillips curve predicted those two variables should move in opposite directions. Yet there they were, climbing together. Economists called it stagflation — stagnation plus inflation — and it shattered the prevailing Keynesian consensus that policymakers could always choose between the two evils.

The culprit was an adverse supply shock. Higher oil prices raised production costs across virtually every industry. Firms cut output and laid off workers while simultaneously passing cost increases to consumers. On the Phillips curve diagram, an adverse supply shock shifts the SRPC upward and to the right: at every unemployment rate, inflation is now higher.

Policymakers faced a lose-lose choice. Fight inflation with contractionary policy and unemployment worsens. Fight unemployment with expansionary policy and inflation worsens. Arthur Burns, the Fed chairman through most of the 1970s, tried to split the difference and mostly made things worse. Inflation was still running near 13% when Volcker took over in August 1979.

Favorable supply shocks work in reverse. The late-1990s technology boom, combined with falling energy prices, shifted the SRPC downward and to the left — delivering the rare combination of lower inflation and lower unemployment simultaneously. The U.S. unemployment rate fell to 3.9% in 2000 while inflation stayed below 3.5%. A golden moment that supply-side conditions made possible.

Worked Example

CPI was 248 last year and 255 this year.

Inflation rate = (255 - 248) / 248 x 100 = 7 / 248 x 100 = 2.8%.

The labor force is 160 million, with 6.4 million unemployed.

Unemployment rate = 6.4 / 160 x 100 = 4.0%.

Context from the Phillips curve framework: if the natural rate is 5.0% and the current rate is 4.0%, the economy is operating below the natural rate. On the short-run Phillips curve, that positions the economy in the upper-left zone — low unemployment, building inflationary pressure. Contractionary policy would push unemployment back toward 5.0% and cool inflation. The U.S. was in roughly this position in late 2021, before the inflation spike of 2022 forced the Fed into its most aggressive rate-hiking cycle since Volcker.

A different scenario: a supply shock drives unemployment to 7.0% while inflation jumps to 5.0%. That is stagflation — the SRPC has shifted upward and to the right. No single demand-side tool fixes both problems simultaneously. Expansionary policy would reduce unemployment but feed inflation. Contractionary policy would tame prices but deepen the jobs crisis. The 1970s taught this lesson at enormous cost.