The Nonlinear Unemployment-Inflation Relationship and the Factors That Define It

Abstract

In this paper, local projections are used to explore the unemployment-price inflation relationship in a more generalized, empirical fashion. We find that inflation’s reaction to changes in the unemployment rate varies across states of the economy, with timing as the primary difference. In low-unemployment environments, inflation reacts immediately and persistently. In high-unemployment environments, the same reaction manifests after a 1-year lag. We then use industry-level data and a two-stage feasible generalized least squares method to explore the factors that drive this relationship. We find that increased reliance on labor and intermediate inputs adds to the inflationary pressures of low unemployment, while increased market concentration (among others) dampens this effect.