The Dynamic Inter Relationship Between Unemployment Rate and Inflation Rate Evidence from Sri Lanka

Abstract

This objective of this study is to empirically investigate the relationship between inflation and unemployment in Sri Lanka using annual data from 1963 to 2010. Firstly, simple scatter plots, scatter with regression, scatter with kernel fit, Nearest Neighbor fit are used to explore the above relationship (Phillips curve). Scatter with kernel fit and Nearest Neighbor fit showed that there was a weak and downward sloping and non-linear relation5hip between inflation rate and unemployment rate in Sri Lanka during the study period. Confidence Ellipse also showed that there was a negative relationship between these variables. Co-integration analysis showed that there was a negative long-run equilibrium relationship between inflation and unemployment during the sample period. A closer look at the data shows that there have been in fact several distinct curves over the past 47 years. Stripping away some of the more volatile data shows that the trade-of between inflation and unemployment shifted both inward and outward at different times. Granger causality test shOW5 that there was a statistically significant causation from unemployment with lag 3 to inflation rate. Another interesting point to note is the change in the gradient of the curve along with time. It implies that the slope of the Phillips curve is a function of the macroeconomic status and the relationship is asymmetric. There is some evidence that the elasticity of CPI inflation with respect to unemployment has fallen recently. Empirical evidence for Sri Lanka shows that the Phillips curve has convex and concave shapes. Sacrifice ratio between inflation rate and unemployment rate also change over the period