Changes in unit labour costs (ulc's) are important in determining the underlying rate of inflation for the economy in the medium term. When the economy experiences an increase in unit labour costs - the effect is to reduce aggregate supply at each price level. The diagram below shows how an inward shift of AS for a given level of aggregate demand causes an increase in the general level of prices - this is known as cost-push inflation

Unit labour costs measure the labour cost per unit of output produced. ULCs will rise when total labour costs rise faster than output. For example if wages rise by 5% and labour productivity (output per worker) grows by 2%, unit labour costs will rise by 3%.  A rise in labour productivity helps to control unit labour costs. This is because a producer is achieving a higher output from each unit of labour employed for a given wage cost.

The annual change in UK unit labour costs since 1981 is shown in the chart below

Unit labour costs tend to rise fastest when (a) there is an acceleration in wage demands / basic pay settlements and (b) there is a slowdown in the growth of productivity. Unit labour costs have grown less quickly in the 1990s compared with the 1980s. In part this is because wage demands have been much lower on average during the current decade. This has been an important factor in explaining the continued low rates of inflation in the British economy over the last ten years.