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Unemployment, NAIRU and the Phillips Curve

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Unemployment, NAIRU and the Phillips Curve

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Types of Unemployment

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Types of Unemployment
Frictional Unemployment: Unemployment caused when people move from job to job and claim benefit in the meantime The quality of the information available for job seekers is crucial to the extent of the seriousness of frictional unemployment
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Types of Unemployment
Structural Unemployment: Unemployment caused as a result of the decline of industries and the inability of former employees to move into jobs being created in new industries

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Types of Unemployment
Seasonal Unemployment: Unemployment caused because of the seasonal nature of employment tourism, skiing, cricketers, beach lifeguards, etc.
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The demand for lifeguard services tends to exist in the summer but nothing like as much in the winter an example of seasonal unemployment. Copyright: Swiassmautz, http://www.sxc.hu

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Types of Unemployment
Demand Deficient: Caused by a general lack of demand in the economy this type of unemployment may be widespread across a range of industries and sectors Keynes saw unemployment as primarily a lack of demand in the economy which could be influenced by the government
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A fall in aggregate demand can lead to a decline in spending forcing businesses across the economy into closing with damaging effects on employment as a result. Copyright: Beeline, http://www.sxc.hu

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Types of Unemployment
Technological Unemployment: Unemployment caused when developments in technology replace human effort e.g in manufacturing, administration etc.

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Unemployment

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Unemployment
Short run and long run unemployment:

Classical theory short run unemployment is a temporary phenomenon; wages will fall and the labour market will move back into equilibrium Long run unemployment will be voluntary

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Unemployment
Keynesian Unemployment: Unemployment in the long run may remain stubbornly high because of imperfections in the market sticky wages

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Inflation

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Inflation
Anticipated Inflation: Occurs where individuals and groups correctly factor in expected changes in inflation into decision making e.g. wage negotiations, contract discussions, etc.
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Inflation
Unanticipated Inflation:
Where changes in inflation are not factored into decision making can lead to:
Changes in distribution of income e.g.factoring in inflation above actual levels in wage negotiations may lead to a redistribution of income from employers to employees Effects on Employment e.g. wage settlements higher than inflation due to incorrect anticipation of inflation imposes costs on employers and may lead to job losses

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Inflation and Unemployment using AS/AD

Inflation AS2 AS1
The Assume the economy has an inflation The riserunAD leads to a fall in is only short in fall in unemployment temporary; as AS but inflationary unemployment shifts, unemployment will rate of 2% and a level of national start incomeagain and unemployment rate pressures givinginflationeconomy will end to rise push an the up to 3.75%. upProducers tryrises a positionreason.at inof 4%. AD toin for some with the long run expand output but unemployment at employing more increased cost 4% but with higher inflation. Expansionary fiscal or monetary expensive capital, paying workers more policy will only lead to reductions results in to do work etc. Increased cost in unemployment to the left workersthe long a shift in AS in the short run. In start to run unemployment will return to its natural be laid off. rate. Attempts to reduce unemployment below the natural rate will be inflationary.

4.0% 3.75% 2%

AD2 AD1
U = 4% U = 3%

Real National Income

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The Philips Curve

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The Phillips Curve

1958 Professor A.W. Phillips Expressed a statistical relationship between the rate of growth of money wages and unemployment from 1861 1957 Rate of growth of money wages linked to inflationary pressure Led to a theory expressing a trade-off between inflation and unemployment
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Wage growth % (Inflation)

The Phillips Curve

The Phillips Curve shows an inverse relationship between inflation and unemployment. It suggested that if governments wanted to reduce unemployment it had to accept higher inflation as a trade-off. Money illusion wage rates rising but individuals not factoring in inflation on real wage rates.

2.5%

1.5%

4%

6%

PC1

Unemployment (%)

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The Phillips Curve

Problems: 1970s Inflation and unemployment rising at the same time stagflation Phillips Curve redundant? Or was it moving?

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Wage growth % (Inflation)

The Phillips Curve

An inward shift of the Phillips Curve would result in lower unemployment levels associated with higher inflation.

3.0%

1.5%

4%

6% PC2

PC1

Unemployment (%)

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The Phillips Curve

Inflation Long Run PC
There is athe economy starts with an inflation rate of Assume the rise in unemployment, government To countershort term fall in unemployment but at a once again injects high unemployment now base their cost of higherresources Individuals at 7%. the result is 1% but very inflation. into the economy aGovernment takes measures to but higher inflation wage negotiations unemploymentreduce short-term fall in on expectations of inflation. This higher inflation fuels further expectation ofthen in the next period. Ifan expansionary fiscal policy unemployment by higher wages are granted higher firms pushesso to processto shed labour and run that costs rise the the right (see the AD/AS inflation and AD they start continues. The long Phillips Curve creeps back up to 7% rate of unemploymentis vertical at the natural again. diagram on slide 15) unemployment. This is how economists have explained the movements in the Phillips Curve and it is termed the Expectations Augmented Phillips Curve.

3.0%

2.0%

1.0% PC1 7% PC3 PC2 Unemployment

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The Phillips Curve

Where the long run Phillips Curve cuts the horizontal axis would be the rate of unemployment at which inflation was constant the so-called Non-Accelerating Inflation Rate of Unemployment (NAIRU)
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The Phillips Curve

To reduce unemployment to below the natural rate would necessitate:
1. Influencing expectations persuading individuals that inflation was going to fall 2. Boosting the supply side of the economy - increase capacity (pushing the PC curve outwards)
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The Phillips Curve

Supply side policies have been focused on: Education:
Boosting the number of those staying on at school Boosting numbers going to university Lifelong learning Vocational education

Welfare benefits:
The working family tax credit Incentives to work

Labour market flexibility

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The Phillips Curve

Expectations have been centred on:
Operational independence of the Bank of England Tight control of public sector pay
The independence of the Bank of England has taken away interest rate decision making from the government who may have been motivated by political ends this has had the effect of influencing expectations.

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