A.

Explain what is meant by the natural rate of unemployment

Natural rate of unemployment is the lowest or minimum rate of unemployment in a certain

economy due to the structure of labor force, seasonal employment and other frictional causes of
unemployment.

Even under the assumption of full employment, there are still forces that is embedded in the
economy which pushes a certain rate of unemployment to exists.

For instance, frictional unemployment. Frictional unemployment happens when workers are
temporarily unemployed or goes from one job to another. Consider a discouraged worker who finally
becomes encouraged and looks for a job. That individual would be added to the labor force under those
unemployed. Moreover, there are contract workers who from time to time becomes unemployed, thus
the filling the constant existence of unemployment rate.

Another instance is structural unemployment. This happens when the structure of labor force
tends to make certain skills obsolete by introduction of new technology. For instance, a factory worker
gets laid off because of an invention or a machine that performs the task he was hired to do better.
Therefore, as we move ahead in the economy, structural changes like these are unavoidable.
Unfortunately, unlike frictional, unemployment of these workers is more permanent in character.

Lastly, we may consider seasonal unemployment as well, to facto in to the natural rate of
unemployment. This happens because in certain seasons, some jobs are less demandable causing a
temporary unemployment on some workers. For example, in season of harvest, fruit pickers are in
demand adding to the total number of employed. However, when the season ends, fruit pickers go back
to their former status of unemployment due to lack of demand for their labor.

Figure A. Philips Curve

Therefore, when we consider economic models such as the Philips Curve (Figure A), it will show
us that in the long run (LRPC), employment will fully adjust to the prices and will set a natural rate of
unemployment (NRU) instead of full employment because 0% unemployment rate is unattainable due to
aforementioned reasons.
B. Discuss the view that there is no trade-off between inflation and unemployment

Before focusing on the trade-off issue, it is important to know inflation and unemployment first.
Inflation is the economic term referring to increase in prices. The higher the increase in prices, the
greater the inflation. On the other hand, unemployment is the economic phenomenon of losing
employment or getting unemployed. Higher unemployment in the economy depicts economic recession.

Figure 1. Aggregate Demand and Aggregate Supply Figure 2. Philips Curve

Now, there is a possible concept of trade-off in terms of inflation and unemployment. Take for
instance Figure 2 which shows the Philips Curve. The graph presents two curves, the Short-run Philips
Curve (SRPC) and the Long-run Philips Curve (LRPC).

Analyzing the SRPC, there is an actual trade-off between inflation and unemployment. Moving
from point A to point B, in order to achieve lower unemployment, there is a trade-off for higher
inflation. This constitutes an inflationary gap. This is further explained by the AS/AD Model. When
unemployment decreases, more people have wages which pushes for higher aggregate demand.
Therefore, from AD, aggregate demand would shift to the right and move to AD’’ with new equilibrium
point, c. In this situation, the demand is higher than the output of the economy which leads to increase
in prices due to shortage. Therefore, if we want lower unemployment, we tend to trade-off higher
inflation. For example, if we open more relaxed on job requirements, many would be employed. Then,
they will earn wages which they would now use to consume products they do not formerly consume.
This would increase aggregate demand which will eventually increase prices.

At the same time, moving from point A to point C of the SRPC constitutes a trade-off that in
order to lower the prices, there would be higher unemployment. This constitutes a recessionary gap.
Decreasing price levels lead to decrease in revenue on outputs which urges companies to lay off
employees. This is called cyclical unemployment – unemployment due to recession. Going back to Figure
1, this situation is located at point b, where AD falls since many are unemployed. Now, we are
demanding less than the full employment output (Q). Therefore, if we want to decrease prices, we must
sacrifice employment and the economy would experience recession. For example, the government sets
a ceiling price on a certain commodity which is lower than the market price. This would cause producers
to lose revenues at large and therefore would constitute them to fire some employee of force them into
an early retirement. Since, many workers lose their jobs, their capacity to consume decreases which
decreases the aggregate demand which creates an economic recession.
 Nonetheless, these trade-offs only happen in the short-run. In the long run, there is an
assumption that output (AD/AS) and employment (NRU) would be able to adjust to price levels thus, the
vertical character of the Long-run Aggregate Supply (LRAS) and Long-run Philips Curve (LRPC). This
connotes that in every change in prices, the output or employment would adjust.

Figure 3. Response of AS to Rightward shift Figure 4. Response of AS to Leftward shift

of AD of AD

Let us refer to Figure 3 and 4 in order to analyze how trade-off between inflation and
unemployment is negated in the long run. Let us say we have lower unemployment. Therefore, the
aggregate demand would increase due to increase in consumption. Again, the more people getting
wage, the higher the consumption. This pushes our demand curve to the right. Just to recall, in the
short-run, this would constitute an inflationary gap where we have increase in prices more than output
Q. But now, we will consider what would happen in the economy in the future. Prices would increase,
therefore, payment for resources also increase. Due to this increase in cost, the suppliers would supply
less leading to the shifting of the aggregate supply AS to the left, having the new aggregate supply AS’’.
The shift now brings back the value of output to the previously set output at LRAS; therefore, cancelling
the trade-off for lower unemployment.

On the other hand, let us analyze long-run effects if there is a recession - where the aggregate
demand shifts leftward from AD to AD’ (Figure 4). In this situation, there is lower price levels and higher
unemployment. Again, this constitutes a recessionary gap in the short-run. Yet, give it time and as prices
decrease cost for resources also decrease, such as wage and price of raw materials. This would
eventually shift the aggregate AS to the right (AS’) which would bring us back to the previously set
output at LRAS; therefore, cancelling the trade-off for lower inflation.

In conclusion, there are trade-offs on inflation and unemployment in terms of short-run

economy. In economic models of aggregate supply and aggregate demand, and the Philips curve as well,
we can see that as we decrease inflation, we need to increase unemployment and vise versa. However,
in the long-run, output and employment will be able to adjust to changes in price levels leading to the
cancellation of trade-off in the economy be it for inflation or for unemployment.