Copyright 2007 – Biz/ed Unemployment, NAIRU and the Phillips Curve

Copyright 2007 – Biz/ed Unemployment, NAIRU and the Phillips Curve

Copyright 2007 – Biz/ed Types of Unemployment

Copyright 2007 – Biz/ed 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

Copyright 2007 – Biz/ed 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

Copyright 2007 – Biz/ed Types of Unemployment Seasonal Unemployment: Unemployment caused because of the seasonal nature of employment – tourism, skiing, cricketers, beach lifeguards, etc. 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,

Copyright 2007 – Biz/ed 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 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,

Copyright 2007 – Biz/ed Types of Unemployment Technological Unemployment: Unemployment caused when developments in technology replace human effort – e.g in manufacturing, administration etc.

Copyright 2007 – Biz/ed Unemployment

Copyright 2007 – Biz/ed 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’

Copyright 2007 – Biz/ed Unemployment Keynesian Unemployment: Unemployment in the long run may remain stubbornly high because of imperfections in the market – ‘sticky wages’

Copyright 2007 – Biz/ed Inflation

Copyright 2007 – Biz/ed 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.

Copyright 2007 – Biz/ed 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

Copyright 2007 – Biz/ed Inflation and Unemployment using AS/AD Inflation Real National Income AD1 AS1 2% U = 4% Assume the economy has an inflation rate of 2% and a level of national income giving an unemployment rate of 4%. AD rises for some reason. AD2 U = 3% 3.75% The rise in AD leads to a fall in unemployment but inflationary pressures push inflation up to 3.75%. Producers try to expand output but at increased cost – employing more expensive capital, paying workers more to do work etc. Increased cost results in a shift in AS to the left – workers start to be laid off. AS2 4.0% The short run fall in unemployment is only temporary; as AS shifts, unemployment will start to rise again and the economy will end up in the long run in a position with unemployment at 4% but with higher inflation. Expansionary fiscal or monetary policy will only lead to reductions in unemployment in the short run. In the long run unemployment will return to its natural rate. Attempts to reduce unemployment below the natural rate will be inflationary.

Copyright 2007 – Biz/ed The Philips Curve

Copyright 2007 – Biz/ed 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

Copyright 2007 – Biz/ed The Phillips Curve Wage growth % (Inflation) Unemployment (%) 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. 1.5% 6%4% 2.5% PC1

Copyright 2007 – Biz/ed The Phillips Curve Problems: 1970s – Inflation and unemployment rising at the same time – stagflation Phillips Curve redundant? Or was it moving?

Copyright 2007 – Biz/ed The Phillips Curve Wage growth % (Inflation) Unemployment (%) An inward shift of the Phillips Curve would result in lower unemployment levels associated with higher inflation. 1.5% 6%4% PC1 3.0% PC2

Copyright 2007 – Biz/ed The Phillips Curve Inflation Unemployment Long Run PC PC1 PC2 PC3 Assume the economy starts with an inflation rate of 1% but very high unemployment at 7%. Government takes measures to reduce unemployment by an expansionary fiscal policy that pushes AD to the right (see the AD/AS diagram on slide 15) 7% 2.0% 1.0% There is a short term fall in unemployment but at a cost of higher inflation. Individuals now base their wage negotiations on expectations of higher inflation in the next period. If higher wages are granted then firms costs rise – they start to shed labour and unemployment creeps back up to 7% again. 3.0% To counter the rise in unemployment, government once again injects resources into the economy – the result is a short-term fall in unemployment but higher inflation. This higher inflation fuels further expectation of higher inflation and so the process continues. The long run Phillips Curve is vertical at the natural rate of unemployment. This is how economists have explained the movements in the Phillips Curve and it is termed the Expectations Augmented Phillips Curve.

Copyright 2007 – Biz/ed 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)

Copyright 2007 – Biz/ed 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)

Copyright 2007 – Biz/ed 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

Copyright 2007 – Biz/ed 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.