Unemployment, NAIRU and the Phillips Curve

Types of Unemployment Unemployment caused when people move from job to job and claim benefit in the meantime Search or Frictional Unemployment:

Types of 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 Structural Unemployment:

Types of Unemployment Unemployment caused because the job can only be done at certain times of the year tourism, skiing, cricketers, beach lifeguards, etc. Seasonal Unemployment: The demand for lifeguard services tends to exist in the summer but nothing like as much in the winter – Copyright: Swiassmautz,

Types of Unemployment 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 Cyclical or Demand Deficient 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,

Types of Unemployment Unemployment caused when developments in machines and computers replace human effort – e.g in manufacturing, administration etc. Technological Unemployment:

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

Inflation

What is Inflation? The rate at which P  for goods and services  purchasing power  Inflation is measured by CPI Consumer Prices Index

How is Inflation measured?

Causes of Inflation Demand Pull Rising AD Cost Push Diminishing resources External Shocks Wage Push M prices rising. Tax Push

Inflation

Who Loses from inflation? Creditors Businesses Especially with a high PED The country as a whole

Who gains? Debtors Businesses with a low PED? People with assets with high inflation

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  AD  a  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  unemployment is only temporary; as AS shifts, unemployment  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 →  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.

The Phillips Curve 1958 – Professor A.W. Phillips There is 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 = there is a trade-off between inflation and unemployment

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

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

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

The Phillips Curve Inflation Unemployment Long Run PC PC3 PC2 PC1 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.

Friedman’s Criticisms Friedman said the relationship only held in the short run In the long run there was no trade off The position of the PC was determined by peoples’ expectations of inflation. then the curve would shift outwards and vice versa. This was the EXPECTATIONS AUGMENTED PHILLIPS CURVE

Searching for the Phillips Curve What factors cause people to change their inflation expectations? Shocks (oil price changes) Macroeconomic policy mismanagement

NAIRU U* = Nairu If U <U* inflationary expectations rise, therefore Inflation will accelerate If U=U* stability If U>U* disinflation.

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

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