8 3 phillips curve-nairu

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Unemployment,
NAIRU and
the Phillips Curve

Unemployment, NAIRU and the
Phillips Curve

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

• 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

• 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, http://www.sxc.hu

• 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, http://www.sxc.hu

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

Unemployment

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’

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

Inflation

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.

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

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.

The Philips Curve

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

The Phillips CurveWage 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 CurveWage 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
PC1
PC2PC3
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.

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)

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)

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

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.

8 3 phillips curve-nairu

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