Macroeconomic Indicators

Unemployment and InflationThe Phillips curve

NAIRUEAPC

Areas covered

Types of Unemployment

• Quick recap– Frictional– Structural– Seasonal– Demand deficient (Keynesian)– Technological

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’

Keynesian Unemployment:• Unemployment in the long run may

remain stubbornly high because of imperfections in the market – ‘sticky wages’

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.

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 anticipationof 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 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

However…..• 1970s – Inflation and unemployment

rising at the same time – stagflation• Was the Phillips Curve redundant?• Or was it moving?• http://money.howstuffworks.com/stagflation2.htm

The Phillips Curve(The Monetarist View)

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 monetarist economists (Milton Friedman) have explained the movements in the Phillips Curve and it is termed the Expectations Augmented Phillips Curve. (EAPC)

• 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)

To reduce unemployment to below the natural rate would mean:

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)

Supply-side solutions• Education:

– Boosting the number of those staying on at school• Raising the leaving age

– Boosting numbers going to university• Grants/loans/bursarys

– Lifelong learning– Vocational education

• Welfare benefits:– The working family tax credit– Incentives to work

• Labour market flexibility– Relaxation of employment laws

Phillips Curve

Building a diagram10 steps to Phillips Fulfilment

1. What goes on the vertical axis?2. What goes on the horizontal axis?3. What shape is the short run Phillips curve?Add this to the diagram assuming inflationary expectations are zero4. Inflationary expectations have increased, where would we put the new short run Phillips curve?5. Inflationary expectations have increased again, where would we put the new short run Phillips curve?6. Again, inflationary expectations have raised the curve further. Add this to the diagram

7. Where would we add the long run Phillips curve?8. What is the long run unemployment rate? Label this A9. What happens if the government adopts expansionary fiscal policy to reduce unemployment to below OA? Label this Z and inflation 5%10. If inflationary expectations remain at 5%, what happens in the long run? Label this B.

NAIRU v NRU• NAIRU = Non accelerating inflation

rate of unemployment (equilibrium unemployment; frictional and structural)

• NRU = natural rate of unemployment (voluntary unemployment)

• Can use either

Quick Quiz

Examination questions

a) Explain how a fall in the rate of inflation might be achieved by both demand-side and supply-side factors (15 marks)

b) Evaluate the possible consequences of a falling rate of inflation for the performance of the UK economy. (25 marks)

Explain how a fall in the rate of inflation might be achieved by both demand-side

and supply-side factors (15 marks)• Demand • Supply

Evaluate the possible consequences of a falling rate of inflation for the performance

of the UK economy. (25 marks)falling rate of inflation• Low inflation• Falling inflation• Deflation

performance of the UK economy• Economic growth• Unemployment• Balance of payments• (Inflation)