Phillips Curve

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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



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, 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 anticipationof inflation imposes costs on employers and may lead to job losses



Inflation and Unemployment using AS/ADInflation

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 CurveInflation

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.

Phillips Curve

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Transcript of Phillips Curve