Macroeconomic Indicators
Unemployment and Inflation
The Phillips curve
NAIRU
EAPC
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 anticipation
of inflation imposes costs on employers
and may lead to job losses
Inflation and Unemployment using AS/AD
AS2
Inflation
4.0%
3.75%
The short run fall in unemployment is only
AS1temporary; as AS shifts, unemployment will
start to rise again
and
theeconomy
economy
will end
The
rise
in AD
to ahas
fall in
Assume
the leads
an inflation
buta inflationary
up in the longunemployment
run
ratein
of a
2%position
and
levelwith
of national
pressures
push
inflation
up
to 3.75%.
income
giving
an unemployment
rate
unemployment
at
4%
but
with
higher
Producers
tryrises
to expand
output
but at
of 4%. AD
for some
reason.
inflation. Expansionary
fiscal
or monetary
increased cost
– employing
more
paying workers
more
policy will onlyexpensive
lead tocapital,
reductions
in
to do work etc. Increased cost results in
unemployment
in the short run. In the long
a shift in AS to the left – workers start to
run unemployment
will return to its natural
be laid off.
rate. Attempts to reduce unemployment
below the natural rate will be inflationary.
2%
AD2
AD1
U = 4%
U = 3%
Real National Income
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 Curve
Wage growth %
(Inflation)
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.
2.5%
1.5%
4%
6%
PC1
Unemployment (%)
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
To counter the rise in unemployment,
government
once
again
resources
into
There
is a short
fall injects
instarts
unemployment
but
Assume
theterm
economy
with an inflation
the
–but
theinflation.
result
is Individuals
aunemployment
short-term
fall at
in
at
a economy
cost of
of 1%
higher
now
rate
very
high
unemployment
higher
This
base
theirGovernment
wagebut
negotiations
on expectations
7%.
takesinflation.
measures
to higher
reduce
inflation
fuels
further
expectation
of higher
of
higher
inflation
in by
the
next
period.
If higher
unemployment
an
expansionary
fiscal
inflation
and
sopushes
thethen
process
The
long
wages
are
granted
firms
costs
rise
– they
policy
that
AD
tocontinues.
the
right
(see
the
run Phillips
Curve
vertical
at
rate
start
to sheddiagram
labourisand
unemployment
creeps
AD/AS
on
slide
15)the natural
of unemployment.
This is how monetarist
back
up to 7% again.
economists (Milton Friedman) have explained
the movements in the Phillips Curve and it is
termed the Expectations Augmented Phillips
Curve. (EAPC)
Long Run PC
3.0%
2.0%
1.0%
PC1
7%
PC3
PC2
Unemployment
• 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 diagram
10 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 zero
4. 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 A
9. 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 supplyside 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)