Natural Rate Of Unemployment

The Natural Rate of Unemployment

Explain what is meant by the natural rate of unemployment and assess the extent this concept has played in the implementation of macroeconomic policies over recent decades.

The natural rate of unemployment, or non-accelerating inflation rate of unemployment (NAIRU) as it is also called is a concept that states there is a level of unemployment to which unemployment will tend towards in the long run, and where unemployment is greater than this level inflation will begin to accelerate. And this concept can be explained through the use of The Phillips Curve.

The Phillips Curve

The Phillips Curve is an empirical theory developed by Professor AW Philips in the 1950s that shows an inverse relationship between changes in money wage rates and the level of unemployment.

The exact formula he found was Ð'- Percentage Change in Wages=-0.900+9.638U-1.394. And as wage rates can be assumed to be closely linked with prices, this has been taken by many economists to suggest a trade off between inflation and unemployment.

As can be seen in figure 1 below as unemployment falls inflation begins to Ð''accelerate,' to rise at an increasing rate. This can be explained as when unemployment falls, the threat of becoming unemployed falls and shortages in skilled labour develop meaning workers can seek greater wage increases.

Figure 1 : The Short Run Phillips Curve

AW Phillip's theory was backed up by 96 years of data, but soon after publishing his theory in the journal "Economica" in 1958, the data seemed to disprove it, and it appeared that there was in fact no fixed relationship between inflation and unemployment as Phillips had believed.

The Phillips Curve and Inflationary Expectations

However, it was then observed that the data in fact showed several distinct curves, and that events in the economy had lead to rises and falls in inflationary expectations shown by shifts in the Phillips Curve which can be seen in the diagram below.

Figure 2: Short Run Phillips Curves between 1971 and 1998

Factors that could have caused people to have changed their inflation expectations include:

Ð'* Exogenous shocks to the economy

Ð'* Macroeconomic Mismanagement

Ð'* Increased flexibility in the labour market

Ð'* A new monetary policy regime

And if we look at the events surrounding these shifts, we see that the shift in the Phillips Curve between 1974 and 1980 can be explained by increased oil prices, expansionary fiscal policy, and high interest rates. And the inward shifts in the 1990s can be explained by an increasingly flexible labour market (through the restriction of Trades Union powers and introduction of the New Deal Gateway) and The Bank of England's ability to deliver consistently low inflation rates.

The Expectations Augmented Phillips Curve

Milton Friedman accepted that the short run Phillips Curve existed, but argued that it is real wages and not money wages, that matter to both workers and employers, as both the demand and supply of labour are dependant on real wages, if the original Phillips Curve was to hold true, then workers must suffer from money illusion.

And stated that people will change their behaviour as a result of what has happened in the past, what is known as adaptive expectations.

He also claimed that in the long run the Phillips Curve was vertical, in other words that there is no trade off between unemployment and inflation, and this can be illustrated by looking at figure 4 below.

Figure 3: The Demand and Supply of Labour

Figure 4: The Expectations Augmented Phillips Curve

In the diagrams above we see government boost aggregate demand (A to B) in an attempt to reduce unemployment, which has the effect of increasing inflation from 3% to 5%. In time workers will then expect inflation of 5%, and so will seek an increase of 5% in money wages. This leads to an increase in firms' costs, and so at this price level, real output falls, unemployment rises and we see a shift in the Phillips Curve from SRPC1 to SRPC2 (B to C). So whilst in the short run there is a trade off between inflation and unemployment, in the long run unemployment remains at the same level. It is this level of unemployment that is known as the natural rate of unemployment.

The Natural Rate of Unemployment

This natural rate of unemployment is the equilibrium rate of unemployment, illustrated in Figure 5 below as the distance AB, and calculated by subtracting the supply of labour from the labour force.

Figure 5: The Natural Rate of Unemployment

This natural rate of unemployment consists of the structurally unemployed and frictionally unemployed that is those who are unemployed as a result of a change in the structure of the economy, possibly the closure of an industry such as coal, where the workers find themselves either unable or unwilling to find a job, and those who are in the transition of moving between jobs.

Any supply side labour market policy that can increase the number of people willing and able to find employment in the labour market will result in a shift of the Labour Supply to the right , narrowing the gap between the Labour Supply and Labour Force (LF), and thus the natural rate of unemployment (BC) .

Figure 6: Reducing the Natural Rate of Unemployment

This reduction in the natural rate of unemployment has the effect of shifting the Long Run Phillips Curve to the left, meaning that a lower level of unemployment could be sustained without leading to inflationary pressures.

Figure 7: Movement of the The Natural Rate of Unemployment

Evidence of NAIRU Movement

In the 1980s the UK, along with all of the major industrialised economies experienced much higher rates of unemployment, even when inflation had stabilised at a low