Economics Lesson

Mr G. Nyamuka
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LESSON OBJECTIVES

• By the end of the lesson students should be able to:

• Differentiate between the short run and the long run Philips curve
• Explain the natural rate of unemployment and the NAIRU
• State and explain the factors that can increase or reduce the natural rate of
unemployment
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RECAP ….The effects of Unemployment

Problems Benefits
• Loss of Income • increases the pool of available
• Failure to Pay Debts labour
• Fiscal Costs • prompt some people to be self-
• The Negative Multiplier Effect employed
• Loss of national output • decrease in AD which will reduce
• Social Cost inflation.
• Bribery/ Theft
• Increase in Poverty
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RECAP ….The Effects of Unemployment

Problems Benefits
• Defective Education System
• Political Instability
• Exploitation of Labour
• Slow Growth of Tertiary Sector
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Recap….Why it is difficult to Measure Unemploymen

Unemployment figures may fail to reflect the actual number of people that are
unemployed because
• Discouraged workers
• Part time workers
• Unreported legal employment
• Unreported illegal
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The Philips curve

• In 1958 A. W Philips plotted a 95 year graph of data of U.K wage inflation
against employment.
• It suggests a short run tradeoff between unemployment and inflation.
• The Philips curve shows the relationship between unemployment and inflation.
• The curve suggests that the changes in the level of unemployment have a
direct and predictable effect on the level of price inflation.
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The Philips curve

• The accepted explanation was that an increase in AD would trigger the
following:
• An increase in the demand for labour as government spending generates
growth.
• The pool of unemployed will fall.
• Firms must compete for fewer workers by raising nominal wages.
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The Philips curve

• Workers have greater bargaining power to seek out increases in nominal
wages
• Wage cost will rise
• Faced with rising wage cost in the firms pass on the costs to consumers.
• The result is an increase in prices(inflation)
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The Philips curve

inflation

unemployment
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The Breakdown of the Philips Curve

• By the mid-1970s it appeared the tradeoff no longer existed. There no longer
seemed to be stable relationship / pattern between unemployment and
inflation.
• This is because it was possible to have a number of inflation rates for any
given unemployment rate
• An American economist Freidman offered an explanation.
• 1. There is not only one Philips Curve but a series of short run Philips curve.
• 2. There is a long run Philips Curve which exists at the natural rate of
unemployment.
• 3. In the long run there is no tradeoff between unemployment and inflation.
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The Breakdown of the Philips Curve

• He accepted that a short run Philip’s curve existed but that in the long run the
PC should be drawn as a vertical line and as a result there was no tradeoff
between inflation and unemployment (expectation –augmented Philips curve).
• In short, attempts to reduce unemployment below its natural rate by fiscal
reflection will only succeed only at the cost of generating a wage-spiral, as
wages are quickly cancelled out by increases in prices
• Each time the government reflates the economy, a period of accelerating
inflation will follow a temporary fall in unemployment as workers anticipate a
future rise in inflation in their pay demands and unemployment returns to its
natural rate
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The Breakdown of the Philips Curve

• The process can be seen on the diagram below by movements from A to B to
C to D to E
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The Breakdown of the Philips Curve

• Each short run P.C was drawn on the assumption of a given expected rate of
inflation.
• An increase in inflation caused by a monetary expansion drives inflation
expectations higher this would cause an upward shift in the short run PC.
• The monetarist view is that attempts to boost AD to achieve faster growth and
lower unemployment only have a temporary effect on jobs
• Government cannot permanently drive unemployment down below N.A.I.R.U.
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The Breakdown of the Philips Curve

• In short, if people see and experience higher inflation in their everyday life they
come to expect a higher average rate of inflation in future time period and they
in cooperate the changing expectations into their pay bargain.
• Wages often follow prices. A burst of price inflation can trigger higher pay
claims, rise in labour cost and ultimately higher prices for goods and services.
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The Long Run Philips Curve

• The long run P.C. is normally drawn as a vertical but can shift inwards overtime.
• An inward shift in the long run P.C. might be due supply side improvements to
the economy and a reduction in the N.R.U.
• Assume that the economy starts at an equilibrium position at a point A with
inflation currently at zero and unemployment at the N.R.U of 8%.
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The Long Run Philips Curve

• Given the public’s concern with unemployment
government reduces it to 3% as jobs are created in
the short run.
• Having more bargaining power workers bid up
their nominal wage as wage cost rise prices are
driven up to 2% at P1.
• The effects of the stimulus to AD quickly wear
out as inflation erodes gains by households
and firms.
• Real spending and output return to their previous
at the natural rate of unemployment
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The Long Run Philips Curve

• Assuming that the economy is stable at Y, an
increase in government spending will shift AD from
AD to AD1 leading to a rise in income to Y1 and a
fall in unemployment , in the short term
• However households will successfully predict the
higher price level, and build these expectations
into their wage bargaining
• As a result wage costs rise and the AS shifts up
to AS1and the economy now moves back to Y
with a higher price level of P2
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The Natural Rate of Unemployment

• It is unemployment that occurs when the economy is at full employment
• The N.R.U. is caused by the supply side factors rather than demand.
• Monetarist argues that the N.R.U. occurs when the long – run Philips curve
crosses the X- axis.
• The N.R.U. therefore include: frictional unemployment and structural
unemployment, e.g. a worker who is not able to get the job because he does
not have the right skills.
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The Natural Rate of Unemployment

What Determines the Natural Rate of Unemployment?
• Availability of job information
• Skills and education
• Degree of labour mobility.
• Flexibility of the labour market e.g. powerful trade union may be able to restrict
the supply side of the labour to certain labour markets.
• Hysteresis – a rise in unemployment caused by recession may cause the NRU
to increase, this is because when workers are unemployed for a certain time
they become deskilled (demotivated) and are less able to get new jobs
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The Natural Rate of Unemployment

Can the NRU Be Reduced?
• Any supply side policy that can increase number of people willing and able to
find employment in the labour market will shift the labour supply curve to the
right narrowing the gap.
• Policies to reduce the NRU focus on removing labour market imperfections e.g.
the government want to achieve a lower equilibrium rate of unemployment
might:
• Reform the system of welfare benefit to reduce the risk of the poverty trap i.e.
where some people find themselves in a situation where it’s not worthwhile to
get a job.
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The Natural Rate of Unemployment

Can the NRU Be Reduced?
• Reform trade unions to reduce their collective bargaining power and some of
the barriers to labour mobility put up by professional bodies and associations
which have the effect of limiting supply of labour into any occupation.
• Reducing the income tax to improve the incentive to look for work and accept
paid work.
• Adopting a more relaxed labour migration to help fill job vacancies.
• Relaxing employment law to reduce the cost for business wanting to employ
extra workers.
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The Natural Rate of Unemployment

• What Can Increase the Natural Rate of Unemployment?
• Rigidity in labour market e.g. minimum wages, maximum working week.
• High degree of unionization.
• Low economic growth.
• Recession.
• Generous unemployment benefits which lessen the pain of unemployment.
• Restriction of closing factors and mandatory pay for workers made
unemployed
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THE Non Accelerating Inflation Rate of Unemployment (NAIRU)

• Freidman criticized the bases of the original P.C. and introduced the concept of
NAIRU.
• The NAIRU is defined as the rate at which inflation is stable. In other words at
this rate of unemployment, prices will rise at the same rate each year

The NAIRU assumes that:

• There is imperfect competition in the labour market.
• Workers have bargaining power perhaps as members of the trade union.
• Some employers have monopsony power.
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THE Non Accelerating Inflation Rate of Unemployment (NAIRU)

The equilibrium level of unemployment is an outcome of a bargaining process
between firms and workers.
• Workers have a target real wage which is influenced by what is happening to
unemployment. The lower the rate of unemployment the higher workers
demand the higher wages.
• If actual unemployment fall below the NAIRU the theory suggest that the
balance of power switches to employees away from employers.
• The result can be an increase in pay settlements ceteris paribus; an increase
in wage inflation will cause a rise in cost push inflation.
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Examination Questions
1. Explain the trade off that exists between inflation and unemployment (10)
2. What is the natural rate of unemployment. (12)
3. What is the NAIRU (15)
Thank you for attending today’s class.
You can access the recorded lesson on:
akelloclassroom.learningequality.org/

Join us for the next lesson on:

Next week Monday at 2pm