Published on April 14, 2008
The Phillips Curve and the NAIRU: The Phillips Curve and the NAIRU A Trade Off between Inflation and Unemployment? This revision presentation focuses on the possible trade offs between unemployment and inflation. Since 1993, unemployment in the British economy has fallen yet inflation has remained remarkably stable.Has the trade off improved for the UK in recent years? If so, what are the factors contributing to this change? Tutor2u Economics Autumn 2002 A Trade Off? Unemployment and Inflation for the UK: A Trade Off? Unemployment and Inflation for the UK A European Perspective: A European Perspective The Basic Phillips Curve Concept: The Basic Phillips Curve Concept Standard Phillips Curve suggests a trade-off between the rate of unemployment and wage inflation A fall in unemployment may lead to an acceleration in wage inflation as the labour market tightens Falling unemployment implies that Labour demand is rising The pool of surplus labour available to employers is diminishing A rising number of unfilled job vacancies – emergence of labour shortages in some industries (particularly skilled workers) Increase in bargaining power of workers A risk that strength of labour demand will lead to a rise in wage claims and basic pay settlements The Original Phillips Curve: The Original Phillips Curve AW Phillips (1958) looked at the unemployment rate and wage inflation rate for the UK over a 96 year period and noticed that there was a stable, inverse and non-linear relationship between the two This implied that an economy could trade off a lower level of unemployment, say, for a higher level of inflation Rationale for the relationship: In the short run, there was a aggregate supply constraint which meant that an increase in AD might lead to inflation Reason for the non-linearity: As unemployment falls, the threat of becoming unemployed falls, so workers seek greater wage increases Growing skilled shortages put further upward pressure on wages The Phillips Curve: The Phillips Curve Wage Inflation (%) Unemployment Rate (%) U1 P1 U2 P2 U3 P3 Short Run Phillips Curve Friedman’s Criticisms of the Phillips Curve: Friedman’s Criticisms of the Phillips Curve Friedman in an address to the US Economics Association (1968) criticised the Phillips Curve Original Phillips relationship only held in the short run In the long run there was no trade-off between inflation and unemployment Position of the Phillips curve in the inflation, unemployment space was determined by peoples’ expectations of inflation If inflation was higher than the expected rate, then the Phillips curve would shift upwards, and vice versa Thus the expectations-augmented Phillips curve was born The Expectations-Augmented Phillips Curve: The Expectations-Augmented Phillips Curve Wage Inflation (%) Unemployment Rate (%) NRU Long Run Phillips Curve (LRPC) Friedman put forward the concept of the long run Phillips Curve Argued that is was vertical – I.e. no long run trade off between unemployment and inflation The Expectations-Augmented Phillips Curve: The Expectations-Augmented Phillips Curve Wage Inflation (%) Unemployment Rate (%) P1 U2 P2 U3 P3 Long Run Phillips Curve (LRPC) SRPC1 The Expectations-Augmented Phillips Curve: The Expectations-Augmented Phillips Curve Wage Inflation (%) Unemployment Rate (%) P1 NRU P2 U3 P3 Long Run Phillips Curve (LRPC) SRPC1 SRPC2 U3 LRAS and the Phillips Curve: LRAS and the Phillips Curve Price Level Real National Output (Y) LRAS AD1 SRAS1 P1 Ye LRAS and the Phillips Curve: LRAS and the Phillips Curve Price Level Real National Output (Y) LRAS AD1 AD2 SRAS1 P1 Ye LRAS and the Phillips Curve: LRAS and the Phillips Curve Price Level Real National Output (Y) LRAS AD1 AD2 SRAS1 P1 Ye P2 Y1 LRAS and the Phillips Curve: LRAS and the Phillips Curve Price Level Real National Output (Y) LRAS AD1 AD2 SRAS1 SRAS2 P1 Ye Y1 P2 LRAS and the Phillips Curve: LRAS and the Phillips Curve Price Level Real National Output (Y) LRAS AD1 AD2 SRAS1 SRAS2 P1 P3 Ye Y1 P2 Long Run Macroeconomic Equilibrium: Long Run Macroeconomic Equilibrium We assume that the economy starts in equilibrium at the full employment level of output Ye - where AD1 equals SRAS1 Then the government introduces a one-off expansion in fiscal policy – outward shift in AD from AD1 to AD2 In the short run, there is an expansion up the SRAS1 curve - firms can increase output beyond the full employment level of output by paying workers overtime; this generates inflation since the price level increases In the long run however, all factors of production are variable - so workers demand higher wage contracts - leading to an upwards shift of AS curve to SRAS2. Long run equilibrium means that output falls back to the full employment level, but the price level has increased And a higher level of prices leads to a rise in inflationary expectations The Shifting Phillips Curve: The Shifting Phillips Curve 1980-1985 1971-1974 1986-1992 1995-1998 1993-1995 Searching for the Phillips Curve : Searching for the Phillips Curve There is no single Phillips curve for the UK between 1965-2001; this is the familiar “breakdown” of the relationship There have been clear examples of (a) An outward shift in the Phillips Curve due to a rise in inflationary expectations in the economy (b) An inward shift of the curve as inflation expectations have fallen and the trade-off between unemployment and inflation has improved What factors cause people to change inflation expectations Exogenous shocks to the economy (e.g. oil prices changes / 11th of September) Macroeconomic policy mismanagement Increased flexibility in the labour market A new monetary policy regime What Determines the NAIRU?: What Determines the NAIRU? The (NAIRU) assumes that there is imperfect competition in the labour market Some workers have collective bargaining power Employers have some monopsony power when they purchase labour The equilibrium level of unemployment is the outcome of the bargaining process between firms and workers: Labour productivity and mark-ups that firms apply to costs determine the real wage that the economy can realistically provide: this is the feasible real wage curve The target wage desired by workers is reflected in the target real wage curve; the lower the rate of unemployment, the higher workers’ wage demands Feasible and Target Real Wages: Feasible and Target Real Wages Real Wage (W/P) Unemployment Rate (%) Feasible Real Wage Target Real Wage The equilibrium level of unemployment is the outcome of the bargaining process between firms and workers NAIRU A Change in the Target Real Wage: A Change in the Target Real Wage Real Wage (W/P) Unemployment Rate (%) Feasible Real Wage TW1 An increase in the target real wage would cause a rise in the NAIRU N1 TW1 N2 Higher Productivity – A Chance to Reduce the NAIRU: Higher Productivity – A Chance to Reduce the NAIRU Real Wage (W/P) Unemployment Rate (%) FRW1 TW1 Higher productivity allows businesses to pay a higher real wage to employees. Target real wage can be achieved at a lower rate of unemployment. Productivity-driven growth is non-inflationary for the economy N1 N2 FRW2 What Factors Might Cause the NAIRU to Change?: What Factors Might Cause the NAIRU to Change? An increase in trade union power, which would reduce the fear of unemployment and therefore cause an upward shift in the target real wage curve An increase in the level of skills mismatch in the labour market which would shift the target real wage curve upwards Sushil Wadhwani (MPC member) comments that increased provision of child care has helped to reduce the NAIRU by allowing greater participation of women in the labour market Greater flexibility in the labour market (I.e. the success of policies to improve the occupational mobility of labour) would reduce skills mismatch and reduce the target real wage The NAIRU may exist in theory – but it is difficult to identify its value in practice – and its value must change over time Deutsche Bank on the Changing NAIRU: Deutsche Bank on the Changing NAIRU When it comes to examining the trade-off between inflation and unemployment (and economic growth), the concept of the NAIRU (the rate of unemployment that can be sustained without generating increases in inflation) is a particularly important one. While approximating the NAIRU is notoriously difficult, most current estimates for the UK place it at around 5% (on the claimant count measure). With the actual rate of unemployment currently below this rate, we should, by definition, have seen evidence of rising inflation. Rather, the latest figures show RPIX inflation dipping to some of the lowest rates on record Deutsche Bank World Economic Outlook Focus on the UK Labour Market: Focus on the UK Labour Market Stable wage inflation in recent years Falling unemployment since 1993 What influences a sustainable rate of unemployment?: What influences a sustainable rate of unemployment? The factors that might unfavourably affect the level of sustainable unemployment include the following: High levels of benefits relative to wages, long duration of benefits and weak tests of job-seeking; High levels of taxation, which drive a wedge between take home pay and the cost of labour to the employer; A high degree of unionisation and union power; A low-skilled labour force; Inadequate capital stock A highly regulated labour market which may discourage recruitment (I.e.new job creation) Lack of competition in the market for goods and services. So Why Has the NAIRU Fallen?: So Why Has the NAIRU Fallen? Less trade unionism: fewer than 1 person -in-3 were covered by trade union membership in 1998 Regional unemployment mismatch has fallen Occupational immobility of labour has reduced (less structural unemployment) – shown by fall in long term unemployment rate Being out of work is penalised more Financially (lower relative value of unemployment benefits) Incentives (e.g. the New Deal programme) Real consumption wage being boosted due to low inflation Increasing labour supply due to minimum wage and increased provision of child care Product markets are more competitive (contestable) Fall in inflation expectations which help to control wage inflation Deflationary effect of e-commerce (in cutting profit margins) A Reduction in Regional Unemployment Mismatch: A Reduction in Regional Unemployment Mismatch Implications of an Inward Shift in the Phillips Curve: Implications of an Inward Shift in the Phillips Curve Price Inflation (%) Unemployment Rate (%) If there is an inward shift in the Phillips Curve, there is an improvement in the trade-off between unemployment and inflation. For a given inflation target, this means that unemployment can reach a lower level U1 U2 SRPC1 SRPC2 Inflation Target Unemployment and Inflation Data for the UK Economy: Unemployment and Inflation Data for the UK Economy This section of the presentation covers key trends in inflation and unemployment for the UK. To what extent has there been an improvement in the trade-off between unemployment and inflation? Trade Offs Between Unemployment and Inflation: Trade Offs Between Unemployment and Inflation Economic Boom of the Late 1980s: Economic Boom of the Late 1980s Strong growth caused unemployment to fall but inflation surged Economic Recession of the Early 1990s: Economic Recession of the Early 1990s Recession brings down inflation – but at the cost of rising unemployment Improved Trade Off Since 1993: Improved Trade Off Since 1993 Sustained fall in unemployment with low, stable inflation Actual Unemployment and the NAIRU: Actual Unemployment and the NAIRU Late 1980s boom – actual unemployment below the NAIRU – sharp acceleration in wage inflation Actual Unemployment and the NAIRU: Actual Unemployment and the NAIRU Early 1990s. High unemployment (above the NAIRU) – little pressure on wage inflation Actual Unemployment and the NAIRU: Actual Unemployment and the NAIRU 1998-2001: Actual unemployment below the NAIRU but no major take-off in wage inflation Fall in inflation expectations has helped to prevent a pick up in wage inflation. And increased labour market flexibility may mean that the bargaining power of workers has reduced Summary Labour Market Data: Summary Labour Market Data Still A Regional Divide – But Smaller Than 10 Years Ago: Still A Regional Divide – But Smaller Than 10 Years Ago The Growth of Average Earnings: The Growth of Average Earnings Conclusions: Clues for the British Economy: Conclusions: Clues for the British Economy The short-run Phillips curve seems to have shifted inwards in recent times; the NAIRU also seems to have fallen This could mean that the trend growth rate of the economy has increased, and that the full employment level of national output has also increased (increased LRAS) The Bank of England’s Monetary Policy Committee could therefore afford to run the economy with lower nominal interest rates than would otherwise be the case This would enable the British economy to take advantage of this higher trend growth rate, without the fear of inflation rising above the Government’s target upper limit of 3.5% But we must be cautious in expecting the NAIRU to remain low – it can change as labour and product market conditions change
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