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Real output and the NAIRU (Phillips Curve).

 

The Phillips Curve

The Phillips Curve demonstrates the trade off between unemployment and inflation.  It is based upon unemployment and wages data between 1862 and 1957.

 

Adaptive Expections and The Phillips Curve

Each short-run Phillips Curve (SRPC) is drawn on the assumption of a given expected rate of inflation. If there is a change in inflation expectations in the economy we see a shift in the Phillips Curve. 

 This theory is based upon adaptive expectations – people base their expectations of inflation on past levels of inflation.

 If we look at an imaginary economy over a number of years it will help us understand the relationship between different SRPCs. 

 

Year 1 - there is no inflation of any sort and it leads to unemployment of 8% at point a on the diagram.

 Year 2 – the government expands AD in order to reduce unemployment.  Unemployment falls to 6%, moving along SRPC I to point b where inflation is now 4% as people are basing their expectations of inflation on year 1.

 

 Year 3 – People now revise their expectations to the level of year 2, 4%.  The SRPC shift upwards by 4% to II.  If money AD continues to rise at the rate, the whole of the increase will be absorbed into higher prices.  Real AD will fall back to its original level and the economy will move to c where unemployment is 8% again, but it’s now associated with 4% inflation.

 Year 4 – the government isn’t happy that unemployment has risen to 8%, therefore it expands AD and the unemployment level falls to 6% again, moving to d on the SRPC II.  Inflation has now risen to 8%.

 Year 5 – Expected inflation is now 8% and the SRPC shifts to III.  If the government wishes to keep unemployment at 6% it must increase AD again moving the economy to e at 12% inflation.

 This adaptive expectations theory of the Phillips curve is sometimes known as the accelerationist theory as the government must accelerate the price level each year if it wishes to keep the level of unemployment below the equilibrium.

 In our example unemployment of 8% will be the natural rate of unemployment or the non-accelerating inflation rate of unemployment (NAIRU).  This means the government can only reduce unemployment below the NAIRU in the short run.  In the longrun we are able to construct a long run Phillips curve, which is drawn vertical at the NAIRU.

 

 

The NAIRU

The Non Accelerating Inflation Rate of Unemployment is the level of unemployment at which inflationary pressures in the economy are stable. According to supply-side economists, unemployment cannot be held permanently below its natural level.  

 Some argue if actual unemployment falls below the NAIRU/natural rate (i.e. equilibrium unemployment) - there is upward pressure on wage inflation that then feeds into general price inflation.

 Clearly changes in unemployment do have an effect on the risk of inflation. Consider this comment from the Bank of England.

 "Developments in the labour market are a key determinant of domestically generated inflation." (UK Monetary Policy Committee minutes)

 As unemployment falls towards the NAIRU, skill shortages exert upward pressure on wages and producer prices, until any further falls in unemployment lead to future higher inflation.

 

 What Determines The Nairu?

The NAIRU can and does vary between countries and changes over time for any one particular economy.

 The rate of unemployment at which inflation starts to accelerate is determined by the efficiency of the labour market and the relative strength of employers and employees in the wage bargaining process

 The changing nature of the wage bargaining process

·        Strength of Trade Unions - Unions have become much less powerful in the UK over the last twenty years. This has tilted the balance of power towards employers and helped to keep "inflation-busting" pay claims in check

·        Centralisation / decentralisation of pay bargaining There has been a switch towards local and regional pay settlements that can take more account of local differences in labour demand and supply

·        Scale of involuntary structural unemployment in the economy - measures to reduce structural unemployment should help to reduce the NAIRU if effective. This is because they increase the available labour supply in the economy, e.g., Labour’s New Deal

 Competitiveness of product markets - impact on producers and labour

·        When product markets are more competitive there is intensive pressure on firms to control costs. Wage increases might only be justified by improvements in productivity

 "External-shock" effects on wage bargaining

The economy can be affected by external economic shocks that effect expected inflation.

·        The global economic crisis in the Far East in 1998 has brought down expectations of inflation

·        The fall in international commodity prices has had a similar effect - causing a sharp fall in inflation in many countries across the world. Lower input costs cause an outward shift in short run aggregate supply in the economy and should help to increase the real volume of national output

·        The events on September 11th caused people to feel that the global economy would move towards recession as aggregate demand falls; this would lead to a reduction in inflation.

 

Most economists believe that the natural rate of unemployment has fallen in the UK over the last decade. This means that the economy can sustain a lower rate of unemployment without triggering off a renewed burst of wage inflation. The evidence supports this positive view often improving trade-off between unemployment and wage/price inflation. By the summer of 2000, unemployment in the UK had fallen to just 3.8% of the labour force (using the claimant count measure) whilst retail price inflation had remained comfortably within the government's target (2.5%) and wage inflation was under control.

 Economists at the OECD have estimated the NAIRU for the leading industrialised countries. Their estimates for 1997 are shown in the chart below. The UK comes out favourably in this international comparison. Our estimated NAIRU is substantially below that of Germany and France - although some way above that for the United States and Japan. The Netherlands (another country to have introduced widespread labour market reforms over the last fifteen years) is also estimated to have a lower NAIRU than the UK.

 

Clockwise Phillips Loops

Over recent years the Phillips curve relationship has broken down, as the UK was able to enjoy low inflation and unemployment during the 1960s.  The clockwise Phillips curve loop was developed to explain the boom/bust years.  If we consider a 10 year period where we start at 0% inflation at the NAIRU.   The government then pursues an expansion policy in order to reduce the level of unemployment and the economy moves through points b, c and d.

 The government now starts to worry about the level of inflation and allows unemployment to rise and the economy moves to e.  There is still some demand pull inflation as expected price level is below the actual price level and the economy moves to f.

 The government now wishes to reduce the level of inflation so it allows unemployment to rise above the natural rate as AD is reduced.  The economy returns to a via g, h, i and j.  We are able to see stagflation (inflation and unemployment rising) from points d to f.

 

 From 1971 we can see that there have in fact been a number of Phillips loops that have occurred.  The shifting loops imply that the natural rate of unemployment changed from 1970-2000. 

 

 Monetary policy is used to control inflation NOT unemployment.  In order to reduce unemployment in the longrun it is necessary to undertake supply side policies.

Further Reading

The Phillips Curve by Kevin Hoover, University of California at Davis

 

 

E-mail Steve Margetts