UNEMPLOYMENT

A country’s economic performance is measured using three key indicators, one of which is the
unemployment rate. When adults who are willing and able to work cannot find a job, it may be a sign that
an economy is producing less than it could. On the other hand, unemployment is also a natural
phenomenon that even healthy economies experience. While the official unemployment rate is helpful in
representing the state of a nation’s workforce, it does have some shortcomings that should be considered,
such as excluding discouraged workers.

Types of Unemployment
For ease of analysis, unemployment is classified into

(i) Frictional Unemployment

The labour market is in a state of flux, workers are moving into and out of jobs. In the

interim, they might be temporarily unemployed. They are said to be frictionally

unemployed.

(ii) Structural Unemployment

It occurs when the state of the economy is undergoing structural changes. Some industries

are contracting and some are expanding. As a result, some skills become redundant and

some other skills become more in demand.

(iii) Demand-deficient Unemployment/Cyclical Unemployment

It exists when the level of aggregate demand is not sufficient to produce the full-

employment level of output. Ye is below Yf.

(iv) Classical Unemployment

This occurs when the wage rate set is above the market clearing level. As a result there is

an excess supply of labour compared to demand by entrepreneurs.

Modern Analysis separates unemployment into:

a) Voluntary: A worker is voluntarily unemployed if he or she would not accept a job offer

at the going wage rate.

b) Involuntary: A worker is involuntarily unemployed if he or she would accept a job offer

at the going wage rate.

The Natural Rate of Unemployment

The natural rate of unemployment is the rate of unemployment when the labour market is in equilibrium.
It is unemployment caused by structural (supply-side) factors. (e.g. mismatched skills).

The natural rate of unemployment is the difference between those who would like a job at the current
wage rate – and those who are willing and able to take a job. In the above diagram, it is the level (Q2-Q1).

The natural rate of unemployment will therefore include:

• Frictional unemployment
• Structural unemployment. For example, a worker who is not able to get a job because he doesn’t
have the right skills
The natural rate of unemployment is unemployment caused by supply-side factors rather than demand-
side factors.

Milton Freidman argued the natural rate of unemployment would be determined by institutional factors
such as:

• Availability of job information. A factor in determining frictional unemployment and how quickly
the unemployed find a job.
• The level of benefits. Generous benefits may discourage workers from taking jobs at the existing
wage rate.
• Skills and education. The quality of education and retraining schemes will influence the level of
occupational mobilities.
• The degree of labour mobility. See: labour mobility
• Flexibility of the labour market E.g. powerful trades unions may be able to restrict the supply of
labour to certain labour markets
• Hysteresis. A rise in unemployment caused by a recession may cause the natural rate of
unemployment to increase. This is because when workers are unemployed for a time period they
become deskilled and demotivated and are less able to get new jobs.

Phillips Curve
The Phillips curve illustrates that there is an inverse relationship between unemployment and inflation in
the short run, but not the long run. The economy is always operating somewhere on the short-run Phillips
curve (SRPC) because the SRPC represents different combinations of inflation and unemployment.
Movements along the SRPC correspond to shifts in aggregate demand, while shifts of the entire SRPC
correspond to shifts of the SRAS (short-run aggregate supply) curve.

The long-run Phillips curve is vertical at the natural rate of unemployment. Shifts of the long-run Phillips
curve occur if there is a change in the natural rate of unemployment.

1958: A.W. Phillips showed that nominal wage growth was negatively correlated with unemployment in
the U.K.

1960: Paul Samuelson & Robert Solow found a negative correlation between U.S. inflation &
unemployment, named it “the Phillips Curve.”

Since fiscal and monetary policy affect aggregate demand, the PC appeared to offer policymakers a
menu of choices:
•low unemployment with high inflation

•low inflation with high unemployment

• anything in between

1960s: U.S. data supported the Phillips curve. Many believed the PC was stable and reliable.

The Vertical Long-Run Phillips Curve

1968: Milton Friedman and Edmund Phelps argued that the tradeoff was temporary.

Natural-rate hypothesis: the claim that unemployment eventually returns to its normal or “natural”
rate, regardless of the inflation rate. Based on the classical dichotomy and the vertical LRAS curve.

In the long run, faster money growth only causes faster inflation.

The Short-run Phillips Curve

The short-run Phillips curve states that when unemployment is low, inflation tends to be high, and when
unemployment is high, inflation tends to be low.

This is because when unemployment is low, employers are in competition for a limited number of
workers, and they will have to offer higher wages to attract and retain employees.
As wages rise, the cost of goods and services also increases, leading to higher inflation.

Conversely, when unemployment is high, employers have a surplus of workers to choose from, and they
do not have to offer as high wages to attract employees. As wages remain low, the cost of goods and
services also remains low, leading to lower inflation.

It is important to note that the short-run Phillips curve is based on the assumption that prices and wages
are "sticky" in the short run, meaning they do not adjust immediately to changes in the economy.

This means that changes in unemployment will only affect inflation with a lag.

Friedman-Phelps Phillips Curve

Evidence (from ’60s): PC slopes downward.

Theory (Friedman and Phelps’ work): PC is vertical in the long run.

To bridge the gap between theory and evidence, Friedman and Phelps introduced a new variable:
expected inflation – a measure of how much people expect the price level to change.
Assume the economy starts at point A and has an initial rate of unemployment and inflation rate. If the
government decides to pursue expansionary economic policies, inflation will increase as aggregate
demand shifts to the right. This is shown as a movement along the short-run Phillips curve, to point B,
which is an unstable equilibrium. As aggregate demand increases, more workers will be hired by firms in
order to produce more output to meet rising demand, and unemployment will decrease. However, due
to the higher inflation, workers’ expectations of future inflation changes, which shifts the short-run
Phillips curve to the right, from unstable equilibrium point B to the stable equilibrium point C. At point C,
the rate of unemployment has increased back to its natural rate, but inflation remains higher than its
initial level.

Although the economy starts with an initially low level of inflation at point A, attempts to decrease the
unemployment rate are futile and only increase inflation to point C. The unemployment rate cannot fall
below the natural rate of unemployment, or NAIRU, without increasing inflation in the long run.

The reason the short-run Phillips curve shifts is due to the changes in inflation expectations.
Relationship Between Expectations and Inflation
Adaptive Expectations
The theory of adaptive expectations states that individuals will form future expectations based on past
events. For example, if inflation was lower than expected in the past, individuals will change their
expectations and anticipate future inflation to be lower than expected.

To connect this to the Phillips curve, consider. Assume the economy starts at point A at the natural rate
of unemployment with an initial inflation rate of 2%, which has been constant for the past few years.
Accordingly, because of the adaptive expectations theory, workers will expect the 2% inflation rate to
continue, so they will incorporate this expected increase into future labor bargaining agreements. This
way, their nominal wages will keep up with inflation, and their real wages will stay the same.
According to adaptive expectations theory, policies designed to lower unemployment will move the
economy from point A through point B, a transition period when unemployment is temporarily lowered
at the cost of higher inflation. However, eventually, the economy will move back to the natural rate of
unemployment at point C, which produces a net effect of only increasing the inflation rate.According to
rational expectations theory, policies designed to lower unemployment will move the economy directly
from point A to point C. The transition at point B does not exist as workers are able to anticipate
increased inflation and adjust their wage demands accordingly.

Now assume that the government wants to lower the unemployment rate. To do so, it engages in
expansionary economic activities and increases aggregate demand. As aggregate demand increases,
inflation increases. Because of the higher inflation, the real wages workers receive have decreased. For
example, assume each worker receives $100, plus the 2% inflation adjustment. Each worker will make
$102 in nominal wages, but $100 in real wages. Now, if the inflation level has risen to 6%. Workers will
make $102 in nominal wages, but this is only $96.23 in real wages.

Although the workers’ real purchasing power declines, employers are now able to hire labor for a
cheaper real cost. Consequently, employers hire more workers to produce more output, lowering the
unemployment rate and increasing real GDP. On, the economy moves from point A to point B.

However, workers eventually realize that inflation has grown faster than expected, their nominal wages
have not kept pace, and their real wages have been diminished. They demand a 4% increase in wages to
increase their real purchasing power to previous levels, which raises labor costs for employers. As labor
costs increase, profits decrease, and some workers are let go, increasing the unemployment rate.
Graphically, the economy moves from point B to point C.
This example highlights how the theory of adaptive expectations predicts that there are no long-run
trade-offs between unemployment and inflation. In the short run, it is possible to lower unemployment
at the cost of higher inflation, but, eventually, worker expectations will catch up, and the economy will
correct itself to the natural rate of unemployment with higher inflation.

Rational Expectations
The theory of rational expectations states that individuals will form future expectations based on all
available information, with the result that future predictions will be very close to the market
equilibrium. For example, assume that inflation was lower than expected in the past. Individuals will
take this past information and current information, such as the current inflation rate and current
economic policies, to predict future inflation rates.

As an example of how this applies to the Phillips curve, consider again. Assume the economy starts at
point A, with an initial inflation rate of 2% and the natural rate of unemployment. However, under
rational expectations theory, workers are intelligent and fully aware of past and present economic
variables and change their expectations accordingly. They will be able to anticipate increases in
aggregate demand and the accompanying increases in inflation. As such, they will raise their nominal
wage demands to match the forecasted inflation, and they will not have an adjustment period when
their real wages are lower than their nominal wages. Graphically, they will move seamlessly from point
A to point C, without transitioning to point B.

In essence, rational expectations theory predicts that attempts to change the unemployment rate will
be automatically undermined by rational workers. They can act rationally to protect their interests,
which cancels out the intended economic policy effects. Efforts to lower unemployment only raise
inflation.

Shifting the Phillips Curve with a Supply Shock

Aggregate supply shocks, such as increases in the costs of resources, can cause the Phillips curve to shift.