a2 econ unemployment and the phillips curve

Unemployment and the Phillip’s Curve:

Unemployment and the Phillip’s Curve

Slide 2:

Measuring unemployment There are two main ways in which we measure unemployment Claimant Count – counts those that claim the Jobseeker’s Allowance Excludes people that don’t meet the eligibility criteria Labour Force Survey Includes those who have looked for work in the past month Tends to exceed the claimant count by about 500,000 Used for international comparison

Slide 3:

Labour Market Equilibrium Achieved when demand for labour is equal to supply Demand is determined by the marginal revenue product of labour As more and more workers are combined with a fixed stock of land and capital the MRP of labour declines Hence the demand curve is downward sloping The supply curve is upward sloping because as the real wage rate increases more people are attracted to the workforce In the very short term employers can also persuade workers to work overtime for extra pay

Slide 4:

Labour Market Equilibrium Unemployment occurs for two reasons Labour market moves away from equilibrium when actual wages increase Or there is still some measured unemployment even when the labour market is in equilibrium

Slide 5:

Unemployment when the labour market is in disequilibrium Sometimes the labour market moves away from equilibrium Actual wage rate is above market clearing rate FE fewer workers are demanded because the wage rate is too high EG more workers want a job because the wage rate is so high There is FG unemployment in the economy If rates fall to 0W unemployment will fall There are a number of reasons why the labour market can be in disequilibrium Cyclical or demand deficient unemployment Classical unemployment (real wage unemployment)

Slide 6:

Cyclical / Demand Deficient unemployment When an economy goes into recession there is less demand for goods and services and so demand for labour drops Shift in the demand curve Employment used to be 0E but now its 0G with the old wage of 0W 0E workers want a job but only 0G workers are demanded

Slide 7:

Cyclical / Demand Deficient unemployment This is sometimes called Keynesian unemployment because it was Keynes that argued in the 1930s that the great depression was caused by lack of demand In a recession the economy is in disequilibrium The macroeconomic forces will work to restore the long run equilibrium position When there is extra demand for goods and services there will be more demand for labour In the long run the demand curve will shift back In the short run there is unemployment Insert fig 3 P 486 anderton

Slide 8:

Classical / Real Wage unemployment This exists when the real wage is above that needed to clear the labour market even when the economy is booming Jobs exist but workers choose not to take them They are not prepared to offer the wages offered This could be due to the replacement ratio If the ratio is 1 the unemployed person would receive the same being unemployed as they would working If tax and benefits are high there may be a disincentive to work A high replacement ratio reinforces the unemployment trap One way of reducing the ratio is reduce benefits Replacement ratio – unemployment benefits divided by the income an unemployed worker could receive if in work

Slide 9:

Classical / Real Wage unemployment Other reasons why the real wage may be above that needed to clear the market minimum wage legislation trade unions forcing up wages

Slide 10:

Unemployment when the labour market is in equilibrium Even when the market is in equilibrium there might still be unemployment Frictional unemployment will always occur Seasonal unemployment will occur due to patterns of demand and supply Structural unemployment will occur because markets develop rigidities It can take decades to reduce the unemployment caused by large scale closures of industry Unemployed workers fail to move to where jobs exist and won’t work for low wages they become long term unemployed This can happen even if the economy is experiencing a shortage of workers in areas Frictional unemployment – voluntary unemployment; workers moving between jobs Structural unemployment – due to a change in the pattern of demand and production e.g. deindustrialisation

Slide 12:

The natural rate of unemployment In a boom period there is no cyclical unemployment When the economy goes into recession workers lose their jobs and have difficulty in finding other Cyclical unemployment is involuntary unemployment Unemployed workers can’t choose to go back to work because there are no jobs available All other types of unemployment are voluntary unemployment Workers refuse opportunities of work at existing wage rates Choosing to spend less time searching for work Choosing not to take work with less pay than they want Seasonal workers taking odd jobs e.g. cleaning between periods of work Those suffering from structural unemployment that could move to a different area Classical unemployment is voluntary because individual workers, trade unions, or governments choose to allow unemployment to exist by maintaining too high wages The natural rate of unemployment – The proportion of the workforce which chooses voluntarily to remain unemployed when the labour market is in equilibrium involuntary unemployment – unemployment which exists when workers are unable to find jobs despite being prepared to accept work at the existing wage rate voluntary unemployment – workers who choose not to accept employment at the existing wage rate

Slide 13:

The natural rate of unemployment The natural rate of unemployment is the % of workers who are voluntarily unemployed The economy is in full employment when there is no involuntary unemployment We can illustrate this in this diagram At 0E the economy is in long run equilibrium Some workers choose not to work at the equilibrium wage level

Slide 14:

The natural rate of unemployment Two supply curves are drawn showing S workers - the number prepared to work S labour force – those that claim they wish to work but are not prepared to work at the given wage rate There is EF unemployment in the economy This unemployment is voluntary and 0E is the natural level of employment in the economy EF is the natural level of unemployment The natural rate of unemployment is the natural level of unemployment divided by the workforce – EF ÷ 0F P487 figure 4

Slide 15:

The natural rate of unemployment If the economy is at output level 0D there will recession There will be cyclical unemployment (involuntary) The market will return to equilibrium at 0e reducing the level of cyclical unemployment to zero P487 figure 4

Slide 17:

The natural rate of unemployment The extent to which unemployment is voluntary or involuntary has been a major controversy in economics Keynesian economists argued that unemployment in the major recessions was demand deficient Classical economists have argue that labour markets will adjust almost instantaneously to large rises in unemployment Wages will fall and the labour market will clear They believe that there were plenty of jobs around in the 1930s and 1980s but workers refused to take them There is no involuntary employment Use this when evaluating!

Slide 18:

The short run Phillips curve Professor Phillips (LSE) looked at the relationship between unemployment and the rate of change of money wage rates As seen in the diagram High rates of unemployment were associated with low rates of change of money wage rates and vice versa The line of best fit became known as the Phillips Curve This relationship gives us an insight into the causes of inflation

Slide 19:

The short run Phillips curve Changes in money wage rate are a key component of changes in prices Wages are a high percentage of firms costs Assume that 70% of a firm’s costs are their wages If money wage rates rise by 10% whilst all other factors remain constant Costs will rise by 7% The firm is likely to pass these costs on in the form of higher prices These higher prices feed through to higher costs for other firms or directly into the inflation rate The higher the rate of change of money wages the higher the likely rate of inflation Hence the phillips curve hypothesis can be altered slightly to state that there is an inverse relationship between inflation and unemployment When unemployment is low, inflation will be high Wages are a huge percentage of firm’s costs hence why we take Phillip’s wages to represent inflation

Slide 20:

The short run Phillips curve The short run Phillips curve can be seen in the Keynesian AS curve At low levels of real output, the AS is horizontal because workers are prepared to accept jobs at the same wage due to high unemployment At output level 0A there is still some unemployment but demand for labour is strong enough for workers to begin asking for higher wages The nearer the economy gets to full employment the greater the ability of the workers to secure wage rises Hence inflation is higher the nearer the level of full employment At 0B real output cannot increase The PPB has been reached The short run Phillips curve is shown by the upward sloping part of the curve between 0A and 0B

Slide 21:

The short run Phillips curve The short run Phillips curve can also be shown using a classical AD and AS model If AD increases and shifts to the right the economy moves along its short fun AS curve from A to B This gives an increase in output and an increase in the price level The increase in output represents a decrease in unemployment The increase in price level is inflation The move from A to B show the Phillips curve trade off: higher inflation for lower unemployment The Phillips curve as originally plotted shows what happens when the economy adjusts in the short run to a demand-side shock

Slide 22:

The long run Phillips curve with zero inflation On classical assumptions point B is not a long run equilibrium point The economy has moved to a position of over-employment at point B Workers will be able to bid up wage rates shifting the short run AS curve upwards The economy will only return to equilibrium at the point C where AD once again equals LRAS Going from B to C gives a rise in unemployment Inflation falls back to zero again at point C at point there was no inflation Once the economy reaches C there are no forces which will increase prices any more In the long run there is no trade off between inflation and unemployment

Slide 23:

The vertical long run Phillips curve When inflation is zero or very low economic agents are likely to suffer from money illusion If a worker receives a money wage increase of 2% they may believe they are 2% better off If inflation is also running at 2% they are no better off They would be suffering from money illusion When they are aware that their income and wealth is eroding they change their behaviour They may negotiate their wages on a real terms basis Instead of negotiating for 2% they may ask for this plus the expected rate of inflation This affects the position of the short run Phillips curve Money illusion – economic agents such as workers believe that changes in money values are the same as changes in real values despite inflation (or deflation) occurring at the time

Slide 24:

The vertical long run Phillips curve The original Phillips curve is PC1 Workers and firms assume that there will be no prices changes There is equilibrium at point A The government now increases AD pushing the economy up to point Z This reduces unemployment but increases inflation to 5% If workers suffer from money illusion the economy will return to point A Insert fig 8

Slide 25:

The vertical long run Phillips curve If workers are more sophisticated and expect inflation to continue at 5% they will bargain for higher wages This pushes up prices and real wages fall Workers drop out of the labour market Unemployment returns to 0A but the inflation rate becomes permanent The curve has shifted to the right The economy will be at B If government tries again to reduce unemployment inflation may rise again to say 10% on PC2 In the long run the economy will return to unemployment 0A but on a higher Phillips curve PC3

Slide 26:

The natural rate of unemployment 0A is known as the natural rate of unemployment It’s the rate of unemployment that exists when the economy is in long run equilibrium If the economy is below the natural rate of unemployment then AD is above LRAS Workers bid up wages rates Short run curve shifts upwards until long run equilibrium is re-established If unemployment is above the natural rate AD is less than LRAS Unemployment will force workers to accept wage cuts Firms will take on more labour expanding output and lowering unemployment to its natural level

Slide 27:

The natural rate of unemployment If the economy is in long run equilibrium the labour market will also be in equilibrium So, another definition of the natural rate of unemployment is that the rate of unemployment which occurs when the demand for labour equals the supply of labour In the long run the economy will always tend towards the natural rate of unemployment Hence the long run Phillips curve is vertical It is the line ABCD There is no trade off between unemployment and inflation A government can reduce unemployment below its natural rate in the short run In the long run unemployment will climb back again and inflation will be higher

Slide 29:

Reducing inflation Another way of defining the natural rate of unemployment is the rate of unemployment which can be sustained without a change in the inflation rate This is sometimes called the NAIRU Consider what happens if government tries to reduce inflation from 10% to 5% It an only do this by travelling down the short run Phillips curve from point A to B This increases unemployment from 1.5m to 3m The economy will now slowly return to its natural rate of unemployment of 1.5m at point C If it is not prepared to pay this price inflation will remain constant at 10% with 1.5m unemployed NAIRU – The non-accelerating inflation rate of unemployment

Slide 30:

Reducing inflation An increase in the inflation rate above 10% can only come about through an increase in AD This increase will gain move the economy off point A This time up the short run Phillips curve to D We can see that the labour market can be in equilibrium at the natural rate of unemployment (NAIRU) with any inflation rate Again the Phillips curve is vertical The only way to reduce the NAIRU (push the vertical long run Phillips curve to the left) according to classical economists is to adopt supply side policies

Slide 32:

Keynesians, Monetarists and classical economists The long run vertical Phillips curve was put forward by Milton Friedman (monetarist) He also suggested that workers suffered from money illusion. Keynesians doubt the existence of the natural rate of unemployment They believe it takes a very long time for labour markets to clear if there is mass unemployment A government that creates unemployment of CB to reduce inflation may find the economy gets stuck with an unemployment level of 3m Unless it waits a decade or more it can only reduce unemployment by expanding demand again and accepting higher inflation

Slide 33:

Keynesians, Monetarists and classical economists New classical economists have suggested that the SR Phillips curve does not exist Rational expectations mean that economic agents are able to see whether inflation and unemployment are likely to rise or fall in the future If government states that it is prepared to accept a rise in unemployment to reduce inflation Workers will immediately moderate wage demands to avoid unemployment Inflation falls immediately The economy will always be on the vertical long run curve because economic agents adapt their expectations in the light of economic news

Slide 34:

Change the marks to 15 and 25

Slide 35:

This mark scheme for part a gives you an idea of what you need to know – it is not good enough to know the theory; you need to do some research and know what has been happening in the UK in some detail

Slide 37:

This is the mark scheme for part b. DO NOT use all of these.