Unemployment & Inflation

Natural Rate of Unemployment and the Phillips Curve Model

The Natural Rate of Unemployment [NRU]

The first thing for you to realise is that the natural rate of unemployment can be considered to be full employment.  It means that there are as many workers employed as possible in the current state in the economy.  It means that labour demand is equal to labour supply.

When I say ‘as many workers as possible’, I am referring to the fact that it is impossible for EVERY worker to be employed because there will always be some frictional and structural unemployment.

(Frictional unemployment is when workers are between jobs. Structural unemployment is when people do not have the skillset that employers are looking for, so they are unemployed until they retrain]

Short-run Philips Curve

This curve shows the basic trade-off between unemployment and inflation.  The basic correlation is that when inflation is high, unemployment is low. It is a negative correlation.  An example of how this works is that when there is greater demand in the economy there will be less unemployment as labour is a derived demand.  However, at the same time the extra demand will result in some demand-pull inflation occurring. 

This is the most basic version of the Phillips Curve. It was initially considered to be correct until it was disproven.  It misses out one vital factor which is the expected rate of inflation.  This is remedied in the Long-Run Phillips Curve diagram.

Long-run Phillips Curve

This curve takes into account inflation expectations.  We first begin at point A.  At this point, inflation is 0% and this is what the economy expects inflation to be.  Our unemployment level is at the natural rate, Un. However, after a brief surge in aggregate demand, the unemployment rate falls below the natural rate of unemployment.  So initially it looks like this is a good thing because unemployment is going down.  So, we move to point B. 

However, this is actually a very bad thing.  In moving to point B, the economy has now adjusted and people are going to start expecting inflation to be 3% rather than the 0% it was before.  So what will happen is that employees will try and negotiate higher wages with their employers and get a 3% pay rise.  Employers will not like this and in turn they will start to lay off workers due to the increased costs of production. 

At this point we will be at point C.

The rate of inflation is 3% which is what people expect, and the unemployment level has just risen back to the natural rate of unemployment.  We are back to square 1, but we have also embedded into the economy a higher rate of inflation.  Great stuff.  [The Short-Run Phillips Curve will always have to shift back to meet the Long-Run Phillips Curve and re-establish equilibrium and the natural rate of unemployment.]

This is why economic booms are no good because demand is going up so much that unemployment falls below its natural level, which is actually harming the economy in the future due to inflation expectations.

Have you ever wondered why in the UK there is a set target rate of 2% inflation?  This is exactly the reason why.  Because we are trying to ensure that inflation expectations do not go out of control.

So in summary, the main points I want you to remember is:

• Natural Rate of Unemployment (NRU) is what we call 'full employment'. Employment will never truly be 'full'.

• Short-run Phillips curve - shows the basic trade off between unemployment and inflation but is not accurate enough to use in the long-run

• Long-run Phillips curve - takes into account the expectations of inflation. So it is more accurate and useful when assessing long-run effects to an economy when there are short boosts of aggregate demand.

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