Tackling Unemployment and Inflation

Question 1

The natural rate of Unemployment occurs at Labour Market Equilibrium

Answer 1

1. Natural rate of Unemployment (NRU) = rate of unemployment when the labour market is in equilibrium - this is when the labour demand is equal to labour supply
2. When there’s equilibrium in the labour market that means there’s enough jobs for every worker in the labour force, but that doesn’t mean that every worker will be in a job (because of frictional and structural unemployment). There can be unemployment when the labour market is in equilibrium, and the rate of that unemployment is the NRU.
3. The NRU can be seen as corresponding to full employment, as it’s not possible for every person in the workforce to have a job. No matter how much AD is increased, frictional and structural unemployment will always exist.

Question 2

The Short Run Phillips Curve shows an Inflation/Unemployment Trade-off

Answer 2

1. The short run Phillips curve shows an apparent trade-off between inflation and unemployment. By plotting historical inflation and unemployment data, the economist A.W Phillips found that as inflation falls, unemployment seems to rise, and vice versa.
2. So it looks like if the government wants to reduce unemployment, then it can increase AD to achieve this… as long as its prepared to accept higher inflation.
3. However, not everyone agrees that it’s quite this simple. One problem is that once inflation has gone up, ppl seem to except it to remain high, and they change their behaviour accordingly.
   = this is the idea of ‘adaptive expectations’

Question 3

Keynesian economists say that the Phillips Curve relationship is basically True

Answer 3

The Phillips curve above shows the same ideaa as appears in the curve section of a Keynesian LRAS curve.

• Below A (i.e. where output is low and unemployment is high), workers will take jobs even if the wages are low- output increases with little effect on inflation.
• Between A and B, as output increases (and unemployment falls), there is an increase in prices (i.e. inflation). This is the same relationship as the one shown in the Phillips curve.

Question 4

The Phillips Curve relationship has sometimes Broken Down

Answer 4

1. In the 1950s and 1960s, governments used the Phillips curve to try and manage the trade-off between inflation and unemployment.
2. However, in the 1970s, the relationship between unemployment and inflation seemed to break down. There was a period of ‘stagflation’ - a stagnant economy (with low growth and high unemployment) along with high inflation.
3. It was monetarist economists who put forward an explanation for this. They said that the short run Phillips curve only takes into account the current rate of inflation - it doesnt take into account the influence of the expected rate of inflation. That’s where the long run Phillips curve comes in.

Question 5

Expectations about Inflation can cause Inflation rises to become embedded.

Answer 5

1. Assume that an economy that’s at point A on the diagram has unemployment at its natural rate (Un) - thats NRU.
2. At point A inflation is 0%, so the economic agents in the economy will expect that inflation will stay at 0% and this will influence things like workers’ wages negociations.
3. However if AD increases and this forces unemployment below the NRU, then this will cause wage demands to go up and inflation willl increase (to 3%).
4. At point B economic agents will now expect inflation to stay at 3%. As a result, future wage negociations will be based on inflation being at 3%.
5. Higher wage demands will mean firms are less willing to take on workers, so unemployment will rise back to the NRU (to Un). So the short run Phillips curve (SRPC1) will shift right to SRPC2.
6. When SRPC1 curve shifts right to SRPC2 (and the economy is at point C), you can see that, despite unemployment returning to the NRU, an inflation rate of 3% has become ‘embedded’ in the economy. Further increases in AD will mean that higher inflation rates can become embedded in the economy.
7. This shows how important it is for governments to use policies that stop inflation rising continuously. In the UK, the Bank of England is tasked with keeping inflation close to the target of 2% so that the expectations of economic agents are based on 2% inflation. On top of this, governments will use the policies to lower unemployment and even lower the NRU.

Question 6

Monetarist economists say there is No Trade-Off between inflation and unemployment

Answer 6

1. In the example above, the increase in AD caused inflation to rise. However, there was no long-term effect on unemployment - this eventually returned to the NRU.
2. This idea => monetarist economists who first suggested the idea of adaptive expectations to conclude that there was no long-term link between inflation and unemployment.
   - No matter how the SRPC shifts, unemployment will always return to the NRU.
   - So the long run Phillips curve, LRPC, will always be a vertical line coming up from Un.
   - This means that in the long run there is no trade-off between unemployment and inflation.
3. In fact, many economists say that the short run Phillips curve relationship doesn’t exist either.
4. The significance of the Phillips curve isnt clear. Supply-side policies may mean that low unemployment and low inflation can exist at the same time. However, at times it does seem that the unemployment-inflation trade-off does exist. In practice, the Phillips curve is now only used in the short run economic policy-making.

Question 7

Demand-side Policies can reduce cyclical unemployment

Answer 7

Governments have to get on with the practical business of making policies. Here are some of the issues they face, and the solutions they can try to use:

1. Reduce unemployment, governments need to understand what type of unemployment they’re trying to tackle.
2. During a recession an economy is likely to have cyclical unemployment, so a government would need to introduce policies that boost AD. e.g. the govt could use reflationary fiscal policies, such as decreasing taxes or welfare payments, or expansionary monetary policies, such as lowering of interest rates.
3. However, there are problems with these kinds of demand-side policies:
   - A lack of information about the size of the economy’s output gap may meant that the government overspends when it tries to boost AD and causes the economy to ‘overshoot’ - leading to inflation. Alternatively, the govt might under-spend and prolong a recession.
   - A lack of info about the size of the multiplier can cause problems too. E.g. if the multiplier in a country is bigger than the govt expects, then an increase in govt spending could => inflation.
4. It’s hard for a govt to use demand-side policies to fine-tune the economy - they can be quite clumsy and cause more problems. Time lags can also mean that improvements are slow to develop - govts may think that their policies aren’t working, so they increase spending further and create inflation.

Question 8

Supply-side policies reduce the Natural Rate of Unemployment

Answer 8

1. To reduce the NRU govts need to use supply-side policies that make the labour market more flexible, and reduce frictional and structural unemployment.
2. The flexibility of labour is determined by three important factors:
   a) labour mobility - ability of workers to switch jobs easily. The more transferable skills workers have, the more easily they can switch jobs- so labour mobility will depend on how skilled workers are. On top of that, labour mobility will also depend on the willingness of workers to move to where there are jobs.
   b) Wage flexibility - the ability of wages to change with changes to the labour market. E.g. during a recession, employers can lower wages to avoid having to lay workers off.
   c) Flexibility of working arrangements - ability of employers to hire workers in a way that suits them. Things such as part-time work, short term contracts and shift employment make it easier and cheaper for firms to hire or fire workers and respond to changes in the market.
3. Policies that improve labour market flexibility will focus on these 3 things:
   - labour mobility can be tackled by the same policies that are used to reduce structural unemployment
   - govts improve wage flexibility by scrapping the NMW and limiting trade union power.
   - the flexibility of working arrangements could be improved if the govt passed laws that made it easier fro firms to hire workers on short-term or zero-hour contracts.
4. Frictional unemployment will be reduced by policies which encourage ppl to find a job and speed up this process:
   - Reducing benefits will give unemployed workers a greater incentive to find a job and it will help the govt avoid the unemployment trap.
   - Income tax cuts will increase the incentive for workers to find a job, or encourage them to work longer hours.
   - Increased info about jobs will help workers find the right job for themselves mroe quickly.
5. Structural unemployment will be reduced by policies which tackle geographical and occupational immobility:
   - Govts improve occupational mobility by investing in traininf schemes that help workers to improve their skills, or by encouraging firms to set up their own training schemes.
   - Geographical immobility can be tackled by giving workers subsidies to move to different areas or by building affordable houses in areas that need workers. However, workers still often be reluctant to leave their homes and families.
   - Govts can bring jobs to areas with high unemployment by providing benefits to firms that locate in certain areas. This might be combined with training schemes to give local workers the skills required for the jobs provided.

Question 9

Monetary policy is usually used to tackle Demand-pull Inflation

Answer 9

1. Govts also need to use policies that deal with demand-pull and cost-push inflation.
2. Monetary policy is usually used to tackle demand-pull inflation.
3. Supply-side policies tackle frictional and structural unemployment are the kinds of policies often used to tackle cost-push inflation.