The natural rate of unemployment and full employment

The natural rate of unemployment (NRU) represents the level of unemployment that exists when the labour market is balanced, with the number of job vacancies matching the number of people seeking work. This balance does not mean zero unemployment, as some types of unemployment are inevitable in any economy.

Key features of the natural rate of unemployment

• Labour market equilibrium - This occurs when the demand for workers equals the supply of workers available. At this point, there are sufficient jobs for the workforce, but not everyone is employed due to ongoing changes in the job market.
• Types of unavoidable unemployment - Frictional unemployment happens when people are temporarily between jobs, such as after leaving one role and searching for another. Structural unemployment arises from mismatches between workers' skills and available jobs, often due to changes in industries or technology.
• Connection to full employment - The NRU aligns with full employment, where the economy is operating at its maximum sustainable level without causing rising inflation. It recognises that complete employment is impossible because of frictional and structural factors.

The non-accelerating inflation rate of unemployment

The non-accelerating inflation rate of unemployment (NAIRU) is the lowest unemployment rate achievable in the long term without triggering a rise or fall in inflation. If unemployment drops below NAIRU, inflation tends to accelerate; if it rises above, inflation remains stable or decreases. In practice, NAIRU is very similar to NRU.

The short-run and long-run Phillips curves

The Phillips curve illustrates the relationship between inflation and unemployment, showing how changes in one can affect the other over different time periods.

The short-run Phillips curve

The short-run Phillips curve demonstrates an inverse relationship between inflation and unemployment. As inflation decreases, unemployment often increases, and the reverse is also true.

Trade-off mechanism:

• Lower inflation can lead to higher unemployment because firms may cut back on hiring or production to control costs.
• Conversely, higher inflation might encourage more economic activity, reducing unemployment.
• This concept explains why the trade-off works in the short run through money illusion, where workers may confuse nominal wages (the actual amount of money received) with real wages (purchasing power after accounting for inflation).

The long-run Phillips curve

In the long run, the Phillips curve is vertical, positioned at the NRU. This means there is no lasting trade-off between inflation and unemployment.

• Return to natural rate - Regardless of inflation levels, unemployment will eventually settle back at the NRU as the economy adjusts.
• Influence of expectations - Adaptive expectations play a key role, where people base future predictions on past experiences. If inflation rises, individuals anticipate it will stay high, embedding it into wage demands and contracts.

Historical context and economic views on the Phillips curve

The Phillips curve has evolved based on real-world economic events and differing schools of thought, highlighting its practical applications and limitations.

Historical use and breakdown of the Phillips curve

• 1950s and 1960s - Governments relied on the Phillips curve to balance inflation and unemployment.
• 1970s stagflation - The curve's relationship failed during this period, with economies experiencing high inflation combined with high unemployment and low growth.

Keynesian and monetarist perspectives

• Keynesian economists - They support the short-run Phillips curve, arguing that during periods of low output and high unemployment, workers are more likely to accept lower wages to secure jobs. This allows output to rise without significant inflation pressure.
• Monetarist economists - They reject a long-term trade-off, asserting that unemployment naturally returns to the NRU. Policies aimed at reducing unemployment below this level only lead to higher inflation without lasting benefits.

Policies to reduce unemployment and inflation

Governments use a mix of demand-side and supply-side policies to manage unemployment and inflation, targeting different types and causes.

Demand-side policies for cyclical unemployment

Demand-side policies focus on boosting overall economic activity to reduce unemployment caused by low demand, known as cyclical unemployment.

Types of demand-side policies:

• Reflationary fiscal policies - These include cutting taxes to increase disposable income or raising welfare payments to encourage spending.
• Expansionary monetary policies - Lowering interest rates makes borrowing cheaper, stimulating investment and consumption.

Challenges with demand-side policies:

• Information gaps make it hard to accurately assess the economy's output level.
• Multiplier effects, where initial spending leads to further economic activity, are unpredictable.
• Time lags mean policies may take effect too late or too strongly.
• Precise control is difficult, potentially leading to over-stimulation and inflation.

Supply-side policies to lower the natural rate of unemployment

Supply-side policies aim to make the labour market more efficient, reducing the NRU by addressing frictional and structural unemployment.

Enhancing labour market flexibility:

• Labour mobility - Improves when workers can easily change jobs, supported by transferable skills and willingness to move locations.
• Wage flexibility - Allows salaries to adjust quickly to market changes, helping balance supply and demand.
• Working arrangements - Increases options like part-time, temporary, or zero-hour contracts, enabling employers to adapt to needs.

Reducing frictional unemployment:

• Cutting income taxes to incentivise work.
• Improving job information systems, such as better online portals or career advice services.
• Lowering benefits to prevent the 'unemployment trap', where people prefer welfare over low-paid jobs.

Tackling structural unemployment:

• Providing training schemes to update skills for new industries.
• Offering relocation support, like subsidies for moving to job-rich areas.
• Promoting affordable housing to aid geographical mobility.
• Creating jobs in regions with high unemployment through incentives for businesses.

Monetary policy, such as adjusting interest rates, complements these by targeting inflation directly.