FA_p18-23 Vol4-4 Inflation and unemployment

18 THE UNEMPLOYMENT ISSUE THE UNEMPLOYMENT ISSUE 19

SKILLS CONTENTBUSTER ESSAYS ARTICLES

In our study of economics, we often mention a trade-off between the key macroeconomic variables of inflation and unemployment. We often say that a fall in unemployment rates will trigger

higher levels of inflation. Where is the basis of this theoretical prediction and is this relationship always true? In this article we’ll seek to uncover the answer. Before we can commence, we need to first sort out one key aspect of this prediction—which is the term NAIRU.

SORTING OUT UNEMPLOYMENT AND NAIRU Classic microeconomic theory suggests that in perfect markets, where the price always clears the market so that demand exactly meets supply, there shouldn’t be any surplus or shortages. Thinking of labour as a commodity, we imagine that this would also be the case in the labour market. In fact, we simply adapt our classical demand-supply analysis for this purpose (see Figure 1). Instead of ‘prices’, we have ‘wages’, and quantity of goods is replaced by quantity of labour. Demand for labour is generated based on the productivity of labour (or think of it in terms of a marginal benefit of every unit of labour fed into producing output) and supply is generated by willingness to exchange labour for wages.

No one should ever be unemployed, as long as wages are at the market-clearing level—but there is unemployment! Like the goods market in reality, where goods

can’t simply materialize in stores when demand for them emerges, there are

frictions in the labour market that prevent the economy from employing every single individual for the

production of output.There are transport costs,

information costs, and other barriers in the labour markets. At any time, there are people undergoing some form of training (whether it’s recognized by statisticians or not), searching for a suitable job, or simply taking a break between jobs. We think of this as ‘frictional unemployment’, a sort of basic level of unemployment that is inevitable and impractical to eliminate. Yet in the real world, there are supply shocks and demand shifts that complicate matters and generate

higher unemployment than simply the frictional level. Therefore, as a convention, economists prefers to imagine that if the source of unemployment is a result of rigidities or friction that can’t be overcome in the market, then inflationary forces will start to set in when unemployment falls below this level. Put another way, if the market isn’t bumping up against these barriers, employers could easily find someone else in the market to do your job at the same wages if you wanted a pay raise. But when it happens that he

INFLATION, UNEMPLOYMENT, AND NAIRU

THEORY

FIGURE 1 Demand and supply in a labour market

The demand for labour is a derived demand, which means demand not for labour itself, but what labour is used to produce. How much labour is demanded depends on the number of units of output that labour is able to produce and how much that output is able to sell for. We call this the marginal benefit of labour.

The quantity of labour supplied depends on the number of persons willing and able to work at the current levels of wages and are actively looking for work.


MICROECONOMICS

What is NAIRU? Why does the level of NAIRU differ

amongst countries? Are countries able to reduce the level of

natural rate of unemployment? Is there really a trade-off between

inflation and unemployment where governments can try to reduce unemployment with consequences of higher prices?

KEY POINTS OF QUERY

FIGURE 2 Level of output where economy grows sustainably

FIGURE 3 Unemployment over time in selected OECD countries

can’t find someone to perform your work and is forced to provide a pay raise to keep you in the firm, surely that means that the market is at its limits. Without inflating wages, it’s not possible to keep you employed.

This rate of unemployment is somewhat clumsily termed ‘Non-Accelerating Inflation Rate of Unemployment’ or

NAIRU. It is thought of as the ‘natural rate’ of unemployment; a level where the economy will be growing sustainably at (Figure 2). The term NAIRU simply refers

to a rate of unemployment that is tied to the healthy growth of an economy where

economists see real GDP growth without inflation.

There is no general agreement on exact the source of the unemployment termed NAIRU. NAIRU assumes no specific theories about the specific source of unemployment, but simply follows from the observation of a short-run relationship between unemployment and inflation.

However, before we explore the relationship between inflation and

unemployment, let’s take a look at some concepts that underpin the unemployment that NAIRU measures.

WHAT DOES NAIRU COUNT?When we look at the data of unemployment across different countries over a period of two decades, we can see that there are huge differences in the levels of unemployment (see Figure 3). More importantly, countries appear to have a range

of different ‘stable rates of unemployment’ that they hover around.

At the same time, estimated NAIRU for these countries varies across time periods. For our purposes, we’ll examine the estimates of NAIRU for selected OECD countries in 2006, a year with no particularly exceptional economic events. Figure 2 shows how much the ‘natural

rate’ varies between countries. It can be different even for countries of comparable level of economic development and economy size. In 2006, Japan had an estimated NAIRU of 4.10 while in Germany the figure was 8.59. In other words, more than double the proportion of

NAIRU is a measure of the natural rate of unemployment, which means the higher it is, the higher the proportion of labour would be unemployed during ‘normal’ times.

Growing sustainably, meaning that the economy can see increases in GDP or positive real GDP growth with 0 rates of inflation of below 3%. This occurs when the economy is operating at nearly full employment levels.

NAIRU is often understood to be made up of the supply side sources of unemployment or unemployment in an economy that arises due to supply side constraints of the economy—namely frictional, structural, and seasonal unemployment.

In the choice of which year to focus on in examining the unemployment rates of different countries, it is important to use data from a year without a recession or exceptional levels of inflation as it will make the study of unemployment data inaccurate.

Source: OECD Stats


the workforce in Germany was deemed ‘naturally unemployed’ compared to Japan.

Earlier, we said that transport costs in a market can be a barrier and physical distance can hinder job search. If this is the case, we could expect that larger countries should experience higher unemployment, since it would be costlier to match workers to the right jobs and the transport costs involved would be higher. However, when we observe the types of economies and their respective NAIRU estimates in Figure 4, we see that physical distance doesn’t account for much of the difference.

Clearly, physical distance isn’t the only source of market imperfection and not even a dominant one, so to speak. Infrastructure and communication networks help to overcome physical distance, so we should see that an economy at a more advanced stage of development has a lower NAIRU than a developing country. Yet it was 3.18 in Mexico, while Sweden languished with 7.22.

Aren’t developed economies supposed to be more efficient than developing ones? When it comes to use of labour, being developed appears to introduce more hurdles to raising employment. This is because labour in sophisticated economies is more specialized, which means that more training and qualifications are required before one can fill a job. This makes the economy less flexible in shifting its labour resources when there is a change in demand or when the competitive advantages of the economy change. As

such, when specialized labour gets fired as a result of contracting demand for their industry’s output, they find their expertise incompatible with those skills in demand. Long periods of retraining are required to get them hired again. Structural issues count towards raising the NAIRU and the potential for that rises as an economy becomes increasingly specialized. In contrast, developing economies with the composition of the economy mainly in the agricultural and low value-added manufacturing areas may see a large

resemblance of the skills required—that of systematic routine-based work, either on a farm or in a factory. Hence, even when labour transitions, the amount of time for that transition tends to be minimal, as the skills to be picked up don’t represent a particularly steep learning curve.

The age structure of the labour force matters just as much. Youthful workers are more willing to move where there are opportunities available and are thus more mobile than older workers with families. Immobility of labour reduces the flexibility of the market and increases the frictional

component of NAIRU. Institutional factors play a dominant role in determining the NAIRU, as well. If labour contracts are flexible with few costs involved with hiring and firing, workers are able to find a good match more quickly. On the other hand, if it’s costly to hire and fire because of labour regulations, employees are keen to hold on to their jobs, even if it’s not a good match, and employers find it too costly to replace them. It may not even be a result of regulation. If fired labour is viewed in a negative light by the culture, employers are discouraged from hiring someone who was fired and employees cling to their jobs desperately. All the above situations reduce the number of job transitions and reduce the NAIRU arising from frictional changes.

In Figure 5, the countries that managed to reduce their NAIRU over time in the

FIGURE 4

FIGURE 5 NAIRU OF SELECTED COUNTRIES ACROSS TIME

In this case, the natural rate of unemployment is associated with structural unemployment that comes about due to a mismatch between skills possessed by workers and the demands of employers.

In a developing economy, we can expect a greater source of NAIRU to be made up from lack of information rather than structural in nature due to the time taken to acquire the right and relevant skills.


Source: OECD Stats

Source: OECD Stats


OECD were rapidly developing economies, like Poland and the Slovak Republic. Yet this may also be due to rapidly changing age structures of the labour force beyond the influence of policy-makers. A rise in NAIRU also happens to economies experiencing deep structural shifts, such as in the case of Spain and Ireland in recent years.

There is no way to systematically untangle the complex factors determining NAIRU and pin down the exact variables that can be targeted for policy to bring down the ‘natural rate of unemployment’. This also explains the variation in NAIRU across space and time. NAIRU increases when there are structural shifts taking place in an economy, but decreases with improvements in communication and transportation networks. However, we’ll never be able to isolate these effects because such improvements introduce structural shifts.

Consequently, policy-makers have no specific direct means of influencing the level of employment in an economy, at least in long run, since the attempt to reduce one source of unemployment counted within the NAIRU creates an increase in another source of unemployment, thereby adding to the NAIRU. Investment in infrastructure

can only do so much as generating additional employment. Even the much-touted ‘supply side’ policies of improving

education standards and providing more training may result in a highly specialized workforce incapable of dealing with sudden shifts in global demand for labour.

A TRADE-OFF? THE RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT Having understood why policy-makers have a hard time dealing with the NAIRU or natural rate of unemployment in the long run, we now will explore the presence of the short-run relationship between inflation and unemployment. It was

For many economies that transitioned from low value- added manufacturing towards high value-added manufacturing (such as Singapore), the years of transition would have bumped up the NAIRU numbers, since a larger segment of workers would have needed to stay unemployed for a longer period of time while being retooled with the skill sets that were in demand.

Changes in technology not only help to reduce NAIRU from frictional unemployment, but it can also increase NAIRU from structural changes in the economy related to the change in technology. Improvements in technology can cause the economy to move more towards technology-driven jobs, such as IT services.

MICROECONOMICS


observed by Keynes while constructing his ‘general theory’ and implied in the aggregate demand-and-supply analysis that we use for the macroeconomic equilibrium.

In the short run, NAIRU is not exactly relevant, since the level of unemployment is determined by the aggregate demand and short-run aggregate supply. An upward sloping segment of the aggregate

supply suggests that as the level of employment increases with a higher level aggregate demand (see Figure 6), the price level has to increase. We often think of this as the economy experiencing bottlenecks, resulting in pressure for prices to rise. This means that the lower the unemployment, the higher the

potential for prices to inflate. Therefore, we get an inverse relationship between inflation and unemployment.

But why would there be a trade-off such that policy-makers could engineer inflation to raise employment levels in short run? How would low unemployment result in higher inflation? The conventional wisdom is that people take time to observe and act upon the real value of their wages and when nominal wages rise, employment

increases as people in the labour market settle for jobs quickly, believing that real wages have risen even when they have not. Therefore, when central bankers flood the economy with liquidity, unemployment may fall in the short run.

Likewise, if a government attempts to reduce unemployment by increasing hiring and paying more wages for the same output (financed by issuing more

currency), the increase in aggregate demand from lower unemployment will eventually result in inflation when those workers spend their wages and bid up the price of goods.

There is an alternative reason for the relationship that puts the state out of the picture, and it relates to the expectations of growth in an economy. An economy may be experiencing a bout of optimism that raises expectations of future growth. This means that firms will be hiring more labour (and willing

NAIRU is not relevant, since unemployment is determined by short-run factors, such as AD and SRAS, rather than long-run factors determining NAIRU explained earlier, including the nature or structure of an economy.

FIGURE 6 KEYNESIAN AD-AS ANALYSIS


The empirical relationship between inflation and unemployment was first formally observed by William Phillips in 1958, and thus the relationship is often termed a Phillips Curve, even though it doesn’t imply any specific theoretical explanation for it. As a matter of fact, the Phillips Curve relationship appeared to break down soon after it was observed.


Laurence Ball and N. Gregory Mankiw (2002). The NAIRU in Theory and Practice. Journal of Economic Perspectives—Volume 16, Number 4.

Dave Turner, Laurence Boone, Claude Giorno, Mara Meacci, Dave Rae and Pete Richardson (2001). Estimating the Structural Rate of Unemployment for the OECD Countries. OECD Economic Studies No. 33, 2001/II

Statistics from OECD Stats

REFERENCES

to pay higher wages) anticipating a rise in demand while consumers spend more, expecting their income to rise in the future. Such coordination of expectations inevitably result in a fall in unemployment—coupled with rising inflation.

CHANGED REALITIESPOLICY BACKFIREEvidently, policies that try to trade off between inflation and unemployment

can’t be sustainable and won’t be particularly effective. Once the economy realizes that real wages aren’t rising and that real profits aren’t rising, unemployment will return to a ‘natural rate’ while inflation will stay at the higher level because of a shift in expectations concerning inflation. Higher inflation can stifle growth and destabilize the economy. Thus, any such policy can’t have stabilizing effects in the long run.

With improvements in communication technology and the ability of consumers to observe and compare prices, adjustments to new price levels are made more quickly and unemployment levels often hardly react to such monetary shocks. The more efficient an economy is in updating their expectations, the more quickly the relationship between inflation and unemployment breaks down. Indeed, policy-makers no longer observe any particular empirical relationship between inflation and unemployment.

Stabilization policies instead focus on ensuring low and stable inflation without implicating unemployment

levels. The state can only create jobs through growth-oriented policies and the provision of vital job matching or retraining services that will reduce friction in the labour markets and improve labour flexibility.

With the rise in sources of inflation being cost push in nature, resulting in both rising prices and rising unemployment, governments have lost their focus on dealing with NAIRU, which bugs them when growth rates are high and countries try to squeeze more output without firing off inflation. So for now the trade-off is not the top priority of a government’s focus.

EVIDENTLY, POLICIES THAT TRY TO TRADE OFF BETWEEN INFLATION

AND UNEMPLOYMENT CAN’T BE SUSTAINABLE AND WON’T BE PARTICULARLY EFFECTIVE.

MICROECONOMICS

A worker seeing an increase in the dollar amount received in his bank sees only a nominal increase in wages. Only after the worker attempts to use that pool of money to buy goods and services at the current market prices will he have a true sense of his real wage. When nominal wages increase along with prices of goods and services, the worker soon realizes that real wages haven’t risen and in turn cuts back on the amount of effort or may even cut back on work, since extra work done with the impression of higher returns was corrected.

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FA_p18-23 Vol4-4 Inflation and unemployment