The Natural Rate of Unemployment
Question
Paper detalis:
Write a concrete summary of both the articles combined. Use only the two as resources. Use samples from them such as graphs as evidence.


Solution
The Natural Rate of Unemployment
Policymakers and
economists use the natural rate of unemployment – also called u-star – to
examine the state of the labor market. However, these policymakers and
economists cannot directly observe the natural unemployment rate. They have to
estimate it. These estimates are useful in answering the central microeconomics
question – why does unemployment exist? According to D’Urbino (2017), “there
are bigger wastes than the loss to the idleness of hours, days, and years by
people who would rather be working.” Joblessness can topple governments, sink
budgets, and ruin lives. Even so, the fight against unemployment is not
extensive. Authorities and responsible institutions such as America’s central
bank target the natural unemployment rate to resolve the problem.
At the natural
rate of unemployment, inflation is stable. Therefore, when authorities and
policymakers target this rate, they aim to control inflation or prevent
unemployment from fluctuating too much. Unfortunately, it is impossible to
eradicate unemployment. For one, its natural rate is an article of faith in
many respects. Economists always seek it but never find it. They do not
understand where it comes from and how it changes human lives (D’Urbino, 2017).
Second, there are many reasons why policymakers cannot fully eradicate
unemployment. First, moving from one job to another is time-consuming. This job
shift causes “frictional unemployment,” which affects the natural rate. In some
cases, shifting from one job to another leads to structural unemployment
because those intending to change jobs have outdated skills.
The concern for
economists around the world is not unemployment per se. It is the tradeoff
between unemployment and inflation. They are following in the footsteps of John
Maynard Keynes – the great British economist. In his book “The General Theory,”
published in 1936, Keynes noted that it was difficult for many people to find
jobs at the going wage in the aftermath of the Great Depression (D’Urbino,
2017). This difficulty did not affect the unskilled employees alone. It also
impacted individuals with the right qualifications, experiences, and skills.
With his treatment of involuntary unemployment, Keynes took the first step
towards the natural-rate hypothesis. Classical economists believed the
involuntary unemployment was due to high wages caused by trade unions
(Barnichon & Matthes, 2017). But Keynes was sure this unemployment was due
to lackluster spending. Keynes believed that workers would still have less to
spend even if wages fell, worsening the demand deficiency. His preferred
solution was for the governments to ensure full employment by managing
aggregate demand.
When managing
aggregate demand, policymakers are doing more than just selecting an
unemployment rate. They are also simultaneously affecting the rate of price
increment. This assertion had become central to Keynesianism by the late 1960s.
Surprisingly, Keynes was not the founder of this component of his theory. He
barely considered inflation in his analysis of unemployment.
Irving Fisher was
the first to study the relationship between unemployment and inflation. He did
so in 1926. His work resulted in the Phillips Curve, named for the London
School of Economics’ William Phillips (see Figure 1). He is particularly noted
for his 1958 study that tracked the association between joblessness and wage increases
in the United Kingdom from 1861 to 1957. The results revealed a pretty stable
relationship between the two: wages rose faster when unemployment was low, and
vice versa. This discovery was remarkable because the numerous workers’ rights
changes had occurred throughout the period. For example, most workers in
Britain could not vote in 1861 (D’Urbino, 2017). By 1957, however, the
government had nationalized the economy.
Figure 1: Effects of supply and
demand shocks on Phillips Curve
Robert Solow and
Paul Samuelson investigated the relationship between inflation and labor in the
United States. With the Phillips Curve shifting around, the two economic
luminaries concluded that no special relationship between the two components
(inflation and unemployment) (Barnichon & Matthes, 2017). However,
Samuelson and Solow noted that “wage rates tend to rise when the labor market
is tight” in any era. They further concluded that the tighter the market, the
faster the rate. The relationship between inflation and unemployment was like a
menu to these two economists. It encouraged the concept that Keynesian policy
makers’ job was picking a point on the Phillips Curve and illustrating how well
that point matched their likes. In this regard, the tolerable rate of inflation
determined the extent to which unemployment could fall because if the wages
rose, prices would go up, too. Although the idea that inflation and
unemployment were like a menu was prominent in the 1960s, it is not clear if
policymakers thought of the relationship that way.
Nobel laureates
Milton Friedman and Edmund Phelps were the two main detractors of the “menu”
idea. Friedman canonically criticized ancient economic thinking when talking to
the American Economics Association in 1967, after Mr. Phelps started issuing
groundbreaking labor market models (D’Urbino, 2017). In his speech, Friedman contended
that a natural unemployment rate would ultimately triumph over the rest even if
policymakers had various options (like a menu). Friedman argued that if a
central bank printed more money to lower unemployment, the large money supply
would encourage spending. As people demand more products and services, prices
for these products and services will increase, leading to inflation that
catches the workers (buyers) by surprise. Since their wage increases happened
when there was no inflation, these payments are worth nothing now that there is
inflation. During this period of inflation, labor would be artificially cheap,
and firms would hire more people, causing the unemployment rate to fall below
the natural rate (and the central bank would have attained its objective).
The next time
workers negotiate their pay, they demand a raise in their pay equivalent to the
prevailing rate of inflation to restore their living standard, forcing the
natural rate of unemployment to re-establish itself because neither the
employer nor the employee has lost their bargaining power. This back and forth
process will continue until employees demand to be paid higher salaries than
the anticipated inflation to maintain their standard of living when this
inflation finally arrives. If employees get a high salary in advance, they will
not experience surprise inflation, and no instance of suddenly inexpensive
labor would exist. Since there will be no hiring, joblessness will not reduce.
This reality implies that central banks can only keep unemployment below the
natural rate by outdoing themselves. Thus, Friedman concluded that it was wrong
for Keynesians to fix a low unemployment rate to a determined high inflation
rate. It was the condition for maintaining joblessness even a bit under the
natural rate. This condition allowed inflation to increase every year.
Yet, no society
can tolerate a rate of inflation that is infinitely increasing or dwindling. A
temporary trade-off between employment and unemployment exists, and none of
this trade-off is permanent. Central banks in developed countries understand
and still utilize this principle. Thus, the Phillips Curve refers to Friedman’s
temporary trade-off, and unemployment always end up being similar to the natural
rate. This idea is still influential today because it emerged at the right
time. Two years before 1968, unemployment was below four percent and inflation
under three percent. When Friedman delivered his address, prices were
increasing. Inflation reached 4.2 percent by the end of 1968 and hit 5.4
percent the following year, and unemployment did not change much (Barnichon
& Matthes, 2017). However, Friedman’s idea was shaky because inflation did
not fall as long as high unemployment. Oil-price shocks and bad supply-side
policies pushed the rate up. Theorists also began attacking Friedman’s concept,
claiming that its basis was the belief that inflation was “adaptive.”
Nonetheless,
economists now understand the natural unemployment rate as a hypothetical rate
of unemployment. Its main distinguishing characteristic is stable aggregate
production and inflation (Barnichon & Matthes, 2017). Economists use this
concept to determine the degree of labor market slack and assess the proper
monetary policies. One challenge regarding the natural unemployment rate is
estimating its value. As a result, various approaches are now available. For
example, some scholars use statistical methods to infer the natural
unemployment rate from the Phillips Curve directly. Others use the Phillips
Curve in the context of more elaborate macroeconomic models. All the available
approaches for approximating the rate have one thing in common: they hope to
separate the fundamental slow-moving unemployment fluctuation components
constant with unwavering growth and inflation. In all approaches, scholars use
some components of the Phillips Curve to make an approximation given this
tool’s ability to capture the relationship between aggregate supply and the
economy. Phillips Curve links business pricing decisions with the production
level. Its typical nature describes the fluctuation of inflation every time
unemployment moves away from its natural level. It generally associates higher
unemployment with lower inflation and vice versa.
Figure 2: Headline unemployment and
natural rate estimate
Changes in what
the public expects to be the future inflation rate can also affect Phillips
Curve. These expectations may influence prices for various future transactions
needing a benchmark value. Cost-push shocks are another typical factor
affecting its performance. When people expect that inflation or cost-push shocks
will increase in the future, the Phillips Curve moves upwards to suggest this
high inflation rate. This understanding is the basis of the new approach for
measuring the natural rate of unemployment used by (Barnichon & Matthes,
2017). They believe that if cost-push factors and inflation expectations are
constant, inflation fluctuations should correspond to changes in this gap. The
change will also convey critical information about the underlying natural rate
of unemployment’s value over time. (Barnichon & Matthes, 2017) estimate the
natural unemployment rate to forecast what is expected to be the unemployment
rate over the long term considering the current state of the economy. This
estimate can and often does vary over time, as shown in figure 2. The most
interesting aspect of the natural unemployment rate estimated by (Barnichon
& Matthes, 2017) is remarkably stable over time, ranging between 4.5 and
5.5 percent over the past century. This approximation is the elusive natural
unemployment rate.



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