13.2 Types of Unemployment and the Phillips Curve
4 min read•july 31, 2024
Unemployment comes in different flavors: frictional, structural, and cyclical. Each type has unique causes and solutions. Understanding these distinctions helps policymakers craft effective strategies to combat joblessness and maintain economic stability.
The illustrates the relationship between unemployment and inflation. While there's a short-term tradeoff, long-term economic stability requires balancing both factors. This concept is crucial for understanding how governments manage economic growth and price stability.
Types of unemployment
Frictional, Structural, and Cyclical Unemployment
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- stems from workers searching for and finding new jobs
- Occurs due to voluntary job changes or labor market entry
- Example: A recent college graduate looking for their first job
- arises from skill mismatches between workers and available jobs
- Caused by technological changes or economic shifts
- Example: Coal miners losing jobs due to increased renewable energy adoption
- fluctuates with business cycles
- Increases during economic downturns, decreases during growth periods
- Example: Mass layoffs during the 2008 financial crisis
- Duration and policy implications vary among unemployment types
- Cyclical unemployment responds more to fiscal and monetary policies
- Frictional and structural unemployment require long-term solutions (job training programs)
Natural Rate Components and Labor Market Dynamics
- Frictional and structural unemployment compose the
- Cyclical unemployment represents deviations from the natural rate
- Labor market efficiency impacts frictional and structural unemployment levels
- Improved job search technologies can reduce frictional unemployment
- Enhanced vocational training programs can address structural unemployment
- Understanding unemployment distinctions guides effective policy strategies
- Example: Implementing re-training programs for displaced workers in declining industries
- Example: Enhancing unemployment benefits during economic recessions
Natural rate of unemployment
Calculation and Components
- Natural rate of unemployment sums frictional and structural unemployment
- Represents lowest sustainable long-term
- Calculation involves estimating frictional and structural unemployment levels
- Uses various economic indicators and labor market data
- Natural rate equation: Natural Rate = Frictional Unemployment + Structural Unemployment
- Factors influencing natural rate include
- Demographic changes (aging population)
- Labor market institutions (minimum wage laws)
- Technological advancements (automation)
- Economic structural shifts (transition from manufacturing to service economy)
Estimation Methods and Policy Applications
- (Non-Accelerating Inflation Rate of Unemployment) closely related to natural rate
- Used in macroeconomic policy formulation
- Time series analysis estimates natural rate changes over time
- Cross-sectional studies compare natural rates across different economies
- Natural rate serves as benchmark for assessing
- Labor market performance
- Effectiveness of employment policies
- Example: Policymakers may adjust fiscal policies if actual unemployment deviates significantly from the estimated natural rate
- Example: Comparing natural rates between countries to identify structural differences in labor markets
Inflation vs unemployment
Phillips Curve Fundamentals
- Phillips Curve illustrates inverse relationship between unemployment and inflation rates
- shows lower unemployment associated with higher inflation
- Due to wage and price pressures in tight labor markets
- Expectations-augmented Phillips Curve incorporates inflation expectations
- Shapes actual inflation-unemployment tradeoff
- Slope of Phillips Curve represents inflation responsiveness to unemployment changes
- Can vary across different economic conditions
- Example: A booming economy with low unemployment may experience wage inflation as businesses compete for workers
Phillips Curve Dynamics and Limitations
- Shifts in Phillips Curve occur due to
- Supply shocks (oil price spikes)
- Changes in productivity (technological innovations)
- Alterations in inflation expectations (central bank policy changes)
- Empirical evidence supporting or challenging Phillips Curve relationship
- Impacts monetary and decisions
- Phillips Curve limitations include
- Potential instability over time
- Variations across different economies
- Example: The stagflation of the 1970s challenged the simple Phillips Curve relationship, as high inflation and high unemployment coexisted
Phillips Curve implications
Short-run Policy Considerations
- Short-run Phillips Curve suggests tradeoff between inflation and unemployment
- Policymakers can exploit for short-term economic management
- Expansionary policies potentially reduce unemployment at cost of higher inflation
- Example: Lowering interest rates to stimulate economic growth and job creation
- Time inconsistency problem in
- Temptation to exploit short-run Phillips Curve can lead to higher long-run inflation expectations
- Concept of hysteresis challenges strict verticality of
- Suggests short-run policies can have long-term effects on natural rate
- Example: Extended periods of high unemployment may lead to skill erosion, increasing the natural rate
Long-run Economic Implications
- Long-run Phillips Curve represented as vertical line
- Indicates no long-term tradeoff between inflation and unemployment
- Aligns with concept of natural rate of unemployment
- Attempts to maintain unemployment below natural rate result in accelerating inflation
- Known as accelerationist hypothesis
- Understanding Phillips Curve framework limitations in policy formulation
- Potential instability and role of expectations in shaping economic outcomes
- Example: Central banks focusing on long-run price stability rather than short-term unemployment targets
- Example: Structural reforms aimed at reducing the natural rate of unemployment instead of relying on monetary policy
Key Terms to Review (21)
A.W. Phillips: A.W. Phillips was a New Zealand economist best known for developing the Phillips Curve, which illustrates the inverse relationship between the rate of unemployment and the rate of inflation in an economy. His work highlights how lower unemployment rates can lead to higher inflation, suggesting a trade-off between these two economic factors. This concept has been instrumental in shaping monetary policy and understanding economic dynamics over time.
Booms: Booms are periods of significant economic expansion characterized by rising levels of employment, increased consumer spending, and overall economic growth. During a boom, businesses often experience higher demand for goods and services, which can lead to inflationary pressures as the economy operates above its potential output. This phase is crucial for understanding the dynamics between economic growth, unemployment rates, and inflation.
Cyclical Unemployment: Cyclical unemployment is the type of unemployment that occurs due to economic downturns or recessions, where there is a decrease in demand for goods and services leading to a reduction in production and job losses. This form of unemployment is directly tied to the fluctuations in the business cycle, as it rises during economic slowdowns and falls during periods of economic expansion. Understanding cyclical unemployment is crucial in analyzing economic policies aimed at stabilizing employment levels and controlling inflation.
Economic Shocks: Economic shocks are unexpected events that significantly disrupt the economy, leading to sudden changes in economic activity, employment levels, and prices. These shocks can stem from various sources, such as natural disasters, financial crises, or significant policy changes, and often have immediate effects on inflation and unemployment rates, making them crucial for understanding economic fluctuations.
Fiscal Policy: Fiscal policy refers to the use of government spending and taxation to influence the economy. It aims to manage economic fluctuations, stabilize growth, and promote full employment by adjusting budgetary policies. Through fiscal policy, governments can impact aggregate demand, which affects overall economic activity and can play a crucial role in stabilizing the economy during business cycles.
Frictional unemployment: Frictional unemployment refers to the short-term unemployment that occurs when individuals are temporarily out of work while transitioning from one job to another. This type of unemployment is a natural part of the job search process, as workers voluntarily leave their jobs for various reasons, including seeking better opportunities or relocating. Frictional unemployment is typically viewed as a sign of a healthy economy, as it reflects the movement of labor within the job market.
Full Employment: Full employment is the economic condition where all available labor resources are being utilized in the most efficient way possible, meaning that virtually everyone who wants to work and is capable of doing so is employed. This concept does not imply zero unemployment, as there will always be some level of frictional and structural unemployment, but it indicates that the economy is operating at its potential output with minimal idle labor resources.
Job creation programs: Job creation programs are initiatives designed to stimulate employment opportunities and reduce unemployment rates by providing financial support, training, or incentives for businesses and individuals. These programs often target specific sectors or demographics, aiming to foster economic growth and reduce the impact of cyclical unemployment, frictional unemployment, and structural unemployment.
Labor Force Participation Rate: The labor force participation rate is the percentage of the working-age population that is either employed or actively seeking employment. This measure is crucial as it provides insight into the active engagement of individuals in the labor market, reflecting economic health and influencing types of unemployment and inflation rates related to the Phillips Curve.
Long-Run Phillips Curve: The long-run Phillips curve represents the relationship between inflation and unemployment in an economy over the long term, indicating that there is no trade-off between the two in the long run. It suggests that, in the long run, the economy will adjust to a natural rate of unemployment, which is consistent with a stable rate of inflation, regardless of short-term fluctuations.
Milton Friedman: Milton Friedman was an influential American economist known for his strong belief in free markets and minimal government intervention. His ideas have shaped modern economic policies and he is particularly recognized for his work on monetary theory, advocating for the control of the money supply to achieve economic stability and growth.
Monetary Policy: Monetary policy refers to the actions taken by a country's central bank to manage the money supply and interest rates in order to influence economic activity. It plays a critical role in stabilizing the economy, controlling inflation, and influencing employment levels, while also interacting with various economic indicators and cycles.
NAIRU: NAIRU stands for Non-Accelerating Inflation Rate of Unemployment, which refers to the specific level of unemployment that exists in an economy that does not cause inflation to increase. Essentially, it's the unemployment rate at which inflation remains stable, balancing the economy between too much and too little demand. Understanding NAIRU helps policymakers gauge how far the actual unemployment rate can deviate from this level without influencing inflation rates.
Natural Rate of Unemployment: The natural rate of unemployment is the level of unemployment that exists when the economy is at full employment, where job seekers can find work without creating inflationary pressures. This rate encompasses frictional and structural unemployment but excludes cyclical unemployment, representing a balance between the number of jobs available and the number of people looking for work. It plays a critical role in understanding economic stability, how different types of unemployment interact, and how economies adjust towards equilibrium.
Phillips Curve: The Phillips Curve represents the inverse relationship between inflation and unemployment in an economy, suggesting that lower unemployment rates are associated with higher inflation rates, and vice versa. This concept connects various economic indicators and policies, highlighting the trade-offs that policymakers face in achieving macroeconomic goals like stable prices and full employment.
Recession: A recession is an economic downturn characterized by a decline in economic activity across the economy lasting more than a few months, typically reflected in falling GDP, income, employment, manufacturing, and retail sales. It often leads to higher unemployment rates and can influence government policies aimed at stimulating growth.
Sacrifice ratio: The sacrifice ratio is a financial metric that reflects the portion of profit each partner in a partnership gives up when a new partner joins, thereby redistributing profits among existing partners. This concept is crucial for understanding how partnerships adjust their profit-sharing agreements when new members are added, and it directly influences the overall equity structure within the partnership.
Short-run Phillips curve: The short-run Phillips curve illustrates the inverse relationship between inflation and unemployment in the short term, suggesting that as inflation increases, unemployment tends to decrease, and vice versa. This concept highlights how policymakers can exploit this trade-off temporarily to stimulate the economy, although it may lead to rising inflation over time if pursued indefinitely.
Structural unemployment: Structural unemployment refers to a form of unemployment that occurs when there is a mismatch between the skills of the labor force and the requirements of available jobs. This type of unemployment often arises due to technological changes, shifts in consumer demand, or globalization, leading to certain industries declining while others grow. As a result, workers may find themselves without the necessary skills for emerging job opportunities, which connects to broader concepts like labor market dynamics and economic fluctuations.
Trade-off hypothesis: The trade-off hypothesis suggests that there is a fundamental relationship between inflation and unemployment, implying that higher inflation can lead to lower unemployment, and vice versa. This concept is often illustrated by the Phillips Curve, which indicates that policymakers may need to choose between stabilizing prices and achieving low unemployment rates, creating a delicate balance in economic management.
Unemployment rate: The unemployment rate is the percentage of the labor force that is unemployed and actively seeking employment. It serves as a key indicator of economic health, reflecting the overall economic performance and influencing various macroeconomic factors such as consumer spending, production levels, and government policy decisions.