Level Of The Natural Rate Of Unemployment example essay topic

"That 5.5 to 6 percent consensus is easily explained: it's where the actual unemployment rate is. And that is usually been true: the estimated NAIRU tracks actual unemployment. When unemployment goes up, conservative economists raise their NAIRU. When it falls, they predict inflation, and if inflation doesn't happen they cut their estimated NAIRU. There is a long and not-very-reputable literature of such estimates -- you can look it up. In fact, this little corner of the professional record is embarrassing".

Apparently one would not doubt that the concept of unemployment also bears political well: conservatives like a high NAIRU, liberals, a low one. Furthermore, when the unemployment rate is high, wages tend to fall, in accordance with the laws of supply and demand on the labor market. Exploiting labor, as they say, is profitable business. The current Fed chairman, Alan Greenspan, is a died-in-the-wool conservative and a self-described "inflation hawk", meaning that he is committed to a high NAIRU. Conversely, liberals prefer a low NAIRU because it raises workers' wages. In order to make this conclusion work, several assumptions must be made.

The most prominent is that information is generally known. If the government conducts an acceleration ist monetary policy in complete secrecy, agents might not know it was systematic and supply more labor. However, as the New Classicals argued, secrecy is never really complete and the workers will soon enough wise up to the fact that the acceleration is systematic. In other words, by perceiving the inflation patterns, etc., they will gradually realize that the government is conducting a systematic acceleration policy, in which case they will incorporate this information and change their expectations accordingly -- and thus foil the government's policy again. The other necessary assumption is no systematic error. Why should not agents be stupid and irrational and just assume that this year's freakish drought implies a drought next year?

The New Classicals admit, indeed, that people can be quite stupid: any particular agent can easily make strange extrapolations and systematic errors. However, they argue that it cannot be that all people make the same systematic error. As we are working with "aggregates", each worker may be make systematic errors and have idiosyncratic errors, but by an intuitive appeal to the law of large numbers, these idiosyncratic errors are washed out in the aggregate. In other words, one agent's peculiar stupidity cancels out another agent's stupidity so that, on average, the "representative agent", the "aggregate", is in fact quite smart - by which we mean, that, on average, workers does not make systematic errors. In conclusion it should be said that when Milton Friedman discovered the natural rate of unemployment, the prestige of the Chicago School of Economics rose and it turned into a leading advocate of unfettered capitalism. But in the end he did not accomplish what he had set out to do: replace Keynesianism.

The proposed theory was not complicated: during the time when unemployment fell below some level (called the natural rate of unemployment), inflation would start to rise. This theory, called the Phillips Curve, has filled economic textbooks for more than 25 years. Unemployment, however, has fallen since the 1990's with no sign as yet of an increase in inflation. When unemployment first started to fall, with no pickup in inflation some economists talked of a shift in the natural rate of unemployment. As this trend has continued, some are questioning whether the world needs another theory regarding the unemployment.

Traditionally, the inverse correlation between unemployment and inflation seemed to be a useful tool for economists. For example, when the unemployment rate fell to 5.3 percent in 1989, economists predicted that inflation would increase. Inflation, which had averaged 2.4 percent between 1984-87, did jump to 4.1 percent in 1990. Tighter monetary policy, oil price shocks and the Gulf War raised unemployment to 7.6 percent in June 1992 and, in accordance with the theory, inflation fell. The Phillips Curve theory was not sufficiently precise to enable economists to accurately forecast the response in either unemployment or inflation. Part of the imprecision involved uncertainty about the level of the natural rate of unemployment.

Commenting on the historical unemployment rates, I would like to note that when during the 1990-92 recession proceeded, unemployment started to fall - to 6.1 percent in 1994 and to 4.2 percent by 1999 and so did inflation. While economists held different opinions as to the level of the natural rate of unemployment, virtually no one believed it was 4.2 percent. No one knew what was happening to the great trade offs. Some economists felt special circumstances, i. e., a decline in health care costs, the widespread use of computers; etc. had temporarily suspended the unemployment / inflation trade off.

Others felt that the natural rate had in fact declined due to productivity growth and a better matching of jobs and vacancies. Even today various economists believe that the relationship between unemployment and inflation is far more complex than first believed. Evidence suggests that the trade off has not worked well outside the United States and even in the United States the relationship was neither very strong nor predictable. It is clear that the economics profession needs to develop a more sophisticated theory to explain inflation.

"A lasting favorable effect on employment might be produced if the State undertook - and succeeded in its undertaking - not merely to make the real demand for labour higher than it would otherwise have been, but to make it progressively higher. The expenditure on public works, the rate of bounty paid to private enterprises, the rates of duties in the protective tariff, or whatever it may be, would have to be raised again and again. If these devices succeeded in expanding progressively the real demand for labor, the time lag that intervenes between the stimulus to and the enforcement of claims to higher wages would enable them to make employment permanently larger than it would otherwise have been". (Arthur Cecil Pigou, Theory of Unemployment, 1933: p. 250-1). Yet in my personal opinion, both Milton and Keynes theories, together with the findings of Phillips should be deployed to work in tandem to the benefit of a given country, while attempting to kill two birds with one stone: tame the inflation and reduce the unemployment, to the rate close to NAIRU. The developing countries indeed present a wonderful research field for the fact that their governments constantly are striving to influence their economies with the tools originally developed by Milton and Keynes.