Explain what is meant by the natural rate of unemployment and assess the extent this concept has played in the implementation of macroeconomic policies over recent decades.
The natural rate of unemployment, or non-accelerating inflation rate of unemployment (NAIRU) as it is also called is a concept that states there is a level of unemployment to which unemployment will tend towards in the long run, and where unemployment is greater than this level inflation will begin to accelerate. And this concept can be explained through the use of The Phillips Curve.
The Phillips Curve
The Phillips Curve is an empirical theory developed by Professor AW Philips in the 1950s that shows an inverse relationship between changes in money wage rates and the level of unemployment.
The exact formula he found was – Percentage Change in Wages=-0.900+9.638U-1.394. And as wage rates can be assumed to be closely linked with prices, this has been taken by many economists to suggest a trade off between inflation and unemployment.
As can be seen in figure 1 below as unemployment falls inflation begins to ‘accelerate,' to rise at an increasing rate. This can be explained as when unemployment falls, the threat of becoming unemployed falls and shortages in skilled labour develop meaning workers can seek greater wage increases.
Figure 1 : The Short Run Phillips Curve
AW Phillip's theory was backed up by 96 years of data, but soon after publishing his theory in the journal "Economica" in 1958, the data seemed to disprove it, and it appeared that there was in fact no fixed relationship between inflation and unemployment as Phillips had believed.
The Phillips Curve and Inflationary Expectations
However, it was then observed that the data in fact showed several distinct curves, and that events in the economy had lead to rises and falls in inflationary expectations shown by shifts in the Phillips Curve which can be seen in the diagram below
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