The Concept of NAIRU and Labour Market Frictions

• Show evidence of understanding issues of definition and measurement when investigating unemployment.

• Demonstrate the ability to compare and contrast different theories of unemployment and critically analyse their attendant assumptions.

• Assess the relevance of these theories in understanding UK unemployment.

• Support the analysis with the appropriate time series data and other relevant statistics.

• Demonstrate reflective use of relevant literature and correct citation.

Non-accelerating inflation rate of unemployment (NAIRU) is the level of unemployment below which the rate of inflation rate rises. Milton Friedman proposed the concept of natural rate of unemployment. In order to prevent the increase in the inflation rate above a given target level, the monetary policy is generally implemented by the government under the assumption of NAIRU so that the minimum unemployment in the economy is allowed. The natural rate hypothesis was presented by Friedman deals with the structure of the labour market. The idea behind the hypothesis is that in labour market it is natural to have some amount of frictional unemployment and the classical unemployment. The frictional unemployment is the situation in which the workers are changing jobs and for a minimum period of time they are considered to be unemployed (Smith, 2011). The classical unemployment arises when the real wages are fixed above the market clearing level of minimum wage laws, trade unions or due to other issue with the different labour institutions. The natural rate hypothesis faced a lot of controversies regarding the fact that the natural rate of unemployment varies in many ways that can eventually cause repercussion in the labour market. The theory of the NAIRU states if the natural rate of unemployment is less than the actual rate of unemployment then the inflationary pressure will rise and vice versa.

The labour market of the UK has been distorted for the past few months.  It has been evident from the statistics that the Britain will not be able to achieve the full employment level and there will be huge creation of jobs. The population is increasing and so there is a rise in the number of workers and thereby the unemployment level will fall. Most of the economists are skeptical about this view. It had been a talked about topic about the agreement on the issue that the full employment concept is slimy in the 21^st Century. Financial Times conducted a survey where 58% of the economists were of the view that the full employment level would not be attained n 2015 but they were quite optimistic about the creation of jobs in spite of the figure that states that the unemployment rate is just 0.2 percentage points from the estimated value in the 2005 which was about 73.2 per cent (Stam and Long, 2010).

Controversies Surrounding the Natural Rate Hypothesis and the Theory of NAIRU

In this scenario a specialized labour market consultant, John Philpott expected that there will be a decline of the unemployment rate from 6 per cent to 5.2 per cent. There would be taciturn wage pressures that would decrease the joblessness rate to fall below the 5 per cent before the government is risked at the 2 per cent inflation target. Here comes the theory of NAIRU but it is still unclear. There are several instances like the flexibility in the labour market, the cumulative impact of the welfare reforms, inadequacies in pension and the financial pressures which caused contraction n the wage along with the high debt of the households have boosted the supply of labour but if these trends continue then there is a chance that the Bank might need to revise the assessment of NAIRU to be low (Batini, 2005).

A section of the economists were of the view that the underemployment will be eliminated before there is pressure on the wages. The rest of the respondents which is about 42% of the economists had clearly opinionated in the survey that the signs of increasing wages will pave the path of attaining the level of full employment and would hit the milestone in the year 2015 in the UK. It has been debated several times on the definition of full employment but in vain. George Osborne had undertaken the objective to define the concept of full employment as the economic aim. The unemployment rate was estimated to be at 7.4 per cent in October 2013 and in October 2014 the rate was 6 per cent. If this slow rate of decline of the unemployment rate grows there are chances that the unemployment rate might reach the level of 5 per cent in the end of the year 2015. In the year 2005 the unemployment rate fell to 4.75 per cent which was below the NAIRU which was about 5per cent. This would enable the economy to reach the level of full employment by the next year. But there remains some gap between the theory and practice where the unemployment rate might be below 5 per cent but about 1.65 million people will still remain unemployed (BBC News, 2015).

Recent data reveals that the current rate of unemployment in the UK fell to the lowest level since 2008 which is about 5.6 per cent. According to the labour market figures the earnings growth has slowed down. About more than 31 million of the people in the UK are still unemployed. The labour market recovery in the UK can be attributed to the part-time jobs and self employment but the data of the Office for National Statistics showed that there will be substantial jobs creation of full time type and this will improve the job security issues in the UK. For the usual estimation the unemployment rate is around and about the NAIRU of the British economy. The question here arises on the degree of low level of unemployment without the taking off of the inflation rate. One of the characteristic of inflation is driving up the real wages of the workers. When on one side the real wages are welcomed by the workers but the inflation rate is generally avoided by them. So it can be the case that the unemployment rate could be around and about the NAIRU but not fall below it so that the real wage rises but the inflation rate must not change.

Debates on Full Employment and Analysis of UK Labour Market Since 2008

The economists are of the view that the NAIRU cannot be directly observed but it can be estimated for the past. The determination of the NAIRU depends on the labour market, the flexible the market is, the lower is the NAIRU rate. Most of the economists are of the view that since the labour market is flexible, the NAIRU will be fall.

The unemployment rate in the UK over the years is depicted in the chart below:

(Tradingeconomics.com, 2015)

The unemployment rate in the UK remained low and unchanged at 5.5 per cent for the three months in 2015 till April which is in accordance with the market expectation. Since the global financial crisis the employment rate has been rising and so as seen from the chart the unemployment rate has decreased over the years and also the wages posted high gains. There were around 31.05 million people who were working. As the employment rose, so did the wage including the bonuses increase 2.7 per cent (Melliss and Webb, 1997). The unemployment rate has declined which can be evident from the decline in the number of individuals who were claiming unemployment benefits. In the current policy debate of the UK, there still remains the unemployment gap in the UK labour market. this gap is defined as the difference between the actual unemployment rate and the structural unemployment in other words NAIRU. This difference was sometimes referred to as cyclical unemployment. The next chart describes the actual unemployment, the NAIRU, and the difference.

(Tradingeconomics.com, 2015)

The importance of the unemployment estimates the measure of the stability of the economy with the inflation rate which is neither increasing nor decreasing. It can be said that if the economy is at stable inflation condition at a target of 2% then the unemployment rate can reach the NAIRU (Inman, 2015).  On the other hand, NAIRU measures the unemployment level derived from the supply side like the workers’ skills, the labour market mechanism, competition in the market etc. and all other things which change in a relatively slow rate. The unemployment gap can be narrowed only when the government will implement macroeconomic policy. The fall in the unemployment rate has raised the wage rate which means that the economy of UK which is consumer led will eventually recover.  The value of pound increased against the dollar. Economic analysts are of the view that the rise in the wages would cause the interest rate to increase. This would be implemented by the Bank of England. The governor of Bank of England, Mark Carney declined the growth in the UK and ordered to keep the productivity this is because the main impetus to the high wages is productivity (Knoema, 2015).

The Importance of Time Series Data in Assessing UK Unemployment

Another theory of the unemployment is depicted by the concept of Phillips Curve. It was presented by William Phillips by analyzing the economic conditions in the UK between the 1861-1957 (Rusticelli, 2015).  He stated the results of his analysis in the form of a relationship between the high inflation rate and low unemployment. In the 1960s, when the inflation rate doubled, the unemployment fell to record low levels. The unemployment rate is as low as 5.6% and there is a provision for the rate to reach the NAIRU (Hughes et al., 2015). The prolonged and dragged unemployment rate which is low would create a wage-price spiral. This can be explained in the following way (Yglesias, 2014). As there are scarce workers, the companies would demand more of the workers and create a situation of excess demand for labours. This situation of excess demand for labours would drive the price of the labours which is the wage to rise. Thus, the companies who are planning to start business would imply that they have to pay more in order to recruit more. The higher pay indicates that there will be an overall rise in the price of the goods and services. The wage spiral starts now when the rise in the prices enables the workers to demand for higher wages again and then the companies again give in the higher wages to attract more workers as they are scarce. Then comes a situation which causes the inflation to go out of control. Thus, the labours are higher more and more at higher wages which causes the unemployment rate to fall and thereby it can be detected that the inflation rate has risen substantially (Claar, 2006). This is explains the concept of Phillips curve.

The wage-price spiral is not desirable within the economy but there are certain reasons behind the occurrence of the spiral within the economy. The first reason is the fluctuations in the NAIRU due to demographic factors, technological advancements and greater openness to trade. Another problem is in the interpretation of NAIRU in which the predictions of the rate is incorrect. The inflation rate in the UK is quite Low:

(Tradingeconomics.com, 2015)

Thus, the basic Phillips theory is not appropriate in the recent findings of the UK economy. With low inflation rate, the unemployment rate must be higher but there is a trade off in the theory. Also attaining NAIRU is difficult as the inflation rate is low and somewhat stabilized in the UK. The unemployment rate can reach the NAIRU when there is scarce worker and excess demand for labours which has the potentiality to increase the wage (Shaw, 2011). With the rise in the wages of the labours, the cost of the companies will be increased and this will eventually raise the price of the goods and services to cover up the increased cost. Thus, inflation rate will rise but this is not the case of the UK, the inflation rate is quite low in spite of the low level of unemployment rate. Thus, with low inflation rate, the wages will not increase tremendously and thus, the workers will be higher more at low wage. This implies that if the inflation rate is low then the unemployment rate will be high according to the theory of Phillips curve but in this case the unemployment rate in the UK is 5.6 per cent which is near to 5 per cent of NAIRU and the theory is not in compliance with the current situation of the UK economy (Worstall, 2015). Thus, it can be said that either the theory of NAIRU is irrelevant in the UK economy or in the long run there is a chance of increasing unemployment rate so that the economy would not reach the NAIRU (Cross and Lang, 2011).

References

Batini, N. (2005). Measuring the UK short-run NAIRU. Oxford Economic Papers, 58(1), pp.28-49.

BBC News, (2015). UK unemployment falls to seven-year low – BBC News. [online] Available at: https://www.bbc.com/news/business-32719779 [Accessed 30 Jun. 2015].

Claar, V. (2006). Is the NAIRU more useful in forecasting inflation than the natural rate of unemployment?. Applied Economics, 38(18), pp.2179-2189.

Cross, R. and Lang, D. (2011). The NAIRU: Still ›Not An Interesting Rate of Unemployment‹. EJEEP, 8(2), pp.317-340.

Hughes, A., McMunn, A., Bartley, M. and Kumari, M. (2015). Elevated inflammatory biomarkers during unemployment: modification by age and country in the UK. Journal of Epidemiology & Community Health, 69(7), pp.673-679.

Inman, P. (2015). UK unemployment falls to 5.5% as wage growth rises above 2%. [online] the Guardian. Available at: https://www.theguardian.com/business/2015/may/13/uk-unemployment-falls-as-wage-growth-rises [Accessed 30 Jun. 2015].

Knoema, (2015). OECD Economic Outlook No 95 – May 2014 – knoema.com. [online] Available at: https://knoema.com/OECDEO95/oecd-economic-outlook-no-95-may-2014?tsId=1025180 [Accessed 30 Jun. 2015].

Melliss, C. and Webb, A. (1997). The United Kingdom NAIRU. OECD Economics Department Working Papers.

Rusticelli, E. (2015). Rescuing the Phillips curve. OECD Journal: Economic Studies, 2014(1), pp.109-127.

Shaw, J. (2011). Business Population Estimates for the UK and Regions †Introducing improved statistics on the UK enterprise population. Economic & Labour Market Review, 5(4), pp.47-67.

Smith, J. (2011). The Ins and Outs of UK Unemployment*. The Economic Journal, 121(552), pp.402-444.

Stam, P. and Long, K. (2010). Explaining exits from unemployment in the UK, 2006–09. Economic & Labour Market Review, 4(9), pp.37-49.

Tradingeconomics.com, (2015). United Kingdom Inflation Rate | 1989-2015 | Data | Chart | Calendar. [online] Available at: https://www.tradingeconomics.com/united-kingdom/inflation-cpi [Accessed 30 Jun. 2015].

Tradingeconomics.com, (2015). United Kingdom Unemployment Rate | 1971-2015 | Data | Chart | Calendar. [online] Available at: https://www.tradingeconomics.com/united-kingdom/unemployment-rate [Accessed 30 Jun. 2015].

Worstall, T. (2015). The UK’s Unemployment Rate, At 5.6%, Is Lower Than America’s At 5.5%. [online] Forbes. Available at: https://www.forbes.com/sites/timworstall/2015/04/18/the-uks-unemployment-rate-at-5-6-is-lower-than-americas-at-5-5/ [Accessed 30 Jun. 2015].

Yglesias, M. (2014). The NAIRU, explained: why economists don’t want unemployment to drop too low. [online] Vox. Available at: https://www.vox.com/2014/11/14/7027823/nairu-natural-rate-unemployment [Accessed 30 Jun. 2015].