Cause and Effect of the Unemployment Rate - Term Paper Example

The paper will also try to identify other causes for such extraordinary situation not seen ever before. Understanding Phillips Curve Below is a typical Phillips Curve drawn for the period between 1961 to 1969 as unemployment rate versus inflation rate. Source: http://www.econlib.org/library/Enc/PhillipsCurve.html The curve shows inverse relationship between the unemployment rate and inflation. During the years 1961-67, as unemployment rate rises from 4 percent to 6 percent, inflation rate reduces from 3 to 1 percent.

A way back in those years, Philips curve was used as a guide for policy makers. To reduce the unemployment rate from 6 percent to 5 percent, the government would think of stimulating the economy by spending more but later on Phelps and Friedman put forward their views that in order to achieve lower unemployment rate government cannot trade with higher inflation rate. If unemployment is at the natural rate and the real wage also remains constant and the government uses monetary and fiscal policy tools to lower unemployment rate below its natural rate, then the resultant increase in demand will encourage firms to raise their prices quickly and would like to pay more.

Due to this, labor supply will increase and unemployment rate goes down. This is an illusion for labor as price will rise more rapidly than they would anticipate. The moment they feel the pinch of inflation, labor supply gets reduced at the old wage rates or they will demand increase in wages. In this process, real wage gets back to its previous level and the unemployment rate comes back to the natural rate. The price inflation continues at the higher rates due to expansionary fiscal policies.

(Hoover 2008) Friedman’s and Phelps’s analyses explained first time that Phillips curves behave differently in the long run. The average inflation rate in 1960s was about 2.5 percent which rose to 7 percent in the 1970s; however during the same period the unemployment rate did not fall but increased from about 4 percent to about 6 percent. This implied that at some rate of unemployment there would always be a stable rate of inflation. This came to be known as NAIRU (nonaccelerating inflation rate of unemployment).

NAIRU is presented here below for the period between 1945 and 2000. (Hoover 2008) Source: http://www.econlib.org/library/Enc/PhillipsCurve.html NAIRU does not suggest that unemployment rate is constant unlike natural rate of unemployment. Milton Friedman developed the Expectations-Augmented Phillips Curve that explained the breakdown of the Phillips Curve. The Expectations-Augmented Phillips Curve for the period from 1976 up to 2002 for the changes in the rate of inflation versus unemployment rate is plotted as per the following.

(Hoover 2008) http://www.econlib.org/library/Enc/PhillipsCurve.html The chart shows NAIRU at about 6 percent. Assuming a situation when economy is at NAIRU, rate of inflation at 3 percent, and the government wants to reduce it to zero. The chart suggests that monetary and fiscal policy which drives unemployment rate from 6 to 7 percent brings down the inflation rate by 1 percentage point. If fiscal management causes unemployment rate to remain at 7 percent; it will take almost three years for inflation to reach to zero.

The expectations-augmented Phillips Curve is considered a most basic macroeconomic forecasting tool used by most of the central banks while modulating fiscal policies. Most diverse schools of macroeconomic thought accept the applicability of this model. It is