Reliability in Measuring the Natural Rate of Unemployment

A paper which covers the meaning and importance of the Natural Rate of Unemployment.
2002, 1770 words, 5 source(s).

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RELIABILITY IN MESURING THE NATURAL RATE OF UNEMPLOYMENT In Friedman's, 1968 Presidential Address to the American Economic Association, he described the Natural Rate of Unemployment as "the level which would be ground out by Walrasian system of general equilibrium equations, provided that there is imbedded in them the actual structural characteristics of the labour and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labour availabilities, the cost of mobility, and so on"1. Throughout this paper, the reader will be able to clearly understand the distinct meaning and importance of the Natural Rate of Unemployment, whether it can be measured reliably, the ways it could guide macroeconomic policy, and finally whether or not the Australian Government should target it. There are certain factors that interfere with the measurement of the Natural Rate of Unemployment or NAIRU, (Non-Accelerating Inflation Rate of Unemployment). Taken in consideration this assumption, it can be assumable that when unemployment rate is below the NAIRU, usually the inflation rate tends to rise. When it is above the NAIRU, the inflation rate would then tend to fall. The NAIRU is a useful method that helps to understand the causes of inflation and is also a basis to predict changes during a certain period in the inflation rate. These changes in the inflation rate are mainly due to a labour market phenomenon. In an experiment carried out by the CEA, they found that twenty percent of variation found in the inflation rate could be explained by unemployment alone (Stiglitz 1997:5). It could then be concluded that there is only a minimal relation between inflation and the unemployment rate (Galbraith 1997:97). Unemployment is a good predictor of the direction in which inflation will move. There are however, many other reasons that may interfere in the process affecting the increase or decrease of the inflation rate in an economy. Some of these reasons that might interfere with the NAIRU changing are: demographics of the labour force, productivity growth (more update with workers expectations), and the general increase in competitiveness of the labor and product markets. One of the most important examples of these type of changes in the demographics of the labour force is the baby boomers; a labour force that has had a traditionally lower unemployment rate and which is now moving out of the labour force. In the second case, the NAIRU is linked with productivity growth, which is also known as the "wage - aspiration effect" (Stiglitz 1997:7). These changes in productivity growth may have temporary effects on the natural rate of unemployment, and thus workers might increase their demand for increased real wages. In addition, less productivity growth can cause a rise in the inflation rate and a rise in the unemployment rate. The NAIRU is a tool used to indicate how the economy behaves out of equilibrium. Therefore, when unemployment is below the NAIRU, real wages demands are greater than the amount firms are willing to pay. Thus, workers do not get the real wages they expect and firms do not get the real prices they expect. Hence, a higher level of unemployment is an indication that there is an excess supply of labor that will produce downward pressure on real wage rates2. Friedman's formulation claims that persistent unemployment below the natural rate results in the labour market rising real wages, whose nominal element is at least part of the cause of rising prices (Galbraith 1997:95). Taking into consideration that the natural rate of unemployment could be measured reliably, meaningful advantages for macroeconomic policies could then surge. Some of these include: a wider control of the monetary policy, the budget policy, the fiscal policy, and the anti-inflation policy. The idea behind the macroeconomic policy is to be able to pinpoint the problems and possible solutions for that determined problem, as well the set of goals and their employment. Being able to properly create a reliable measure of the natural rate of unemployment would give economist a more concise idea of what the major problems facing an economy are. The concept of natural rate of unemployment or non-accelerating inflation of unemployment, has ruled over three decades and still it is not clear. It is a process that implies too much effort and cost to do it. Friedman first presented the concept of natural rate of unemployment in 1968. Before his address, the best solution to give concise testimony of the relationship between the unemployment rate and the inflation rate was the Phillips curve. Labor supply and demand cannot be assigned in terms of real wage. Workers cannot negotiate for their own real wages thus, this creates an irregularity between nominal wage cuts and nominal price increases. If there is no aggregative labor market in any sense meaningful to economics, the theories based on shifts in wages clearing labor markets will fail to hold (Galbraith 1997:102). Since Friedman's statement, macroeconomic policies have been against supporting full employment. "However, when a higher NAIRU accompanies a higher unemployment, it cuts against the case for a policy expansion, given that a higher proportion of the existing unemployment is necessary to preserve stable inflation" (Galbraith 1997:102). At the same time when unemployment is falling, it cuts against the case for a policy expansion, since a lower proportion of falling unemployment is necessary to preserve stable inflation. Therefore, policymakers come to a point where the situation is no longer clear: whether to increase the unemployment rate or increase the inflation rate. This might occur at a moment when policymakers decide to increase the unemployment rate and the inflation rate fall or vice versa. Yet, it is given that if there are a mistake in policy making it will be to late, and that the cost of potential gains from having the estimates wrong will affect the entire economy. On the other hand, it can be gathered that economist have always been trying to solve the central macroeconomics problem of unemployment and have left aside the existence of inequality, a fact that undermines the middle-class character of society, and separates the well suited from the poor. The relation between unemployment and inequality is a strong reason for devoting intellectual and material resources to the pursuit of full employment. "It also makes it reasonable to ask that advocates of speed limit theorems and natural rate hypotheses prove their cases convincingly and in a unified way, something that in three decades they have not notice" (Galbraith 1997:104). Whether or not Australia should attempt to target its natural rate of unemployment is highly debatable. Unemployment in Australia over the last 15 years has proven to be steadily high. The government has been faced with fluctuating unemployment rates that have been primarily the result of the restrictive macroeconomic policies, which have dominated economic policy-making. Australia currently tends to refer mostly to the NRU that differs from the NAIRU. The latter avoids the perception or idea that unemployment is inevitable but makes the difficulty clear of considering full employment and low inflation. Besides from what has been mentioned above, there are two other main causes of unemployment in Australia that have been broadly divided into two major components: Frictional and Structural Unemployment, where as structural are those considered with lack of skills, and frictional unemployment is refer to job skills. Some other reasons to explain the unemployment rate in Australia are: The inappropriateness of the level of real wages, the lack of aggregate demand for goods and services, and the existence of a natural rate of unemployment (Lombard 1998:65). Measuring the unemployment rate can be a very difficult task if not almost impossible, nearly all national governments have some statistical agency or department in charge of gathering the necessary data and estimating the unemployment rate for the guidance of policymakers. The OECD can be an example of this type of organization. However, people may falsely claim they would accept a job offer at current wage rates when in fact they are making no effort to locate such job, continuing to receive unemployment benefits. Other people may be actively seeking a job and yet not show up in such a count because they are ineligible for unemployment benefits. On the other hand there are people who have illegal activities such as prostitution, drug dealing, illegal gambling, to avoid taxes and deny having a job. Due to all these reasons, it can be seen that it is almost impossible to have a reliable source when measuring the unemployment rate. However, the Australian Government should consider trying to "target" the estimated rate of unemployment in order to have more control over the facts that can affect the economy. It should be taken as a point of reference to be able to compare with other more reliable sources that could give a more accurate measurement of the natural unemployment rate. In conclusion, the reliability of natural rate of unemployment has caused many a headache. However, could this rate be measured accurately, the benefits on macroeconomic policy would be of great dimensions. Monetary, budget, fiscal, and anti-inflation policies would all find the reliability of this measure to be of immense advantages. Australia could attempt to target this NRU but only for reference purposes as use in any other context could create much unexpected cost and loss of time. Unfortunately for all, this theory remains unproven to its entirety and the natural rate of unemployment remains unreliable due to various reasons that have to be taken into consideration when assessing the whole of the economy. SYNOPSYS Throughout this paper I will discuss the following questions in extent, providing the reader with information that would enable them to understand the topics in discussion. 1. If natural rate of unemployment could be measured reliably, how would this measure be used to guide macroeconomic policy? 2. Can it be measured reliably? 3. Should the Australian Government try to 'target' the estimate rate? BIBLIOGRAPHY * Stiglitz, Joseph (1997) 'Reflections on the Natural Rate Hypothesis'. Journal of Economic Perspectives, Vol. 11, No. 1. * Galbraith, James K. (1997) 'Time to Ditch the NAIRU'. Journal of Economic Perspectives, Vol. 11, No. 1. * Groeneweld, N. and A. J. Hagger (1998). 'Natural Rate Estimates as a Policy Toll in Australia'. Economic Papers, Vol. 17, No. 3. * Lombard, Marc (1998). 'Unemployment in Australia: the effects of Macroeconomic Policies'. Journal of Australian Political Economy, No. 41. * Jackson J., McIver R., Mc Connel C., Brue S. (1998). Macro Economics 5th Edition. Roseville. McGraw-Hill. 1 N. Groenewold and A. J. Hagger, Friedman 1968, page 72. 2 James K. Galbraith, Friedman 1968, page 95.