The institutional underpinnings of the unemployment-inflation relationship: a review paper

Abstract

The Phillips curve depicted a trade-off between unemployment and inflation. As the economy grows faster and unemployment falls, it becomes easier for workers to gain wage rises and for firms to raise prices - either to pass on increased costs or even to raise profit margins. This is particularly so if bottlenecks occur because of insufficient capacity. If there is a shortage of a particular type of skilled labour, for example, then their wage rates are likely to be bid up as firms compete to attract and retain them. If demand outstrips supply for office or other space, rents will be bid up. And so on. The key to achieving sustainable, non-inflationary growth is to ensure that industrial and economic capacity expands in line with demand. This Phillips curve relation underpinned public policy during the 1960s and 1970s. This was replaced in the 1980s by monetarism and the associated 'natural rate of unemployment' which posited no trade-off between unemployment and inflation over the long run. Any such trade-off would be a short-term effect, whereby lowering unemployment below its natural rate would lead not just to higher inflation but to accelerating inflation. Weaknesses in the theory and problems with the practice led to the abandonment of what might be termed this Friedmanite - monetarist approach. It was replaced by the 'Non-Accelerating Inflation Rate of Unemployment' (NAIRU). Like the natural rate and unlike the original Philips curve, the NAIRU was taken to be vertical, allowing only one rate of unemployment at which inflation would be stable. But like the original Philips curve, and unlike the natural rate, the theoretical framework for NAIRU recognised that wage and price setting are influenced by market structure and bargaining power. The NAIRU approach thus puts more emphasis on how policy might shift the NAIRU, rather than accept it as 'given'. The move from the natural rate to the NAIRU recognised that the labour market is segmented and that active labour market policies can reduce unemployment without necessarily creating inflationary pressures, and that competition policy can put downward pressure on prices.