UNIT 13 TRADITIONAL THEORIES

[ Structure
13.0 Objectives
13.1 Introduction
13.2 Types of Unemployment
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13.3 Classical View on Unemployment
I 13.4 Keynesian view on Unemployment
13.5 Phillips Curve
13.6 Costs of Unemployment and Inflation
I 13.7 Non-Accelerating Inflation Rate of Unemployment (NAIRU)
I 13.8 Let Us Sum Up
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13.9 Key Words
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13.10 Some Useful Books
t 13.11 Answers1 Hints to Check Your Progress Exercises
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13.0 OBJECTIVES
After going through this unit you should be able to:
identify different types of unemployment;
1 explain the classical and Keynesian views on unemployment;
b

I establish a relationship between unemployment and inflation; and

identify the costs of unemployment and inflation.

13.1 INTRODUCTION
Labour is demanded by firms as it contributes to production of goods and
services. In return of its contribution, labour is rewarded with wages. In the
market for labour the wage rate is determined at a level where supply of and
demand for labour are equal. While human beings supply more labour at higher
wage rate, firms demand lower quantity of labour when wage rate is high. Thus
supply of labour has a positive relationship with wage rate (implying upward
sloping supply curve) while demand for labour has a negative relationship with
wage rate (implying downward sloping demand curve).
A fact that has perturbed everyone, no less economists, is that total labour force
is not fully employed at the prevailing wage rate. Certain percentage, which
fluctuates over time, of the labour force remains unemployed at.any point of
time. The nature of and the reasons behind unemployment in the economy have
been put to much debate in economics. Economists have come up with varied
explanations of unemployment, which we will consider in this unit.

13.2 TYPES OF UNEMPLOYMENT

A person can be either in the labour force or not in the labour force of an
economy. The person not included in the labour force includes those who are
retired, too ill to work, keeping the house, or simply not looking for work. On
the other hand, persons counted under the category labour force includes those
who are employed or unemployed. By employed persons we mean those who
perform any paid work (thus housewives are not included) and those who have
jobs. On the other hand, the unemployed as a category includes people who are
Unemployment
not employed but are actively looking for work. Thus while considering
unemployment we do not take into account those who are not in the labour
force.
There are three kinds of unemployment, viz., frictional, structural and cyclical.
Fictional unemployment takes place because people switch over from one job to
another. In many cases the tenure of job gets over and workers remain
unemployed till they get another job. In other cases workers migrate from one
region to another in search of better jobs or opt to remain out of job for short
time periods. Frictional unemployment takes place because in an economy with
imperfect information job search and matching is not smooth and there are
frictions in the economy. Structural unemployment, on the other hand, results
from the mismatch between supply and demand for different kinds of jobs. For
example, in India in early 1990s, when the information technology sector
witnessed a surge in growth, there was a scarcity of computer professionals. In
recent years, in response to policy changes, a number of private airlines have
come up in India and there is an acute shortage of pilots. Structural
unemployment takes place largely due to structural shifts in an economy and
adjustments ,to such shifts take time. Cyclical unemployment arises due to
fluctuations in aggregate demand. When aggregate demand declines, there is
simultaneous decline in the demand for labour and consequent increase in
unemployment. On the other hand, a general boom in the economy increases
demand for labour and unemployment decreases. Thus overall employment is
pro-cyclical in nature.
Empirical data shows that the labour force in an economy is much less than the
total population in the working age group. In the US, for example, for which
data are readily.available, labour force constitutes about two-third of the adult
population. The percentage of population in the labour force, however, varies
across countries and depends upon the level of development and social
traditions. The rate of unemployment u is defined as the ratio of unemployed
persons to total labour force. The rate of unemployment varies across countries
and for a country, over time.

13.3 CLASSICAL VIEW ON UNEMPLOYMENT

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The classical economists. as we observed in Unit 1 of this course, were of the

view that full employment prevailed in the economy all the time. This was
consistent with the view that whatever amount of labour was supplied got
demanded by firms. A basic assumption in the classical framework was the
flexibility in wage rate and prices. Thus the gap between supply of and demand
for labour got wiped out through adjustments in wage rate.

L I w
0 L* labour
Fig. 13.1: Equilibrium Level of Employment
In Fig. 13.1 we measure real wage rate (w) on y-axis and quantity of labour (L)
on x-axis. The equilibrium wage rate reached through interaction of supply of
6
 -

labour (L,) and demand for labour (Ld) is W* and quantity of labour employed is 'raditional Theorks
L*, which represents full employment.
As we learnt in Unit 1, the aggregate supply curve according to classical
economists is a vertical straight line at the full employment output level. At the
equilibrium wage rate everyone seeking employment gets engaged. If the wage
rate is above w (see Fig. 13.1) there is excess supply of labour compared to its
demand. In their efforts to get employed some of the currently unemployed
workers will be willing to work at a wage lower than the prevailing one and in
the process will bring down the wage rate till it reaches w*. On the other hand,
when wage rate is below w* there will be excess demand compared to supply.
Due to shortage of labour firms will compete with each other and will be willing
to pay higher wage, as a result of which wage rate will increase. Remember that
classical economists were concerned with real wage in the economy, which is
W
defined as the ratio of nominal wage (W)to price level (P) such that w = -.
P
Thus flexibility in real wage assured that a rise in price level is accompanied by
a proportionate rise in nominal wage. In fact the dichotomy between real and
monetary sectors of the economy, as envisaged in classical model, ensures such
proportional changes. The classical economists did not rule out the possibility of
decrease in nominal wage rate. Nonetheless, it was always in response to
decrease in money supply and price level.
In theory, the classical model appears to have a sound base. When compared
with reality, however, it does not explain the obvious phenomenon of
unemployment in the economy. As we will see below, there is much rigidity in
the economy, which does not allow smooth and instantaneous changes in wage
rate. Moreover, some amount of frictional unemployment is always present in
an economy as workers switch over from one job to another. The neoclassical
economists recognized the limitations of classical model and made amendments
to the classical position of zero unemployment. They assumed that the economy
in normal times has certain minimum unemployment called 'natural rate of
unemployment'.

13.4 KEYNESIAN VIEW ON UNEMPLOYMENT

Keynes in his General Theory presented a view that fluctuations in aggregate
demand (AD) influences the equilibrium level of output. Thus the economy is
not necessarily at the full employment output level all the time and equilibrium
can be realized at a level of output below full employment and corresponding to
that level, part of the labour force remains unemployed. Recall that the
Keynesian view emerged on the aftermath of the Great Depression when there
was widespread unemployment in the economy accompanied by declining
prices and output. At this point Keynes analysed the problem in the short run
context and assumed that the aggregate supply (AS) curve is horizontal. It
implies that AS is infinitely elastic and any level of output can be supplied
without increase in prices so long as unemployment persisted. Keynes
diagnosed the problem during the Great Depression to be a result of demand
deficiency and suggested that AD should be increased, may be through
increases in government expenditure. In fact, fiscal policy through appropriate
designing of tax rates and government expenditure emerged as a major policy
instrument largely due to the pioneering work of Keynes.
In Fig. 13.2 we present an infinitely elastic AS curve and a downward sloping
AD curve, the intersection of which provides us with equilibrium output (f)
and prices (P*). In response to a decliae in aggregate demand there is a
downward shift in AD to ADI. Corresponding to this shift there is a decline in
equilibrium output from (Y*)to (Y,'). Note that price level remains unchanged
in the above model. In synchronization with the level of output, the quantity of
labour used in production varies. For example, corresponding to a decline in
equilibrium output the quantity of labour decreases. Simultaneously there is an
increase in unemployment.

Fig. 13.2: Equilibrium Output in Keynesian Model

On the behaviour of wage rate, Keynes assumed that there is downward rigidity
in nominal wage in the sense that workers oppose decline in the money wage, as
they perceive it to be a decline in their income. During periods of recession
when there is a decline in price level, real wage increases in spite of the fact that
W
nominal wage remains fixed. Recall that we defined real wage as w = -;hence
P
decline in P would increase w when W is constant. The basic idea behind the
simplest Keynesian model is that w varies inversely with P as W remains fixed.
Thus in periods of boom, when there is an increase in prices, real wage tend to
decline. Consequently, firms hire more labour and unemployment in the
economy is lower.
<

In Fig. 13.2 we discussed the extreme Keynesian case where AS curve is

horizontal. On the basis of Keynesian ideas, economists analyse the
unemployment issue by resorting to an upward sloping AS curve. As mentioned
above, real wage falls when prices increase, as a result of which more labour is
demanded. The outcome of such an increase is production of more output. Thus
as price level increases we have increasing level of output, implying an upward
sloping AS curve. The change in level of employment due to change in price
level can be explained through the following diagram.
Fig. 13.3 comprises three segments. In panel-a we have described a production
h c t i o n such that corresponding to each level of output we can find out the
level of employment. Thus when output produced is at full employment level
(QJ we have corresponding level of employment at Lj In panel-b we plot the
AS curve which depicts the output supplied (Q)at each price level (P). Thus
when Qfis the output produced prevailing prices is Pj. In panel-c we depict real
wage (W/P)on y-axis and employment level on x-axis. Note that we assume
nominal rigidity in prices so that W is fixed. Thus real wage (w)increases as P
decreases. Through the interaction of L, and Ld we have full employment (Lj)in
the economy corresponding to real wage Wf W/Pj Thus we assume the initial
position of the economy to be full employment corresponding to Qj; Lj,Pf and
W/Pj
 Traditional Theories

Fig. 13.3: Unemployment in Keynesian Model

Suppose there is a decline in AD (not given in the figure). Consequen;ly, there
is a decline in equilibrium output fiom QI to Ql and decline in prices fiom Pj to
PI (see Fig. 13.3 (b)). Corresponding to the new output level Ql, the level of
employment is Ll, which is less then Lf. In fig. 13.3(c) we see that a decrease in
prices from P, to PI leads to an increase in real wage from W/P, to W/P1. At this
level of real wage there is excess supply of labour compared to its demand.
Thus unemployment to the extent 'U' (as shown in Fig. 13.3(c)) takes place.
In Fig. 13.2 where we assumed the short run AS curve to be horizontal, upward
shift in AD resulted in increase in output, keeping prices unchanged. In Fig.
13.3, on the other hand, AS is assumed to be upward-sloping and shift in AD
influenced both output and prices.
We observe that nominal wage is not completely sticky in an economy. Keynes
in fact recognized that nominal wage would adjust to the requirement of labour
market equilibrium. However, such adjustments would be too slow so that full
employment may not prevail always. Adjustments in nominal wage in response
to price changes is always with a lag. For example, if nominal wage adjusts in
period 2 but prices increase in period 1, there is a decline in real wage in period
1. In period 2, however, nominal wage can be increased proportionately and real
wage at the previous level be maintained. Salary indexation followed in India
on a six-monthly basis is an example of such a lag in wage adjustments.
When we compare the classical and Keynesian positions we find that rigidity in
wage rate gives rise to unemployment in the economy. We will learn more
about real and nominal rigidities and their implications on unemployment in
Unit 15.
Check Your Progress 1
1) Under certain basic assumptions the classical economists could rule out
the possibility of unemployment. Elaborate.
9
Unemployment

2) In the Keynesian model why does unemployment take place?

PHILLIPS CURVE
The Phillips curve, named after A. W. Phillips, describes the relationship
between unemployment and inflation. In 1958 Phillips, then professor at
London School of Economics, took time series data on the rate of
unemployment and the rate of increase in nominal wage rate for the United
Kingdom for the period 1861-1957 and attempted to e'stablish a relationship. He
took a simple linear equation of the following form:

where w is the rate of wage increase, a and b are constants and u is the rate of
unemployment. He found that there exists an inverse relationship between w
and u, with the implication that lower rate of unemployment is associated with
higher rate of wage increase. The policy implication of such a result was
astounding - an economy cannot have both low inflation and low
unemployment simultaneously. In order to contain unemployment an economy
has to tolerate a higher rate of wage increase and vice versa.
Subsequent to the publication of the results by Phillips, economists followed
suit and attempted similar exercises for other countries. Some of the studies
carried out refinements to the simple equation estimated by Phillips such as the
use of inflation (the rate of increase in prices) instead of wage rate increase. 1n/
many cases the scatter of plot of variables appeared to be a curve, convex to the/
origin. As empirical studies reinforced the inverse relationship between the rate:
of inflation and the rate of unemployment the Phillips curve soon became an:
important tool of policy analysis. The prescription was clear: during periods of?
high unemployment the government should follow an expansionary monetary
policy which leaves more money in the hands of people. It may accelerate the
rate of inflation while lowering unemployment.

13.6 COSTS OF UNEMPLOMENT AND

INFLATION
In an economy both unemployment and inflation have adverse effects and
policy makers formulate policy instruments to contain both the problems. The
costs of unemployment at the macro level could be loss of potential output and
wastage of valuable resources (manpower). At the household level it is a loss of
income and consequent deterioration in standard of living of the household. It is
difficult to measure the human cost of unemployment with precision as social
stigma and psychological trauma of the problem are also involved. On the
whole, policy makers and political leaders see to the fact that the cost of
unemployment is minimal. Ideally the economy should not have a rate of
unemployment higher than the natural rate of unemployment.
Inflation is defined as a situation of persistent price rise. While the rate of Traditional Theories
inflation varies over time and across countries there is much debate on
permissible rate of inflation. While inflation rate has been moderately high in
certain countries, there are instances of hyperinflation in some countries where
rate of inflation has been more than 1,000 per cent per year (for example, Latin
American countries in 1980s and former socialist economies in 1990s).
Inflation is widely considered as a social evil. Policy makers are always on the
look out for price trend so that high inflation can be checked through
appropriate policy measures. General public also are widely vigilant about price
movements so that pressure can be exerted on the government if there is
acceleration in inflation rate. During inflation money loses its purchasing power
and nominal costs of goods and services increase. Moreover, there is a reduction
in real income of fixed income groups (salaried class, for example), as their
income does not change at the same pace as price rise. When there is a price rise
borrowers gain in fixed interest rate environment as the value money they return
is lower than anticipated at the time of borrowing. On the other hand, lenders
stand to lose as the value of money they receive after a lapse of time gets
eroded.
During periods of high inflation, there is fair chance that government revenue is
much less than government expenditure resulting in huge fiscal deficits. In order
to finance the deficit the government has three options: borrow from public, run
down on foreign exchange reserve, and print money. Usually a government
running huge deficit is already under heavy debt and paying a high amount of
interest. Hence, further borrowing becomes difficult. Moreover, such
governments also have low foreign exchange reserve and therefore, printing
money becomes an easy option which fuels the rate of inflation fiuther. You can
recall the Indian condition in 1990-91 when it was loaded with heavy debt,
foreign exchange reserve was abysmally low and there was double-digit
inflation. In general, high inflation put the economy out of gear aid it becomes
difficult to maintain economic stability.
When inflation is anticipated correctly then individuals take precaution and
adjust their future paymentslreceipts keeping the rate of inflation in mind.
However, unexpected inflation provokes income re-distribution between income
groups. Usually the wage earning class who have a fixed nominal wage are the
looser as real wage gets deteriorated due to price rise while profit earning class
gain handsomely.

13.7 NON-ACCELERATING INFLATION RATE OF

UNEMPLOYMENT
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During 1970s economists encountered a puzzle in the sense that inflation and
unemployment data did not fit into the Phillips curve for many developed
economies. In fact many countries witnessed 'stagflation' - a combination of
stagnation (a situation of high unemployment) and high inflation. The instability
in the Phillips curve prompted economists to look into the possible reason of
high inflation in spite of high unemployment in the economy.
A limitation of the Phillips curve is that both workers and employers take
decisions on the basis of real wage, not nominal wage. As we mentioned earlier
when we enter into a contract on a hture date we incorporate expected inflation
into it. Milton Friedman and Edmund Pheips suggested that since real wage is
what matters, the change in nominal wage has to be corrected by inflationary
expectations. In the short-run the Phillips curve is stable but in the long run it
shifts from one level to another, which makes the long run. Phillips curve a
vertical-straight line. We explain the process through which shifts in Phillips
curve takes place in Fig. 13.4.

Fig. 13.4: Shift in Phillips Curve

In order to explain the long run Phillips curve (LRPC) we take an example from
Samuelson (2005). Let us assume an economy which is operating at the natural
rate of unemployment (u*). The economy is operating at point A with low
inflation rate I1 as in Fig. 13.4. People expect inflation rate to continue at I, in
the next period also.
In the second period suppose the government follows an expansionary policy so
that unemployment declines and is lower than u*. In this environment firms
compete with each other to hire workers as a result of which wage rate
increases. With little scope for further expansion in output the expansionary
policy results in an increase in wage rate and prices so that the economy moves
to point B on SRPCl in Fig. 13.4. We note that inflation expectation has not
changes so far and the economy is operating on SRPC I .
In the period 3 workers and employers perceive that there is an unexpected
increase in inflation rate. Such a surprise prompts them to revise their
inflationary expectations and they incorporate inflation at the rate I2 into their
decisions. This results in an upward shift in the short run Phillips curve from
SRPCnto SRPC2. Note that we have drawn SRPCz with inflation rate 13 which
is equal to 12. With inflation at the rate 4, there is a decline in demand for labour
the unemployment rate starts increasing and the economy moves to point C in
Fig. 13.4.
The outcome of the above process- is that the economy ends up with higher
inflation rate although the rate of unemployment remains the same. Real GDP
of the economy remains unchanged while nominal GDP is higher.
The natural unemployment rate mentioned above is called non-accelerating
inflation rate of unemployment (NAIRU). When unemployment is equal to
NAIRU there will be stability in the rate of inflation. When unemployment
departs from NAIRU, there is acceleration or deceleration in inflation rate. Thus
if actual unemployment is less than u*, inflation will continue to accelerate-
higher and higher in subsequent years. The concept of NAIRU and expectations
formation explains the hyperinflation witnessed by some Latin American
countries. Unless unemployment returns to its natural rate inflation spiral will
keep on accelerating. The recessionary trend can also be explained by NAIRU.
When unemployment is more than u*, inflation will tend to fall as long as
unemployment is above u*. You have already read about expectations formation
in Unit 5, Block 3 of this course. The details of inflation-unemployment trade
off under adaptive and rational expectations have been given there. We have
recapitulated the basic results in this Unit.
Researchers have attempted to estimate NAIRU for certain couniries. It is
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Traditional Theories
observed that NAIRU varies across countries, and over time for the same
country.
Check Your Progress 2
1) What are the policy implications of Phillips curve?
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2) What do you mean by NAIRU? What are its implications?

13.8 LET US SUM UP

Unemployment results in loss of not only potential output at the macro level but
also in income at the individual level. Many a time widespread unemployment
culminates into a crisis situation in the economy. The social sigma and
psychological trauma associated with unemployment often compels policy
makers to cut down on the rate of unemployment.
The classical economists assumed flexibility in real wage and prices, which
ensured h l l employment in the economy for all the time. Keynesian
economists, however, contest such an assumption and speak about rigidities in
wage rate and prices. In case of sticky prices there is a possibility of
'
unemployment as per the Keynesian model.
Phillips curve describes the inverse relationship between i~flation and
unemployment. It shows the possibility, or rather the compulsion on the part of
policy makers, that unemployment can be reduced at the cost of higher inflation.
Empirical observation from some economies, however, shows that Phillips
curve is not stable in the long run. Due to change in inflationary expectations on
the part of workers and employers there is a possibility of shifts in the Phillips
curve. While short run Phillips curve is convex to the origin, the long run
Phillips curve is vertical straight line at an unemployment rate equal to NAIRU.

13.9 KEY WORDS

Aggregate Demand: It tantamount to the sum of expenditure on consumption,
investment, government expenditure and net exports. In symbols, AD = C' + I +
G + (X-M).
Fiscal Policy: The policy of a government with respect to government
expenditure and taxation.
Labour Force: The sum of population who are willing to work, and either
employed or unemployed.
NAIRU: It is the abbreviation for non-accelerating inflation rate of
unemployment. It is an unemployment rate that is consistent with a constant
inflation rate. The NAIRU is the uilemployment rate at which the long-run
Phillips curve is vertical.
Phillips Curve: It is a graph named after A. W. Phillips, which shows the trade
off between unemployment and inflation.
Real Wage: Nominal wage divided by price level.

13.10 SOME USEFUL BOOKS

Dombusch, R., S. Fischer and R. Startz, 2004, Macroeconomics, Ninth Edition,
Tata McGraw-Hill, New Delhi.
Sachs, Jeffrey. D. and Felipe Larrain B., Macroeconomics in the Global
Economy, Prentice Hall lnc., New York.
Samuelson, P. A. and W. D. Nordhaus, 2005, Economics, Eighteenth Edition,
Tata McGraw Hill, Delhi.

1cl1 *NS=R/HINTS TO CHECK YOUR

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PROGRESS EXERCISES
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Check Your Progress 1

1) The basic assumptions underlying classical approach is flexibility in real
wage and prices. Elaborate on the classical model based on Section 13.3
2) Keynes assumes rigidity in nominal wage rate. In the even of decline in
prices, the're is an increase in real wage, which does not clear the market
for labour. Excess supply of labour compared to demand results in
unemployment. Go through section 13.4.
Check Your Progress 2
1) Go through Section 13.5 and answer. You have to explain the nature of
trade-off between inflation and unemployment.
2) Go through Section 13.7 and answer.