Editing Full employment (section)

== Relation to inflation ==
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The theories behind the [[Phillips curve]] point to the inflationary costs of lowering the unemployment rate. That is, as unemployment rates fell and the economy approached full employment, the [[inflation]] rate would rise.  But this theory also says that there is no single unemployment number that one can point to as the "full employment" rate. Instead, there is a [[trade-off]] between unemployment and inflation: a government might choose to attain a lower unemployment rate but would pay for it with higher inflation rates. In essence, in this view, the meaning of “full employment” is really nothing but a matter of opinion based on how the benefits of lowering the unemployment rate compare to the costs of raising the inflation rate.

Though their theory had been proposed by the Keynesian economist [[Abba Lerner]] several years before,<ref>{{Harv|Lerner|1951|loc=Chapter 15}}</ref> it was the work of [[Milton Friedman]], leader of the [[monetarist]] school of economics, and [[Edmund Phelps]] that ended the popularity of this concept of full employment. In 1968, Friedman posited the theory that full employment rate of unemployment was '''''unique''''' at any given time. He called it the "natural" rate of unemployment. Instead of being a matter of opinion and normative judgment, it is something we are stuck with, even if it is unknown. As discussed further, below, inflation/unemployment trade-offs cannot be relied upon.  Further, rather than trying to attain full employment, Friedman argues that policy-makers should try to keep prices stable (meaning a low or even a zero inflation rate). If this policy is sustained, he suggests that a free-market economy will gravitate to the "natural" rate of unemployment automatically.

=== NAIRU ===
{{Unreferenced section|date=September 2020}}
{{main|NAIRU}}

[[Image:NAIRU-SR-and-LR.svg|thumb|right|200px|[[Phillips Curve]] before and after Expansionary Policy, with Long-Run Phillips Curve ([[NAIRU]])]]

In an effort to avoid the normative connotations of the word "natural," James Tobin (following the lead of Franco Modigliani), introduced the term the “'''N'''on-'''A'''ccelerating '''I'''nflation '''R'''ate of '''U'''nemployment” (NAIRU), which corresponds to the situation where the real gross domestic product equals potential output. It has been called the  "inflation threshold" unemployment rate or the inflation barrier.  This concept is identical to [[Milton Friedman]]’s concept of the "natural" rate but reflects the fact that there is nothing "natural" about an economy. The level of the NAIRU depends on the degree of "supply side" unemployment, i.e., joblessness that can't be abolished by high demand. This includes frictional,  mismatch, and Classical unemployment. When the actual unemployment rate equals the NAIRU, there is no cyclical or deficient-demand unemployment. That is, Keynes’ involuntary unemployment does not exist.

To understand this concept, start with the actual unemployment equal to the NAIRU. Then, assume that a country's government and its [[central bank]] use demand-side policy to reduce the unemployment rate and then attempt to keep the rate at a specific low level: rising budget deficits or falling interest rates increase aggregate demand and raise employment of labor. Thus, the actual unemployment rate falls, as going from point '''A''' to  '''B''' in the nearby graph. Unemployment then stays below the NAIRU for years or more, as at point '''B'''. In this situation, the theory behind the NAIRU posits that inflation will accelerate, i.e. get worse and worse (in the absence of wage and price controls). As the short-run [[Phillips curve]] theory indicates, higher inflation rate results from low unemployment. That is, in terms of the "trade-off" theory, low unemployment can be "bought," paid for by suffering from higher inflation. But the NAIRU theory says that this is not the whole story, so that the trade-off breaks down: a persistently higher inflation rate is eventually incorporated as higher ''inflationary expectations''. Then, if workers and employers expect higher inflation, it results in higher inflation, as higher money wages are passed on to consumers as higher prices. This causes the short run Phillips curve to shift to the right and upward, worsening the [[trade-off]] between inflation and unemployment. At a given unemployment rate, inflation accelerates. But if the unemployment rate rises to equal the NAIRU, we see higher inflation than before the expansionary policies, as at point '''C''' in the nearby diagram. The fall of the unemployment rate was temporary because it could not be sustained. In sum, the trade-off between inflation and unemployment cannot be relied upon to be stable: taking advantage of it causes it to disappear. This story fits the experience of the United States during the late 1960s, during which unemployment rates stayed low (below 4% of the civilian labor force) and inflation rates rose significantly.

Second, examine the other main case. Again start with the unemployment rate equal to the NAIRU. Then, either shrinking government budget deficits (or rising government surpluses) or rising real interest rates encourage higher unemployment. In this situation, the NAIRU theory says that inflation will get better (decelerate) if unemployment rates exceed the NAIRU for a long time.  High unemployment leads to lower inflation, which in turn causes lower inflationary expectations and a further round of lower inflation. High unemployment causes the short-run inflation/unemployment trade-off to improve. This story fits the experience of the United States during the early 1980s ([[Paul Volcker]]'s war against inflation), during which unemployment rates stayed high (at about 10% of the civilian labor force) and inflation rates fell significantly.

Finally, the NAIRU theory says that the inflation rate does not rise or fall when the unemployment equals the "natural" rate. This is where the term NAIRU is derived. In macroeconomics, the case where the actual unemployment rate equals the NAIRU is seen as the long-run [[Economic equilibrium|equilibrium]] because there are no forces inside the normal workings of the economy that cause the inflation rate to rise or fall. The NAIRU corresponds to the ''long-run Phillips curve''. While the short-run Phillips curve is based on a constant rate of inflationary expectations, the long-run Phillips curve reflects full adjustment of inflationary expectations to the actual experience of inflation in the economy.

As mentioned above, [[Abba Lerner]] had developed a version of the NAIRU before the modern "natural" rate or NAIRU theories were developed. Unlike the currently dominant view, Lerner saw a range of "full employment" unemployment rates. Crucially, the unemployment rate depended on the economy's institution. Lerner distinguished between "high" full employment, which was the lowest sustainable unemployment under [[incomes policies]], and "low" full employment, i.e., the lowest sustainable unemployment rate without these policies.

Further, it is possible that the value of the NAIRU depends on government policy, rather than being "natural" and unvarying. A government can attempt to make people "employable" by both positive means (e.g. using training courses) and negative means (e.g. cuts in unemployment insurance benefits).  These policies do not necessarily create full employment. Instead, the point is to reduces the amount of mismatch unemployment by facilitating the linking of unemployed workers with the available jobs by training them and or subsidizing their moving to the geographic location of the jobs.

In addition, the [[hysteresis (economics)|hysteresis hypothesis]] says that the NAIRU does not stay the same over time—and can change due to economic policy.<ref>Hargreaves Heap, Shawn P. (1980). Choosing the Wrong “Natural” Rate: Accelerating Inflation or Decelerating Employment and Growth? ''Economic Journal''. vol. 90 (September): 611-620.</ref> A persistently low unemployment rate makes it easier for those workers who are unemployed for "mismatch" reasons to move to where the jobs are and/or to attain the training necessary for the available vacancies (often by getting those jobs and receiving on-the-job training). On the other hand, high unemployment makes it more difficult for those workers to adjust, while hurting their morale, job-seeking skills, and the value of their work skills. Thus, some economists argue that British Prime Minister [[Margaret Thatcher]]'s anti-inflation policies using persistently high unemployment led to higher mismatch or structural unemployment and a higher NAIRU.