Productivity growth, inflation, and unemployment

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We know that it takes time for job seekers and employers to find each other, and this time is the cause of frictional unemployment. After all, there will always be workers who are unemployed while looking for a job that is a better match for their skills. There will always be employers that have an open position, while looking for a worker that is a better match for the job. Ideally, these matches happen quickly, but even when the economy is very strong there will be some natural unemployment and this is what is measured by the natural rate of unemployment.

The neoclassical view of unemployment tends to focus attention away from the problem of cyclical unemployment—that is, unemployment caused by recession—while putting more attention on the issue of the rates of unemployment that prevail even when the economy is operating at potential GDP. To put it another way, the neoclassical view of unemployment tends to focus on how public policy can be adjusted to reduce the natural rate of unemployment.

Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need, but also offer greater encouragement for job-hunting. It might involve redesigning business rules with an eye to whether they are unintentionally discouraging businesses from taking on new employees. It might involve building institutions to improve the flow of information about jobs and the mobility of workers, to help bring workers and employers together more quickly. For those workers who find that their skills are permanently no longer in demand for example, the structurally unemployed , policy can be designed to provide opportunities for retraining so that these workers can reenter the labor force and seek employment.

Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, if economic output is determined by a vertical aggregate supply curve , then aggregate demand has no long-run effect on unemployment. Instead, neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the right—keeping the price level much the same and inflationary pressures low.

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If aggregate demand rises rapidly in the neoclassical model, in the long run it leads only to inflationary pressures. As the macroeconomic equilibrium rises from E 0 to E 1 to E 2 , the price level rises, but real GDP does not budge; nor does the rate of unemployment, which adjusts to its natural rate. Conversely, reducing inflation has no long-term costs, either. During this process, the price level falls, but, in the long run, neither real GDP nor the natural rate of unemployment is changed.

Figure However, there is inflationary pressure for a higher price level as the equilibrium changes from E0 to E1 to E2. Visit this website to read about how inflation and unemployment are related. Neoclassical economists believe that the economy will rebound out of a recession or eventually contract during an expansion because prices and wage rates are flexible and will adjust either upward or downward to restore the economy to its potential GDP.

Thus, the key policy question for neoclassicals is how to promote growth of potential GDP. We know that economic growth ultimately depends on the growth rate of long-term productivity. Productivity measures how effective inputs are at producing outputs.

We know that U. We also know that productivity growth varies a great deal in the short term due to cyclical factors.

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It also varies somewhat in the long term. From —, U. Low inflation is key to such an environment, for two reasons. First, low inflation leads to more predictable real interest rates, which in turn allow for surer long-term planning for investment projects that increase productivity. High-inflation economies tend to have higher and more volatile real interest rates, which makes businesses much more leery of investing for the longer term.


This harms productivity growth. Second, recessions are less likely and less severe in a low-inflation environment. This permits productivity growth to increase as production operations are fine-tuned through relatively steady output. Sharp, boom-bust swings in output raise havoc with productivity growth.

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Sustained, stable output is especially important in bringing marginal workers into the work force and then raising their job skills, which of course is key to raising productivity. Subscribe Now. Register with JOC.

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