in the concerns about second round effects discussed here is the fear that domestic actors will resist that switch in the composition of demand by seeking to maintain their income and spending levels at pre - shock levels, which is inconsistent with the necessary and inevitable adjustment to the real shock to the economy and can ultimately lead to inflation. 9. as discussed in footnote 8, the composition of demand across domestic and external sources is also important for adjustment to real exchange rate shocks. in this regard, the ability and willingness of domestic firms and households to substitute away from more expensive natural gas imports – both to other sources of energy, and also to non - energy goods and services – can influence the adjustment and its potential inflationary consequences. this was discussed in box b of the mpc ’ s november 2022 monetary policy report.

committee uses the available empirical information about the uk labour market when deciding on interest rates. how do unemployment figures and earnings data enter the mpc ’ s decisions? the third issue is the way in which unemployment enters the objectives of monetary policy. with an explicit inflation target, is it true that the mpc neither cares about unemployment nor takes it into consideration when setting interest rates? the labour market and the monetary transmission mechanism the theory of unemployment has spawned more concepts, and – without doubt – more acronyms, than almost any other field of economics ( apart, perhaps, from measures of price inflation ). i shall return to the language of unemployment later. but i want first to discuss the two concepts which are at the heart of any discussion of monetary policy and the labour market. they are the natural rate of unemployment and the rate of unemployment consistent with stable inflation, usually known as the nairu. the concept of the natural rate of unemployment introduced by milton friedman and edmund phelps 30 years ago is the level of unemployment that – as friedman famously described – would be “ ground out by the walrasian system of general equilibrium equations ” reflecting the structural characteristics of the labour and product markets. friedman was the first to recognise that this natural rate of unemployment was neither constant over time nor immune to policy influences. the natural rate hypothesis implies a vertical long - run phillips curve. in other words, if the monetary authorities attempted to “ peg ” the level of unemployment below the natural rate, then this in time would cause the inflation rate to rise indefinitely. the work of friedman and phelps soon proved highly relevant. the futility of using monetary policy to choose between different combinations of unemployment and inflation became only too apparent in the 1970s. monetary shocks can – and in the early 1980s and 1990s did – cause unemployment to deviate from its natural rate, but only for a period. as inflation expectations catch up with the consequences of the monetary shock, unemployment returns to the natural rate. – 3 – but the responses of unemployment and inflation expectations to monetary shocks are far from immediate. indeed, friedman speculated that the full adjustment to an unexpected change in inflation might take up to “ a couple of decades ”. such long lags in the dynamics of the labour market mean that there is unlikely to be a simple relationship between deviations of unemployment from its natural rate and changes in the inflation rate. chart 1 shows that it did indeed take almost 20 years to bring inflation and inflation expectations ( implied by financial market returns on indexed and conventional gil