Adigrat University Dep.

t of AcFn Macroeconomics 2019

5. Inflation, Unemployment and Macroeconomic Debates

5.1 Inflation
Inflation is a rise in the general level of prices of goods and services in an economy over a
period of time. When the price level rises, each unit of currency buys fewer goods and services.
A chief measure of price level is the inflation rate. When Prices rise, the Value of Money falls.
Inflation and the Price Level
• Inflation is a process in which the price level rises and money loses value.

• Inflation is fundamentally a monetary phenomenon.

• The average level of prices is rising.

• Inflation is not high prices and inflation is not a jump in prices

5.1.1 Causes of Inflation

There are two causes of inflation. These are:

1. Demand-Pull Inflation

Demand-pull inflation is inflation that results from an initial increase in aggregate demand. A
demand pull inflation can result from any influence that increases aggregate demand.

In a demand-pull inflation, initially aggregate demand increases, real GDP increases above
potential GDP and the price level rises, money wages rises, and then the price level rises further
and real GDP decreases toward potential GDP.

A one-time increase in aggregate demand raises the price level but does not always start a
demand-pull inflation. For demand pull inflation to occur, aggregate demand must persistently
increase and the money supply must persistently grow at a rate that exceeds the growth rate of
potential GDP.

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Figure 5. 1. Demand Pull Inflation

2. Cost-Push Inflation

Cost-push inflation is an inflation that results from an initial increase in costs. The two main
sources of cost-push inflation are: an increase in the money wage rate and an increase in the
money prices of raw materials.

In a cost-push inflation, initially short-run aggregate supply decreases, real GDP decreases below
potential GDP and the price level rises and then the economy could become stuck in this
stagflation situation for some time.

A one-time decrease in aggregate supply raises the price level but does not always start a cost-
push inflation. For cost-push inflation to occur, aggregate demand must increase in response to
the cost push. Just like the case of demand-pull inflation, the money supply must persistently
grow at a rate that exceeds the growth rate of potential GDP if inflation is to become persistent.

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Figure 5.2. Cost Push Inflation

5.1.2 Stages of Inflation

Inflation has different stages depending on its percentage increment as creeping inflation
(0%-3%); walking inflation (3% - 7%); running inflation (10% - 20 %); hyperinflation (20% and
above) and very high inflation rates, over 50% per month.

Hyperinflation: occurs in countries that have large deficits, but cannot borrow and are forced to
print new money. Hyperinflation is stopped by eliminating the deficit, which is the basic cause
for increase taxes and cut spending. Once the deficit has been cut and the government stops
printing money, the hyperinflation will end. During hyperinflation; money no longer works very
well in facilitating exchange, since prices are changing so fast and unpredictably, there is
typically massive confusion about the true value of commodities; different stores may be raising
prices at different rates; the same commodities might be sold for radically different prices;
everyone spends all their time hunting for bargains and finding the lowest prices and
governments are forced to put an end to hyperinflation before it destroys their economies.

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The Cause of Hyperinflation

Excessive Money Growth : If a government wants to spend a specified amount of money, but is
collecting less in taxes, it must cover the difference in some way: 1) the government may borrow
the difference from the public and issue bonds, for which it must pay back what it borrows and
interest in the future, 2) the government may print new money or 3) the government could mix
borrowing and printing money to cover the deficit so that government deficit = new borrowing +
new money created.

Indexed: Describes something whose payments are adjusted for changes in prices, such as bonds
or nominal contracts. In practice, countries find that indexing is not the perfect solution to
problems caused by inflation: Because; policymakers worry indexing lowers the resolve to fight
inflation, Price indices are far from perfect and are extremely difficult to construct when prices
are increasing rapidly. But some economists believe that indexing builds inflation into the
economic system and makes it difficult to reduce inflation.
Effects of Inflation

Regardless of whether its origin is demand-pull or cost-push, inflation imposes costs. And the
costs depend on whether the inflation is anticipated or unanticipated.

1. Anticipated Inflation

Fully Anticipated Inflation: Inflation at 5% would mean workers would know that nominal wage
increase of 5% is not real wage increase, and investors earning 8% rate of interest on bonds
would know that their real return would be 4% after adjusting for inflation. However, most of tax
systems and financial systems do not fully adjust even to fully anticipated inflation.

Anticipating inflation also avoids the redistribution of income and wealth and errors that might
occur in investment and saving decisions. But besides, anticipated inflation does have some
costs. The costs of anticipated inflation are: “boot leather” costs, other transactions costs,
decrease in potential GDP and decrease in the long-term growth rate. These costs have been
estimated to be very high, even for a modest inflation. The main problem is that taxes on capital
income are seriously distorted by inflation.
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Unanticipated Inflation: Unanticipated inflation can cause problems such as: redistribute
income between firms and workers, move real GDP away from potential GDP, redistribute
wealth between borrowers and lenders, and result in too much or too little saving and investment,

Because unanticipated inflation is costly, people try to anticipate it.To make the best possible
forecast of inflation, people use all the information they can about the source of inflation and
likely trends in those sources. Such a forecast is called a rational expectation. An anticipated
inflation avoids some of the costs of inflation.

Inflation can have positive and negative effects on an economy. Negative effects of inflation
include loss in stability in the real value of money and other monetary items over time;
uncertainty about future inflation may discourage investment and saving, and high inflation may
lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in
the future. Positive effects include a mitigation of economic recessions, and debt relief by
reducing the real level of debt.

5.2 Unemployment

The Working definition of unemployment represents People able, available and willing to find
work and actively seeking work but not employed.So as to arrive at calculating unemployment
rate we have to start from calculating the total number of population in a particular economy as
follows.
Composition of Population in terms of Economic Status

Labor Force: It is the total number of workers which is calculated as the sum of the employed
and the unemployed. The labor-force participation rate is the percentage of the adult population
that is in the labor force. Labor-force Participation Rate= (Labor Force/Adult Population)*100.
Not in the Labor Force is a person who fits neither of these categories, such as a full-time
student, homemaker, or retiree.

Unemployed: An internationally agreed standard measure of unemployment states that,

Unemployed must be individuals actively sought work in the previous four weeks and be

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available to start work immediately. Or a person is unemployed if he or she is on temporary
layoff, is looking for a job, or is waiting for the start date of a new job or a person who is
involuntarily out of gainful employment during the reference period but either has been actively
looking for a job or was willing to work but not looking for work because of illness. The
unemployment rate is the percentage of the labor force that is unemployed. Unemployment
Rate= (Unemployed/Labor Force)*100 .

Employed: A person is considered employed if he or she has spent most of the previous week
working at a paid job. In other words, a person who was either working during the previous week
for one or more hours for pay or profit or working without pay in a family farm or enterprise
during the week or found not working but had a job or business from which he/she was
temporarily absent during the week.

5.2.1 Types of unemployment

1. Seasonal Unemployment

It is a periodic unemployment. Example: Agricultural workers suffer from unemployment during

agricultural lean seasons. Workers in developed countries can however easily switch skills to
meet varying labor demands. It can also be countered through government intervention. In
addition to the laborers, rregular seasonal changes in employment / labour demand affects certain
industries more than others such as: Catering and leisure, Construction, Retailing, Tourism and
Agriculture.
2. Frictional Unemployment

It is a transitional unemployment due to people moving between jobs: Includes people

experiencing short spells of unemployment, and new and returning entrants into the labor market
Imperfect information about available job opportunities can lengthen the period of someone’s job
search. In general, frictional unemployment refers to the unemployment those results from the
time that it takes to match workers with jobs. In other words, it takes time for workers to search
for the jobs that are best suit their tastes and skills.

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3. Structural Unemployment

Arises from the mismatch of skills and job opportunities as the pattern of labour demand in the
economy changes and often involves long-term unemployment. This type of unemployment is
pprevalent in regions where industries go into long-term decline. Good examples of structural
unemployment include industries such as mining, engineering and textiles.

Structural unemployment is the unemployment that results because the number of jobs available
in some labor markets is insufficient to provide a job for everyone who wants. It occurs when the
quantity of labor supplied exceeds the quantity demanded.

Structural unemployment is often thought to explain longer spells of unemployment and Large
scale unemployment caused by low productive capacity. Unlike cyclical unemployment,
structural unemployment is of long-term nature; thus, reduction of structural unemployment
requires expansion of productive capacity which takes time.

4. Cyclical (Keynesian) Unemployment

Under cyclical (Keynesian) unemployment there is a cyclical relationship between demand,

output, employment and unemployment. It is caused by a fall in aggregate demand leading to a
loss of real national output and employment. A slowdown can lead to businesses lying off
workers because they lack confidence that demand will recover.

Keynes argued that an economy can become stuck with a low rate of AD and an economy
operating persistently below its potential. Look at the graphs below; Y* representing full
employment output level, sometimes national output falls due to a fall in demand, this is called
recession. Labor demand declines, additional unemployment occurs to the extent of ee*. This is
called cyclical unemployment.

Note that short-run unemployment is the cyclical rate of unemployment and long-run
unemployment is the natural rate of unemployment.

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Natural Rate of Unemployment

The amount of unemployment that the economy normally experiences and does not go away on
its own even in the long run is called natural rate of unemployment. In other words, it is the long-
run average or “steady state” rate of unemployment. The labor market is in steady state, or in
long-run equilibrium, if the unemployment rate is constant.

Natural rate of unemployment is the average or long-run rate of unemployment around which the
economy fluctuates. In a recession, the actual unemployment rate rises above the natural rate. In
a boom, the actual unemployment rate falls below the natural rate.

Economists believe that such kind of unemployment is created when real wages are maintained
above their market clearing level leading to an excess supply of labour at the prevailing wage
rate or if the national minimum wage is set too high.

Job Search: It is the process by which workers find appropriate jobs given their tastes and skills.
It results from the fact that it takes time for qualified individuals to be matched with appropriate
jobs. The unemployment on the way is caused by the time spent searching for the “right” job.

5.2.2 Economic and Social Costs of Unemployment

The private costs for the unemployed are loss of income, fall in real living standards, increase in
health risks, stress, and reduction in quality of diet, ssocial exclusion because of loss of work and
income and loss of marketable skills (human capital) and motivation.

The economic consequences for businesses are negative consequences, fall in demand for goods
and services, fall in demand for businesses further down the supply chain. However, there are
some positive consequences such as bigger pool of surplus labour is available – but still a
problem if there is plenty of structural unemployment, less pressure to pay higher wages, less
risk of industrial / strike action – fear of job losses – leading to reduced trade union power.

There are also consequences for the Government (Fiscal Policy) such as increased spending on
unemployment benefits and other income related state welfare payments; fall in revenue from

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income tax and taxes on consumer spending, fall in profits, reduction in revenue from
corporation tax and it may lead to rise in government borrowing (i.e. a budget deficit).

Unemployment again has consequences on the economy as a whole. These are loss in output
(real GDP) from people being out of work, the economy will be operating well within its
production frontier; uunemployment seen as an inefficient way of allocating resources, some of
the long-term unemployed may leave the labour force permanently that causes fall in potential
GDP and increase in the inequality , i.e., rise in relative poverty.

Moreover, unemployment has an effect on the circular flow and the multiplier such as incomes
flowing into households will grow if unemployment falls down and falling unemployment adds
to demand and creates a positive multiplier effect on incomes, demand and output .

When incomes and spending are growing, in times of fall in unemployment, there is an increase
in the demand for imports. Unless this is matched by a rise in export sales, the trade balance in
goods and services will worsen (balance of payment).

With more people in work paying income tax, national insurance and value added tax, the
government can expect a large rise in tax revenues and a reduction in social security benefits
(government finance).

Unemployment has again inflationary effects in a particular economy. Falling unemployment can
also create a rise in inflationary pressure; particularly when the economy moves close to
operating at full capacity.However, this is not really a risk when the economy is coming out of
recession, since aggregate supply is likely to be highly elastic because of a high level of spare
capacity. The longer the duration of unemployment, the lower the chances of finding fresh
employment - the unemployed become less attractive to potential employers

Issues in Measuring Unemployment

It is difficult to distinguish between a person who is unemployed and a person who is not in the
labor force. Discouraged workers, people who would like to work but have given up looking for
jobs after an unsuccessful search, don’t show up in unemployment statistics; and other people

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may claim to be unemployed in order to receive financial assistance, even though they aren’t
looking for work.

Length of unemployment does matter. Most spells of unemployment are short. Most
unemployment observed at any given time is long-term. Moreover, most of the economy’s
unemployment problem is attributable to relatively few workers who are jobless for long periods
of time. Hence, unemployment measurement becomes difficult.

5.2.3 Stabilization Policy

Developed countries can stabilize cyclical unemployment through expansionary monetary or

fiscal policies. Expansionary monetary policy increases credit supply which raises aggregate
demand. An expansionary fiscal policy on the other hand reduces taxes.
1. Demand side Policies to Reduce Unemployment

These are mainly measures to boost total labor demand (reduce cyclical unemployment); lower
interest rates (a monetary policy stimulus); lower exchange rate (helps exporters); lower direct
taxes (fiscal stimulus to spending power); ggovernment spending on major capital projects
(example: improving the transport infrastructure); employment subsidies; and incentives to
encourage flows of foreign investment – particularly in areas of above average unemployment.

2. Supply side Policies to Reduce Unemployment

These are measures to improve labor supply (reduce frictional and structural unemployment).
These are increased spending on education & training including an emphasis on “lifetime-
learning”); improved flows of information on job vacancies; changes to tax and benefits to
improve incentives; and mmeasures designed to make the labour market more flexible so that
workers have the skills and education that gives them improved employment options.

5.3 The Relationship Between Inflation and Unemployment

The Phillips Curve: It is a graph depicting a relationship between unemployment rate and
inflation rate.

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Figure 5.3 Short Run Phillips Curve

The implication of the negative slope is that the unemployment rate and the inflation rate are
inversely related i.e. there is a trade-off between the two.

Figure 5.4 Long Run Phillips Curve

Earlier in this chapter, we discussed the natural rate of unemployment. It was defined to be fixed
at a point in the long-run, and it was shown that the economy tends to automatically return to that
level on its own. Then the long-run Phillips Curve must be a vertical line at the specific level of
unemployment if the long-run Phillips Curve is vertical at a point like on the graph above, then
policymakers must be able to choose any inflation rate they desire along this line.

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5.4 Macroeconomic Policy Debates

There have been debates whether policy is to be active or passive. Active policy associates a
high cost with the failure to pursue a discretionary policy. Despite the lags involved, advocates
of active policy prefer action whether through fiscal policy, monetary policy, or some
combination of the two to inaction.
Advocates of an active approach believed that prices and wages are not that flexible, particularly
in the downward direction. They think that when adverse supply shocks or sagging demand push
unemployment above its natural rate, market forces may be too slow to respond. The longer
market forces take to reduce unemployment to the natural rate, the greater the output lost and the
greater the economic and psychological cost to those unemployed. Because advocates of an
active policy associate a high cost with the passive approach, they favor an active stabilization
policy to stimulate aggregate demand.

Passive policy, on the other hand, advocators believed that uncertain lags and ignorance about
how the economy works prevent the government from accurately determining or effectively
implementing the appropriate active policy so that the passive approach, rather than pursuing a
misguided activist policy, relies more on the economy’s natural ability to correct itself and on the
government’s automatic stabilizers. Those who subscribe to the passive approach, as did their
classical predecessors, have more faith in the self correcting forces of the economy than do those
who favor the active approach.

 In what sense is the economy is self correcting?

According to the passive approach, wages and prices are flexible enough to adjust within a
reasonable period to labor shortages or surpluses. High unemployment causes wages to fall,
which reduces production. Government intervenes in the economy to achieve potential growth
which may shift the short run aggregate supply curve rightward. However, money wages need
not actually fall; money wage increases need only lag behind price increases, so that real wages
fall or perhaps nonwage compensation is reduced, such as health care benefits. Passive policy is
to do nothing beyond the automatic stabilizers already built into taxes, have more faith in
the self-correcting forces of the economy than do those who favor the active approach.
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The best ways to illustrate the arguments of the two sides are given below:

I. Closing Contractionary Gap

Contractionary gap (recessionary gap) occurs when actual GDP is below the potential so that the
economy is not producing output at its potential. The question thus is how to increase output
level which would call for different policy suggestions by active versus passive policy
advocators.

Proponents of active approach suggest that government should boost aggregated demand using
expansionary fiscal policy measures such as increasing government purchase of goods and
services or reducing tax level so that investment demand would increases leading to higher
output.

However, advocates of passive policy believe that an increase in supply side factors like output
level, human skill or research and development or other supply side measures should be used to
increase output. They oppose government intervention because they believe government
intervention is inaccurate and due to time lag it could result in unintended outcomes which could
be hurtful to the future economic environment.

Fig 5.5 Policy response to Contractionary gap

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II. Closing Inflationary Gap

Inflationary gap occurs when the economy tries to produce above its level of output. The result is
that the economy would try to increase output level in aggressive trend beyond its potential.
Therefore in order to stabilize the economy back to the GDP level of its potential, policy
interventions are required. However, in the same model active versus passive policy suggestions
differ greatly in this respect too.

Figure 5.6 Policy response to an inflationary gap

Problem of Lags
 A recognition lag is the time needed to identify a macroeconomic problem and assess its
seriousness
 A decision making lag is the time needed to decide what to do after a macroeconomic
problem is identified
 An implementation lag is the time needed to introduce a change in monetary or fiscal
policy
 An effectiveness lag is the time necessary for changes in monetary or fiscal policy to
have an effect on the economy
Role of Expectations
 Since the short-run aggregate supply curve is drawn for a given expected price level,
the effectiveness of particular government policy depends on what people expect

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Rational Expectations
 Rational expectations is a school of thought that claims people form expectations based
on all available information, including the probable future actions of government policy
makers:

 If the population forms expectations rationally, fiscal and monetary policy will
be fully anticipated when, for example, long run labor contracts are negotiated
 This make fiscal and monetary policy ineffective, even in the short run
To illustrate the existing macroeconomic policy debates the following questions should be
addressed:
i. Should Monetary and Fiscal Policymakers Try to Stabilize the Economy?
Pro: Policymakers Should Try to Stabilize the Economy
1. When households and firms feel pessimistic, aggregate demand falls. This causes output to
fall and unemployment to rise.
2. There is no reason for the economy to suffer through a recession when policymakers can
reduce the severity of economic fluctuations.
3. Thus, policymakers should take an active role in leading the economy to stability.
4. When aggregate demand is inadequate to ensure full employment, policymakers should act
to boost spending in the economy. When aggregate demand is excessive and there is a risk
of inflation, policymakers should act to lower spending.
5. Such policy actions put macroeconomic theory to its best use by leading to a more stable
economy.
Against: Policymakers Should Not Try to Stabilize the Economy
1. There are substantial difficulties associated with running fiscal and monetary policy. One
of the most important problems to remember is the time lag that often occurs with policy.
2. Economic conditions change over time. Thus, policy effects that occur with a lag may hit
the economy at the wrong time, leading to a more unstable economy.
3. Therefore, policymakers should refrain from intervening and be content with doing no
harm.
II. Should Monetary Policy Be Made by Rule Rather than by Discretion?
Pro: Monetary Policy Should Be Made by Rule

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1. Discretionary monetary policy leads to two problems:

a. It does not limit incompetence and abuse of power. For example, a central banker may
choose to create a political business cycle to help out a particular candidate.
b. It may lead to a greater amount of inflation than is desirable. Policymakers often renege the
actions that they promise. If individuals do not believe that the central bank will follow a
low inflation policy, the short run Phillips curve will shift, resulting in a less favorable
tradeoff between inflation and unemployment.
2. one way to avoid these problems is to force the central bank to follow a monetary rule. This
rule could be flexible enough to allow for some information on the state of the economy.

Against: Monetary Policy Should Not Be Made by Rule

1. Discretionary monetary policy allows flexibility. This gives the Fed the ability to react to
unforeseen situations quickly.
2. It is also unclear that Fed central bankers use policy to help political candidates. Often, the
policy used is one that actually lowers the candidate’s popularity such as during the Carter
administration.
3. The Fed can gain the confidence of people by following through on its promises. If it
promises to fight inflation and then runs policies that keep the growth of the money supply
low, there is no reason why inflation expectations would be high. Thus, the economy can
achieve low inflation without a policy rule. This has been shown to be the case in the
United States in the 1990s.
4. It would also be very difficult to specify a precise rule.
III. Should the Central Bank Aim for Zero Inflation?
Pro: The Central Bank Should Aim for Zero Inflation
1. Inflation confers no benefits on society, but it poses real costs:
 Shoe leather costs
 Menu costs
 Increased variability of relative prices
 Tax distortions
 Confusion and inconvenience
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 Arbitrary redistributions of wealth
2. Reducing inflation usually is associated with higher unemployment in the short run.
However, once individuals see that policymakers are trying to lower inflation, inflation
expectations will fall, and the short run Phillips curve will shift down. The economy will
move back to the natural rate of unemployment at a lower inflation rate.
3. Therefore, reducing inflation is a policy with temporary costs and permanent benefits.
It is not clear that a case could be made for any other level of inflation. Price stability only
occurs if the inflation rate is zero.
Against: The Central Bank Should Not Aim for Zero Inflation
1. The benefits of zero inflation are small relative to the costs. Estimates of the sacrifice ratio
suggest that lowering inflation by one percentage point lowers output in the economy by
5%. These costs are borne by the workers with the lowest level of skills and experience
who lose their jobs.
2. There is no evidence that the costs of inflation are large. Also, policymakers may be able to
lower the costs of inflation (by changing tax laws, for example) without actually lowering
the inflation rate.
3. Although, in the long run, the economy will move back to the natural rate of unemployment,
there is no certainty that this will occur quickly. It may take time for the central bank to gain
the trust of the people.
4. Moreover, recessions have permanent effects. Investment falls, lowering the future capital
stock. When workers become unemployed, they lose valuable job skills.
5. A small amount of inflation may actually benefit the economy.
IV. Should the Government Balance Its Budget?
Pro: The Government Should Balance Its Budget

1. Future generations of taxpayers will be burdened by the federal government’s debt. This
will lower the standard of living for these future generations.
2. Budget deficits cause crowding out effect. Reduced national saving raises interest rates and
lowers investment. A lower capital stock reduces productivity and thus leads to a smaller
amount of economic growth than would have occurred in the absence of this budget deficit.

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3. While it is sometimes justifiable to run budget deficits such as in times of war or recession,
recent budget deficits are not easily justified. It appears that Congress simply found it easier
to borrow to pay for its spending instead of raising taxes.
Against: The Government Should Not Balance Its Budget
1. The problems caused by the government debt are overstated. The future generation’s burden
of debt is relatively small when compared with their lifetime incomes.
2. It is important that any change in government spending is examined for external effects. If
education spending is cut, for example, these will likely lead to lower economic growth in
the future. This will certainly not make future generations better off.
3. To some extent, parents who leave a bequest to their children can offset the effects of the
budget deficits on future generations.
V. Should Tax Laws Be Reformed to Encourage Saving?
Pro: The Tax Laws Should Be Reformed to Encourage Saving
1. The greater the amount of saving in an economy, the more funds there are available for
investment. This increases productivity, raising the nation’s standard of living.
2. Because people respond to incentives, changing the tax laws to make saving more
attractive will raise the amount of funds saved. Current laws tax the return on saving fairly
heavily. Some forms of capital income such as corporate profits are taxed twice: first at the
corporate level and then at the stockholder level. Large bequests are also taxed, limiting the
amount of incentive parents have to save for their children.
3. Tax laws are not the only government policy that discourage saving. Transfer programs
such as welfare and Medicaid are reduced for those who have saved past income. College
financial aid policies also are a function of income and wealth, penalizing those who have
saved.
4. There are various ways to change the tax laws to encourage saving:
a. Expand the ability of households to use tax-advantaged savings accounts such as
Individual Retirement Accounts.
b. Replace the current income tax system with a tax on consumption.
Against: The Tax Laws Should Not Be Reformed to Encourage Saving

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1. Increasing saving is not the only goal of tax policy. Policymakers are interested in using tax
policy to redistribute income, making sure that the burden of taxation falls on those who
can most afford it. Any tax change that encourages saving will favor high income
households as they are more likely to be saving in the first place.
2. Changes in tax rates have conflicting substitution and income effects.
3. Saving can be increased in other ways. For example, governments could lower budget
Deficits or increase budget surpluses to rise public saving.
4. Lowering the tax on capital income lowers the revenue of the government. This may
increase the budget deficit, lower public saving, and push national saving down as well.

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