CHAPTER 4 - INFLATION AND UNEMPLOYMENT Objectives: After studying this chapter, you should be able to: define inflation

ne inflation identify the different degrees of inflation identify the causes of inflation calculate the inflation rate consider the various costs that inflation imposes on society identify ways to control inflation define unemployment compute the measurement of unemployment identify different types of unemployment consider the various costs that unemployment imposes on identify policies to reduce unemployment explain the relationship between inflation and

society

unemployment using Phillips Curve INFLATION Definition

Inflation can be defined as a situation where there is a continuous increase in general price level over time generally inflation is a situation where there is too much money chasing too few goods cost of living has increased there is persistent fall in the value in the economy prices are rising

Degrees of inflation i) Mild inflation not serious condition normally the general price level would increase up to 5 %,

i.e. the CPI is about 105 ii) Creeping inflation more serious than mild inflation occurs when demand is rising but supply is constant , the general price level would normally increase by 10%

hence leading to rising prices and CPI is 110 iii) Hyperinflation / galloping inflation / runaway inflation very serious economic condition where the value of money inflation that exceeds 50% per month price level increases more than 100-fold over the course of in some countries money becomes valueless and a new is persistently falling

a year currency system has to be adopted

Causes of inflation a) Demand pull inflation the basic cause of inflation comes from the demand side

there is persistent increase in demand which could be due increase in money supply (expansionary monetary policy) increase in government purchases (expansionary fiscal increase in exports when demand is rising and cannot be met by a

factors such as

policy)

corresponding increase in supply , then the general price level will increase and inflation will occur as depicted in Figure 4.1 , the rightward shift in the AD the effect is to push prices upwards from P1 to P2 curve from AD1 to AD2 will result in excess demand

Price

AS P2 P1 AD2 AD1 Output Q1 Q2

Figure 4.1 b) Cost push inflation ( supply push inflation ) the basic cause is the rising costs of production , such as an increase in wage rates an increase in the prices of raw materials

when industries are faced with rising production costs , in terms of AD-AS diagram , this is depicted in Figure 4.2 as the AS curve from AS1 to AS

they will push prices up an upward shift in

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the result is a rise in prices from P1 to P2

Price AS2 AS1 P2 P1

Output

Figure 4.2

Q2 Q1

c) Imported Inflation If there is inflation in the source countries of imports, imported inflation comes in along with the imported goods and services. E.g. as inputs or raw materials such as crude oil are purchased at high, inflated prices from the Middle East where the inflation originates, non-oil producers like Singapore import the inflation as well. 4.1.4 Measurement of Inflation

 i) ii)

general price level is measured using price index the GDP deflator (refer to chapter 1) the CPI an index that measures changes in prices of a fixed basket of goods defined as CPI in year K = (cost of basket in year K / cost of basket in base year) X 100

e.g. suppose a basket of goods costs RM200 in the base year of 1992 and RM250 in 1997 then CPI for 1992 and 1997 are given as CPI1992 = (RM200 / RM200) X 100 = 100 CPI1997 = (RM250 / RM200) X 100 = 125

assuming CPI is used to measure inflation , then the rate of inflation between 2 periods , say period t and period (t-1 ) is given by inflation rate = (CPIt CPIt-1) / CPIt-1 x 100%

e.g. in Dec 1999, CPI was 118.9, and in Dec 1998, it was 115.7, so the inflation rate during 1998 was
118 .9 115 .7 X 100 % = 2.77% 115 .7

it is possible for inflation to be negative, but this rarely happens, this would occur when the general price level falls and it is called deflation

Costs of Inflation

A) Anticipated Inflation (inflation that is expected) i) Menu costs costs of inflation that arise from actually changing prices restaurant owners, catalogue producers, and any other

business that must post prices will have to incur costs to change their prices because of inflation ii) Shoe-leather costs costs of inflation that arise from trying to reduce holdings of cash B) Unanticipated Inflation (inflation that is not expected) failure to anticipate inflation correctly imposes costs in the labour market and the capital market In the labour market , unanticipated inflation causes a) redistribution of income cause wages to be set at the wrong level and create unintended redistribution of income a burst of unanticipated inflation lowers workers real lower than expected inflation causes real wages to be high wages , and employers gain at the expense of workers and workers gain at the expense of employers b) departures from full employment higher than anticipated inflation lowers workers real wages , so some quit to search for other jobs such quitting imposes costs on both workers and firms

lower than expected inflation raises the real wage , so firms lay off some workers and the unemployment rate rises costs are imposed on both workers and firms

In the capital market , unanticipated inflation causes a) redistribution of income and too much or too little lending and borrowing b) interest rates based on incorrectly anticipated inflation imposes a cost on either the borrower or lender if the inflation rate is unexpectedly high , borrowers gain but lenders lose if the inflation rate is unexpectedly low , lenders gain but borrowers lose c) inaccurate inflation expectations also create an inappropriate amount of borrowing and lending when the inflation rate is higher than anticipated , the real interest rate is lower than anticipated , and borrowers want to have borrowed more and lenders want to have loaned less when the inflation rate is lower than anticipated , the real interest rate is higher than anticipated , and borrowers want to have borrowed less and lenders want to have loaned more Ways to control inflation 3 main ways by which inflation can be controlled

i)

adopt tight monetary policy undertaken by Central Bank (Bank

Negara) that use some instruments to influence the economy by reducing money supply and higher interest rates ii) iii) contractionary fiscal policy that deals with reducing government direct control - direct govt intervention in the price mechanism of expenditures and increasing tax the country a) price pegging government fixed the floor and ceiling prices , so that producers will not be able to increase prices according to prices will not increase rapidly their own wishes b) control of trade union demand for higher wages has caused cost-push inflation persuade not to make these demands

c) anti-hoarding campaign done in Msia , where reports were made against producers and consumers who store their goods unnecessarily because such storage could cause artificial shortage and push prices up d) price tagging e) rationing prices of all goods have to be labelled prevent producers from over-charging the consumers

This is done as a last resort whereby consumers are given

coupons to buy goods in certain quantities, for example, one family is only allowed to buy 10 kilograms of rice per month. In other words, the demand for the good is predetermined. To be effective all 3 methods, i.e. monetary policy, fiscal policy and direct control must be implemented simultaneously

UNEMPLOYMENT Definitions the unemployed are those individuals who do not currently have a job but who are looking for work individuals who looked for work in the past but are not looking currently are not counted as unemployed the employed are individuals who currently have jobs thus, employed + unemployed = labour force

people who are not working and are not looking for work are not considered to be in the labour force such as a full-time student, homemaker, or retiree is not in the labour force

discouraged workers also not included in the official count of the unemployed as they are workers who left the labour force because they could not find jobs

Measurement of Unemployment Unemployment rate the percentage of the labour force that is unemployed it is computed as:
No. of unempl oyed worke rs X 100% labour for ce

OR
Labour for ce - no. of employ ed workers X 100% labour for ce

Types of unemployment i) unemployment can be classified into 3 types : frictional unemployment unemployment that occurs naturally during the normal workings of an economy can occur for a variety of reasons such as people change jobs, move across the country, search for new opportunities or take their time after they enter the labour force to find appropriate job arises because it takes time for workers to be matched during this time , workers engaged in a job search will be the problem is that information is imperfect with suitable jobs registered as unemployed

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employers are not fully informed about what labour is workers are not fully informed about what jobs are to remedy frictional unemployment - better job information

available . available . provided by government job centers , local and national newspaper . ii) Structural unemployment arises from changes in the pattern of demand and supply pattern of demand - declining demand - change in

in the economy consumer tastes , goods out of fashion , competition from other industries , etc. pattern of supply - methods of production - new techniques Unemployment may result from labour-saving of production.

techniques of production or a whole new technology which requires workers with different skills. people cannot immediately take up jobs in other parts because there is mismatch between workers skill and job requirements due to not having sufficient education lack of skills and training E.g. when products such as black and white television

become obsolete workers engaged in their production may become unemployed. iii) Cyclical unemployment

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arises because the economy is in recession and there is e.g.: in the recession year 1982, the unemployment rate unemployment increases during recession and decreases expansion .

deficiency of demand rose in 48 of the 50 states in U.S. during in any economy , actual rate of unemployment = natural rate of unemployment + cyclical rate of unemployment the natural rate of unemployment is defined as the rate of unemployment that prevails when output and employment are at the full level of employment level . even though the economy is operating at the full employment level of employment , there will still be people who are facing frictional and structural unemployment in other words , natural rate of unemployment = frictional + structural unemployment .

Costs of Unemployment i) Costs to the unemployed Even though, people may have more time to pursue leisure

activities, they may be constrained in so doing by a lack of income The unemployed also suffer a loss of status as a certain amount of social stigma is still attached to being unemployed.

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More likely to experience divorce, nervous breakdowns, bad health and are more likely to attempt suicide than the rest of the adult population

Long periods of unemployment reduce the value of human capital. When people are out of work, their skills can become rusty, and they miss out on training in new methods.

ii)

Costs to society The main cost to society is the output which is lost people will enjoy fewer goods and services than they could have consumed with higher employment The country will be producing inside its PPF Whilst government revenue will fall as unemployment rises, it will have to increase its spending on unemployment related benefits (such as unemployment benefit)

there has been increased evidence of a link between crime and unemployment, particularly in the case of young unemployed men

Policies to reduce unemployment policies to reduce unemployment depend on the type of

unemployment i) Frictional unemployment focus primarily on improving the information flows between employment agencies need to be set up to pool and employers and job-seekers provide information on the type of job opportunities that are

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available on the kind of workers who are searching for employment another much more controversial remedy is for the government to reduce the level of unemployment benefit ii) structural unemployment encouraging people to look more actively for jobs, if encourage people to adopt a more willing attitude towards necessary in other parts of the country retraining, and if necessary to accept some reduction in wages use wage subsidy programs to encourage employers to hire and train those who otherwise lack the necessary skills to get the jobs iii) cyclical unemployment

adopt expansionary monetary policies by increasing money interest rates to stimulate aggregate

supply and reducing

demand or expansionary fiscal policy by increasing government expenditure and reducing tax

4.2.6 Curve

Trade-off between Inflation and Unemployment - The Phillips

a Phillips curve shows the relationship between the inflation rate and the unemployment rate there are 2 times frame for PC : the short-run PC the long-run PC

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the short-run PC shows the relationship between inflation and unemployment holding constant the expected inflation rate and natural rate of unemployment .

Figure 4.3 illustrates a short-run PC

Inflation rate (%)

SRPC

Figure 4.3

Unemployment rate (%)

it demonstrate that a higher inflation rate lowers the unemployment rate the negative relationship between the inflation rate and unemployment rate is explained by the aggregate demand and aggregate supply model

an unexpectedly large increase in aggregate demand raises the inflation rate and increases real GDP , which lowers the unemployment rate

hence , higher inflation is associated with lower unemployment shown by a movement along a short-run PC . Figure 4.4 depicts the Phillips curve and the AD/AS curves

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AS
0

Figure 4.4 the long-run PC shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate the long-run PC is vertical at the natural unemployment rate along the long-run PC , an increase in the inflation rate has no effect on the unemployment rate .

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The long-run PC tells us that any anticipated inflation rate is possible at the natural unemployment rate when inflation is anticipated, real GDP= potential GDP ==> unemployment is at the natural rate

How is the Short-run Phillips Curve related to the Long-run Phillips curve? e.g.: An increase in the growth of the money supply

Inflation rate

6 3

C A SRPC' (Pe=6%) SRPC (P =3%) UE rate

e

Figure 4.5

5 (Natural rate of UE)

Suppose the economy is at point A in figure 4.5. At that point, the inflation rate is 3% and the unemployment rate is at the natural rate, 5%.

Now suppose the growth rate of the money supply increases. The increase in the growth rate of money supply will stimulate aggregate demand.

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In the short run, the increase in AD will increase output and decrease unemployment, as the economy moves up along the short-run Phillips curve, from point A to point B, where the actual inflation rate has increased from 3% to 6% and the unemployment rate has fallen below the natural rate to 3%.

Because the increase in inflation was unanticipated, real wages fall. Firms are now receiving higher prices relative to their input costs, so they expand output - unemployment rates fall - movement along the SRPC from A to B.

Eventually, workers (and other input owners) realize that their real wage has fallen because of the increase in the inflation rate that was not initially anticipated. Workers now vigorously negotiate for higher wages - this increases costs to producers, and as a result, they reduce output and unemployment rises - rightward shift in the SRPC from point B to point C in figure 4.5.

REFERENCES: 1. Principles of Economics, Second Edition, N.Gregory Mankiw, Harcourt, 2001 2. Economics Fourth Edition, David N. Hyman, Irwin Book Team, 1996

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