Inflation and Unemployment

Content
• The causes and consequences of unemployment
• The natural rate of unemployment hypothesis
• The phillips curve
• The causes and consequences of inflation
 Unemployment
• There are a number of types of unemployment:
– Structural unemployment
– Cyclical unemployment
– Frictional unemployment
• Structural unemployment occurs when the economy
changes and industries die out
• Training is needed to give the unemployed workers
new skills
 Unemployment
• Cyclical unemployment is caused by the business
cycle
• Frictional unemployment is caused when people are
temporarily out of work as they are moving jobs
 Unemployment and PPF
• Unemployment means that
scarce economic
resources are being
wasted reducing the long
run potential of the
economy
• Where there are high
levels of unemployment an
economy will be operating
inside the perimeters of its
PPF
 Unemployment and AD / AS
• As Aggregate demand increases unemployment will
decrease
• Supply side policies can be used to increase
aggregate supply in the economy and thereby
reduce the level of unemployment
• However if the growth in the level of aggregate
demand is less than the underlying trend growth in
output unemployment is likely to occur
 Causes and Consequences of
Unemployment
• Unemployment is caused by demand and supply
side factors
• On the demand side if the demand curve shifts
inwards unemployment will rise
• Supply side factors such as an excess of supply of
workers also means unemployment will increase
 Policies that increase labour market
flexibility
• A number of policies can be implemented to
increase market flexibility and reduce
unemployment
• Policies can be implemented on the supply side and
the demand side by the government
 Supply side policies
• Supply side policies include:
• Reducing the occupational mobility of labour – this
can be through providing training for the
unemployed, increasing the availability and quality
of education and providing incentives for people to
work
 Demand side policies
• Employment subsidies can be used by the
government to encourage businesses to give jobs
to the long term unemployed
 Effects of Unemployment
• On an individual level unemployment reduces the level of income
that an individual earns
• As their income is reduced consumption also reduces as they pay for
necessities rather than luxuries
• Goods that are income elastic will be consumed less
• Quality of life will be reduced for the unemployed worker
• Workers may become discouraged and give up searching for jobs
becoming part of the long term structural unemployment in the
country
 Effects of Unemployment
• Unemployment can have significance effects on the
performance of the economy as a whole
• The effects are most marked due to long terms
unemployment
• If there is unemployment in the economy resources
are not being used effectively and the economy will
be operating below any points on the PPF curve
 Economic effects of unemployment
• If unemployment rates are rising there will be a negative
impact on economic growth potential
• Consumption is likely to fall as consumers will have had a
decrease in income levels
• Government spending will increase as the government will
be responsible for benefit payments
• Taxation levels will decrease as less people are in work
and therefore paying taxes
Natural Rate of Unemployment Hypothesis
• The natural rate of unemployment recognizes that
there will always be some level of unemployment in
an economy
• At the natural rate all unemployment will be
voluntary
• This is the employment rate when the economy is
operating at full employment
 Determinants of the natural rate
• The natural rate is determined by the interaction of
the demand for labour and the supply of labour
• At the equilibrium wage rate all people who want a
job can get a job
• However at this wage rate their will be some people
who choose not to work
 Determinants of the natural rate
• The natural rate of unemployment is determined by:
– Value of welfare benefits
– Trade union power
– Taxation system
– Migration of labour
– Social factors
 Natural rate of unemployment and policy
• If governments want to reduce the natural rate of
unemployment they need to concentrate on supply
side policies
• If the benefits system is relatively high in a country it
will cause less people to want to work
 Inflation
• Inflation- The rise in the general level of prices
• In the long term, inflation erodes consumer purchasing
power.
• That means that accumulated wealth buys less and less,
with the passage of time.
• Where there is high inflation it is difficult for businesses to
plan for the future as there is uncertainty regarding the cost
of raw materials
 The Aggregate Demand Curve

• Aggregate demand
is the total demand for
goods and services in
the economy.

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Deriving the Aggregate Demand
Curve
• To derive the aggregate
demand curve, we examine
what happens to aggregate
output (income) (Y) when the
price level (P) changes,
assuming no changes in
government spending (G), net
taxes (T), or the monetary policy
variable (Ms).
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Deriving the Aggregate Demand
Curve
• The aggregate
demand (AD) curve
is a curve that shows
the negative
relationship between
aggregate output
(income) and the
price level.

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 The Aggregate Demand Curve:
A Warning
• At all points along
the AD curve, both
the goods market
and the money
market are in
equilibrium.

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Other Reasons for a Downward-
Sloping Aggregate Demand
Curve
• The consumption link: The
decrease in consumption
brought about by an
increase in the interest rate
contributes to the overall
decrease in output.

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Other Reasons for a Downward-
Sloping Aggregate Demand
Curve
• The real wealth effect, or
real balance, effect is the
change in consumption
brought about by a change
in real wealth that results
from a change in the price
level.

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 Aggregate Expenditure
and Aggregate Demand
• At every point along the
aggregate demand curve,
the aggregate quantity of
output demanded is exactly
equal to planned aggregate
expenditure.
Y=C+I+G
equilibrium condition

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Shifts of the Aggregate Demand
Curve
• An increase in the
quantity of money
supplied at a given
price level shifts the
aggregate demand
curve to the right.

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Shifts of the Aggregate Demand
Curve
• An increase in
government
purchases or a
decrease in net
taxes shifts the
aggregate demand
curve to the right.

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Shifts of the Aggregate Demand
Curve
Factors That Shift the Aggregate Demand Curve
Expansionary monetary policy Contractionary monetary policy

Ms AD curve shifts to the right Ms AD curve shifts to the left

Expansionary fiscal policy Contractionary fiscal policy

G AD curve shifts to the right G AD curve shifts to the left

T AD curve shifts to the right T AD curve shifts to the left

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 The Aggregate Supply Curve

• Aggregate supply is
the total supply of all
goods and services in
the economy.

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 The Aggregate Supply Curve

• The aggregate supply

(AS) curve is a graph that
shows the relationship
between the aggregate
quantity of output supplied
by all firms in an economy
and the overall price level.

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 Aggregate Supply in the Short
Run
• In the short run, the
aggregate supply
curve (the
price/output
response curve)
has a positive
slope.

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 Shifts of the Short-Run
Aggregate Supply Curve
• A cost shock, or supply shock, is a
change in costs that shifts the aggregate
supply (AS) curve.

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 Shifts of the Short-Run
Aggregate Supply Curve
Factors That Shift the Aggregate Supply Curve

Shifts to the Right Shifts to the Left

Increases in Aggregate Supply Decreases in Aggregate Supply
Lower costs Higher costs
lower input prices higher input prices
lower wage rates higher wage rates
Economic growth Stagnation
more capital capital deterioration
more labor
technological change
Public policy Public policy
supply-side policies waste and inefficiency
tax cuts over-regulation
deregulation
Good weather Bad weather, natural
disasters, destruction
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 Causes of Inflation

• Inflation is an increase in
the overall price level.
• Sustained inflation occurs
when the overall price level
continues to rise over
some fairly long period of
time.

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 Causes of Inflation
• Demand-pull inflation is • Cost-push, or supply-side,
inflation is inflation caused by an
inflation initiated by an increase in costs.
increase in aggregate
demand.

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 Cost-Push, or Supply-Side
Inflation
• Stagflation occurs
when output is falling at
the same time that
prices are rising.
• One possible cause of
stagflation is an
increase in costs.

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 Cost-Push, or Supply-Side
Inflation
• Cost shocks are bad
news for policy
makers. The only
way to counter the
output loss is by
having the price level
increase even more
than it would without
the policy action.
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 Money and Inflation

• Hyperinflation is a
period of very rapid
increases in the
price level.

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 Money and Inflation

• An increase in G with
the money supply
constant shifts the AD
curve from AD0 to
AD1. This leads to an
increase in the interest
rate and crowding out
of planned investment.

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 Money and Inflation

• If the Central bank tries

to prevent crowding, it
will increase the money
supply and the AD curve
will shift farther and
farther to the right. The
result is a sustained
inflation, perhaps
hyperinflation.

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 The causes of inflation
• inflation results when the macro economy has too much
demand for available production. These alternatives fall
under two general categories:
• Demand-Pull Inflation: This inflation occurs when
household, business, government, and foreign industries
collectively try to purchase more output than the economy
is capable of producing. In effect, the demand side of the
aggregate market is "pulling" the price level higher.
• Cost-Push Inflation: Cost-push inflation is inflation
attributable to decreases in supply, primarily due to
increases in production cost
Cost Push Inflation
• As costs rise it causes the
aggregate supply curve to
shift onwards so less is
supplied at each price
level
• Each time the aggregate
supply curve shifts inwards
the price rises causing
inflation
Demand pull inflation
• As aggregate demand
increases then the general
price level rises
• When total demand exceeds
total supply demand pull
inflation occurs
• If the economy is close to full
capacity the effects of demand
pull inflation will be greater
 Preventing inflation
• One of the best ways to prevent inflation is through stock
and variable universal life insurance. These alternatives
provide the potential for returns that exceed inflation over
the long term.
• Central banks place high interest rates using
unemployment and the decline of production to prevent
price increases.
Short Run Trade Off Between
Inflation and Unemployment
 Unemployment and Inflation
• The natural rate of unemployment
depends on various features of the labor
market.
• Examples include minimum-wage laws,
the market power of unions, the role of
efficiency wages, and the effectiveness of
job search.
• The inflation rate depends primarily on
growth in the quantity of money, controlled
by the Central Bank.
 Trade Off
• Society faces a short-run tradeoff between
unemployment and inflation.
• If policymakers expand aggregate demand,
they can lower unemployment, but only at
the cost of higher inflation.
• If they contract aggregate demand, they
can lower inflation, but at the cost of
temporarily higher unemployment.
 Phillips Curve
• The Phillips curve illustrates the short-run
relationship between inflation and
unemployment.
 The Phillips Curve

Inflation
Rate
(percent
per year)

6 B

A
2

Phillips curve

0 4 7 Unemployment
Rate (percent)

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 AD, AS, and Phillips Curve
• The Phillips curve shows the short-run
combinations of unemployment and
inflation that arise as shifts in the
aggregate demand curve move the
economy along the short-run aggregate
supply curve. The greater the aggregate
demand for goods and services, the
greater is the economy’s output, and the
higher is the overall price level.
• A higher level of output results in a lower
level of unemployment.
 (a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Inflation
Level Short-run Rate
aggregate (percent
supply per year)
6 B
106 B

102 A
High
A
aggregate demand 2
Low aggregate
Phillips curve
demand
0 7,500 8,000 Quantity 0 4 7 Unemployment
(unemployment (unemployment of Output (output is (output is Rate (percent)
is 7%) is 4%) 8,000) 7,500)

Copyright © 2004 South-Western

 Long-Run Phillips Curve
• In the 1960s, Friedman and Phelps
concluded that inflation and
unemployment are unrelated in the long
run.
– As a result, the long-run Phillips curve is
vertical at the natural rate of unemployment.
– Monetary policy could be effective in the short
run but not in the long run.
 The Long-Run Phillips Curve

Inflation
Rate Long-run
1. When the Phillips curve

Central Bank
increases High B
the growth rate inflation

of the money

supply, the
2. . . . but unemployment
rate of inflation A remains at its natural rate
Low
in the long run.
inflation
increases . . .

0 Natural rate of Unemployment

unemployment Rate

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 (a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Long-run aggregate Inflation Long-run Phillips

Level supply Rate curve
1. An increase in 3. . . . and
the money supply increases the
increases aggregate inflation rate . . .
B
P2 demand . . . B
2. . . . raises
the price
A
level . . . P A
AD2
Aggregate
demand, AD
0 Natural rate Quantity 0 Natural rate of Unemployment
of output of Output unemployment Rate
4. . . . but leaves output and unemployment
at their natural rates.

Copyright © 2004 South-Western

 Summary
• There are three main types of unemployment:
– Structural
– Cyclical
– Frictional
• Unemployment means that an economy cant operate on its ppf
• As AD increases unemployment decreases
• The natural rate of unemployment recognises there will always be some level of
unemployment in the economy
• The Phillips curve shows an inverse relationship between unemployment and
inflation
• Inflation is a rise in the general level of prices
• There are two causes of inflation:
– Cost push
– Demand pull