chap-7-8 unemployment & inflation

7/31/2019 Chap-7-8 Unemployment & Inflation

1/41

UNEMPLOYMENT

&INFLATION


2/41

Unemployment

Unemployed

Those with no job who are looking for work

Unemployment rate

Measures the percentage of those in the labor forcewho are unemployed

Equals the number of unemployed divided by the

number in the labor force

Does not include discouraged workers

Discouraged workers

Those who are no longer looking for work but are

unemployed


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Sources of Unemployment

Frictional

Seasonal

Structural

Cyclical


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Frictional Unemployment

Caused by time required to bring together

labor suppliers and labor demanders

Employers need time to learn about the talent

available Job seekers need time to learn about employment

opportunities

Generally short-term and voluntary


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Seasonal Unemployment

Caused by seasonal changes in labor demandduring the year

To eliminate the impact of such changes,

monthly unemployment statistics are seasonallyadjusted, which smoothes out these factors


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Structural Unemployment

Exists because unemployed workers often Do not have the skills demanded by employers, or

Do not live where their skills are in demand

Occurs because changes in tastes, technology,taxes, or competition reduce the demand forcertain skills and increase the demand for other

skills


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Cyclical Unemployment

Fluctuates with the business cycle,

increasing during contractions and

decreasing during expansions Means the economy is operating inside its

PPF

Government policies to stimulateaggregate demand recessions is aimed at

reducing this type of unemployment


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Full Employment

Occurs only if there is no cyclicalunemployment

Occurs when the only unemployment is

frictional, structural, or seasonal Does not mean zero unemployment

Frictional, seasonal, and structuralunemployment can still occur

Occurs when from 4% to 6% of the laborforce is unemployed


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INFLATION

Inflation is a continual rise in the price level.

The rate of change in the overall price level of

goods and services that we consume.

According to Keynes, "Inflation refers to a rise inprice level after full employment level has been

achieved."

Under such conditions, only prices will rise, andthe output will remain the same.


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Inflation Since 1900

3020101900 40 50 60 70 80 90 2000

10

5

0

5

10

15

20

25


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Types of Inflation

Inflation is classified into three categories:

Creeping Inflation : a small increase in

prices.

Running Inflation : Price will increase at 8

to 10 % per annum.

Hyper or galloping inflation: When inflationreaches double or triple digit figures.


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Deflation

Average prices of goods and services do

not always increase.

i.e. the price decrease for some goods

and services may outweigh the increase in

prices of other goods and services.

Disinflation: a reduction in the rate of

inflation


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Inflation

Inflation is typically measured annually

Annual inflation rate is the percentage

increase in the average price level fromone year to the next

Two sources of inflation Demand-pull inflation

Cost-push inflation


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Aggregate demand (AD) Relationship between various quantities of

output that all people together will buy atvarious price levels in a defined period.

The aggregate demand curve slopesdownward because of real balance effect,foreign trade effect and interest rate effect

Real balance effect: a decrease in the pricesof goods and services makes the rupee more

valuable. Inverse relationship between real output and

price level i.e., aggregate demand curve is

downward sloping.


15/41

Foreign trade effect & Interest rate

effect

Foreign trade effect:if the prices fall in Domestic

Market, consumer will buy more goods that are

produced in Domestic Market.

Interest rate effect:When money is available at acheaper rate, it encourages people to borrow

more and make loan financed purchases. So,

it can be said that when price levels are lower,

people buy more. Again, this is an inverserelationship between price and quantity.


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Aggregate supply (AS)

Aggregate supply is the real value of

output producers are willing and able to

bring to market at alternative price levels

Profit effect

Cost effects


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Inflation Caused by Shifts of AD and AS Curves

Increase in the AD curvepulls up

the price level. To generate

continuous demand-pull inflation,

the AD curve must keep shifting

outward along a given AS curve

Increase in costs of productionpush

up the price level. To generate

continuous cost-push inflation, the AS

curve must keep shifting to the left

along a given AD curve.


18/41

Unemployment from a Wage Above

the Equilibrium Level

Quantity of

Labor

0

Surplus of labor=

Unemployment

Labor

supply

Labor

demand

Wage

Minimum

wage

LD LS

WE

LE


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Inflation and Unemployment

The natural rate of unemploymentdepends on various features of the labormarket.

Examples include minimum-wage laws, themarket power of unions, the role of efficiencywages, and the effectiveness of job search.

The inflation rate depends primarily on growthin the quantity of money, controlled by thebank.


20/41

Inflation and Unemployment

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.


21/41

THE PHILLIPS CURVE

The Phillips curveshows the short-run trade-

off between inflation and unemployment.


22/41

The Phillips Curve

Unemployment

Rate (percent)

0

Inflation

Rate

(percent

per year)

Phillips curve

4

B6

7

A2


23/41

Aggregate Demand, Aggregate Supply,

and the Phillips Curve

The Phillips curve shows the short-runcombinations of unemployment and inflation thatarise as shifts in the aggregate demand curvemove the economy along the short-run aggregatesupply curve.

The greater the aggregate demand for goods andservices, the greater is the economys output, andthe higher is the overall price level.

A higher level of output results in a lower level ofunemployment.


24/41

Phillips Curve and Aggregate Demand and

Aggregate Supply

Quantity

of Output

0

Short-run

aggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply

Unemployment

Rate (percent)

0

Inflation

Rate

(percent

per year)

Price

Level

(b) The Phillips Curve

Phillips curve

Low aggregate

demand

High

aggregate demand

(output is

8,000)

B

4

6

(output is

7,500)

A

7

2

8,000

(unemployment

is 4%)

106 B

(unemployment

is 7%)

7,500

102 A


25/41

SHIFTS IN THE PHILLIPS

CURVE

The Phillips curve seems to offer

policymakers a menu of possible inflation

and unemployment outcomes.


26/41

The 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 shortrun but not in the long run.


27/41

The Long-Run Phillips Curve

Unemployment

Rate0 Natural rate of

unemployment

Inflation

Rate Long-run

Phillips curve

BHigh

inflation

Low

inflation

A

2. . . . but unemployment

remains at its natural rate

in the long run.

1. When thebank increases

the growth rate

of the money

supply, the

rate of inflation

increases . . .

H th Philli C i R l t d t


28/41

How the Phillips Curve is Related to

Aggregate Demand and Aggregate Supply

Quantity

of Output

Natural rate

of output

Natural rate of

unemployment

0

Price

Level

P

Aggregate

demand, AD

Long-run aggregate

supply

Long-run Phillips

curve


Unemployment

Rate

0

Inflation

Rate


2. . . . raises

the price

level . . .

1. An increase in

the money supply

increases aggregatedemand . . .

A

AD2

B

A

4. . . . but leaves output and unemployment

at their natural rates.

3. . . . and

increases the

inflation rate . . .P2

B


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The Meaning of Natural

The natural rate of unemployment is the

rate to which the economy gravitates in

the long run.

The natural rate is not necessarily

desirable, nor is it constant over time.

Monetary policy cannot change the natural

rate, but other government policies that

strengthen labor markets can.


30/41

The Short-Run Phillips Curve

Expected inflation measures how much

people expect the overall price level to

change.

Once people anticipate inflation, the only

way to get unemployment below the

natural rate is for actual inflation to be

above the anticipated rate.


31/41

The Short-Run Phillips Curve

This equation relates the unemployment

rate to the natural rate of unemployment,

actual inflation, and expected inflation.

The Unemployment Rate =

( )Natural rate of unemployment -a Actualinflation Expectedinflation

How Expected Inflation Shifts the Short


32/41

How Expected Inflation Shifts the Short-

Run Phillips Curve

Unemployment

Rate

0 Natural rate of

unemployment

Inflation

Rate Long-run

Phillips curve

Short-run Phillips curve

with high expected

inflation


with low expected

inflation

1. Expansionary policy moves

the economy up along the

short-run Phillips curve . . .

2. . . . but in the long run, expected

inflation rises, and the short-runPhillips curve shifts to the right.

CB

A


33/41

The Natural Experiment for the Natural-

Rate Hypothesis

The view that unemployment eventually returnsto its natural rate, regardless of the rate ofinflation, is called the natural-rate hypothesis.

Historical observations support the natural-ratehypothesis.

The concept of a stable Phillips curve brokedown in the in the early 70s.

During the 70s and 80s, the economyexperienced high inflation and highunemployment simultaneously.


34/41

The Phillips Curve in the 1960s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

Unemployment

Rate (percent)

Inflation Rate

(percent per year)

1968

1966

19611962

1963

1967

19651964


35/41

The Breakdown of the Phillips Curve

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

Unemployment

Rate (percent)

Inflation Rate

(percent per year)

1973

1966

1972

1971

19611962

1963

1967

1968

1969 1970

19651964


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SHIFTS IN THE PHILLIPS CURVE:

THE ROLE OF SUPPLY SHOCKS

Historical events have shown that the

short-run Phillips curve can shift due to

changes in expectations. The short-run Phillips curve also shifts

because of shocks to aggregate supply. Major adverse changes in aggregate supply can

worsen the short-run trade-off between unemployment

and inflation.

An adverse supply shock gives policymakers a less

favorable trade-off between inflation and

unemployment.


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A supply shock is an event that directly

alters the firms costs, and, as a result, the

prices they charge.

This shifts the economys aggregate

supply curve

. . . and as a result, the Phillips curve.


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An Adverse Shock to Aggregate

Supply

Quantity

of Output

0

Price

Level

Aggregate

demand


Unemployment

Rate

0

Inflation

Rate


3. . . . and

raises

the price

level . . .

AS2 Aggregate

supply,AS

A

1. An adverse

shift in aggregate

supply . . .

4. . . . giving policymakers

a less favorable tradeoff

between unemploymentand inflation.

BP2

Y2

PA

Y

Phillips curve, PC

2. . . . lowers output . . .

PC2

B


39/41



In the 1970s, policymakers faced two

choices when OPEC cut output and raised

worldwide prices of petroleum.

Fight the unemployment battle by expanding

aggregate demand and accelerate inflation.

Fight inflation by contracting aggregate

demand and endure even higherunemployment.


40/41

The Supply Shocks of the 1970s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

Unemployment

Rate (percent)

Inflation Rate

(percent per year)

1972

19751981

1976

1978

1979

1980

1973

1974

1977


41/41

Disinflationary Monetary Policy in the

Short Run and the Long Run

Unemployment

Rate

0 Natural rate of

unemployment

InflationRate

Long-run

Phillips curve

Short-run Phillips curvewith high expected

inflation


with low expectedinflation

1. Contractionary policy moves

the economy down along the

short-run Phillips curve . . .

2. . . . but in the long run, expected

inflation falls, and the short-run

Phillips curve shifts to the left.

BC

A

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