Chap-7-8 Unemployment & Inflation
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Transcript of Chap-7-8 Unemployment & Inflation
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UNEMPLOYMENT
&INFLATION
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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.
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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.
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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.
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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.
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THE PHILLIPS CURVE
The Phillips curveshows the short-run trade-
off between inflation and unemployment.
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The Phillips Curve
Unemployment
Rate (percent)
0
Inflation
Rate
(percent
per year)
Phillips curve
4
B6
7
A2
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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.
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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
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SHIFTS IN THE PHILLIPS
CURVE
The Phillips curve seems to offer
policymakers a menu of possible inflation
and unemployment outcomes.
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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.
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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
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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
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
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.
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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.
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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
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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
Short-run Phillips curve
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
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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.
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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
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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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SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
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
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
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
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SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
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.
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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
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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
Short-run Phillips curve
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