Inflation & unemployment

Types of Unemployment: Frictional Unemployment: Unemployment caused

when people move from job to job and claim benefit in the meantime

The quality of the information available for job seekers is crucial to the extent of the seriousness of frictional unemployment

Types of Unemployment: Structural Unemployment: Unemployment caused

as a result of the decline of industries and the inability of former employees to move into jobs being created in new industries

Seasonal Unemployment: Unemployment caused because of the

seasonal nature of employment – tourism, agriculture, sports etc.

CYCLICAL UNEMPLOYMENT: Caused by a general lack of demand

in the economy – this type of unemployment may be widespread across a range of industries and sectors

Keynes saw unemployment as primarily a lack of demand in the economy which could be influenced by the government

Okun’s Law: This law states that 1 extra point

of unemployment costs 2%of GDP Consequences of unemployment:1. Loss of potential output2. Loss of human capital3. Increasing inequalities and

distribution of income4. Social costs

Inflation & Phillips curve:

The inflation rate is the percentage change in the price level.

The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.

Causes of Inflation:

Demand-pull inflation is inflation initiated by an increase in aggregate demand.

• Cost-push, or supply-side, inflation is inflation caused by an increase in costs.

Demand pull :

Increase in AD can be due to a fiscal or monetary policy, thus increasing prices

Cost push:

Upward shift of the AS will be due to increase in costs due to increase in price of inputs.

Stagflation:

Stagflation occurs when output is falling at the same time that prices are rising.

One possible cause of stagflation is an increase in costs.

Combination of both:

Costs of inflation: Redistribution of income and wealth-

borrowers gain and creditors lose.fixed income earners lose.

Balance of payments effect- exports become expensive. Hence exchange rate depreciates.

Uncertainty about the value of money Resource cost of changing prices – menu

costs Economic growth and investment suffers

Philips Curve:

It is a statistical relationship between unemployment and money wage inflation.

Rate of inflation= rate of wage growth less rate of productivity growth.

Phillips Curve: 1958 – Professor A.W. Phillips Expressed a statistical relationship

between the rate of growth of money wages and unemployment from 1861 – 1957

Rate of growth of money wages linked to inflationary pressure

Led to a theory expressing a trade-off between inflation and unemployment

The Philips CurveWage growth % (Inflation)

Unemployment (%)

The Phillips Curve shows an inverse relationship between inflation and unemployment. It suggested that if governments wanted to reduce unemployment it had to accept higher inflation as a trade-off.

Money illusion – wage rates rising but individuals not factoring in inflation on real wage rates.

1.5%

6%4%

2.5%

PC1

The curve crosses the horizontal axis at a positive value of unemployment. Hence it is not possible to have zero inflation and zero unemployment

The concave shape implies that lower the level of unemployment higher the rate of inflation.

Govt. should be able to use demand management policies to take the economy to acceptable levels of inflation and unemployment.

In order to achieve full employment, some inflation is unavoidable.

However, this relationship broke down at the end of 1960s when Britain began to experience rising inflation and unemployment.

This raised a question on the application of Phillips curve in the long run.

Long run Phillips curve: dp/dt = f(1/u) + dpe/dt To keep unemployment below the natural

rate, inflation must keep on increasing every year. In the long run Philips curve will be vertical at the rate of unemployment where real aggregate demand equals real aggregate supply. This rate is called the natural rate of unemployment. It is also called NAIRU or Lowest sustainable unemployment rate (LSUR).

the inflation augmented Philips curve is given by the eqn :

π =πe -(U – U* ) expected inflation is passed on to

real inflation unemployment is at the natural

rate when actual unemployment equals expected inflation

inflation

The Philips Curve

Unemployment

Long Run PC

PC1

PC2PC3

Assume the economy starts with an inflation rate of 1% but very high unemployment at 7%. Government takes measures to reduce unemployment by an expansionary fiscal policy that pushes AD to the right (see the AD/AS diagram on slide 15)

7%

2.0%

1.0%

There is a short term fall in unemployment but at a cost of higher inflation. Individuals now base their wage negotiations on expectations of higher inflation in the next period. If higher wages are granted then firms costs rise – they start to shed labour and unemployment creeps back up to 7% again.

3.0%

To counter the rise in unemployment, government once again injects resources into the economy – the result is a short-term fall in unemployment but higher inflation. This higher inflation fuels further expectation of higher inflation and so the process continues. The long run Phillips Curve is vertical at the natural rate of unemployment. This is how economists have explained the movements in the Phillips Curve and it is termed the Expectations Augmented Phillips Curve.

7% becomes the natural rate in this case.

Whenever unemployment rate is pushed below natural rate , wages increase, pushing up costs. This leads to a lower level of output which pushes unemployment back to the natural rate.

Countering inflation:Demand -pull Reduce demand by higher taxation, lower govt.

expenditure, lower govt borrowing, higher interest rates

Cost push Take steps to reduce production costs by deregulating labour markets, encouraging greater productivity, apply control over wages and prices

Import factors

reduce quantity of imports or their prices via trade policies.

Controlling inflation (cont)Excessive growth on money supply

Reduce money supply by cutting down on public sector borrowingFunding Govt borrowing from non bankReduce bank lendingMaintain interest rates

Expectations of inflation

Pursue policies which indicate Govt’s determination to reduce inflation