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Inflation, Unemployment and Philip’s Curve

* Report *
Inflation, Unemployment and the
Philip’s Curve

Group # 7
Group members:-

6565 - Khwaja Ali Jibran
8056 - Tajdar Ahmad Hashmi
Zaid Imad
7608 - Hayat Omer Malik

Report: Group # 7 1

Unemployment and Philip’s Curve Table of Contents Click on the part you want to view with the control key being pressed Unemployment Cost of Unemployment Inflation Cost of Inflation Philip’s Curve Report: Group # 7 2 . Inflation.

Types of unemployment Economists distinguish between four major kinds of unemployment. we may see recession and cyclical unemployment until expectations adjust to the new conditions. i. or low exports net of imports may also have this result.) Real-world unemployment may combine different types. while all five might exist at one time. the level of employment and unemployment that represents the inflation barrier to demand-side growth. structural and classical. Unemployment and Philip’s Curve Unemployment By Shehzad { 7857 } An economic condition marked by the fact that individuals actively seeking jobs remain unhired. frictional. The level of unemployment varies with economic conditions and other circumstances. (Another distinction. Some consider this type of unemployment one type of frictional unemployment in which factors causing the friction are partially caused by some cyclical variables. though it can also be persistent. All but cyclical unemployment can be seen as existing at full employment. not discussed here. The magnitude of each of these is difficult to measure. cyclical. Unemployment is expressed as a percentage of the total available workforce. under consumption. Inflation. partly because they overlap and are thus hard to separate from each other. Gross domestic product is not as high as potential output because of demand failure. due to (say) pessimistic business expectations which discourages private fixed investment spending. Cyclical unemployment This type of unemployment exists due to inadequate effective aggregate demand. a surprise decrease in the money supply may shock participants in society.e. It gets its name because it varies with the business cycle. Low government spending or high taxes. For example.. Then. is between voluntary and involuntary unemployment. Report: Group # 7 3 . as during the Great Depression of the 1930s.

if a handicapped worker is employed). the number of unemployed workers exceeds the number of job vacancies. This is in fact beneficial to the economy since it results in a better allocation of resources. if the search takes too long and mismatches are too frequent.g. searching for new ones. • facilities to increase availability and flexibility (e. Policies to reduce frictional unemployment include: • educational advice. • schooling and training facilities. risk or compromise. location. which aims to increase non-governmental spending by lowering interest rates.g. • information on available jobs and workers. seeing the attainment of full employment of resources and potential output as the normal state of affairs. the economy suffers. attitude. governments will seek ways to reduce unnecessary frictional unemployment. Frictional unemployment exists because both jobs and workers are heterogeneous. Inflation. daycare centers). Therefore. and a multitude of other factors. Report: Group # 7 4 . Frictional unemployment This unemployment involves people being temporarily between jobs. It is sometimes called search unemployment and can be voluntary. since some work will not get done. but usually not right away. payment. Workers as well as employers accept a certain level of imperfection.g. it accepts the theory to some extent as full employment can never be reached. taste. • combating prejudice (against certain workers. However. it is compatible with full employment.g. Unemployment and Philip’s Curve In this case. Such a mismatch can be related to skills. However. work time. New entrants (such as graduating students) and re-entrants (such as former homemakers) can also suffer a spell of frictional unemployment. Classical economics rejects the conception of cyclical unemployment. • relocation of industries and services. when the frictionally unemployed receive benefits). Keynesian economists see it as possibly being solved by government deficit spending or by expansionary monetary policy. • incentives and regulations (e. This kind of unemployment coincides with Unused industrial capacity (unemployed capital goods). they will invest some time and effort to find a better match. so that if even all open jobs were filled. by taxing consumption instead). • Reduction of the gap between gross and net wages (e. • aid or grants to overcome a specific obstacle (e. some workers would remain unemployed. jobs or locations). and a mismatch can result between the characteristics of supply and demand.

Examples One kind of frictional unemployment is called wait unemployment: it refers to the effects of the existence of some sectors where employed workers are paid more than the market-clearing equilibrium wage. It is a mismatch of skills and opportunities Report: Group # 7 5 . However. for example. Even though the number of vacancies may be equal to the number of the unemployed. If the economy changes. Unemployment and Philip’s Curve Frictional unemployment coincides with an equal number of vacancies. Inflation. This is because people will usually be able to find jobs that suit them more quickly when the economy is doing well This involves a mismatch between the good workers looking for jobs and the vacancies available. Formulae have been derived for the Normal distribution[1] and the Weibull distribution[2]. the unemployed workers lack the skills needed for the jobs — or are in the wrong part of the country or world to take the jobs offered. so that they are not counted as unemployed. The imperfection of the labor market is sometimes graphically presented with a UV-curve. the frictionally unemployed will be few as they will get many job offers. Another type of frictional unemployment is seasonal unemployment. In Hollywood. but it attracts workers from other sectors who wait to try to get jobs there. Structural unemployment The better the economy is doing. the labor market will move along this curve. It is possible to derive this curve mathematically by aggregating (infinitely small) submarkets of the labor market. it is therefore maximal when the labor market is in equilibrium. if it is assumed that these submarkets follow a probability distribution. the lower this type of unemployment is likely to be. those who are waiting for acting jobs also wait on tables in restaurants for pay (while acting in "Equity Waiver" plays at night for no pay). Factors that affect friction will shift the curve inwards or outwards. When for instance demand far exceeds supply. a hyperbolic or similarly shaped curve that shows a fixed relationship between the unemployment rate on one axis and the vacancy rate on the other. Examples include workers employed during farm harvest times or those working winter jobs on the ski slopes or summer jobs such as life-guarding at outdoor pools and agricultural labor. the latter has the hyperbolic UV-curve (U x V = c) as a special case. Numerically. these workers might be seen as underemployed (definition 1). The main problem with this theory is that such workers will likely "wait" while having jobs. where specific industries or occupations are characterized by seasonal work which may lead to unemployment. Not only does this restrict the amount of employment in the high-wage sector.

except to say that it lasts longer. because of the need for new specialized training. the cost of selling one's house in a depressed local economy). such as discrimination. Unemployed programmers cannot easily become nurses. The implication is that sustained high demand may lower structural unemployment. due to the replacement of workers by robots) might be counted as structural unemployment. Some economists see this scenario as occurring under British Prime Minister Margaret Thatcher during the 1970s and 1980s. The latter provide a "cushion" of income which allows a job-seeker to avoid simply taking the first job offered and to find a vacancy which fits the worker's skills and interests. the willingness to switch into the available jobs. anti-discrimination policies. That is. along with the kind of labor-market policies mentioned in the previous paragraph. Some sort of direct attack on the problems of the labor market — such as training programs. so that the two types of policy are complementary. it is very expensive to unite the workers with jobs. Structural unemployment is a result of the dynamic changes of a capitalist economy (such as technological change and capital flight) — and the fact that labor markets can never be as fluid as (say) financial markets. mobility subsidies.. Workers are "left behind" due to costs of training and moving (e. while their skills (including job-searching skills) become "rusty" and obsolete. (This theory of rising structural unemployment has been referred to as an example of path dependence or "hysteresis. One possible example in the rich countries is the present combination of the shortage of nurses with an excess labor supply in Information Technology. However. These policies may be reinforced by the maintenance of high aggregate demand. Structural unemployment may also be encouraged to rise by persistent cyclical unemployment: if an economy suffers from long-lasting low aggregate demand.") Much technological unemployment (e. it also may encourage inflation. This means that they may not fit the job vacancies that are created when the economy recovers. so some kind of incomes policies (wage and price controls) may be needed. it means that many of the unemployed become disheartened. a Basic Income Guarantee. Alternatively. Unemployment and Philip’s Curve due to the structure of the economy changing. simple demand-side stimulus will not work to easily abolish this type of unemployment. It is also more painful.g. plus inefficiencies in the labor markets. Problems with debt may lead to homelessness and a fall into the vicious circle of poverty.g. technological unemployment might refer to the way in which steady increases in labor productivity mean that fewer workers Report: Group # 7 6 . and the legal requirements of such professions. As with frictional unemployment. and/or a Citizen's Dividend — seems required. Inflation. Structural unemployment is hard to separate empirically from frictional unemployment.

official statistics often underestimate unemployment rates. Inflation. The fact that aggregate demand can be raised to deal with this problem suggests that this problem is instead one of cyclical unemployment. Because of hidden unemployment. The most-cited official unemployment measures erase this kind of unemployment from the statistics using "seasonal adjustment" techniques. The statistic also does not count the "underemployed" . Unemployment and Philip’s Curve are needed to produce the same level of output every year. However.. Seasonal unemployment might be seen as a kind of structural unemployment. even though they are not employed. Classical unemployment In this case. Hidden unemployment Hidden. As indicated by Okun's Law. Report: Group # 7 7 . the problem here is not aggregate demand failure.g. Those who have given up looking for work (and sometimes those who are on Government "retraining" programmes) are not officially counted among the unemployed. abolishing minimum wages or employee protection). For a different meaning of hidden unemployment see Underemployment. the number of job- seekers exceeds the number of vacancies. The same applies to those who have taken early retirement to avoid being laid off.those with part time or seasonal jobs who would rather have full time jobs. like that of cyclical unemployment. we see a jobless recovery such as those seen in the United States in both the early 1990s and the early 2000s. migratory farm work). In many countries only those who have no work but are actively looking for work (and/or qualifying for social security benefits) are counted as unemployed. due to the way the statistics are collected. In this situation. to make the labor market more like a financial market. but would prefer to be working. In simple terms. unemployment is the unemployment of potential workers that is not reflected in official unemployment statistics. Otherwise. the demand side must grow sufficiently quickly to absorb not only the growing labor force but also the workers made redundant by increased labor productivity. because the cost would exceed the technologically-determined benefit of hiring them (the marginal product of labor). Some economists theorize that this type of unemployment can be reduced by increasing the flexibility of wages (e. institutions such as "the minimum wage" deter employers from hiring all of the available workers. real wages are higher than the market-equilibrium wage. or covered. since it is a type of unemployment that is linked to certain kinds of jobs (construction work.

This is the famous Phillips curve. To the extent that hidden unemployment exists. it implies that official unemployment statistics provide a poor guide to what unemployment rate coincides with "full employment". it is possible to abolish cyclical unemployment by increasing the aggregate demand for products and workers. making it hard to use the NAIRU in policy-making. this means that if the unemployment rate gets "too low. The margin of error can be quite high relative to the actual unemployment rate. it would be impossible to attain this full-employment target using only demand-side Keynesian stimulus without getting below the NAIRU and suffering from accelerating inflation (absent incomes policies)." inflation will get worse and worse (accelerate) in the absence of wage and price controls (incomes policies). Inflation. Report: Group # 7 8 . However. normative. However. Some economists see the inflation barrier as corresponding to the natural rate of unemployment. eventually the economy hits an "inflation barrier" imposed by the four other (supply-side) kinds of unemployment to the extent that they exist. More scientifically. definition of full employment might be called the ideal unemployment rate. This type of "full employment" unemployment would correspond to only frictional unemployment (excluding that part encouraging the McJobs management strategy) and would thus be very low. Training programs aimed at fighting structural unemployment would help here. The "natural" rate of unemployment is defined as the rate of unemployment that exists when the labor market is in equilibrium and there is pressure for neither rising inflation rates nor falling inflation rates [1]. It would exclude all types of unemployment that represent forms of inefficiency. Unemployment and Philip’s Curve Full employment In theory. this rate is sometimes referred to as the NAIRU or the Non-Accelerating Inflation Rate of Unemployment No matter what its name. Others simply see the possibility of inflation rising as the unemployment rate falls. One of the major problems with the NAIRU theory is that no-one knows exactly what the NAIRU is (while it clearly changes over time). Another.

mental stress. Unemployment insurance keeps an available supply of workers for the low-paying jobs. and loss of self-esteem. Social Report: Group # 7 9 . Inflation. leading to depression. Some hold that many of the low-income jobs are not really a better option than unemployment with a welfare state (with its unemployment insurance benefits). lack of financial resources. these jobs and unemployment are more complementary than they are substitutes. Unemployment and Philip’s Curve Costs of unemployment By: Khawaja Ali Jibran { 6565 } Individual Unemployed individuals are unable to earn money to meet financial obligations. few chances for advancement) is made with the existence of unemployment insurance in mind. Combination Another cost for the unemployed is that the combination of unemployment. Unemployment can cause underemployment. (These jobs are often held short-term. Failure to pay mortgage payments or to pay rent may lead to homelessness through foreclosure or eviction. But since it is difficult or impossible to get unemployment insurance benefits without having worked in the past. in excess of 30%/year. either by students or by those trying to gain experience. The loss of health insurance benefits that comes with unemployment increases susceptibility to illness. turnover in most low-paying jobs is high. The fear of job loss can spur psychological anxiety. while the employers' choice of management techniques (low wages and benefits. and social responsibilities may push unemployed workers to take jobs that do not fit their skills or allow them to use their talents.

GOOD TO KNOW .despite the fact that this is not supported by economics. and/or tariffs and similar trade barriers against foreign competitors. The most developed countries have aids for the unemployed as part of the welfare state. i. United Kingdom 5. they would be likely to be operating at below their skill level. Inflation.e. Being unemployed can also reduce the life expectancy of workers by about 7 years .70 2007 est.00 2001 est.70 2007 est. These unemployment benefits include unemployment insurance. Iran 11. those frictionally unemployed are in fact usefully employed in looking for work: if they accepted the first job they were offered. Pakistan 7. Report: Group # 7 10 . however. legal obstacles to immigration.10 2007 est. This means it is operating at below its production possibility frontier and could have higher output if the entire workforce were usefully employed.10 2007 est. India 7. to allow workers more time to search for a good job. During a long period of unemployment.60 2008 Japan 3. This means efforts to preserve existing jobs (of the "insiders") via barriers to entry against "outsiders" who want jobs.30 2006 est. not less. Entity Unemployment rate Source / date of information (%) Singapore 1. South Africa 25. Additionally. efficient. reducing the economy's efficiency. unemployment compensation and subsidies to aid in retraining.40 2005 Afghanistan 30.High unemployment can encourage protectionism as workers fear that foreigners are 'stealing' their jobs. United States 4. In this view. The main goal of these programs is to alleviate short-term hardships and. more importantly. labor. available to it.00 2004 est. Government programs to artificially raise employment. . causing a loss of human capital.50 2007 Germany 9. Unemployment and Philip’s Curve An economy with high unemployment is not using all of the resources. welfare. for example by building totally pointless pyramids or digging holes do not employ the workers usefully: this would make the economy more. . workers can lose their skills.

Gordon. Unemployment and Philip’s Curve Inflation By: Tajdar Ahmad Hashmi { 8056 } Inflation is a rise in the general level of prices over time. Inflation. Types of inflation. according to Robert J. • Demand-pull inflation: inflation caused initially by increases in aggregate demand due Report: Group # 7 11 . There are two major types of inflation. It may also refer to a rise in the prices of a specific set of goods or services.

A. Inflation. Take for instance a sudden decrease in the supply of oil. Both the types of inflation occurs in the long run as well as in the short run so lets have a look at them in turn. Unemployment and Philip’s Curve to increased private and government spending. for example. • Cost-push inflation: presently termed "supply shock inflation. which would increase oil prices. The increase in AD might be due to a change in MS by the central bank or any change in the autonomous spending. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. In the short run an initial increase in AD causes the price level to rise with an increase in equilibrium level of output. Report: Group # 7 12 ." caused by drops in aggregate supply due to increased prices of inputs. etc.

A. Thus we employ more labour and consequently the Cost of Production increases causing AS to decrease. Inflation. Unemployment and Philip’s Curve Now let’s have look at the case of demand pull inflation in the long run. This increase in the AD causes AS to decrease as in the long run we have 100% employment level. Report: Group # 7 13 . What happens here is that AD increases due to a change in MS by the central bank or any change in the autonomous spending.

Inflation. Report: Group # 7 14 . Unemployment and Philip’s Curve In the short run any increase in the cost of production of goods causes a decrease inAS. This decreases in AS causes the equilibrium price level to rise and the output to fall.

Unemployment and Philip’s Curve What happens in the long run is that AS decreases due to an increase in the Cost of Production. The decrease in AS results in unemployment and the economy enters recession. To overcome unemployment government expenditures (G) increases causing the AD to increase and due to this the output returns back to Y1. Inflation. Report: Group # 7 15 .

Such as there labour. cost of printing new price list and catalos. With the rise in prices each dollar of income will buy fewer amounts of goods and services. The term is not to be taken literally: the actual cost of inflation is the time and convenience you must sacrifice to keep less money on hand. When prices rise buyers pay more for goods and services at the same time seller receive more for what they sell. Unemployment and Philip’s Curve The Cost of Inflation Inflation is closely watched and widely discussed because it is thought to be a serious problem. the cost of sending these new prices to dealers and customers. Inflation. inflation not in itself reduces people’s purchasing power. Consider an example of a person who receives an annual raise of 10% and the rate of inflation in that particular country is 7%. Thus it might seem that inflation directly lowers the living standards. Because most people earn there living by selling there services. inflation in income goes hand in hand with inflation in prices. There is a fallacy in this answer. Menu Cost It is the cost of changing prices. Report: Group # 7 16 . The resources wasted when inflation encourages people to reduce their money holding. If nominal income tends to keep pace with rising prices then why is inflation a problem? Economists have identified several costs of inflation. If you ask a person why inflation is bad he will tell you that the answer is obvious: inflation robes him of his purchasing power. Although the raise in purchasing power was expected to be 10% but due to the effect of inflation. which are following: Shoeleather Costs The cost of reducing your money holding is called the Shoeleather cost of inflation because making more frequent trips to the bank causes your shoes to wear out more quickly. Menu cost include the cost of deciding new prices. and the cost of advertising the new prices. the real raise in purchasing power is only by 3%. What they don’t realize is that if the inflation rate was zero then the annual raise would have been 3% rather then 10%. Now in this situation the person doesn’t realize that the raise in the salary was adjusted for inflation. The term is derived from a restaurants cost of printing a new menu. So in this situation the person believes he has been cheated of his rightful due. Thus.

Inflation. During an unexpected inflation the value of money may rise or reduce. since many loans are in terms of unit of account (money). Unemployment and Philip’s Curve Tax Distortion Tax code concludes that inflation tends to raise the tax burden on income earned from saving:- Tax on nominal income capital gains and on nominal interest income are two examples of how tax affects savings. Redistribution of Wealth In case of unexpected inflation there could be redistribution of wealth among the debtors and creditors in a way that has nothing to do with either merit or need. Report: Group # 7 17 . Higher burden of tax reduces the amount of saving which in result depress the long run economic growth by reducing the amount of investment because the savings provide the resources of investment.

The idea that there was a simple. many countries experienced high levels of both inflation and unemployment also known as stagflation. in data from a number of countries and historical periods. and the curve came under concerted attack from a group of economists headed by Milton Friedman—arguing that the demonstrable failure of the relationship demanded a return to non-interventionist. Inflation. Report: Group # 7 18 . Stagflation In the 1970s. A typical Philips curve looks like this. Unemployment and Philip’s Curve Philip’s Curve By: Hayat Omer Malik {7608 } The Phillip’s curve is a historical inverse relation between the rate of unemployment and the rate of inflation in an economy. free market policies. If you notice it is a negatively sloped curve. and persistent relationship between inflation and unemployment was abandoned by most if not all macroeconomists. Any move of decreasing the inflation rate will result in a rise in the rate of unemployment. Stated simply. predictable. Theories based on the Phillips curve suggested that this could not happen. the lower the unemployment in an economy. the higher the rate of change in wages paid to labor in that economy.

also known as the "natural rate of unemployment". Edmund Phelps won the Nobel Prize in Economics in 2006 for this. The latter theory. Report: Group # 7 19 . exploiting this short-run tradeoff will raise inflation expectations. with Long-Run Phillips Curve (NAIRU) New theories. only a single rate of unemployment (the NAIRU or "natural" rate) was consistent with a stable inflation rate. but shifted in the long run as expectations changed. In the diagram. Policymakers can therefore reduce the unemployment rate temporarily. and lead only to higher inflation in the long run. distinguished between the "short-term" Phillips curve and the "long-term" one. moving from point A to point B through expansionary policy. such as rational expectations and the NAIRU (non- accelerating inflation rate of unemployment) arose to explain how stagflation could occur. inflation will be stable. Inflation. Unemployment and Philip’s Curve NAIRU and rational expectations Short-Run Phillips Curve before and after Expansionary Policy. Thus the reduction in unemployment below the "Natural Rate" will be temporary. The long- run Phillips Curve was thus vertical. The short-term Phillips Curve looked like a normal Phillips Curve. The NAIRU theory says that when unemployment is at the rate defined by this line. according to the NAIRU. shifting the short-run curve rightward to the "New Short-Run Phillips Curve" and moving the point of equilibrium from B to C. In the long run. However. in the short-run policymakers will face an inflation-unemployment rate tradeoff marked by the "Initial Short-Run Phillips Curve" in the graph. so there was no trade-off between inflation and unemployment. the long-run Phillips curve is the vertical red line. However.