Inflation and Unemployment

Chapters 19-21
What is inflation?
Inflation is a persistent increase in the general price level. A sustained
inflation takes place when the general price level continues to rise over
a period of time.

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How do we measure inflation?
• Measure a price index (General price Level)
- Consumer price Index
- Wholesale price index

• Take changes in the above price index

• GDP/GNP deflator

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The Economic and Social Effects of Inflation
• Chapter 19, pg 274-277

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Theories of Inflation: Chapter 20-Vanita
Agarwal
• Classical approach to Inflation

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 Keynesian Approach to Inflation
Inflation: Demand Side (Demand Pull)
Demand Pull Inflation arising from real factors:
- An increasing in Government spending
- A decrease in tax
- Increasing in investment
- Increase in exports
- Decrease in imports
Demand Pull Inflation arising from monetary
factors:
- An increase in money supply
- A decrease in speculative demand for money
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Inflation: Supply Side (Cost Push)
Factors for cost push inflation
- Wage push inflation: arising because of excess
demand for labor, increased labor
productivity, monopoly power of trade union
- Profit push inflation: Existence of monopoly
and/or oligopoly in markets increases price
for greater profit margins
- Supply-Shock Inflation: factors external to
business such as oil price hike, crop failures
etc.
Demand Pull Inflation Cost Push Inflation
AS2
P AS1 P

P2
P2
P1
P1

AD2
AD1
Y1 Y2 Y Y2 Y1
Y

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Control of Demand Pull Inflation
Restrictive Monetary and /or Fiscal Policy to reduce aggregate demand

P AS1

P2

P1

AD2
AD1
Y1 Y2 Y

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 Control of Cost Push Inflation
Restrictive Monetary and /or Fiscal Policy to reduce aggregate demand

AS2
P AS1

P2

P1

AD2 AD1
Y2
Y3 Y1 Y

Is Restrictive Monetary and /or Fiscal Policy to reduce aggregate demand and hence inflation is appropriate for cost push?
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 Unemployment
Chapter 21: Vanita Agarwal

What is Unemployment?
Unemployment is a phenomenon that occurs when a person who is actively
searching for employment is unable to find work during the previous four
weeks. Unemployment includes people who are jobless, actively seeking
work, and available to take a job.

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Labor Force Unemployment
Labor force: The labor force is made up of the employed and the
unemployed.

Unemployment can be defined more specifically as:

Number of people unemployed=Labor Force-Number of People
employed

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Unemployment rate

LE
Unemployment rate=
L
U

L

E=Total number of employed persons

L=Total labor force
U=Total number of unemployed persons

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Types of Unemployment
Natural rate of Unemployment:
Often known as Non-accelerating Inflation Rate of Unemployment
(NAIRU), natural rate of unemployment that prevails in the economy in
the long run. Natural unemployment is called the long-run average
unemployment rate, frictional plus structural unemployment

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Types of Unemployment

Frictional Unemployment:
Frictional unemployment arises when a person is in-between jobs.
After a person leaves a company, it naturally takes time to find another
job, making this type of unemployment short-lived. It is also the least
problematic from an economic standpoint.

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Types of Unemployment

Cyclical Unemployment:
Cyclical unemployment comes around due to the business cycle itself.
Cyclical unemployment rises during recessionary periods and declines
during periods of economic growth.

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Types of Unemployment

Structural Unemployment:
Structural unemployment comes about through technological
advances, when people lose their jobs because their skills are
outdated.

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Types of Unemployment

Wait Unemployment:
Wait Unemployment is the unemployment which is caused by wage
rigidity above the equilibrium level which in turn results in job
rationing. Example: Minimum wage law.

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What do you think is the relationship
between inflation and unemployment?
Behavior of the organized labor market
- During situations of low unemployment rates and tight labor market,
there is buoyant demand for goods and the firms are making profits.
Under these conditions, laborers can demand higher wages.
- In situations of high unemployment rates and low profits, the
employers resist to even moderate increases in the wages.

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Relationship between inflation and
unemployment Phillip’s Curve
Low unemployment is associated Rate of change of
money wage
with high aggregate demand, which
in turn puts upward pressure on
wages and prices throughout the
economy. g w  e(U  U *)
“Phillips Curve” shows the short-run
trade off between inflation and
unemployment

W  W1
Unemployment

gw 
rate

W1

U=unemployment rate
gw=the rate of wage inflation U*=natural rate of unemployment
W=wage in the current period U-U*=unemployment gap
e= measures the responsiveness of wages
W-1= wage in the preceding period to unemployment
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