Lecture 5: Unemployment and Inflation

Contents
• Defining unemployment
• Introducing several important labour market indicators
• Explaining the different types of unemployment – frictional,
structural and cyclical
• Outlining the relationship between GDP and unemployment
• Defining inflation
• Differentiating between the different types of inflation
depending on its pace
• Analysing the types of inflation depending on its causes
• Describing the effects of inflation
• The relationship between unemployment and inflation
 1. Unemployment – definitions

Definition – the existence of a certain number of people above a certain age

who do not have a full- or part-time job but are fully capable of working
and are making efforts to find a job.

Employed and unemployed people as part of a country’s population:

Population

Working-age population Young and institutionalised

Labour force Not in labour force

Employed Unemployed
 2. Labour market indicators

• Labour force participation rate – the ratio between the number of people
in the labour force (LF) and the working-age population (WAP):
𝑳𝑭
𝑳𝑭𝑷𝑹 = . 𝟏𝟎𝟎
𝑾𝑨𝑷

• Employment rate – the ratio between the number of people employed (E)
and the working-age population (WAP):
𝑬
𝑬𝑹 = . 𝟏𝟎𝟎
𝑾𝑨𝑷

• Unemployment rate – the ratio between the number of people

unemployed (U) and the number of people in the labour force (LF):
𝑼
𝑼𝑹 = . 𝟏𝟎𝟎
𝑳𝑭
 3. Flows in and out of unemployment

Inflows to unemployment:
• People who lose their job
• People who leave their job voluntarily
• People turning the legal age at which they are allowed to start work
• People who have previously withdrawn from the labour market

Flows out of unemployment:

• People who find a new job
• People who are recalled to their previous job
• Discouraged workers
• People who temporarily withdraw from the LM to raise a family
• People who reach the retirement age
• Emigrants and others
 4. Types of unemployment
Three main types of unemployment:

Frictional – caused by people continually entering and leaving the labour

force and the ongoing creation and destruction of jobs; exists at all times.

Structural – arises from technological changes in the economy and the

subsequent structural changes in employment in different industries; exists
at all times.

Natural unemployment = frictional + structural unemployment

Cyclical – caused by fluctuations in the business cycle. It increases when the

economy enters a recession and decreases when it begins to expand. Exists
depending on the phase of the business cycle.
 5. Types of unemployment 2
Other types of unemployment:

Classical – caused by wages being above their equilibrium level and the
existence of factors which prevent them from falling. Example – minimum
wages.

Voluntary – it’s a result of workers’ decisions, e.g., leaving one’s job to

search for a better one. In classical theory this is the only type of
unemployment which exists when the labour market is in equilibrium.
Frictional unemployment is largely voluntary.

Involuntary – caused by economic factors out of workers’ control – usually

structural or cyclical changes. Structural and cyclical unemployment are
involuntary.
 -5,0
15,0
20,0

10,0

-10,0
0,0
5,0
2003Q1
2003Q4
2004Q3
2005Q2
2006Q1
2006Q4
2007Q3
2008Q2
2009Q1
2009Q4

GDP growth rate (%)

2010Q3
2011Q2
2012Q1
2012Q4
6. Okun’s law

2013Q3
2014Q2
2015Q1
2015Q4
Unemployment rate (%)

2016Q3
2017Q2
2018Q1
2018Q4
2019Q3
 7. Okun’s law

• Okun’s law – describes the close relationship that usually exists between
changes in the economy’s output (GDP) and the level of unemployment. A
reduction of output by 2-2.5% below its potential level causes a 1 p.p.
increase in the unemployment rate above its natural level.

𝒀𝒏 − 𝒀
∗ 𝟏𝟎𝟎 = 𝒌(𝑼 − 𝑼𝒏 )
𝒀𝒏

k – Okun’s ratio
Yn – potential GDP
Y – current GDP
Un – natural unemployment rate
U – current unemployment rate
 8. Inflation – definition and measuring

• Definition – the process of a general rise in the level of prices in an

economy over a period of time.

• Measuring inflation – the rate of inflation is measured, most often, by the

percentage increase in the Consumer Price Index over a period of time.

𝑪𝑷𝑰𝒕 − 𝑪𝑷𝑰𝟎
𝑰𝑹 = ∗ 𝟏𝟎𝟎
𝑪𝑷𝑰𝟎

• Other indices that can be used to measure inflation include the Producer
Price index, Core Price Index, the GDP deflator, etc.
 9. Types of inflation
Depending on the pace of inflation, we differentiate between:

• Moderate – annual rate of up to 10%; limited negative effects; can

stimulate investment through slowly increasing prices; purchasing power is
stable. Planning horizon – over 1 year.

• High – over 10% annual rate; negative effects include loss of purchasing
power; a slowdown in investment; significant redistribution of income from
lenders to borrowers; disruptions in the allocation of resources. Planning
horizon – a few months.

• Hyperinflation – 50% monthly rate; caused by natural disasters, political

turmoil, wars, etc.; purchasing power is destroyed; money can no longer
serve its purposes. Planning horizon – less than 1 month.
 10. Causes of inflation and effects
Depending on its causes inflation can be:

• Demand-pull inflation – caused by an initial increase in aggregate demand

which can be caused by any of its factors.

• Cost-push inflation – caused by an increase in firms’ costs, because of a

rise in nominal wages or resource prices.

Effects:
• Loss of purchasing power;
• Redistribution of income;
• Reduced productivity;
• Allocative inefficiency
• Hoarding
 11. Types of inflation depending on the cause
• Demand-pull inflation Deflator LAS SAS1
2 SAS
0

defl2 E2
defl1 E1
defl0 E0

1
AD1
AD0

Y0 Y1 Y
• Cost-push inflation
Deflator LAS SAS
1
SAS0
defl2 E2
E1
defl1
defl0 E0
1 2

AD1
AD0

Y1 Y0 Y
 12. The Phillips curve
The original Phillips curve is a representation of the inverse relationship
between the rate of unemployment and the rate of growth of nominal
wages.

Original form:
w

B
0
-a u
A
 13. The Phillips curve
The modern Phillips curve is a representation of the inverse relationship
between the rate of unemployment and the rate of inflation.

Modern form:

ir

NAIRU

0
u
A
Unemployment and Inflation

Practice questions
 Unemployment and Inflation
1. The table below presents labor market data for a fictional economy for a particular
year.

Total population 103 million

Population under 15 12 million
Not in the labor force 21 million
Employed 64.4 million
Unemployed 5.6 million

Use this information to:

a. Calculate the labor force participation rate, the employment rate, and the
unemployment rate for this economy.
b. Calculate the economy’s potential GDP, assuming that its current GDP is €237.5
bn., the natural unemployment rate is 6%, and the Okun ratio is 2.5.
c. In the following year the number of people unemployed falls by 700,000, while
the size of the labor force remains unchanged. Meanwhile, potential GDP increases
by 1% and the natural unemployment rate and the Okun ratio also remain
unchanged. Calculate the growth rate of GDP in the second year.