Inflation & Unemployment

Unemployment 29.2
• Unemployment is the state a person is in if he or she cannot get a job despite being willing to work
and actively seeking work. Unemployment is a waste because we must count as a loss all the goods
and services that unemployed workers could have produced if they had been working.(page 555)
Types of Unemployment
• There are three types of unemployment: frictional, structural, and cyclical.
• Frictional unemployment: This unemployment consist of search unemployment and wait
unemployment—for workers who are either searching for jobs or waiting to take jobs in the near
future. Many workers who are voluntarily between jobs are moving from low-paying, low-productivity
jobs to higher-paying, higher-productivity positions. Frictional unemployment is short-term.
• Structural Unemployment: Changes over time in consumer demand and in technology alter the
“structure” of the total demand for labor, both occupationally and geographically. structural
unemployment is more likely to be long-term. Occupationally, the demand for certain skills (for
example, sewing clothes or working on farms) may decline or even vanish. Unemployment results
because the composition of the labor force does not respond immediately or completely to the new
structure of job opportunities.
• Cyclical Unemployment: Cyclical unemployment results from insufficient demand for goods and
services. It is caused by a decline in total spending. It begins in the recession phase of the business
cycle. Cyclical unemployment is a very serious problem when it occurs.
Inflation 29.3
• Inflation is a rise in the general level of prices. When inflation occurs, each dollar of income will buy
fewer goods and services than before. Inflation reduces the “purchasing power” of money.
Types of Inflation
• Demand-Pull Inflation: Usually, increases in the price level are caused by an excess of total spending
beyond the economy’s capacity to produce. When resources are already fully employed, the
business sector cannot respond to excess demand by expanding output. So the excess demand bids
up the prices of the limited output, producing demand-pull inflation.
• Cost-Push Inflation: The theory of cost-push inflation explains rising prices in terms of factors that
raise per-unit production costs at each level of spending. Rising per-unit production costs squeeze
profits and reduce the amount of output firms are willing to supply at the existing price level. As a
result, the economy’s supply of goods and services declines (AS shift leftwards) and the price level
rises. For example, as energy prices surged upward during these periods, the costs of producing and
transporting virtually every product in the economy rose.
Equilibrium in the AD-AS model 32.5
• The equilibrium price level and equilibrium real GDP. The intersection of the aggregate demand
curve and the aggregate supply curve determines the economy’s equilibrium price level.
Increases in AD: Demand-Pull Inflation 32.6
• Suppose the economy is operating at its full-employment output and businesses and government
decide to increase their spending—actions that shift the aggregate demand curve to the right.
• An increase in aggregate demand that causes demand-pull inflation. The increase of aggregate
demand from AD1 to AD2 causes demand-pull
inflation, shown as the rise in the price level
from P1 to P2. If the price level had remained
at P1, the increase in aggregate demand from
AD1 to AD2 would increase output from Qf to
Q2 and the multiplier would have been at full
strength. But because of the increase in the
price level, real output increases only from Qf
to Q1 and the multiplier effect is reduced.
Decreases in AS: Cost-Push Inflation
• The increase in cost of production cause the cost push inflation. Higher energy prices would spread
through the economy, driving up production and distribution costs on a wide variety of goods. The
aggregate supply curve would shift to the left, say, from AS1 to AS2 in Figure 32.10. The resulting
increase in the price level would be cost-push inflation.
• A leftward shift of aggregate supply from AS1 to AS2 raises the price level from P1 to P2 and
produces cost-push inflation. Real output declines and a recessionary GDP gap (of Q1 minus Qf)
occurs.
Decrease in Aggregate Demand that causes a recession
• If the price level is downwardly inflexible at P1, a
decline of aggregate demand from AD1 to AD2
will move the economy leftward from a to b
along the horizontal broken-line segment and
reduce real GDP from Qf to Q1. Idle production
capacity, cyclical unemployment, and a
recessionary GDP gap (of Q1 minus Qf) will
result. If the price level were flexible downward,
the decline in aggregate demand would move
the economy depicted from a to c instead of
from a to b.
Decreases in AD: Recession and Cyclical Unemployment
• Recession is caused by decrease (shift leftward) in aggregate demand at or below the full
employment level of output.
• Many important prices in the economy are downwardly inflexible such that the price level is sticky
downward even when aggregate demand substantially declines.
• Cyclical Unemployment: This decline of real output from Qf to Q1 constitutes a recession, and since
fewer workers are needed to produce the lower output, cyclical unemployment arises.
• The distance between Q1 and Qf is a negative,
or “recessionary,” GDP gap—the amount by which
actual output falls short of potential output.
Reasons for Downward price stickiness
• Fear of price wars Some large firms may be concerned that if they reduce their prices, rivals not only
will match their price cuts but may retaliate by making even deeper cuts.
• Menu costs: It is the total cost of changing price. Firms that think a recession will be relatively short-
lived may be reluctant to cut their prices. It includes:
• the cost of printing new menus
• Re-pricing items held in inventory
• printing and mailing new catalogs; and
• communicating new prices to customers, perhaps through advertising
• Wage contracts: Firms rarely profit from cutting their product prices if they cannot also cut their
wage rates. Wages are usually inflexible downward
• Morale, effort, and productivity: lower wages might impair worker morale and work effort, thereby
reducing productivity. Some advocates efficiency wages (wage above equilibrium level to increase
labor productivity and job turn over)—wages that elicit maximum work effort and thus minimize
labor costs per unit of output.
• Minimum wage: Firms paying minimum wages cannot reduce that wage rate when aggregate
demand declines.
The Inflation-Unemployment Relationship 38.3
• Every economy wants low inflation and low unemployment rates as its major economic goals, its
ability to control inflation brings up at least two interesting policy questions:
• Are low unemployment and low inflation compatible goals or conflicting goals?
• What explains situations in which high unemployment and high inflation coexist?

• The AD-AS model supports three significant generalizations relating to these questions:
• Under normal circumstances, there is a short-run trade-off between the rate of inflation and
the rate of unemployment.
• Aggregate supply shocks can cause both higher rates of inflation and higher rates of
unemployment.
• There is no significant trade-off between inflation and unemployment over long periods of
time.
The Phillips Curve (Short-run)
• The Phillips Curve relates annual rates of inflation and annual rates of unemployment for a series of
years. In short run there is an inverse relationship in unemployment and inflation, there presumably
is a trade-off between unemployment and inflation.
• This curve suggests an inverse relationship between the
rate of inflation and the rate of unemployment. Lower
unemployment rates (measured as leftward movements
on the horizontal axis) are associated with higher rates of
inflation (measured as upward movements on the
vertical axis).
• Short-run Phillips Curve simply is a manifestation of the
following principle: When the actual rate of inflation is
higher than expected, profits temporarily rise and the
unemployment rate temporarily falls.
Why Short-run Philips curve depict inverse Relationship
• The short-run effect of changes in aggregate demand on real output and the price level. Comparing
the effects of various possible increases in aggregate demand leads to the conclusion that the larger
the increase in aggregate demand, the higher the rate of inflation and the greater the increase in real
output. Because real output and the unemployment rate move in opposite directions, we can
generalize that, given short-run aggregate supply, high rates of inflation should be accompanied by
low rates of unemployment.
• Demand pull inflation leads to increase
the real output and firms employ more inputs
(including labor) that increase employment as a
result unemployment decreases. Hence the rise in
inflation leads to decrease the unemployment in
the short run.
Long-Run Phillips Curve 38.4
• There is no long-run trade-off between inflation and unemployment. So long run Philips Curve is
vertical.

• Increases in aggregate demand beyond those

consistent with full-employment output may
temporarily boost profits, output, and
employment (as from a1 to b1 ). But nominal
wages eventually will catch up so as to sustain
real wages. When they do, profits will fall,
negating the previous short-run stimulus to
production and employment (the economy now
moves from b1 to a2 ). Consequently, there is no
trade-off between the rates of inflation and
unemployment in the long run; that is, the long-
run Phillips Curve is roughly a vertical line at the
economy’s natural rate of unemployment.