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Inflation and Unemployment

Content
The causes and consequences of unemployment The natural rate of unemployment hypothesis The phillips curve The causes and consequences of inflation

Unemployment
There are a number of types of unemployment:
Structural unemployment Cyclical unemployment Frictional unemployment

Structural unemployment occurs when the economy changes and industries die out Training is needed to give the unemployed workers new skills

Unemployment
Cyclical unemployment is caused by the business cycle Frictional unemployment is caused when people are temporarily out of work as they are moving jobs

Unemployment and PPF


Unemployment means that scarce economic resources are being wasted reducing the long run potential of the economy Where there are high levels of unemployment an economy will be operating inside the perimeters of its PPF

Unemployment and AD / AS
As Aggregate demand increases unemployment will decrease Supply side policies can be used to increase aggregate supply in the economy and thereby reduce the level of unemployment However if the growth in the level of aggregate demand is less than the underlying trend growth in output unemployment is likely to occur

Causes and Consequences of Unemployment


Unemployment is caused by demand and supply side factors On the demand side if the demand curve shifts inwards unemployment will rise Supply side factors such as an excess of supply of workers also means unemployment will increase

Policies that increase labour market flexibility


A number of policies can be implemented to increase market flexibility and reduce unemployment Policies can be implemented on the supply side and the demand side by the government

Supply side policies


Supply side policies include: Reducing the occupational mobility of labour this can be through providing training for the unemployed, increasing the availability and quality of education and providing incentives for people to work

Demand side policies


Employment subsidies can be used by the government to encourage businesses to give jobs to the long term unemployed

Effects of Unemployment
On an individual level unemployment reduces the level of income that an individual earns As their income is reduced consumption also reduces as they pay for necessities rather than luxuries Goods that are income elastic will be consumed less Quality of life will be reduced for the unemployed worker Workers may become discouraged and give up searching for jobs becoming part of the long term structural unemployment in the country

Effects of Unemployment
Unemployment can have significance effects on the performance of the economy as a whole The effects are most marked due to long terms unemployment If there is unemployment in the economy resources are not being used effectively and the economy will be operating below any points on the PPF curve

Economic effects of unemployment


If unemployment rates are rising there will be a negative impact on economic growth potential Consumption is likely to fall as consumers will have had a decrease in income levels Government spending will increase as the government will be responsible for benefit payments Taxation levels will decrease as less people are in work and therefore paying taxes

Natural Rate of Unemployment Hypothesis


The natural rate of unemployment recognizes that there will always be some level of unemployment in an economy At the natural rate all unemployment will be voluntary This is the employment rate when the economy is operating at full employment

Determinants of the natural rate


The natural rate is determined by the interaction of the demand for labour and the supply of labour At the equilibrium wage rate all people who want a job can get a job However at this wage rate their will be some people who choose not to work

Determinants of the natural rate


The natural rate of unemployment is determined by:
Value of welfare benefits Trade union power Taxation system Migration of labour Social factors

Natural rate of unemployment and policy


If governments want to reduce the natural rate of unemployment they need to concentrate on supply side policies If the benefits system is relatively high in a country it will cause less people to want to work

Inflation
Inflation- The rise in the general level of prices In the long term, inflation erodes consumer purchasing power. That means that accumulated wealth buys less and less, with the passage of time. Where there is high inflation it is difficult for businesses to plan for the future as there is uncertainty regarding the cost of raw materials

The Aggregate Demand Curve


Aggregate demand is the total demand for goods and services in the economy.

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Deriving the Aggregate Demand Curve


To derive the aggregate demand curve, we examine what happens to aggregate output (income) (Y) when the price level (P) changes, assuming no changes in government spending (G), net taxes (T), or the monetary policy variable (Ms).
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Deriving the Aggregate Demand Curve


The aggregate demand (AD) curve is a curve that shows the negative relationship between aggregate output (income) and the price level.

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The Aggregate Demand Curve: A Warning


At all points along the AD curve, both the goods market and the money market are in equilibrium.

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Other Reasons for a DownwardSloping Aggregate Demand Curve


The consumption link: The decrease in consumption brought about by an increase in the interest rate contributes to the overall decrease in output.

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Other Reasons for a DownwardSloping Aggregate Demand Curve


The real wealth effect, or real balance, effect is the change in consumption brought about by a change in real wealth that results from a change in the price level.
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Aggregate Expenditure and Aggregate Demand


At every point along the aggregate demand curve, the aggregate quantity of output demanded is exactly equal to planned aggregate expenditure.
Y=C+I+G
equilibrium condition
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Shifts of the Aggregate Demand Curve


An increase in the quantity of money supplied at a given price level shifts the aggregate demand curve to the right.

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Shifts of the Aggregate Demand Curve


An increase in government purchases or a decrease in net taxes shifts the aggregate demand curve to the right.

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Shifts of the Aggregate Demand Curve


Factors That Shift the Aggregate Demand Curve
Expansionary monetary policy Ms AD curve shifts to the right Contractionary monetary policy Ms AD curve shifts to the left

Expansionary fiscal policy G T AD curve shifts to the right AD curve shifts to the right

Contractionary fiscal policy G T AD curve shifts to the left AD curve shifts to the left

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The Aggregate Supply Curve


Aggregate supply is the total supply of all goods and services in the economy.

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The Aggregate Supply Curve


The aggregate supply (AS) curve is a graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level.
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Aggregate Supply in the Short Run


In the short run, the aggregate supply curve (the price/output response curve) has a positive slope.

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Shifts of the Short-Run Aggregate Supply Curve


A cost shock, or supply shock, is a change in costs that shifts the aggregate supply (AS) curve.

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Shifts of the Short-Run Aggregate Supply Curve


Factors That Shift the Aggregate Supply Curve Shifts to the Right
Increases in Aggregate Supply Lower costs lower input prices lower wage rates
Economic growth more capital more labor technological change Public policy supply-side policies tax cuts deregulation Good weather
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Shifts to the Left


Decreases in Aggregate Supply Higher costs higher input prices higher wage rates
Stagnation capital deterioration

Public policy waste and inefficiency over-regulation Bad weather, natural disasters, destruction from wars

Causes of Inflation
Inflation is an increase in the overall price level. Sustained inflation occurs when the overall price level continues to rise over some fairly long period of time.
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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.

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Cost-Push, or Supply-Side Inflation


Stagflation occurs when output is falling at the same time that prices are rising.
One possible cause of stagflation is an increase in costs.

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Cost-Push, or Supply-Side Inflation


Cost shocks are bad news for policy makers. The only way to counter the output loss is by having the price level increase even more than it would without the policy action.
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Money and Inflation


Hyperinflation is a period of very rapid increases in the price level.

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Money and Inflation


An increase in G with the money supply constant shifts the AD curve from AD0 to AD1. This leads to an increase in the interest rate and crowding out of planned investment.

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Money and Inflation


If the Central bank tries to prevent crowding, it will increase the money supply and the AD curve will shift farther and farther to the right. The result is a sustained inflation, perhaps hyperinflation.
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The causes of inflation


inflation results when the macro economy has too much demand for available production. These alternatives fall under two general categories: Demand-Pull Inflation: This inflation occurs when household, business, government, and foreign industries collectively try to purchase more output than the economy is capable of producing. In effect, the demand side of the aggregate market is "pulling" the price level higher. Cost-Push Inflation: Cost-push inflation is inflation attributable to decreases in supply, primarily due to increases in production cost

Cost Push Inflation


As costs rise it causes the aggregate supply curve to shift onwards so less is supplied at each price level Each time the aggregate supply curve shifts inwards the price rises causing inflation

Demand pull inflation


As aggregate demand increases then the general price level rises When total demand exceeds total supply demand pull inflation occurs If the economy is close to full capacity the effects of demand pull inflation will be greater

Preventing inflation
One of the best ways to prevent inflation is through stock and variable universal life insurance. These alternatives provide the potential for returns that exceed inflation over the long term. Central banks place high interest rates using unemployment and the decline of production to prevent price increases.

Short Run Trade Off Between Inflation and Unemployment

Unemployment and Inflation


The natural rate of unemployment depends on various features of the labor market. Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. The inflation rate depends primarily on growth in the quantity of money, controlled by the Central Bank.

Trade Off
Society faces a short-run tradeoff between unemployment and inflation. If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

Phillips Curve
The Phillips curve illustrates the short-run relationship between inflation and unemployment.

The Phillips Curve


Inflation Rate (percent per year) 6 B

A Phillips curve

Unemployment Rate (percent)


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AD, AS, and Phillips Curve


The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. The greater the aggregate demand for goods and services, the greater is the economys output, and the higher is the overall price level. A higher level of output results in a lower level of unemployment.

(a) The Model of Aggregate Demand and Aggregate Supply Price Level Short-run aggregate supply B A High aggregate demand Low aggregate demand Inflation Rate (percent per year) 6

(b) The Phillips Curve

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A 2 Phillips curve

7,500 8,000 (unemployment (unemployment is 7%) is 4%)

Quantity of Output

4 (output is 8,000)

Unemployment 7 (output is Rate (percent) 7,500)

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Long-Run Phillips Curve


In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.
As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. Monetary policy could be effective in the short run but not in the long run.

The Long-Run Phillips Curve


Inflation Rate

1. When the
Central Bank increases High the growth rate inflation

Long-run Phillips curve B

of the money
supply, the rate of inflation Low inflation A 2. . . . but unemployment remains at its natural rate in the long run.

increases . . .

Natural rate of unemployment

Unemployment Rate

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(a) The Model of Aggregate Demand and Aggregate Supply

(b) The Phillips Curve Long-run Phillips curve 3. . . . and increases the inflation rate . . . B

Price Level

P2 2. . . . raises the price P level . . .

Long-run aggregate supply 1. An increase in the money supply increases aggregate B demand . . . A AD2 Aggregate demand, AD

Inflation Rate

Natural rate of output

Quantity of Output

Natural rate of unemployment

Unemployment Rate

4. . . . but leaves output and unemployment at their natural rates.

Copyright 2004 South-Western

Summary
There are three main types of unemployment:
Structural Cyclical Frictional

Unemployment means that an economy cant operate on its ppf As AD increases unemployment decreases The natural rate of unemployment recognises there will always be some level of unemployment in the economy The Phillips curve shows an inverse relationship between unemployment and inflation Inflation is a rise in the general level of prices There are two causes of inflation:
Cost push Demand pull