Inflation, Unemployment

and Underemployment
Chapter 7

1
Inflation
“ There is no subtler, no surer means of
overturning the existing basis of society
than to debauch the currency. The process
engages all the hidden forces of economic
law on the side of destruction, and does it
in a manner which not one man in a million
is able to diagnose.”
-John Maynard Keynes

2
Definition of inflation
 Inflation is defined as a persistent rise in the
general price level over a period of time. It is a
situation where a rise in general level of prices
is accompanied by an increase in output.
 Disinflation, deflation, and stagflation are also
associated with inflation.
 Disinflation is a reduction in the rate at which
prices are increasing. For example, if prices
rise at 5% compared to earlier 7% rise, this is
disinflation.
3
Definition of inflation
 Deflation is a decrease in the overall level
of prices. This means aggregate price rise
rate is negative.
 Stagflation is situation of twin evils. In this
situation, prices rise, output falls and
unemployment rises.

4
Definition of inflation
 Inflation is the percentage change in the
overall price level.
 Rate of inflation in year ‘t’:
= price level (year t)- price level (year t-1) x100
price level (year t-1)

5
Three strains of inflation
 Like disease, inflations exhibit different levels of
severity. It is usually classified into three
categories: low inflation, galloping inflation, and
hyperinflation.
1. Low inflation: a situation in which prices rise slowly
and predictably. In general, this is a situation of
single-digit annual inflation. When prices are
relatively stable, people trust money. People are
willing to hold money and long term contracts
between parties in business take place given the
price predictability.

6
Three strains of inflation
 Low inflation sometimes also classified into: creeping,
and walking inflation. Inflation below 3% a year is
termed creeping inflation and inflation between 3% to
9% a year is termed walking inflation.
2. Galloping inflation: According to Samuelson and
Nordhaus, inflation in the double or triple digit range of
20, 100, or 200 percent a year is called galloping
inflation. In this situation, serous economic distortions
take place in economy. Money loses its value very
quickly, financial markets wither away as capital flees
abroad, people hoard goods, buy houses and never
lend money at low nominal interest rates.

7
Three strains of inflation
3. Hyperinflation: A third and deadly strain
takes hold when the cancer of hyperinflation
takes place. In this case, inflation is
immeasurable and absolutely
uncontrollable. A case of hyperinflation was
in Germany where the price index rose from
1 in January 1922 to 10,000,000,000 in
November 1923. This was on average was
a 500 percent price rise per month.
8
A situation of hyperinflation
“We used to go to the stores with money in our
pockets and come back food in our baskets. Now
we go with money in our baskets and return with
food in our pockets. Everything is scarce in except
money! Prices are chaotic and production
disorganized. A meal that used to cost the same
amount as an opera ticket now costs twenty times
as much. Everybody tends to hoard “things” and
try to get rid of the “bad” paper money, which
drives the “good “ metal money out of circulation.
A partial return to barter inconvenience is the
result.” (Mentionings during the civil war)
9
Measurement of inflation
 There are various measures of inflation:
Consumer Price Index (CPI), Wholesale
Price index (WPI), GDP deflator, Import
price index, export price index etc. Mainly
used are the former three. In Nepal, CPI is
used to measure (calculate) the rate of
inflation.

10
Consumer Price Index (CPI)
 A measure of the overall level of prices
 Published by the Nepal Rastra Bank in Nepal
 Uses:
 tracks changes in the typical household’s
cost of living
 adjusts many contracts for inflation allows
comparisons of dollar amounts over time

11
How the NRB constructs the
CPI
1. Survey consumers to determine composition of
the typical consumer’s “basket” of goods.
2. Every month/week, collect data on prices of all
items in the basket; compute cost of basket
3. CPI in any month equals

Cost of basket in that month

100 
Cost of basket in base period

12
How CPI is developed?
 Assume that consumers buy three
commodities: food, shelter and medical care.
A hypothetical budget survey finds that
consumers spend 20% of their budget on
food, 50% on shelter and 30% on medical
care. Using a year as the base year, say
2005, we rest the price of each commodity
100 so that difference in units of commodity
will not affect the price index. This means
CPI is also 100 in the base year= (0.2x100)+
(0.5x100)+(0.3x100) 13
How CPI is developed?
 Assume that in 2006, food prices went up
by 2%, thus food price index reached 102,
shelter prices rise by 6% to 106, and
medical care prices by 10% to 110.
 Now, CPI for 2006 will be :
=(0.2x102)+ (0.5x106)+(0.3x110)=106.4
 Now you can calculate the rate of inflation
using the formula.
 See how it is calculated by NRB
14
Inflation in Nepal
Separation of CPI into its major groups (Based on Five Year Average)
Period CPI Inflation FBG Inflation NFS Inflation
1976 - 80 5.22 4.76 6.75
1981 - 85 9.69 9.40 10.37
1986 - 90 11.62 12.55 10.02
1991 - 95 11.26 11.47 10.92
1996 - 00 7.85 8.31 7.32
2000 - 05 3.72 2.62 5.00
2006 7.97 7.82 8.11

 Food and beverages group (FBG) and non-food and services

group (NFS).
 Source: NRB

15
Wholesale price index
 The producer price index or wholesale price
index measures the prices at the wholesale
or producer stage.
 The fixed weights used to calculate the PPI
are the net sales of each commodity.
 The procedure to calculate the WPI is same
that of CPI.
 See how it is calculated by NRB

16
Causes of inflation
Causes of inflation can be categorized into:
Demand pull factors:
 The early quantity theory approach
 The Keynesian approach of inflationary gap
 The general equilibrium approach

Cost push factors

 Wage-push inflation
 Profit-push inflation
 Increase in the price of raw materials

Structural factors
17
The quantity theory of money
(QTM)
 Classical and neoclassical economists believe that the only
way to price rise, and hence inflation, is through the over-
supply of quantity of money in an economy. If money is
doubled, price also doubles in full employment situation
where money plays as a means of transaction only. The
well known equation that explains QTM is:
 M V PT
 where, M is money supply; V is the velocity of money,
which is the measure of number of times one unit of money
crosses the hands from one transaction to another; P is the
general price level; and T represents the real volume of
transactions.
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Causes of inflation:QTM
 In classical system, both V and T are assumed to be constant
in the short run and Y (output) is the proxy for T. Hence the
above equation can be rewritten to yield a price equation for
the economy as follows:
 M V PY
 It simply states that doubling the money supply doubles the
price level, proportionate relationship between quantity of
money and price
 The modern QTM accepts that inflation occurs when the rate
of growth of the money supply exceeds the growth rate of the
real aggregate output in the economy. According to the
monetarists, the QTM implies that inflation is always and
everywhere a monetary and demand-side phenomenon.

19
Causes of inflation:QTM
Money supply as the sole cause of inflation:
P P=f(M)

P2

M
M2
M1

20
Causes of inflation:QTM
Monetarists’ assumptions are:
 Vertical aggregate supply curve at full employment
level
 Increase in money increases AD, increase in AD
increases the price.
P

P1

D1
D
Q
21
Keynesian approach-
inflationary gap
 According to this theory, inflation is generated by
pressure of excess demand of goods and services
for the available supply in the economy,
especially when the economy approaches to the
full employment level If aggregate demand rises,
the multiplier effect of the increase in aggregate
demand becomes disabled due to supply
constraint and hence the only way to clear the
goods market is through raising the money prices
of the goods.
22
Keynesian approach-
inflationary gap
AD Y
Inflationary gap
AD=C+I
P
Price

Y
YP Output

23
Keynesian approach-
inflationary gap
 The demand-pull inflation is shown in the figure
in next slide. If the aggregate demand curve of the
economy shifts upward, the price level rises. If the
economy is in less than full equilibrium there is
output effect as well. However, if the aggregate
demand increases beyond AD2 as shown in
figure, it will be adjusted by increase in prices
only without affecting the output.

24
Keynesian approach-
inflationary gap

25
General equilibrium approach
 This approach combines the real factors and monetary
factors to explain the inflationary process. This is often
called the ISLM approach. IS curve refers to goods (real)
market equilibrium and LM refers to money market
equilibrium.
 Real factors such as change in government expenditure
and taxes shift the IS curve and monetary factors such
as change in money supply shift the LM curve.

26
Causes of increase in AD
 The main causes of increase in aggregate demand
are the following - some are related with Keynesians
and others with Monetarists:
 Depreciation or devaluation of the exchange rate:
This increases the price of imports and reduces the
foreign price of economy's exports. If consumers buy
fewer imports while foreigners buy more exports; or
if export is more elastic than imports, the aggregate
demand in the economy will rise. If the economy is
already at full employment or there is supply
bottleneck, it is hard to increase output and so prices
are pulled upwards.
27
Causes of increase in AD
 Reduction in taxation: If taxes are reduced (either by
lowering the rate or by escaping the people from tax-net),
consumers will have more disposable income causing
demand to rise. A reduction in indirect taxes (taxes on
goods and services such as VAT) will mean that a given
amount of income will now buy a greater real volume of
goods and services than it would be before its reduction.
 Deficit financing of the government: It results increase in
money supply and then aggregate demand of the
economy, whatever be the sources of financing.
 Faster economic growth in other countries - It may
accelerate the exports of goods and services of the
economy. Since exports are counted as an injection of
aggregate demand, it causes demand-pull inflation in the
economy.
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Cost push theory of inflation
 Cost-push theories of inflation largely attribute
inflation to non-monetary, supply-side effects that
change the unit cost and profit markup components
of the prices of individual products. Cost-push
inflation occurs due to increase in cost of production
of goods and services in the economy. Main factors
pushing the cost of production are:
 Wage-push inflation
 Profit-push inflation
 Increase in prices of raw mateials

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Cost push theory of inflation

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Cost push theory of inflation
 Main causes of increases in the cost:
 Wages: The trade unions may be able to push wages
up without increasing the productivity of labours.
Firms, then, are forced to increase their prices to pay
the higher claims and maintain their profitability.
 Profits: Firms having more power and ability to raise
prices, independently to demand, can make more
profit and result cost-push inflation. This is most likely
to occur, when markets become more concentrated
and move towards monopoly or perhaps oligopoly.

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Cost push theory of inflation
 Main causes…..
 Imported inflation: In a global economy, firms import a
significant proportion of their raw materials or semi-
finished products. If the cost of these imports increases
for reasons out of domestic control, then once again firms
will be forced to increase prices to pay the higher raw
material costs.
 Exchange rate changes - If there is depreciation in the
exchange rate, then exports will become cheaper abroad,
but imports will appear to be more expensive. Firms will
be paying more for their overseas raw materials leading
to increase prices of domestic economy.

32
Cost push theory of inflation
 Main causes……
 Commodity price changes - If there are price increases on
world commodity markets, firms will be faced with higher
costs if they use these as raw materials. Important
markets would include the oil market and metals markets.
 External shocks - This could be either for natural reasons
or because a particular group or country will gain more
economic power. An example of the first was the Kobe
earthquake in Japan, which disrupted world production of
semi-conductors for a while. An example of the second
was the case of OPEC which forced up the price of oil
four-fold in the early 1970s.

33
Cost push theory of inflation
 Main causes……
  Exhaustion of natural resources: As resources run out,
their price will inevitably gradually rise. This will increase
firms' costs and may push up prices until they find an
alternative source of raw materials (if they can). For
example, in many countries such problem occurred
because of land erosion when forests were cleared. The
land quickly became useless for agriculture.
 Taxes: Increase in indirect taxes (taxes on expenditure)
increases the cost of living and push up the prices of
products in the shops.

34
Structural factors
 The structuralists argue that change in AD
and AS are not only the factors causing
inflation particularly in developing countries.
The theory suggests that structural
bottlenecks such as lack of transportation,
black marketing, inefficient regulatory
mechanism, artificial shortages, subsistence
level of production, and government
regulation on prices are the main reasons for
inflation in developing countries.
35
Meaning of unemployment
 What is Unemployment?
- In economics one who is willing to work at a prevailing
wage rate but is unable to find a paying job is considered
to be unemployed.
 What is Unemployment rate?
- The unemployment rate is the no. of unemployed
workers divided by the total civilian labor force.
 According to the ILO, a person is said to be unemployed if
the person is:
1. Not working
2. Currently available for work
3. Seeking work
36
Types of Unemployment
 Economists have found it useful to
classify unemployment into four different
categories
 Frictional unemployment
 Seasonal unemployment
 Structural unemployment
 Cyclical unemployment
 Each arises from a different cause
and has different consequences

37
Frictional Unemployment
 Arises because of transactions costs associated with
normal entry and exit from the labor market, voluntary
job changes, or lay offs or firings. Also called search
unemployment. Mainly in industrial countries because of
the frequent change in technology or because of
dynamic economy.
 By definition, it is short-term, it causes little hardship to
those affected by it.
 By spending time searching rather than jumping at the
first opening that comes their way. People find jobs for
which they are better suited and in which they will
ultimately be more productive.

38
Seasonal Unemployment
 Joblessness related to changes in weather,
tourist patterns, or other seasonal factors.
 A common phenomenon is developing
countries and specially in agriculture
economies.
 Mainly occurs in agriculture, construction and
tourism business-a demand driven situation.
 Also in supply side, teenage unemployment
rises during vacations.

39
Structural Unemployment
 Joblessness arising from mismatches
between workers’ skills and employers’
requirements
 Generally a stubborn, long-term problem
 Often lasting several years or more because it
can take considerable time to relocate or
acquire new skills.

40
Unemployment
 Frictional, structural, and seasonal unemployment arise
largely from microeconomic causes, they cannot be
entirely eliminated since they are attributed to changes
in specific industries and specific labor markets.
 Some amount of microeconomic unemployment is a
sign of a dynamic economy.
 When there is no cyclical unemployment, it is called
natural rate of unemployment.
 Thus, the natural rate of unemployment is defined as
the rate of unemployment at which the actual rate of
inflation equals the expected rate of inflation. It is thus
an equilibrium rate of unemployment towards which the
economy moves in the long – run.

41
 Cyclical Unemployment
 When the economy goes into a recession and total
output falls, the unemployment rate rises
 Since it arises from conditions in the overall economy,
cyclical unemployment is a problem for macroeconomic
policy
 It is caused by the business cycle hence called ‘cyclical’
 Macroeconomists say we have reached full employment
when cyclical unemployment is reduced to zero
 But the overall unemployment rate at full
employment is greater than zero
 Because there are still positive levels of frictional,
seasonal, and structural unemployment

42
Inflation and Unemployment
Trade-off (The Phillips Curve)
 Okun’s law states that 1 extra point of
unemployment costs 2 percent of GDP.
 The Phillips curve examines the relationship between the
rate of unemployment and rate of money wage changes.
The wage push inflation is simply given by:
 Rate of inflation = Rate of wage growth – Rate of
labor productivity growth.
 This formula shows that if the rate of money wage
change is faster than the rate of labor productivity growth
(change), it causes the inflation. In this case, the Phillips
curve shows the relationship between the rate of
unemployment and the rate of money wage changes or
the rate of inflation. Thus, Phillips curve depicts the
trade–off relationship between unemployment rate and
inflation rate.
43
Inflation and Unemployment
Trade-off (The Phillips Curve)
 The Phillips curve is so named because it was
popularized by a New Zealand economist, A. W. Phillips,
when he was working at the London School of
Economics in the 1950s.
 A Phillips curve is a curve showing the relationship
between inflation and unemployment. There are two
time-frames for Phillips curves:
 The short-run Phillips curve
 The long-run Phillips curve

44
Inflation and Unemployment
Trade-off (The Phillips Curve)
Following Figure Shows Short – Run Phillips Curve.

PC
Expected inflation rate 4%
Natural unemployment rate 2%
C
4
Inflation rate (%)

B
2

O
2 3
Unemployment Rate (%)

45
Inflation and Unemployment
Trade-off (The Phillips Curve)
 The short-run Phillips curve (SRPC) shows the
relationship between inflation and unemployment at a
given expected inflation rate and given natural
unemployment rate. With an expected inflation rate of 4
percent a year and a natural unemployment rate of 2
percent, the short run Phillips curve passes through point
‘c’. An unanticipated increase in AD lowers
unemployment and increases inflation-a movement up
the SRPC. An unanticipated decrease in AD increases
unemployment and lowers inflation-a movement down
the SRPC.

46
Inflation and Unemployment
Trade-off (The Phillips Curve)
 The long-run Phillips curve (LRPC) is a curve that shows
the relationship between inflation and unemployment,
when the actual inflation rate equals the expected
inflation rate. The LRPC is vertical at the natural
unemployment rate. The LRPC tells us that any
anticipated inflation rate is possible at the natural
unemployment rate. When inflation is anticipated, real
GDP remains at potential GDP. Real GDP being at
potential GDP is equivalent to unemployment being at
the natural ate.

47
Inflation and Unemployment
Trade-off (The Phillips Curve)
LRPC
Inflation rate

10 a

7 c
d
SRPC
SRPC1
6 9
Unemployment rate
48
Inflation and Unemployment
Trade-off (The Phillips Curve)
 The LRPC is a vertical line at the natural
unemployment rate. A fall in inflation expectations
shifts the SRPC downward by the amount of the fall
in the expected inflation rate. In the figure of the
previous slide, when the expected inflation rate falls
from 10 percent a year to 7 percent a year, the
SRPC shifts downward. The new SRPC intersects
the LRPC at the new expected inflation rate-point d.
With the original expected inflation rate (10 percent),
an inflation rate of 7 percent a year would occur at
an unemployment rate of 9 percent-point c.
 Remember change in the natural rate of
unemployment shifts both SRPC and LRPC.
49
Inflation and Unemployment
Trade-off (The Phillips Curve)
Following Figure Shows Tobin's Phillips Curve.
Infla tion Rate %

PS

O Uc Unemployment Rate %

50
Tobin’s view
 According to this view, there is a Phillips curve
within the limits but as the economy expands and
employment grows, the curve becomes even more
fragile and vanishes until it becomes vertical at
some critically low rate of unemployment. The
Phillips curve is kinked – shaped, a part like a
normal Phillips curve and the rest vertical, as shown
in the previous slide.
 The unemployment rate at which the Phillips curve
is vertical is called critical unemployment rate.

51
Costs of inflation
 The problems of a wage-price spiral – price rises can
lead to higher wage demands as workers try to
maintain their real standard of living. Higher wages
over and above any gains in labour productivity causes
an increase in unit labour costs. To maintain their profit
margins they increase prices. The process could start all
over again and inflation may get out of control. 
 Higher inflation causes an upward spike in inflationary
expectations that are then incorporated into wage
bargaining. It can take some time for these expectations
to be controlled. Higher inflation expectations can cause
an outward shift in the Phillips Curve.

52
Costs of inflation
 Inflation can also cause a reduction in the real
value of savings - especially if real interest rates
are negative. This means the rate of interest does
not fully compensate for the increase in the general
price level. In contrast, borrowers see the real
value of their debt diminish. Inflation, therefore,
favors borrowers at the expense of savers.
 Consumers and businesses on fixed incomes
will lose out. Many pensioners are on fixed
pensions so inflation reduces the real value of their
income year on year. The state pension is normally
uprated each year in line with average inflation so
that the real value of the pension is not reduced. 
53
Costs of inflation
 Inflation usually leads to higher nominal interest
rates that should have a deflationary effect on GDP.
 Inflation can also cause a disruption of business
planning – uncertainty about the future makes
planning difficult and this may have an adverse
effect on the level of planned capital investment. 
 Budgeting becomes a problem as firms become
unsure about what will happen to their costs. If
inflation is high and volatile, firms may demand a
higher nominal rate of return on planned investment
projects before they will go ahead with the capital
spending. 
54
Costs of inflation
 Inflation usually leads to higher nominal interest
rates that should have a deflationary effect on GDP.
 Inflation can also cause a disruption of business
planning – uncertainty about the future makes
planning difficult and this may have an adverse
effect on the level of planned capital investment. 
 Budgeting becomes a problem as firms become
unsure about what will happen to their costs. If
inflation is high and volatile, firms may demand a
higher nominal rate of return on planned investment
projects before they will go ahead with the capital
spending. 
55
Costs of inflation
 Cost-push inflation usually leads to a slower
growth of company profits which can then
feed through into business investment
decisions.
 Inflation distorts the operation of the price
mechanism and can result in an inefficient
allocation of resources. When inflation is
volatile, consumers and firms are unlikely to
have sufficient information on relative price
levels to make informed choices about which
products to supply and purchase.
56
Costs of inflation
 Two further costs of inflation are often mentioned in
the textbooks:
 Shoe leather costs - when prices are unstable
there will be an increase in search times to discover
more about prices. Inflation increases the
opportunity cost of holding money, so people make
more visits to their banks and building societies
(wearing out their shoe leather!).
 Menu costs -extra costs to firms of changing price
information. This can be important for companies
who rely on bulky catalogues to send price
information to customers. (Note there are also
significant menu costs associated with any future
transition to the European Single Currency)
57
Anticipated and unanticipated
inflation
 When inflation is volatile from year to year, it becomes
difficult for individuals and businesses to correctly predict
the rate of price inflation that will happen in the near future.
When people are able to make accurate predictions of
inflation, they can anticipate what is likely to happen and
take steps to protect themselves. For example, people can
bid for increases in money wages so as to maintain their
real wages. Savings can be shifted into accounts offering a
higher rate of interest, or into assets where capital gains
might outstrip general price inflation. Companies can
adjust their prices; lenders can adjust interest rates.
 Unanticipated inflation occurs when economic agents
(people, businesses and governments) make errors in
their inflation forecasts. Actual inflation may end up well
below, or significantly above expectations.
58
Inflation targeting
 Inflation-targeting is one of the operational
framework for monetary policy aimed at attaining
price stability. In contrast to alternative strategies
such as money or exchange rate targeting, which
seek to achieve low or stable inflation through
targeting intermediate variables-for example the
growth rate of monetary aggregates or the level of
the exchange rate of an “anchor” currency-inflation
targeting directly targets inflation.
 Inflation targeting has two main characteristics that
distinguish it from other monetary policy strategies:

59
Inflation targeting
1. The central bank is mandated, and commits
to, a unique numerical target in the form of a
level or a range for annual inflation. A single
target for inflation emphasizes the fact that
price stabilization is the primary focus of the
strategy, and the numeric specification
provides a guide to what the authorities
(central bank) intend as price stability.

60
Inflation targeting
2. The inflation forecast over some horizon is the de
facto intermediate target of policy. For this reason
inflation targeting is sometimes referred to as
“inflation forecast targeting”. Since inflation is
partially predetermined in the short term because
of existing price and wage contracts and/or
indexation to past inflation, monetary policy can
only influence expected future inflation. By altering
monetary conditions in response to new
information, central banks influence expected
inflation and bring it in line over time with the
inflation target, which eventually leads actual
inflation to the target.
61
Inflation targeting
 Inflation-targeting regimes generally identify
price stability as the primary objective,
usually in the context of a hierarchical
mandate.
 They set an explicit numerical target for
inflation and set a period over which any
deviation of inflation from its target is to be
eliminated, although some regimes provide
escape clauses and others flexibility related
to the pace of return to price stability.
62
Inflation targeting

Targeting the inflation as the sole objective of central

bank requires:
 Central Bank legal framework (Instrument
Independence, Mandate for Price stability)
 Design of the inflation target (CPI Measure or GDP
Deflator Measure)
 The Target Horizon: When is the target set?
 Point Target or Target Range
 Transparency and Accountability:

63