Chapter 5 Inflation and Unemployment

CHAPTER
5
INFLATION AND UNEMPLOYMENT
LEARNING OUTCOMES
At the end of this chapter, you should be able to:

 Define and measure inflation.
 Differentiate the three types of inflation.
 Explain the effects of and measures available to control
inflation.
 Define and measure unemployment.
 Differentiate the types of unemployment and measures
available to control unemployment.
 Discuss the effects of unemployment.
 Interpret the relationship between inflation and
unemployment.
Fundamentals of Economics All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–3
INFLATION
 Defined as a persistent and sustained increase in the

general price level.
 Implies that there is an increase in the cost of living that
causes lower purchasing power.
 There is an inverse relationship between inflation and
the value of money. A rise in the general price means a
drop in the value of money.
 Measures of inflation:
– Inflation is measured by using the Consumer Price
Index (CPI).

Inflation Rate
 Consumer Price Index(CPI) is used to measure

inflation
 CPI base year is considered 100
 If CPI c.y. > CPI b.y. , it indicate inflation.
 If CPI c.y. < CPI b.y. , it indicates deflation or a
decrease in GPL.
 Inflation rate = CPI cy- CPI by X 100%
CPI by
© Oxford Fajar Sdn. Bhd. (008974-T), 2017
5 1–5
INFLATION (cont.)
Types and Causes of Inflation
(i) Demand-pull inflation (shift in demand side)

This type of inflation is caused by excess demand in
fully employed economy.
Demand-pull inflation occurs when aggregate demand

(AD) exceeds the aggregate supply (AS).
As AD = C + I + G + (X - M), any increase of these

variables will cause aggregate demand to rise.

INFLATION (cont.)
 When the
economy is at
full
employment
level, an
increase in
aggregate
demand will
cause an
increase in
general price
level.

INFLATION (cont.)
 In Figure 14.2, 0YF is the full employment aggregate output

which is determined at the point of intersection of the
aggregate demand curve, AD1 and aggregate supply curve,
AS.
 An increase in the aggregate demand from AD0 to AD1 shows

an increase in the price level from P0 to P1.
 As AD1 shift to AD2 (in full employment stage), price

increases to P2. Real output has reached the maximum limit,
but prices rise rapidly.
INFLATION (cont.)
(ii) Cost Push Inflation (shift in supply side)

Caused by a decrease in aggregate supply due to an increase in
cost of production for each unit of output produced.
For instance, when price of raw materials or wages increase, the
cost of production will also increase causing aggregate supply to
decrease and the price of goods and services to increase.
The shift in the aggregate supply curve may result from various
factors:

INFLATION (cont.)

INFLATION (cont.)

INFLATION (cont.)
 In Figure 4.3, 0YF is the full employment aggregate output. It

is determined at the point of intersection of the aggregate
demand curve, AD and aggregate supply curve, AS0.
 When AS0 shift to AS1,the equilibrium aggregate output falls

from 0YF to OY1, the general price level rises from P0 to P1.
 A further upward shift in the aggregate supply curve from AS1

to AS2 creates a further increases in price to P2. The increase
in the general price level is called the cost push inflation.

INFLATION (cont.)
Effects of Inflation
(i)Unequal income distribution and wealth
(ii)Reduce investment and production
(iii)The amount of saving will decrease
(iv)Deficit in the balance of trade
(v)Breakdown in functions of money

Gainers
 Businessmen who earn higher profits from rising
price.
 Property owners when property price increases.
 Shareholders who receive high dividends since
companies receive high profit.
 Debtors because the real value of money decreases
so they pay the debt at lesser value.
Losers
 People who receive fixed income such as pensioners
 Holders of government bonds, fixed depositors,
holders of life insurance policy etc.(change after
maturity period)
 Creditors – when real value of money decreases the
value of money they lend becomes less.

INFLATION (cont.)
Measures to Control Inflation

(1) Contractionary Fiscal Policy (Budget Surplus: T > G)
(i)Increase in Taxes
An increase in tax will reduce the disposable income of
individuals income and their consumption on goods and
services. This is turn will lead to a fall in prices.
(ii)Decrease in government spending
A reduction in government spending will directly affect
aggregate demand. The government will cut the salary of its
civil servant and postpone development projects to reduce the
purchasing power of the public.

INFLATION (cont.)
Measures to Control Inflation

(2) Contractionary Monetary Policy
(i)Open Market Operations
The central bank may sell government securities, short-term
bonds or treasury bills in the open market to the public to
reduce bank deposits and credit creation of commercial banks.
Money supply will reduce, hence reducing aggregate demand
and price level.
(ii)Raising Required Reserve Ratio
In the event of inflation, the central bank will increase the
required reserve ratio of all commercial banks.

INFLATION (cont.)
(iii) Raising the base lending rate/bank rate (Interest on loan)

A rise in the bank rate will cause an increase in the cost of
borrowing. Loans become costly to borrow and firms will reduce
borrowing and spending. Aggregate will reduce and inflation
rate will drop.
(iv) Raising the interest rate (Interest on saving)

Central bank would direct the commercial banks to raise their
interest rate for deposits from public. The high interest rates will
encourage more public to save and increase the saving level to
decrease the aggregate demand and price level.

INFLATION (cont.)
(i) Income policy: to ensure wages do not rise faster than

productivity.
(ii) Price control and rationing: control directly on prices of
certain goods. Price pegging either by fixing a floor price or
ceiling price is implemented.
(iii) Supply side policies: to increase the production of essential
consumer goods give tax incentives, grant and encourage
research and development
(iv) Exchange rate policies: reduce quantities or the price of
imports.
(v) Increase in savings: introduce compulsory provident fund or
provident fund-cum-pension schemes to increase savings in
controlling inflation.

UNEMPLOYMENT
 Unemployment occurs when people who are in the

working age group, are able and willing to work, but
are unable to find a suitable job.
 Defined as a situation in the economy, where there are
people between the age 16 and 65 who are not
working, but are actively seeking jobs.

UNEMPLOYMENT (cont.)
 We can categorize the population into three different

age groups:
(i) Less than 16 years old
(ii) 16–65 years old
(iii) More than 65 years old
 The age between 16–65 years is considered as the

total labour force.


Labour Force
All persons above the age of 16 and older who are
employed or are actively seeking employment.
The labour force consists of employed and unemployed
persons.
Is everyone above 16 years of age included in the labour
force?
– No, because students, housewives, pensioners and
discouraged workers are consider as outside of labour
force.

Discouraged Worker
A discouraged worker is an individual who wants to work,
but who has been unsuccessful for a long period of time in
finding a job and who has consequently given up on
seeking jobs.
A discouraged worker would like to work if the job
prospects are good.
Since the labour force is defined as people who are
above 16 years of age and who are actively seeking
employment, discouraged workers are excluded from the
labour force.

Types of Unemployment
(1) Frictional Unemployment
This is short term or temporary unemployment.
Occurs when people enter the labour market to look for jobs or
people leave their jobs, either voluntarily or from being sacked,
and are unemployed for a period of time while they are looking
for a new job.
Includes new entrants such as school-leavers, fresh graduates
and re-entrants, such as people who quit their jobs for a better
position or higher wages, or former homemakers. Hence, there
is a time lag during which a worker is unemployed when moving
from one job to another.

(2) Seasonal Unemployment

Seasonal unemployment occurs when certain products
cannot be produced during a certain season.
Hence, many workers are temporarily laid off on a short-
term basis during certain times of the year.
Example: construction workers who will be unemployed
during rainy season, a fisherman who is unable to fish during
the monsoon season or in winter, and tourist workers who
are unemployed during off-peak periods in tourist spots.

(3) Structural Unemployment

This unemployment results from structural decline of
industries, unable to compete or adapt to changing demand
and new products, or changing method of production.
A change in the pattern of demand results when tastes
change, demographic profile change or introduction of new
products or technology made the existing product obsolete,
hence the skills of workers are no longer suitable with the
jobs available.
As major industries tend to be heavily concentrated in
certain region, structural unemployment often leads to
regional unemployment and the impact can be quite serious.

(4) Cyclical Unemployment

This unemployment is caused by a decrease in aggregate
demand, due to a downswing of the business cycle.
When an economy is under recession, aggregate demand
falls and via the multiplier effect, national income falls
further. Hence, consumption falls, production reduces,
companies may close down and workers are laid off,
resulting in cyclical unemployment.
Cyclical unemployment is a serious form of unemployment
because it usually creates more unemployment.


(c) Lowering the bank rate (interest on borrowing)

The bank rate is also known as discount rate. A decline
in the bank rate makes loans less costly to borrow and firms will
increase investment by employing more workers.
(d) Lowering interest rate (interest on saving)
The central bank would direct the commercial banks to
lower their interest rate for deposits as to encourage the public
to spend. This would increase aggregate demand and
production and hence, decrease cyclical unemployment.

(2) Fiscal Policies

(a) Increase government expenditure (G)
Increase government expenditure (G) through creating
more development projects will increase aggregate demand
(AD) via the multiplier effect. Production will increase, hence
reducing the cyclical unemployment.
(b) Decrease in taxes (T)
Decrease in taxes (T), such as a reduction in excise tax,
service tax, sales tax, income tax or corporate tax, will increase
the consumption on goods and services and also induce
investment. Hence, aggregate demand will increase and
production will increase. Thus, cyclical unemployment will
reduce.
(3) Direct Control Policies

This refers to all direct measures other than monetary
and fiscal policy taken by the government.
(a) Providing training and technical education
Set up training centres to retrain workers in new
skills to improve occupational mobility.
(b) Diversification and integration of economy in

agricultural, manufacturing, construction, transportation,
finance, insurance, services sectors
To match seasonal industries which can share the labour
force.
(c) Better job information

Set up job centres, better flow of job information
through newspapers, radio or Internet.
(d) Migration of labour

Encourage workers to move to regions and industries
where job are available.
(e) Job creation in various sectors

Encourage firms to move into areas where there are
high levels of unemployment by giving tax incentives.

Effects of Unemployment
(i) Loss of job skills
If unemployment persists for a long period, individuals
will lose their job skills, causing a loss in human capital. It
will also lead them to radical social and political activities
by increasing crime rates.
(ii) Permanent loss of output of goods and services
An economy with high unemployment is not using all of
their resources, especially labour available to it.
The economy is operating below its production
possibility frontier, reducing the economy’s efficiency and
production.

(iii) Loss in government revenue

High unemployment means that the government will
receive less taxation revenue but will have to pay more on
unemployment benefits.
(iv) Social problems
Unemployment results in lower morale and human

suffering. The family unit will be affected if the sole bread-
winner were to lose his job.
Social problems arise if the unemployed turn to drugs or
crime.

 Natural rate of unemployment is the rate of unemployment

that occurs when the economy is at full employment. It is
composed of frictional and structural unemployment.
 It is affected by the changing demographic structure of the

labour force, government social policies and rising structural
unemployment.

Monetary Policy
Contractionary Expansionary
Aims To control inflation To control unemployment
To reduce money supply ( MS) To increase money supply( MS)
Tools
Open Market Operation Government will sell securities, people Government will buy securities, people
(OMO) will have less money to spend, Ms will have more money to spend, Ms
decrease, AD decrease, price increase, AD increase, production
decrease, inflation decrease increase, unemployment decrease
Cash Ratio (CR)/Required BNM will increase CR, credit creation BNM will decrease CR, credit creation
Reserve Ratio (RRR) will decrease, Ms decrease, AD will increase, Ms increase, AD increase,
decrease, price decrease, inflation production increase, unemployment
decrease decrease
Interest Rate (i) Raising interest rate, people will be Lowering interest rate, people will not
attracted to save money, Ms decrease, save money, , Ms increase, AD
AD decrease, price decrease, inflation increase, production increase,
decrease unemployment decrease
Discount Rate/cost of Raising discount rate, cost of Lowering discount rate, cost of
borrowing borrowing will increase, investment will borrowing will decrease, investment will
decrease, Ms decrease, AD decrease, increase, Ms increase, AD increase,
price decrease, inflation decrease production increase, unemployment
Fundamentals of Economics decrease All Rights Reserved
37 1–37
Fiscal Policy
Contractionary Expansionary
Aims To control inflation To control unemployment
To reduce Aggregate Demand To increase Aggregate

Tools ( AD) Demand( AD)
Government decrease government Government increase government

Government Spending (Gs) spending, people will have less spending, people will have more
money to spend, AD decrease, price money to spend, AD increase,
decrease, inflation decrease production increase, unemployment
decrease
Government will increase tax rate, Government will decrease tax rate,
Taxes (T) people will have less money to people will have more money to
spend, AD decrease, price decrease, spend, AD increase, production
inflation decrease increase, unemployment decrease

38 1–38

Chapter 5 Inflation and Unemployment

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 5 Inflation and Unemployment

Uploaded by

Copyright:

Available Formats

CHAPTER

At the end of this chapter, you should be able to:

 Defined as a persistent and sustained increase in the

Fundamentals of Economics All Rights Reserved

 Consumer Price Index(CPI) is used to measure

Types and Causes of Inflation

(i) Demand-pull inflation (shift in demand side)

Demand-pull inflation occurs when aggregate demand

As AD = C + I + G + (X - M), any increase of these

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

 In Figure 14.2, 0YF is the full employment aggregate output

 An increase in the aggregate demand from AD0 to AD1 shows

 As AD1 shift to AD2 (in full employment stage), price

(ii) Cost Push Inflation (shift in supply side)

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

 In Figure 4.3, 0YF is the full employment aggregate output. It

 When AS0 shift to AS1,the equilibrium aggregate output falls

 A further upward shift in the aggregate supply curve from AS1

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Measures to Control Inflation

Fundamentals of Economics All Rights Reserved

Measures to Control Inflation

Fundamentals of Economics All Rights Reserved

(iii) Raising the base lending rate/bank rate (Interest on loan)

(iv) Raising the interest rate (Interest on saving)

Fundamentals of Economics All Rights Reserved

(i) Income policy: to ensure wages do not rise faster than

Fundamentals of Economics All Rights Reserved

 Unemployment occurs when people who are in the

Fundamentals of Economics All Rights Reserved

 We can categorize the population into three different

 The age between 16–65 years is considered as the

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

(2) Seasonal Unemployment

Fundamentals of Economics All Rights Reserved

(3) Structural Unemployment

Fundamentals of Economics All Rights Reserved

(4) Cyclical Unemployment

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

(c) Lowering the bank rate (interest on borrowing)

Fundamentals of Economics All Rights Reserved

(2) Fiscal Policies

(3) Direct Control Policies

(b) Diversification and integration of economy in

(c) Better job information

(d) Migration of labour

(e) Job creation in various sectors

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

(iii) Loss in government revenue

Unemployment results in lower morale and human

Fundamentals of Economics All Rights Reserved

 Natural rate of unemployment is the rate of unemployment

 It is affected by the changing demographic structure of the