Unit 4: Unemployment and Inflation
Measuring unemployment
To measure unemployment, we first divide the adult population into three categories:
- Employed: People who are currently working (full-time or part-time).
- Unemployed: People who are not employed, are available for work, and have actively looked for work in the recent past.
- Not in the Labor Force: People who fit neither of the first two categories (e.g., students, homemakers, retirees, discouraged workers who have given up looking).
Key Formulas:
Labor Force = Employed + Unemployed
Unemployment Rate = (Number of Unemployed / Labor Force) × 100
Labor Force Participation Rate = (Labor Force / Adult Population) × 100
Common Pitfall: The unemployment rate is not (Unemployed / Population). A person who is not working and not looking for work (e.g., a retiree) is not counted as unemployed; they are "not in the labor force."
Types of unemployment
Unemployment can be broken down into several types:
- 1. Frictional Unemployment:
- Definition: Short-term unemployment that arises from the time it takes for workers to search for new jobs that best suit their skills and tastes.
- Nature: It is "search" unemployment. It is unavoidable and occurs even in a healthy, dynamic economy (e.g., graduates looking for their first job, people moving between jobs).
- 2. Structural Unemployment:
- Definition: Long-term unemployment that arises from a mismatch between the skills of the unemployed workers and the skills required for available jobs.
* - Causes: Technological change (automation), globalization (jobs moving overseas), or changes in the structure of the economy (e.g., decline of the coal industry).
- 3. Cyclical Unemployment:
- Definition: Unemployment caused by a downturn in the business cycle (a recession). It is due to a deficiency of aggregate demand.
- Nature: When the economy slows down, firms lay off workers. This is the type of unemployment Keynesian policies (fiscal/monetary) aim to fix.
Natural Rate of Unemployment (NRU): This is the "normal" rate of unemployment that exists even when the economy is at "full employment." It is the sum of Frictional + Structural unemployment.
Actual Unemployment = Natural Rate + Cyclical Unemployment
Inflation: Meaning, Inflationary Gap
Meaning of Inflation
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.
- Sustained: A one-time jump in prices is not inflation.
- General: The price of *one* good (e.g., petrol) rising is not inflation. It must be a broad increase across many goods (as measured by an index like the CPI or GDP Deflator).
Deflation is the opposite: a sustained *decrease* in the general price level.
Disinflation is a *slowing down* of the rate of inflation (e.g., inflation falling from 8% to 5%).
Inflationary Gap (Keynesian Concept)
This gap explains demand-pull inflation in the Keynesian model.
- Full-Employment Output (Y_f): The level of national income (GDP) where the economy is at its natural rate of unemployment.
- Inflationary Gap: A situation where the actual equilibrium output (Y*) is greater than the full-employment output (Y_f). This happens because Aggregate Expenditure (AE) is *too high*.
Since the economy is already at full employment, it cannot produce more real output (Y). This excess demand (AE > Y_f) simply pulls up the general price level, causing demand-pull inflation. The size of the gap is the vertical distance by which the AE curve is *above* the 45-degree line at the full-employment level (Y_f).
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Types, Causes and Consequences of Inflation
Types of Inflation (by speed)
- Creeping Inflation: Slow and mild (e.g., 1-3% per year). Generally considered healthy.
- Walking Inflation: Moderate (e.g., 3-10% per year). A warning sign.
- Galloping Inflation: High (e.g., 10-100% per year). Causes serious economic distortions.
- Hyperinflation: Extremely rapid (e.g., 50% *per month* or more). Money becomes worthless. (e.g., 1920s Germany, Zimbabwe).
Causes of Inflation (The Two Main Theories)
- Demand-Pull Inflation:
- Slogan: "Too much money chasing too few goods."
- Cause: Occurs when Aggregate Demand (AD) increases and "pulls" prices up.
- Triggers: Increased government spending (G), tax cuts (boosting C), expansionary monetary policy (boosting M), or a rise in exports (X).
- Model: The AD curve shifts to the right.
- Cost-Push Inflation:
- Slogan: "Too few goods for the money."
- Cause: Occurs when Aggregate Supply (AS) decreases due to a rise in the cost of production, which "pushes" prices up.
- Triggers: A rise in oil prices (an "supply shock"), a rise in wages, or a natural disaster that destroys crops/factories.
- Model: The AS curve shifts to the left.
Consequences of Inflation
- Redistribution of Income and Wealth:
- Hurts: People on fixed incomes (pensioners), savers (the real value of their savings falls), and lenders (get paid back with "cheaper" money).
- Helps: Borrowers (pay back loans with "cheaper" money) and owners of real assets (e.g., property, gold).
- Uncertainty: Makes it hard for firms to plan and invest, which can slow economic growth.
- Loss of Competitiveness: If a country's inflation is higher than its trading partners, its exports become more expensive, and imports become cheaper, worsening the trade balance.
- "Menu Costs" and "Shoe-leather Costs": Menu costs are the costs to firms of constantly changing prices. Shoe-leather costs are the costs to individuals of holding less cash and making more frequent trips to the bank.
Okun's Law
Okun's Law describes the empirical (observed) negative relationship between unemployment and real GDP.
Coined by economist Arthur Okun, the law states that for every 1 percentage point that the actual unemployment rate rises above the natural rate of unemployment (NRU), real GDP falls by a certain percentage (e.g., 2-3%).
Core Idea: When unemployment is high, the economy is not using all its available labor, so it is producing *below* its potential output.
This law provides a quantitative link between the two main macroeconomic problems: high unemployment means lost output (low GDP).
The trade-off between inflation and unemployment
This topic introduces the core concept of the Phillips Curve.
In the short run, policymakers often face a trade-off:
- Policies to reduce unemployment (like increasing AD) tend to increase inflation.
- Policies to reduce inflation (like decreasing AD) tend to increase unemployment.
This inverse relationship suggests that a country must choose a point on this trade-off: either low unemployment with high inflation, or low inflation with high unemployment. However, this trade-off was found to be unstable.
Philip's Curve in the Short run and Long run
The Short-Run Phillips Curve (SRPC)
- What it is: A downward-sloping curve showing the inverse short-run relationship between the inflation rate and the unemployment rate.
- Mechanism: It is based on a specific level of expected inflation. If AD increases, firms see demand rise. They hire more workers (unemployment falls) and also raise prices (inflation rises). This is a movement *up along* the SRPC.
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The Long-Run Phillips Curve (LRPC)
Theorized by Milton Friedman and Edmund Phelps, this concept argues that in the long run, there is NO trade-off between inflation and unemployment.
- What it is: A vertical line at the Natural Rate of Unemployment (NRU).
- Mechanism (Adaptive Expectations):
- The economy is at the NRU (point A).
- Govt. uses policy to increase AD, lowering unemployment (moving up the SRPC to point B).
- Workers now *expect* higher inflation. They demand higher wages.
- Higher wages raise firms' costs, so they lay off workers. Unemployment returns to the NRU, but now at a permanently higher inflation rate (point C).
- The SRPC has *shifted up* (from SRPC1 to SRPC2).
- Conclusion: Any attempt to keep unemployment below the NRU will only result in accelerating, runaway inflation. The LRPC is vertical, meaning in the long run, the unemployment rate is *independent* of the inflation rate.
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The concept of Stagflation
Stagflation is a toxic combination of economic stagnation (falling output, high unemployment) and high inflation, occurring at the same time.
The 1970s saw a period of global stagflation, primarily caused by the OPEC oil shocks. This was a classic cost-push inflation scenario.
- The price of oil (a key input) soared.
- This caused a negative Aggregate Supply shock (the AS curve shifted to the left).
- A leftward AS shift causes both problems simultaneously:
- Prices rise (inflation).
- Output falls (stagnation/recession, which means high unemployment).
Importance: Stagflation *broke* the original, simple Phillips Curve. It showed that it was possible to have high inflation and high unemployment at the same time, proving the short-run trade-off was not stable. This gave credibility to Friedman's long-run (vertical) Phillips Curve theory.