infaltion & unemployment notes

8/8/2019 Infaltion & Unemployment Notes

1/11

1

CHAPTER 4 - INFLATION AND UNEMPLOYMENT

Objectives:

After studying this chapter, you should be able to:

j define inflationj

identify the different degrees of inflationj identify the causes of inflationj calculate the inflation ratej consider the various costs that inflation imposes on societyj identify ways to control inflationj define unemploymentj compute the measurement of unemploymentj identify different types of unemploymentj consider the various costs that unemployment imposes on societyj identify policies to reduce unemploymentj explain the relationship between inflation and unemployment using Phillips

Curve

4.1. INFLATION4.1.1.Definitiony Inflation can be defined as a situation where there is a continuous increase ingeneral

price levelover time

y generally inflation is a situation wherey there is too much money chasing too few goodsy cost of living has increasedy there is persistent fall in the value in the economyy prices are rising

4.1.2.Degrees of inflationi) Mild inflation

y not serious conditiony normally the general price level would increase up to 5 %, i.e. the CPI is about

105

ii) Creeping inflationy more serious than mild inflationy occurs when demand is rising but supply is constant , hence leading to rising

prices

y the general price level would normally increase by 10% and CPI is 110iii)Hyperinflation / galloping inflation / runaway inflation

y very serious economic condition where the value of money is persistently fallingy inflation that exceeds 50% per month


2/11

2

y price level increases more than 100-fold over the course of a yeary in some countries money becomes valueless and a new currency system has to be

adopted

4.1.3. Causes of inflationa) Demand pull inflation

y the basic cause of inflation comes from the demand sidey there is persistent increase in demand which could be due factors such as

increase in money supply (expansionary monetary policy) increase in government purchases (expansionary fiscal policy) increase in exports

y when demand is rising and cannot be met by a corresponding increase in supply ,then the general price level will increase and inflation will occur

y as depicted in Figure 4.1 , the rightward shift in the AD curve from AD1 to AD2will result in excess demand

y the effect is to push prices upwards from P1 to P2

Figure 4.1

b) Cost push inflation ( supply push inflation )y the basic cause is the rising costs of production , such as

an increase in wage rates an increase in the prices of raw materialsy when industries are faced with rising production costs , they will push prices up

y in terms of AD-AS diagram , this is depicted in Figure 4.2 as an upward shift iny the AS curve from AS1 to AS 2y the result is a rise in prices from P1 to P2

Price

Output

AD1AD2

AS

Q1 Q2

P2P1


3/11

3

Figure 4.2

c) I

mportedI

nflation

y If there is inflation in the source countries of imports, imported inflation comes inalong with the imported goods and services.

y E.g. as inputs or raw materials such as crude oil are purchased at high, inflated pricesfrom the Middle East where the inflation originates, non-oil producers like Singaporeimport the inflation as well.

4.1.4 Measurement ofInflationy general price level is measured using price indexi) the GDP deflator (refer to chapter 1)ii) the CPIy an index that measures changes in prices of a fixed basket of goodsy defined as

CPIin year K = (cost of basket in year K / cost of basket in base year) X 100

y e.g. suppose a basket of goods costs RM200 in the base year of 1992 and RM250 in1997

y then CPI for 1992 and 1997 are given asCPI1992 = (RM200 / RM200) X 100 = 100

CPI1997 = (RM250 / RM200) X 100 = 125

y assuming CPI is used to measure inflation , then the rate of inflation between 2periods , say period t and period (t-1 ) is given by

inflation rate = (CPItCPIt-1) /CPIt-1 x 100%

Price

Output

AS1

AS2

P2P1

Q2 Q1


4/11

4

y e.g. in Dec 1999, CPI was 118.9, and in Dec 1998, it was 115.7, so the inflation rateduring 1998 was %100

7.115

7.1159.118X

= 2.77%

y it is possible for inflation to be negative, but this rarely happens, this would occurwhen the general price level falls and it is called deflation

4.1.5 Costs ofInflationA) Anticipated Inflation (inflation that is expected)

i) Menu costsy costs of inflation that arise from actually changing pricesy restaurant owners, catalogue producers, and any other business that must post

prices will have to incur costs to change their prices because of inflation

ii) Shoe-leather costsy costs of inflation that arise from trying to reduce holdings of cashB) Unanticipated Inflation (inflation that is not expected)

y failure to anticipate inflation correctly imposes costs in the labour market and thecapital market

In the labour market , unanticipated inflation causesa) redistribution of income

y cause wages to be set at the wrong level and create unintended redistribution ofincome a burst of unanticipated inflation lowers workers real wages , and employers gain

at the expense of workers

lower than expected inflation causes real wages to be high and workers gain at theexpense of employers

b) departures from full employment

y higher than anticipated inflation lowers workers real wages , so some quit to searchfor other jobs such quitting imposes costs on both workers and firms

y lower than expected inflation raises the real wage , so firms lay off some workers andthe unemployment rate rises costs are imposed on both workers and firms

In the capital market , unanticipated inflation causes

a) redistribution of income and too much or too little lending and borrowing


5/11

5

b) interest rates based on incorrectly anticipated inflation imposes a cost on either theborrower or lender

y if the inflation rate is unexpectedly high , borrowers gain but lenders losey if the inflation rate is unexpectedly low , lenders gain but borrowers losec) inaccurate inflation expectations also create an inappropriate amount of borrowing and

lending

y when the inflation rate is higher than anticipated , the real interest rate is lower thananticipated , and borrowers want to have borrowed more and lenders want to haveloaned less

y when the inflation rate is lower than anticipated , the real interest rate is higher thananticipated , and borrowers want to have borrowed less and lenders want to haveloaned more

4.1.6 Ways to control inflationy 3 main ways by which inflation can be controlledi) adopt tight monetary policy undertaken by Central Bank (Bank Negara) that usesome instruments to influence the economy by reducing money supply and higher

interest ratesii) contractionary fiscal policy that deals with reducing government expenditures andincreasing taxiii) direct control - direct govt intervention in the price mechanism of the countrya) price pegging

y government fixed the floor and ceiling prices , so that prices will not increaserapidly

y producers will not be able to increase prices according to their own wishesb) control of trade union

y demand for higher wages has caused cost-push inflationy persuade not to make these demands

c) anti-hoarding campaigny done in Msia , where reports were made against producers and consumers

who store their goods unnecessarily because such storage could causeartificial shortage and push prices up

d) price taggingy prices of all goods have to be labelledy prevent producers from over-charging the consumers

e) rationing


6/11

6

y This is done as a last resort whereby consumers are given coupons to buygoods in certain quantities, for example, one family is only allowed to buy 10

kilograms of rice per month. In other words, the demand for the good ispredetermined.

To be effective all 3 methods, i.e. monetary policy, fiscal policy and direct control mustbe implemented simultaneously

4.2. UNEMPLOYMENT4.2.1.Definitionsy the unemployed are those individuals who do not currently have a job but who are

looking for work

y individuals who looked for work in the past but are not looking currently are notcounted as unemployed

y the employed are individuals who currently have jobsy thus, employed + unemployed = labour forcey people who are not working and are not looking for work are not considered to be in

the labour force such as a full-time student, homemaker, or retiree is not in the labour

forcey discouraged workers also not included in the official count of the unemployed as they are workers who

left the labour force because they could not find jobs

4.2.2. Measurement of Unemploymenty Unemployment ratey the percentage of the labour force that is unemployedy it is computed as:

No. of unemployed workers

labour forceX100%

OR

Labour force - no. of employed workers

labour forceX100%

4.2.3.Types of unemploymenty unemployment can be classified into 3 types :i) frictional unemploymenty unemployment that occurs naturally during the normal workings of an economy


7/11

7

y can occur for a variety of reasons such as people change jobs, move across thecountry, search for new opportunities or take their time after they enter the labour

force to find appropriate job

y arises because it takes time for workers to be matched with suitable jobsy during this time , workers engaged in a job search will be registered as

unemployedy the problem is that information is imperfect

employers are not fully informed about what labour is available . workers are not fully informed about what jobs are available .

y to remedy frictional unemployment - better job information provided bygovernment job centers , local and national newspaper.

ii) Structural unemploymenty arises from changes in the pattern of demand and supply in the economyy pattern of demand - declining demand - change in consumer tastes , goods out of

fashion , competition from other industries , etc.y pattern of supply - methods of production - new techniques of production.

Unemployment may result from labour-saving techniques of production or awhole new technology which requires workers with different skills.

y people cannot immediately take up jobs in other parts because there is mismatchbetween workers skill and job requirements due to not having sufficient education lack of skills and training

y E.g. when products such as black and white television become obsolete workersengaged in their production may become unemployed.

iii) Cyclical unemploymenty arises because the economy is in recession and there is deficiency of demand

e.g.: in the recession year 1982, the unemployment rate rose in 48 of the 50states in U.S.

y unemployment increases during recession and decreases during expansion .y in any economy ,

actual rate of unemployment = natural rate of unemployment + cyclical rate ofunemployment

y the natural rate of unemployment is defined as the rate of unemployment that prevailswhen output and employment are at the full level of employment level .

y even though the economy is operating at the full employment level of employment ,there will still be people who are facing frictional and structural unemployment

y in other words ,natural rate of unemployment = frictional + structural unemployment .


8/11

8

4.2.4. Costs of Unemploymenti) Costs to the unemployedy Even though, people may have more time to pursue leisure activities, they may be

constrained in so doing by a lack of incomey The unemployed also suffer a loss of status as a certain amount of social stigma is

still attached to being unemployed.

y More likely to experience divorce, nervous breakdowns, bad health and are morelikely to attempt suicide than the rest of the adult population

y Long periods of unemployment reduce the value of human capital. When people areout of work, their skills can become rusty, and they miss out on training in newmethods.

ii) Costs to societyy The main cost to society is the output which is losty people will enjoy fewer goods and services than they could have consumed with

higher employment

y The country will be producing inside its PPFy Whilst government revenue will fall as unemployment rises, it will have to increase

its spending on unemployment related benefits (such as unemployment benefit)

y there has been increased evidence of a link between crime and unemployment,particularly in the case of young unemployed men

4.2.5. Policies to reduce unemploymenty policies to reduce unemployment depend on the type of unemploymenti) Frictional unemployment

y focus primarily on improving the information flows between employers and job-seekers

y employment agencies need to be set up to pool and provide information on thetype of job opportunities that are available on the kind of workers who aresearching for employment

y another much more controversial remedy is for the government to reduce the levelof unemployment benefit

ii) structural unemploymenty encouraging people to look more actively for jobs, if necessary in other parts of

the country

encourage people to adopt a more willing attitude towards retraining, and ifnecessary to accept some reduction in wages

y use wage subsidy programs to encourage employers to hire and train those whootherwise lack the necessary skills to get the jobs


9/11

9

iii) cyclical unemploymenty adopt expansionary monetary policies by increasing money supply and reducing

interest rates to stimulate aggregate demand or expansionary fiscal policy by

increasing government expenditure and reducing tax

4.2.6 Trade-off between Inflation and Unemployment - The Phillips Curve

y a Phillips curve shows the relationship between the inflation rate and theunemployment rate

y there are 2 times frame for PC : the short-run PC the long-run PC

y the short-run PC shows the relationship between inflation and unemployment holdingconstant the expected inflation rate and natural rate of unemployment .

y Figure 4.3 illustrates a short-run PC

Figure 4.3

y it demonstrate that a higher inflation rate lowers the unemployment ratey the negative relationship between the inflation rate and unemployment rate is

explained by the aggregate demand and aggregate supply model

y an unexpectedly large increase in aggregate demand raises the inflation rate andincreases real GDP , which lowers the unemployment rate

y hence , higher inflation is associated with lower unemployment shown by amovement along a short-run PC .

y Figure 4.4 depicts the Phillips curve and the AD/AS curves

Unemployment rate (%)

Inflation rate (%)

SRPC


10/11

10

Figure4.4

y the long-run PC shows the relationship between inflation and unemployment whenthe actual inflation rate equals the expected inflation rate

y the long-run PC is vertical at the natural unemployment ratey along the long-run PC , an increase in the inflation rate has no effect on the

unemployment rate .

y The long-run PC tells us that any anticipated inflation rate is possible at the naturalunemployment rate

y when inflation is anticipated, real GDP= potential GDP ==> unemployment is at thenatural rate

How is the Short-run Phillips Curve related to the Long-run Phillips curve?

e.g.: An increase in the growth of the money supply

Figure 4.5

UE %

Inflation rate (%)

Price level

AS

AD0

AD1

Real GDP

(Billions of

RM)

P1

P0

Y0 Y1

5% 4%

UE UE

4

2

4 5

C

A

B

Inflation rate

UE rate

SRPC (Pe=3%)

SRPC' (Pe=6%)

3 5(Natural rate of UE)

6

3


11/11

11

y Suppose the economy is at point A in figure 4.5. At that point, the inflation rate is3% and the unemployment rate is at the natural rate, 5%.

y Now suppose the growth rate of the money supply increases. The increase in thegrowth rate of money supply will stimulate aggregate demand.

y In the short run, the increase in AD will increase output and decrease unemployment,as the economy moves up along the short-run Phillips curve, from point A to point B,where the actual inflation rate has increased from 3% to 6% and the unemploymentrate has fallen below the natural rate to 3%.

y Because the increase in inflation was unanticipated, real wages fall. Firms are nowreceiving higher prices relative to their input costs, so they expand output -unemployment rates fall - movement along the SRPC from A to B.

y Eventually, workers (and other input owners) realize that their real wage has fallenbecause of the increase in the inflation rate that was not initially anticipated. Workersnow vigorously negotiate for higher wages - this increases costs to producers, and as

a result, they reduce output and unemployment rises - rightward shift in the SRPCfrom point B to point C in figure 4.5.

REFERENCES:1. Principles ofEconomics, Second Edition, N.Gregory Mankiw, Harcourt, 2001

2.Economics Fourth Edition, David N. Hyman, Irwin BookTeam, 1996

infaltion & unemployment notes

Documents