Inflation and Unemployment

A2 Economics

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 has been 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 UK

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 their 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

The Phillips Curve

• Short run phillips curve is curve shaped• The long run phillips curve the curve is vertical • At this rate the where unemployment is at its natural

rate inflation is stable• In the UK since 1997 there has been low inflation

and low unemployment

Phillips Curve

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 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, variable annuities, 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.

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