UNEMPLOYMENT AND

INFLATION
Week09-10
 IDENTIFYING UNEMPLOYMENT
• Natural Rate of Unemployment
– The natural rate of unemployment is unemployment
that does not go away on its own even in the long run.
– It is the amount of unemployment that the economy
normally experiences.
• Cyclical Unemployment
– Cyclical unemployment refers to the year-to-year
fluctuations in unemployment around its natural rate.
– It is associated with short-term ups and downs of the
business cycle.
 MEASURING UNEMPLOYMENT
• Employed
– A person is considered employed if he or she has spent most of
the previous week working at a paid job.
• Unemployment
– A person is unemployed if he or she is on temporary layoff, is
looking for a job, or is waiting for the start date of a new job.
• Not in the labor force
– A person who fits neither of these categories, such as a full-time
student, homemaker, or retiree, is not in the labor force.
• Labor force
– The labor force is the total number of workers, including both
the employed and the unemployed.
 How is unemployment measured?

• The unemployment rate is calculated as the

percentage of the labor force that is
unemployed.
Number unemployed
Unemployment rate =  100
Labor force
 Impact of Unemployment
• The largest single cost of unemployment is
lost production
• Okun’s law states that for every 2% that GDP
falls relative to potential GDP, the
unemployment rate rises about 1 percentage
point
 Okun’s Law
Percentage 10 Y
change in 1951 1966  3.5  2 u
real GDP 8 Y
1984
6
2003
4

2 1987

0 1975
2001
-2 1982
1991
-4
-3 -2 -1 0 1 2 3 4
Change in unemployment rate
 Equilibrium vs. Disequilibrium
Unemployment
• Equilibrium Unemployment arise when people
become unemployed voluntarily as they move from
job to job or into and out of the labor force
• The voluntarily unemployed workers might prefer
leisure or other activities to jobs at the going wage
rate, or
• They may be frictionally unemployed, perhaps
searching for their first job, or
• The might be low-productivity workers who prefer
retirement or unemployment insurance to low-paid
work.
 Equilibrium vs. Disequilibrium
Unemployment
• Disequilibrium unemployment occurs when the
labor market or the macroeconomy is not
functioning properly and some qualified people
who are willing to work at the going wage cannot
find jobs.
– Structural unemployment signifies a mismatch
between the supply of and the demand for worker,
and market do not quickly adjust.
– Cyclical unemployment exist when the overall
demand for worker declines in business-cycle
downturns
 Public Policy and Job Search
• Government programs can affect the time it takes
unemployed workers to find new jobs.
• These programs include the following:
– Government-run employment agencies give out
information about job vacancies in order to match
workers and jobs more quickly
– Public training programs aim to ease the transition of
workers from declining to growing industries and to
help disadvantaged groups escape poverty
– Unemployment insurance aim to protects workers’
incomes when they become unemployed
 Why is there Structural
Unemployment?
• Minimum-wage laws
• Unions
• Efficiency wages
Equilibrium vs. Disequilibrium
Unemployment
INFLATION
 Definition
• Inflation is an increase in the overall level of
prices.
• Inflation can be categorized into
 Low inflation
 Galloping inflation – double digit or triple digit per
year
 Hyperinflation
 THE CLASSICAL THEORY OF INFLATION

• The quantity theory of money is used to explain the

long-run determinants of the price level and the
inflation rate.
• Inflation is an economy-wide phenomenon that
concerns the value of the economy’s medium of
exchange.
• When the overall price level rises, the value of
money falls.
– What is determine the value of money?
 Money Supply, Money Demand, and the Equilibrium Price Level

Value of Price
Money, 1/P Money supply Level, P

(High) 1 1 (Low)

3 1.33
/4

A
12
/ 2

Equilibrium Equilibrium
value of price level
14 4
money /
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the CB Money

Copyright © 2004 South-Western

 The Effects of Monetary Injection

Value of Price
Money, 1/P MS1 MS2 Level, P

(High) 1 1 (Low)

1. An increase
3
/4 in the money 1.33
2. . . . decreases supply . . .
the value of
3. . . . and
money . . . A
12
/ 2 increases
the price
level.
14
B
/ 4
Money
demand
(Low) (High)
0 M1 M2 Quantity of
Money

Copyright © 2004 South-Western

The Classical Dichotomy and Monetary Neutrality

• According to Hume and the contemporaries,

economic variables should be divided into two
groups:
– Nominal variables are variables measured in
monetary units.
– Real variables are variables measured in physical
units.
The Classical Dichotomy and Monetary Neutrality

• According to Hume and others, real economic

variables do not change with changes in the
money supply.
– According to the classical dichotomy, different
forces influence real and nominal variables.
• Changes in the money supply affect nominal
variables but not real variables.
– The irrelevance of monetary changes for real
variables is called monetary neutrality.
 Velocity and the Quantity Equation

• The velocity of money refers to the speed at

which the typical dollar bill travels around the
economy from wallet to wallet.
 Velocity and the Quantity Equation

V = (P  Y)/M

– Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
 Velocity and the Quantity Equation

• Rewriting the equation gives the quantity

equation:
MV=PY
• The quantity equation relates the quantity of
money (M) to the nominal value of output
(P  Y).
 Velocity and the Quantity Equation

• The quantity equation shows that an increase

in the quantity of money in an economy must
be reflected in one of three other variables:
– the price level must rise,
– the quantity of output must rise, or
– the velocity of money must fall.
 Velocity and the Quantity Equation

• The Equilibrium Price Level, Inflation Rate, and the

Quantity Theory of Money
– The velocity of money is relatively stable over
time.
– When the CB changes the quantity of money, it
causes proportionate changes in the nominal
value of output (P  Y).
– Because money is neutral, money does not affect
output.
 The Fisher Effect

• Recall:
– According to the principle of money neutrality, an
increase in the rate of money growth raises the
rate of inflation but does not effect any real
variable.
– An important application of this principle
concerns the effect of money on interest rates.
– Nominal interest rate = real interest rate +
inflation rate
 The Fisher Effect

• The one-for-one adjustment of the nominal

interest rate to the inflation rate is called
Fisher effect.
• According to the Fisher effect, when the rate
of inflation rises, the nominal interest rate
rises by the same amount.
• The real interest rate stays the same.
 DEMAND PULL AND
COST PUSH INFLATION
• Demand pull inflation (or demand shocks
inflation) occurs when AD rises more rapidly
than the economy’s productive potential,
pulling prices up to equilibrate AS and AD.
• Cost push inflation (or supply shocks inflation)
occurs when the cost of production rise even
in periods of high unemployment and idle
capacity.
 DEMAND PULL AND
COST PUSH INFLATION
 THE COSTS OF INFLATION
• A Fall in Purchasing Power? The Inflation
Fallacy
– Inflation does not in itself reduce people’s real
purchasing power.
• Remember the classical dichotomy
 THE COSTS OF INFLATION
• Shoe leather costs
• Menu costs
• Relative price variability
• Tax distortions
• Confusion and inconvenience
• Arbitrary redistribution of wealth
 Shoe leather Costs

• Shoe leather costs are the resources wasted

when inflation encourages people to reduce
their money holdings.
• Inflation reduces the real value of money, so
people have an incentive to minimize their
cash holdings.
 Shoeleather Costs

• Less cash requires more frequent trips to the bank to

withdraw money from interest-bearing accounts.
• The actual cost of reducing your money holdings is
the time and convenience you must sacrifice to keep
less money on hand.
• Also, extra trips to the bank take time away from
productive activities.
 Menu Costs

• Menu costs are the costs of adjusting prices.

• During inflationary times, it is necessary to
update price lists and other posted prices.
• This is a resource-consuming process that
takes away from other productive activities.
 Relative-Price Variability and
the Misallocation of Resources

• Inflation distorts relative prices.

• Consumer decisions are distorted, and
markets are less able to allocate resources to
their best use.
 Inflation-Induced Tax Distortion

• Inflation exaggerates the size of capital gains

and increases the tax burden on this type of
income.
• With progressive taxation, capital gains are
taxed more heavily.
 Inflation-Induced Tax Distortion

• The income tax treats the nominal interest

earned on savings as income, even though
part of the nominal interest rate merely
compensates for inflation.
• The after-tax real interest rate falls, making
saving less attractive.
How Inflation Raises the Tax Burden on Saving
 Confusion and Inconvenience

• When the CB increases the money supply and

creates inflation, it erodes the real value of
the unit of account.
• Inflation causes dollars at different times to
have different real values.
• Therefore, with rising prices, it is more difficult
to compare real revenues, costs, and profits
over time.
 A Special Cost of Unexpected Inflation: Arbitrary
Redistribution of Wealth
• Unexpected inflation redistributes wealth
among the population in a way that has
nothing to do with either merit or need.
• These redistributions occur because many
loans in the economy are specified in terms of
the unit of account—money.
The Short-Run Tradeoff between
Inflation and Unemployment
 Unemployment and Inflation
• Society faces a short-run tradeoff between
unemployment and inflation.
– If policymakers expand aggregate demand, they can lower
unemployment, but only at the cost of higher inflation.
– If they contract aggregate demand, they can lower
inflation, but at the cost of temporarily higher
unemployment.
 The Phillips Curve

Inflation
Rate • The Phillips curve illustrates
(percent the short-run relationship
per year)
B
between inflation and
6
unemployment.

A
2

Phillips curve

0 4 7 Unemployment
Rate (percent)

Copyright © 2004 South-Western

 Aggregate Demand, Aggregate Supply, and the
Phillips Curve

• The Phillips curve shows the short-run

combinations of unemployment and inflation
that arise as shifts in the aggregate demand
curve move the economy along the short-run
aggregate supply curve.
 How the Phillips Curve is Related to Aggregate
Demand and Aggregate Supply

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Inflation
Level Short-run Rate
aggregate (percent
supply per year)
6 B
106 B

102 A
High
A
aggregate demand 2
Low aggregate
Phillips curve
demand
0 7,500 8,000 Quantity 0 4 7 Unemployment
(unemployment (unemployment of Output (output is (output is Rate (percent)
is 7%) is 4%) 8,000) 7,500)

Copyright © 2004 South-Western

 The Long-Run Phillips Curve

• In the 1960s, Friedman and Phelps concluded

that inflation and unemployment are
unrelated in the long run.
– As a result, the long-run Phillips curve is vertical at
the natural rate of unemployment.
– Monetary policy could be effective in the short
run but not in the long run.
 How the Phillips Curve is Related to Aggregate
Demand and Aggregate Supply

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Long-run aggregate Inflation Long-run Phillips

Level supply Rate curve
1. An increase in 3. . . . and
the money supply increases the
increases aggregate inflation rate . . .
B
P2 demand . . . B
2. . . . raises
the price
A
level . . . P A
AD2
Aggregate
demand, AD
0 Natural rate Quantity 0 Natural rate of Unemployment
of output of Output unemployment Rate
4. . . . but leaves output and unemployment
at their natural rates.

Copyright © 2004 South-Western

 SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF
EXPECTATIONS
• The Phillips curve seems to offer policymakers a menu of
possible inflation and unemployment outcomes.
• Expected inflation measures how much people expect
the overall price level to change.
• In the long run, expected inflation adjusts to changes in
actual inflation.
• The CB’s ability to create unexpected inflation exists only
in the short run.
– Once people anticipate inflation, the only way to get
unemployment below the natural rate is for actual
inflation to be above the anticipated rate.
 SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF
EXPECTATIONS

Unemployment Rate =


Natural rate of unemployment - a Actual  Expected
inflation inflation 
• This equation relates the unemployment rate
to the natural rate of unemployment, actual
inflation, and expected inflation.
 How Expected Inflation Shifts the Short-Run Phillips Curve

2. . . . but in the long run, expected

inflation rises, and the short-run
Inflation Phillips curve shifts to the right.
Rate Long-run
Phillips curve

C
B

Short-run Phillips curve

with high expected
inflation

A
Short-run Phillips curve
1. Expansionary policy moves
with low expected
the economy up along the
inflation
short-run Phillips curve . . .
0 Natural rate of Unemployment
unemployment Rate
Copyright © 2004 South-Western
 The Natural Experiment for the Natural-Rate
Hypothesis

• The view that unemployment eventually

returns to its natural rate, regardless of the
rate of inflation, is called the natural-rate
hypothesis.
• Historical observations support the natural-
rate hypothesis.
 The Natural Experiment for the Natural Rate
Hypothesis

• The concept of a stable Phillips curve broke

down in the in the early ’70s.
• During the ’70s and ’80s, the economy
experienced high inflation and high
unemployment simultaneously.
 The Phillips Curve in the 1960s

Inflation Rate
(percent per year)

10

1968
4
1966
1967

2 1962
1965
1964 1961
1963

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent)
Copyright © 2004 South-Western
 The Breakdown of the Phillips Curve

Inflation Rate
(percent per year)

10

6 1973
1971
1969 1970
1968 1972
4
1966
1967

2 1965 1962
1964 1961
1963

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent)
Copyright © 2004 South-Western
 SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF
SUPPLY SHOCKS
• Historical events have shown that the short-
run Phillips curve can shift due to changes in
expectations.
 SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF
SUPPLY SHOCKS
• The short-run Phillips curve also shifts
because of shocks to aggregate supply.
– Major adverse changes in aggregate supply can
worsen the short-run tradeoff between
unemployment and inflation.
– An adverse supply shock gives policymakers a less
favorable tradeoff between inflation and
unemployment.
 SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF
SUPPLY SHOCKS
• A supply shock is an event that directly alters
the firms’ costs, and, as a result, the prices
they charge.
• This shifts the economy’s aggregate supply
curve. . .
• . . . and as a result, the Phillips curve.
 An Adverse Shock to Aggregate Supply

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Inflation
Level AS2 Rate 4. . . . giving policymakers
Aggregate a less favorable tradeoff
supply, AS between unemployment
and inflation.
B
P2 B
3. . . . and 1. An adverse
raises A shift in aggregate A
the price P supply . . .
level . . . PC2
Aggregate
demand Phillips curve, P C
0 Y2 Y Quantity 0 Unemployment
of Output Rate
2. . . . lowers output . . .

Copyright © 2004 South-Western

 SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF
SUPPLY SHOCKS
• In the 1970s, policymakers faced two choices
when OPEC cut output and raised worldwide
prices of petroleum.
– Fight the unemployment battle by expanding
aggregate demand and accelerate inflation.
– Fight inflation by contracting aggregate demand
and endure even higher unemployment.
 The Supply Shocks of the 1970s

Inflation Rate
(percent per year)

10
1981 1975
1980
1974
1979
8
1978

6 1977
1976
1973

4 1972

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent)
Copyright © 2004 South-Western
 THE COST OF REDUCING INFLATION

• To reduce inflation, the CB has to pursue

contractionary monetary policy.
• When the CB slows the rate of money growth,
it contracts aggregate demand.
• This reduces the quantity of goods and
services that firms produce.
• This leads to a rise in unemployment.
 Disinflationary Monetary Policy in the Short Run and
the Long Run
1. Contractionary policy moves
the economy down along the
Inflation short-run Phillips curve . . .
Long-run
Rate
Phillips curve

Short-run Phillips curve

with high expected
inflation
C B

Short-run Phillips curve

with low expected
inflation
0 Natural rate of Unemployment
unemployment 2. . . . but in the long run, expected Rate
inflation falls, and the short-run
Phillips curve shifts to the left.
Copyright © 2004 South-Western
 THE COST OF REDUCING INFLATION

• To reduce inflation, an economy must endure

a period of high unemployment and low
output.
• The sacrifice ratio is the number of percentage
points of annual output that is lost in the
process of reducing inflation by one
percentage point.
Thank You