Inflation & unemployment

Types of Unemployment:

Frictional Unemployment:
Unemployment caused
when people move from job to job
and claim benefit in the meantime
The quality of the information
available for job seekers is crucial
to the extent of the seriousness of
frictional unemployment

Types of Unemployment:

Structural Unemployment:
Unemployment caused
as a result of the decline of industries
and the inability of former employees to
move
into jobs being created
in new industries
Seasonal Unemployment:
Unemployment caused because of the
seasonal nature of employment
tourism, agriculture, sports etc.

CYCLICAL UNEMPLOYMENT:
Caused by a general lack of
demand in the economy this type
of unemployment
may be widespread across a range
of industries and sectors
Keynes saw unemployment as
primarily a lack of demand in the
economy which could be influenced
by the government

Okuns Law:

1.
2.
3.

4.

This law states that 1 extra point

of unemployment costs 2%of GDP
Consequences of unemployment:
Loss of potential output
Loss of human capital
Increasing inequalities and
distribution of income
Social costs

Inflation & Phillips curve:

The inflation rate is the
percentage change in the price
level.
The Phillips Curve shows the
relationship between the
inflation rate and the
unemployment rate.

Causes of Inflation:

Demand-pull inflation is inflation

initiated by an increase in
aggregate demand.
Cost-push, or supply-side,
inflation is inflation caused by an
increase in costs.

Demand pull :
Increase in AD
can be due to a
fiscal or
monetary policy,
thus increasing
prices

Cost push:
Upward shift of the
AS will be due to
increase in costs
due to increase in
price of inputs.

Stagflation:

Stagflation occurs when output is

falling at the same time that prices
are rising.
One possible cause of stagflation is
an increase in costs.

Combination of both:

Costs of inflation:

Redistribution of income and wealthborrowers gain and creditors lose.fixed

income earners lose.
Balance of payments effect- exports
become expensive. Hence exchange rate
depreciates.
Uncertainty about the value of money
Resource cost of changing prices menu
costs
Economic growth and investment suffers

Philips Curve:

It is a statistical relationship
between unemployment and
money wage inflation.
Rate of inflation= rate of wage
growth less rate of productivity
growth.

Phillips Curve:

1958 Professor A.W. Phillips

Expressed a statistical relationship
between the rate of growth
of money wages and unemployment
from 1861 1957
Rate of growth of money wages
linked to inflationary pressure
Led to a theory expressing a trade-off
between inflation and unemployment

The Philips Curve

Wage growth %
(Inflation)

The Phillips Curve shows an

inverse relationship between
inflation and unemployment. It
suggested that if governments
wanted to reduce unemployment
it had to accept higher inflation as
a trade-off.

2.5%

Money illusion wage rates rising

but individuals not factoring in
inflation on real wage rates.

1.5%

4%

6%

PC1

Unemployment (%)

The curve crosses the horizontal axis at a positive

value of unemployment. Hence it is not possible
to have zero inflation and zero unemployment
The concave shape implies that lower the level of
unemployment higher the rate of inflation.
Govt. should be able to use demand management
policies to take the economy to acceptable levels
of inflation and unemployment.
In order to achieve full employment, some
inflation is unavoidable.
However, this relationship broke down at the end
of 1960s when Britain began to experience rising
inflation and unemployment.
This raised a question on the application of
Phillips curve in the long run.

Long run Phillips curve:

dp/dt = f(1/u) + dpe/dt

To keep unemployment below the natural
rate, inflation must keep on increasing
every year. In the long run Philips curve will
be vertical at the rate of unemployment
where real aggregate demand equals real
aggregate supply. This rate is called the
natural rate of unemployment. It is also
called NAIRU or Lowest sustainable
unemployment rate (LSUR).

the inflation augmented Philips

curve is given by the eqn :
=e -(U U* )
expected inflation is passed on to
real inflation
unemployment is at the natural
rate when actual unemployment
equals expected inflation

The Philips Curve

To counter the rise in unemployment,
government once again injects resources
into the economy the result is a shortThere
Assume
is
athe
short
term fallstarts
in unemployment
with an
inflation
butrate
at aof
term
fall
ineconomy
unemployment
but
higher
cost
1% of
buthigher
very high
inflation.
unemployment
Individuals at
now
7%.base their
inflation.
This
higher
inflation
fuels further
wage
Government
negotiations
takesonmeasures
expectations
to reduce
of higher inflation
expectation
of
inflation
and
so
the
inunemployment
the next period.
byIfhigher
an
higher
expansionary
wages
arefiscal
granted
policy
then
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that pushes
costs continues.
rise
AD to
they
thestart
right
to(see
shed
thelabour
AD/AS
process
The
long
runand
Phillips
unemployment
diagram on slide
creeps
15) back up to 7% again.
Curve is vertical at the natural rate of
unemployment. This is how economists
have explained the movements in the
Phillips Curve and it is termed the
Expectations Augmented Phillips
Curve.

Long Run PC

inflation

3.0%

2.0%

1.0%
PC1
7%

PC3

PC2

Unemployment

7% becomes the natural rate in

this case.
Whenever unemployment rate is
pushed below natural rate , wages
increase, pushing up costs. This
leads to a lower level of output
which pushes unemployment back
to the natural rate.

Countering inflation:
Demand -pull Reduce demand by higher taxation, lower govt.
expenditure, lower govt borrowing, higher
interest rates

Cost push

Take steps to reduce production costs by

deregulating labour markets, encouraging
greater productivity, apply control over wages
and prices

Import
factors

reduce quantity of imports or their prices via

trade policies.

Controlling inflation (cont)

Excessive
growth on
money supply

Reduce money supply by cutting down on

public sector borrowing
Funding Govt borrowing from non bank
Reduce bank lending
Maintain interest rates

Expectations
of inflation

Pursue policies which indicate Govts

determination to reduce inflation