Sebas Topol College

Chapter two
National Income Accounting

11/15/2024 Slide 14-1

 UNIT OBJECTIVES
After the end of this unit, the students will be able to:
Differentiate between the different approaches of
measuring GDP.
Distinguish between real and nominal GDP.
Distinguish between GDP deflator and consumer price
index.
Explain the problem of measuring GDP.
Explain business cycle.
Explain the different types of inflation and
unemployment.
11/15/2024 Slide 14-2
 2.1 The concepts of GDP and GNP

Defn: National income is a measure of the value of

goods and services produced in the economy in a
given period of time, usually a year.
Defn :National income accounting refers to a set of
rules and techniques that are used to measure the
national income of a country.

11/15/2024 Slide 14-3

 Gross Domestic Product (GDP)and Gros
National Product(GNP)

• Gross Domestic Product (GDP) is the total monetary value of all

final goods and services produced in an economy in a given
period, usually a year .
– It is the single most-used economic measure.
 Gross National Product (GNP) is the aggregate final monetary value
of output of citizens and businesses of an economy in a given
period, usually a year.
• For instance, if Japanese resident owns an apartment building
in Addis Ababa, the rental income he earns is part of Ethiopian
GDP .
• However, because this rental income is a factor payment to
abroad, it is not part of Ethiopian GNP.

11/15/2024
 Con…
GNP= GDP +NFP
• Where ,NFP ( Net Factor Payment) is the
income from foreign domestic factor
sources less foreign factor incomes
earned domestically.
• In other words, we must add the foreign
income of our citizens and subtract the
income of residents who are not citizens

11/15/2024 Slide 14-5

2.2 Approaches of measuring national income
(GDP/GNP)
• There are three approaches to measuring
GDP/GNP.
Product or value added approach
Expenditure approach
Income approach
• Except for problems such as incomplete or
misreported data, all three approaches give identical
measurements of the amount of current economic
activity

11/15/2024 Slide 14-6

Product or the Value Added Approach
is the increase in value that a firm contributes to a
product or service.
In this method, there is a problem of double counting.
 Because output of some firms are used as the inputs of other
firms.
 There are two ways to avoid the problem double
counting.
1. taking only the value of final goods and services
2. taking the sum of the added value.

11/15/2024 Slide 14-7

Production Generated
Added
Farmer harvest wheat $100 $100
Miller makes into flour $200 $100
Baker makes into bread $300 $100
$600 $300
GDP counts only the $ value of the
final good

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Slide 14-8
 The Income Approach

• This approach consists of the payments in terms of

money to the factors of production annually in a
country.
Thus GDP is the sum total of the following items.
• Compensation of employees (W): wages, salaries, and
fringe benefits such as pension funds.
• Rental income(R): service of land, mineral rights, and
building for use by others.
• Net interest(I): The interest domestic businesses pay
less the interest they receive, plus interest earned
from foreigners.
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Slide 14-9
• Proprietor’s income (Πp): is net income of sole
proprietorships and partnerships.
• Corporate profit (Πc): dividends, undistributed
profits, and corporate profit taxes.
• Indirect business taxes (IBT): other part of market
price of an output is indirect business tax. Indirect
business tax's collected by business firms are
incomes of the government; it is represents part of
national income.
 Example: sales tax, excise tax, VAT.
• Capital consumption allowance ( depreciation) D:
GDP= W +R+I+Π+D+IBT, where Π= Πc+ Πp
11/15/2024 Slide 14-10
The Expenditure Approach
• The expenditure approach calculates GDP by adding
together these four components of spending. In
equation form:
Y = C + I + G+ NX.
Consumption(c)
• Personal consumption expenditures (C) are expenditures
by consumers on the following:
Durable goods: Goods that last a relatively long time,
such as cars and household appliances.
Nondurable goods: Goods that are used up fairly
quickly, such as food and clothing.

11/15/2024 Slide 14-11

 Services: The things that we buy that do not
involve the production of physical things, such as
legal and medical services and education.
• Investment refers to the purchase of new capital.
• Total investment by the private sector is called
gross private domestic investment.
It includes the purchase of new housing, plants,
equipment, and inventory by the private (or non-
government) sector.

11/15/2024 Slide 14-12

  Government expenditure (G) counts expenditures by
federal, state, and local governments for final goods and
services.
The government is treated as a final consumer even
though it acts like a firm in that it uses resources in the
production of goods and services for consumption by its
citizens.
It supplies such items as military equipment, national
defence, public education, building and maintenance of
roads, and the services that government workers provide.
• Net exports (EX – IM) is the difference
between exports (sales to foreigners of U.S.-
produced goods and services) and imports
(U.S. purchases of goods and services from
abroad). The figure can be positive or
negative.

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Slide 14-14
• GDP also excludes two non-productive transactions
i.e,
1. Purely financial transactions, which include:
Public transfer payments
Private transfer payments
Buying and selling of securities
 because recipients make no contribution to current production
in return for them.

2. Second hand sales because such sales either reflect

no current production, or they involve double
counting.
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Slide 14-15
 2.3 Other Social Accounts (GNP, NNP, NI, PI and DI)
• The national income accounts include other
measures of income that differ slightly in definition
from GDP.
• To see how the alternative measures of income
relate to one another, we start with GDP and add or
subtract various quantities.
• To obtain GNP , we add receipts of factor income
(wages, profit, and rent) from the ROW and subtract
payments of factor income to the ROW: GNP=GDP+
NFP.

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Slide 14-16
 Con…

• To obtain net national product (NNP), we

subtract the depreciation of capital-the
amount of the economy’s stock of plants,
equipment, and residential structures that
wears out during the year:
NNP =GNP-Depreciation
• In the national income accounts, depreciation
is called the consumption of fixed capital.

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Slide 14-17
 Con…
• The next adjustment in the national income
accounts is for indirect business taxes, such as
sales taxes.
 These taxes place a wedge between the price
that consumers pay for a good and the price
that firms receive.
 Because firms never receive this tax wedge, it
is not part of their income.

11/15/2024 Slide 14-18

 Con…

National income (NI)= NNP-Indirect Business

Taxes
It measures the income earned by resource supplies
for their contribution(of Land, Labour, capital and
entrepreneurial ability, which go into the year‘s net
production. In other words ,NI measures the
composition of economic resources i.e., the sum of
wages ,rent interest and profit

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Slide 14-19
 Con…
• The national income accounts divide national income
into five components.
 These are: Compensation of employees, proprietors' income
,rental income, corporate profits, and net interest
• A series of adjustments from national income to personal
income, the amount of income that households and non-
corporate businesses receive.
Personal Income(PI) =National Income - Corporate
Profits - Social Insurance Contributions - Net Interest +
Dividends + Government Transfers to Individual +
Personal Interest Income.

11/15/2024 Slide 14-20

 Con…

• Next, if we subtract personal tax payments and

certain non-tax payments to the government (such
as parking tickets), we obtain disposable personal
income:
Disposable Personal Income=Personal Income-
Personal Tax and Non tax Payments.

11/15/2024 Slide 14-21

 2.4 Nominal versus Real GDP
• Nominal GDP represents the market value of all final goods
and services at current price
 Consider the economy is produces only apples and oranges.
GDP =(Price of Apples × Quantity of Apples) + (Price of
Oranges × Quantity of Oranges).
 Notice that GDP can increase either because prices rise or
quantities rise.
 This measure does not accurately reflect how well the
economy can satisfy the demands of households, firms, and
the government.
 If all prices doubled without any change in quantities, GDP
would double.
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Slide 14-22
 Con…
Real GDP
• Measures each years output in terms of the price
prevailed in a selected base year as opposed to nominal
GDP.
A better measure of economic well-being and would not
be influenced by changes in prices.
 it is the value of goods and services measured using a
constant set of prices.
To see how real GDP is computed, imagine we wanted to
compare output in 2002 and output in 2003 in our apple-
and-orange economy.
We could begin by choosing a set of prices, called base-
year prices, such as the prices in 2002.
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Slide 14-23
 Con…

Real GDP for 2002 would be

 Real GDP = (2002 Price of Apples ×2002 Quantity of
Apples) + (2002 Price of Oranges ×2002 Quantity of
Oranges).
 Similarly, real GDP in 2003 would be
Real GDP= (2002 Price of Apples ×2003 Quantity of
Apples) + (2002 Price of Oranges×2003 Quantity of
Oranges).

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Slide 14-24
 2.5 The GDP Deflator and the Consumer Price Index

• The Consumer Price Index

 A birr today does not buy as much as it did 20 years
ago
 The cost of almost everything has gone up.
 This increase in the overall level of prices is called
inflation, and it is one of the primary concerns of
economists and policymakers.
 Here we discuss how economists measure changes
in the cost of living.

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Slide 14-25
• The most commonly used measure of the level of
prices is the consumer price index (CPI).
The Central Statistical Agency, has the job of
computing the CPI.
 It begins by collecting the prices of thousands of
goods and services.
Just as GDP turns the quantities of many goods and
services into a single number measuring the value of
production,
the CPI turns the prices of many goods and services
into a single index measuring the overall level of
prices.

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Slide 14-26
 Con…
• How CPI is computed?
The CSA weights different items by computing the
price of a basket of goods and services purchased by
a typical consumer.
The CPI is the price of this basket of goods and
services relative to the price of the same basket in
some base year.
For example, suppose that the typical consumer buys
5 apples and 2 oranges every month.
 Then the basket of goods consists of 5 apples and 2
oranges, and the CPI is

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Slide 14-27
 Con…

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Slide 14-28
 The GDP Deflator
• From nominal GDP and real GDP we can compute a third
statistic: the GDP deflator.
The GDP deflator, also called the implicit price deflator for
GDP, is defined as the ratio of nominal GDP to real GDP:
GDP deflator =Nominal GDP/Real GDP
The GDP deflator reflects what is happening to the overall
level of prices in the economy.
To better understand this, consider again an economy with
only one good, bread.
 If P is the price of bread and Q is the quantity sold, then
nominal GDP is the total number of dollars spent on bread
in that year, P×Q.

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Slide 14-29
 Con…
Real GDP is the number of loaves of bread produced
in that year times the price of bread in some base
year ,QxPbase .
The GDP deflator is the price of bread in that year
relative to the price of bread in the base year,
P/Pbase .
• The definition of the GDP deflator allows us to
separate nominal GDP into two parts: one part
measures quantities (real GDP) and the other
measures prices (the GDP deflator).
That is,
Nominal GDP=Real GDP ×GDP Deflator.
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Slide 14-30
 Con…
 The GDP deflator measures the price of output
relative to its price in the base year.
 We can also write this equation as:
Real GDP =Nominal GDP/ GDP deflator
• In this form, you can see how the deflator earns its
name: it is used to deflate
That is, take inflation out of nominal GDP to yield real
GDP.

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Slide 14-31
 Con…

• The CPI Versus the GDP Deflator

1. GDP deflator measures the prices of all goods and
services produced, whereas the CPI measures the
prices of only the goods and ser-vices bought by
consumers.
Thus, an increase in the price of goods bought only
by firms or the government will show up in the
GDP deflator but not in the CPI.
2.GDP deflator includes only those goods produced
domestically.

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Slide 14-32
 Con…

3. The most subtle(slight or not obvious) difference results

from the way the two measures aggregate the money
prices in the economy.
 The CPI assigns fixed weights to the prices of different
goods, whereas the GDP deflator assigns changing
weights.
The following example shows how these
approaches differ.

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Slide 14-33
 Con…
 Suppose that major frosts destroy the nation’s
orange crop.
 The quantity of oranges produced falls to zero, and
the price of the few oranges that remain on grocers’
shelves is driven sky-high.
 Because oranges are no longer part of GDP, the
increase in the price of oranges does not show up in
the GDP deflator.
 But because the CPI is computed with a fixed basket
of goods that includes oranges, the increase in the
price of oranges causes a substantial rise in the CPI.

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Slide 14-34
 Con…
Reasons why the CPI may overstate inflation(problem in
measuring by CPI)
1. Substitution bias: The CPI uses fixed weights, so it
cannot reflect consumers’ ability to substitute toward
goods whose relative prices have fallen.
2. Introduction of new goods: The introduction of new
goods makes consumers better off and(having more
choice ), in effect, increases the real value of the birr.
But it does not reduce the CPI, because the CPI uses
fixed weights.
3. Unmeasured changes in quality : Quality
improvements increase the value of the birr, but are
often not fully measured.

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Slide 14-35
 2.6 GDP and Welfare
• GDP is a reasonably accurate and extremely useful
measure of national economic performance.
 It is not, and was never intended to be, an index of
social welfare.
• There are important items affecting our wellbeing
that are not included in GDP

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Slide 14-36
 Con…

1.Non-market production:-many useful services are

produced by members of households for the benefit
of themselves or their families.
But, GDP as a measure of market value of output
fails to include these productive transactions.
 It significantly undervalues the total output of the
nation by excluding non-market household’s
production.

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Slide 14-37
2.The value of leisure:- the satisfaction you get from
recreational activities and other use of your leisure
time also escapes inclusion in GDP.
3.Improved product quality:- GDP is a quantitative
rather than a qualitative measure.
It does not accurately reflect improvements in the
quality of products.
 Quality improvement obviously affects economic well-
being.

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Slide 14-38
 Con…
4.The composition and distribution of output:-
changes in the composition and the allocation of total
output among specific households may influence
economic welfare.
 GDP, however, reflects only the size of output and
does not tell us anything about whether this allocation
of goods is right for the society.

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Slide 14-39
5.Cost of environmental damage:- The costs of
environmental damage are not subtracted from the
market value of final products when GDP is calculated.
It over estimates the value of output.
6.The under ground economy:- this economy consists of
transactions that never reported to tax and other
government authorities.
 It includes illegal goods and services- narcotics trading,
gambling and prostitution.
 It also includes participants in legal activities, which do
not report their income to the revenue authority.
Example: waitress.

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Slide 14-40
 2.7 The business cycle
Definition and Characteristics of Business
Cycle
• Business cycle refers to the recurrent up and downs
in the level of economic activity that extends over a
period of several years.
The economy cycles continuously between growth
and contraction.
Some periods of growth are greater than others, and
some periods of contraction are deeper than the
others are.
 Peaks, recession ,troughs and periods of contraction
or expansion characterize the business cycle.
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Slide 14-41
 Con…
Real
GDP Actual GDP
Long run growth
of GDP
peak
Recovery

Trough
Recession
Time
Fig 2.1: The business cycle

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Slide 14-42
 Con…

Peak- represents the tope of the cycle .

 There is shortage of labor and materials at this
point.
 National income and national product correspond to
a very high degree of utilization of labor, factories
and offices.
 Inflation is usually present in the peak of economic
cycle.

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Slide 14-43
 Con…
Recession or contraction:-According to an old rule of
thumb, a recession is a period of at least two
consecutive quarters of declining real GDP.
 This rule, however, does not always hold.
 In the most recently revised data, for example, the
recession of 2001 in USA had two quarters of
negative growth, but those quarters were not
consecutive
 During recession Output, trade, income and
employment both decline.
 Price also decline as unemployment starts to increase.

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Slide 14-44
 Con…
Trough- is where output and employment ‘bottom
out’ at their lowest level.
During this time, there is an excess amount of
unemployment and idle productive capacity.
Businesses are more likely to fail because of low
demand for their product.
At the trough, unemployment is high and output
is low.
Expansion (recovery): the economy’s level of output
and employment expand towards full
employment.
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Slide 14-45
 • Output is not always at its trend level, that is, the level
corresponding to full employment of the factors of
production.
 Rather output fluctuates around the trend level.
 During expansion (or recovery) the employment of
factors of production increased, and that is a source of
increased production.
 Conversely, during a recession unemployment increases
and less output is produced than can in fact be produced
with the existing resources and technology.
 Deviations of output from trend are referred to as the
output gap.
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Slide 14-46
 Con…
 The output gap measures the gap between actual
output and the output the economy could produce
at full employment given the existing resources.
 Full employment output is also called potential
output.
Output gap  potential output – actual output

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Slide 14-47
 Unemployment and Okun’s Law
 The business cycle is apparent not only in data from the
national income accounts but also in data that describe
conditions in the labor market.
 What relationship should we expect to find between
unemployment and real GDP?
 Because employed workers help to produce goods and
services and unemployed workers do not, increases in the
unemployment rate should be associated with decreases
in real GDP.
 This negative relationship between unemployment and
GDP is called Okun’s law, after Arthur Okun, the economist
who first studied it.

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Slide 14-48
 Con…
We can be more precise about the magnitude of the
Okun’s law relationship.
Okun’s law says that the unemployment decline when
growth is above the trend rate of 2.25 percent .
Specifically for every percentage point of growth in real
GDP above the trend rate sustained for a year , the
unemployment rate decline by one half percentage
point .
u = -0.5(y – 2.25)
 where u is change in unemployment, y is actual
growth rate of output.
Suppose growth in a given year if 4.25 %
That would imply unemployment rate reduction of
1%(=0.5(4.25-2.25)
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Slide 14-49
 Con…
 u = -0.5(y – 2.25)
 where u is change in unemployment, y is actual growth
rate of output.
 Suppose growth in a given year if 4.25 %
 That would imply unemployment rate reduction of
1%(=0.5(4.25-2.25)

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Slide 14-50
 2.8 UNEMPLOYMENT, INFLATION AND THE PHILIPS
CURVE
Unemployment
• A person is said to be unemployed if he/she is in the
working-age, available for work, actively seeking work,
and have not found a job.
Unemployment rate is the percentage of total labor force
that is currently unemployed (total unemployment
divided by total employment force times 100).
Let L denote the labor force, E the number of employed
workers, and U the number of unemployed workers.
L=E+U
 In this notation, the rate of unemployment is U/L*100.
 There are different types of unemployment

11/15/2024 Slide 14-51

 Frictional unemployment: caused by the time it takes
workers to search for a job
• occurs even when wages are flexible and there are
enough jobs to go around
• occurs because
 workers have different abilities, preferences
 jobs have different skill requirements
 flow of information about vacancies and job
candidates is imperfect

11/15/2024 Slide 14-52

 Con…
• Structural unemployment: is unemployment
resulting from permanent shifts in the pattern of
demand for goods and services or from changes in
technology such as automation or computerization.
 To regain employment, workers in the pool of
structurally unemployed have to find jobs in other
industries or locations, or learn new skills.
• Cyclical unemployment: is the amount of
unemployment resulting from declines in real GDP
during periods of recession or in any period when
the economy fails to operate at its potential.

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Slide 14-53
 Con…

The problem of unemployment is of great concern to

economists because it has costs.
The main costs of unemployment are:
1. Output is lost (GDP falls) because the economy is not at
full employment.
2. Distortional impact – unemployment usually hits poorer
people harder than the rich and this increases the concern
about the problem (income inequality rises).

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Slide 14-54
 Con….
3.The unemployed may have more leisure when not
working.
But this benefit is more than offset by the costs to the
society since:
i. The value placed on that leisure is small as much of it is
unwanted leisure, and
ii. The government loses income tax revenue and thus job
loss hurts the society than the individual

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Slide 14-55
 Inflation

• Inflation is a rising general level of prices. There

are different causes of inflation:
• Inflation is a sustained increase in the general level of prices over time.
 Creeping inflation refers to small and gradual rises in prices over time while
hyper inflation describes a situation of large and accelerating prices rises.
 Demand-pull inflation: changes in the price level have been attributed to an
excess of total demand.
 Economists describe demand-pull inflation as a
result of too many dollars chasing too few goods..
 Therefore, this excess demand will bid up the price of the fixed real output,
causing demand pull inflation.

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Slide 14-56
 Con…
 Figure 2.2 above illustrates the effect of an increase
aggregate demand (AD) on price.
 with the initial aggregate demand of AD0 and a given
short –run aggregate supply schedule macroeconomic
equilibrium exists with real GDP to Y0 and price level at
100.
 The increase to AD1 leads to higher level of price that is
Y1 but also higher level of price (15% of inflation)
• It is useful to differentiate between the possible short-
run effect of an increase in aggregate demand and the
longer-run effect when prices and wages adjust fully

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Slide 14-57
Fig 2.3 Demand-Pull Inflation in the Long-Run Effect
LRAS
Price
level SRAS1
120 c
SRAS0
115 b
100 a
AD1
AD0
Y0 Y1 Real GDP

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Slide 14-58
 Con….
 In figure 2.3 real GDP does not rise from Y0 to Y1.
 This if because higher price resulting from increase
aggregate demand leads to lower real wage .
 The economy moves from a to b in the figure.
 However, it is to be expected that workers will quickly
respond to higher prices by demanding higher money
wages to restore the original real wage.
 The result is that, as shown in Figure 2.3, the short-run
aggregate supply curve ( SRAS0) shifts to the left, to
SRAS1. The price

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Slide 14-59
 Con…
 The price level rises further to 120 and real GDP returns
to its previous level, Y0, as the economy moves from b to
c.
 This level of real GDP, Y0, is the output determined by
the long-run aggregate supply curve (LRAS).
 Therefore, the long-run effect of the increase in
aggregate demand is an increase in prices and not real
GDP

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Slide 14-60
 Con…
Cost push inflation – inflation may arise on the supply
or cost side of the market.
 Unions have considerable control over wage rates.
 They obtain a wage increase.
 Large corporate employers faced now with increased
costs but also in the possession of considerable
market power, push their increased wage cost on to
consumers by raising the prices of their production.
 The other cause is an increase in the price of
imported raw materials and fuels.

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Slide 14-61
Fig 2.4 Cost-push inflation – short-run effect
Price level
SRAS1
110 b SRAS0
100 a

AD
Y1 Y0 Real GDP

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Slide 14-62
 Con…
• The short-run effects of both domestic and international
cost factors on prices and real GDP are illustrated in
Figures 2.4.
In Figure 2.4 the leftward shift in the short-run aggregate
supply curve(from SRAS0to SRAS1) leads to a price rise
from 100 to 110 and a fall in output from Y0 to Y1 as the
economy tracks from a to b.
Exercise: Draw the graph for Cost-push inflation – long
-run effect?

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Slide 14-63
Expectations-induced inflation
• Expectations can play a very important part in the
causes of inflation.
For instance, if workers expect prices to rise they
are likely to react in advance of actual inflation by
demanding higher money wages to retain the real
value of their wages.
Similarly, if firms expect inflation then they are
likely to respond by building in inflationary
expectations into their price planning and
government may anticipate higher costs of
running public services and raise taxes in
advance.

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Slide 14-64
 Con…
 Also, consumers expecting goods to be more
expensive in the future may buy now rather than
delay their spending.
 The overall consequence is that the expectation of
inflation can induce inflationary pressures both on
the supply and demand sides of the economy.

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Slide 14-65
Cost of inflation

1.Shoe leather
• In times of high and accelerating inflation (i.e.
hyperinflation) people tend to spend considerable time
and effort searching for the lowest possible prices of
goods and services – thereby using resources without
any consequent increase in output.
 Such resource costs are commonly labeled shoe-leather costs .
2. Menu costs Organizations, such as restaurants and
shops, need to alter advertised price lists more frequently
because of the rapid inflation.
Again, this represents a use of economic resources
without a resulting increase in the economy’s output –
such costs are commonly referred to as menu costs.

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 Con…
3.Inflation can result in a redistribution of income and
wealth from creditors to debtors.
As a result of inflation, debtors can pay back loans in
currency units that have less purchasing power than
what they borrowed.
It can also harm savers, who, in effect are creditors
because the purchasing power of currency units in
savings decreases as a result of inflation.

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 Con…
4.Hyperinflation seriously impairs the functioning of the
economy by causing credit markets to collapse and by
wiping out the purchasing power of accumulated savings.
5. Actions taken in anticipation of inflation can adversely
affect the performance of the economy.
When buyers and sellers try to anticipate, they base their
economic decisions, in part, on the gains and loses they
expect to get/incur.
This can affect the supply of and the demand for
particular goods and services thereby distorting market
prices.
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 Con…
6.Anticipated inflation can distort consumer choices by
causing buyers to purchase goods now that they might
otherwise prefer to purchase in the future.
• Expansionary aggregate demand policies tend to produce
inflation, unless they occur when the economy is at high
levels of unemployment.

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 Con…
The Trade offs between Inflation and
Unemployment- the Philips Curve
• Macroeconomic policies are implemented in order
to achieve government’s main objectives of full
employment and stable economy through low
inflation.
 We can use Philips Curve as a tool to explain the
trade-off between these two objectives.
 Philips Curve describes the relationship between
inflation and unemployment in an economy.

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 Con…

 You already know that the Inflation is defined by

increase in the average price level of goods and
services over time.
 Unemployment exists when someone is actively
seeking for job but unable to find any despite their
willingness to accept the going market wage rate.
 When there is inflation, value of money falls.
 A low inflation rate indicates that average price of
goods would not rise as high.

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 Con…
• New Zealand-born economist A.W Philips first put
this theory forward in 1958 gathered the data of
unemployment and changes in wage levels in the
UK from 1861 to 1957.
 He observed that one stable curve represents the
trade-off between inflation and unemployment and
they are inversely/negatively related.
 In other words, if unemployment decreases,
inflation will increase, and vice versa.

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 Con…
Fig 2.5 short –run Philips Curve
Inflation
(%) Philips curve

0 Unemployment

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 Con…
• 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.
• For example, after the economy has just been in
recession, the unemployment level will be fairly high.
 This will mean that there is a labor surplus.
 As the economy has just started growing, the
aggregate demand (AD) will increase and therefore
leading to an increase in employment.

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 Con…
 In the beginning, there will be little pressure for a
raise in wages.
 However, as the economy grows faster and more
people are employed, wages will start rising slowly.
 This will increase the firm’s cost of production and
the high costs are usually passed on to the customers
in the form of higher prices.
 Therefore, a decrease in unemployment has led to an
increase in inflation and vice versa.

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 Con…
• unemployed might suffer from money illusion as
they thought the increase in wages offered to them
represented a real wage.
 They underestimate inflation by not realizing that
higher wages will be eaten up by higher prices.
 Thus, they will accept job more readily and this will
reduce the frictional unemployment.
• The relationship is a phenomenon in the short-run.
 But in the long run, since unemployment always
returns to its natural rate, there is no such trade-off.

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