Chapter name: Inflation

1. Inflation: An increase in the price level of all goods and services.

2. Price Level: A weighted average of the prices of all goods and services.

3. Inflation measurement system: There are 3 (three) different approaches to measure inflation
rate.

a) CPI (Consumer Price Index)

b) PPI (Producer Price Index)
c) GDP deflator

a) Consumer Price Index (CPI): The weighted average prices of a specific set of goods and
services purchased by a typical household.

Total dollar expenditure on market basket in current year

CPI = __________ _ _________ _ _________ __________ _________ × 100
Total dollar expenditure on market basket in base year

Market Current year Current year Base year Base year Last year Last year
Basket price (per expenditure price expenditure price expenditure
unit)
10 pens $ 0.70 $ 7.00 $ 0.20 $ 2.00 $ 0.50 $ 5.00
5 shirts $ 14.00 $ 70.00 $ 7.00 $ 35.00 $ 12.00 $ 60.00
3 pair of $ 30.00 $ 90.00 $ 10.00 $ 30.00 $ 23.00 $ 69.00
shoes
= $ 167.00 = $ 67.00 = $ 134

$ 167
CPI current year = × 100 = 249
$ 67

$ 134
CPI last year = × 100 = 200
$ 67
249 - 200
Inflation (CPI)current year = × 100 = 24.5 %
200
b) PPI (Producer Price Index): Measures the average change over time in the selling prices
received by domestic producers for their output.

c) GDP deflator: The GDP deflator measures the changes in prices for all of the goods and
services produced in an economy.

Nominal GDP
GDP deflator (GD) = × 100
Real GDP

GD current year – GD last year

Inflation (GD) current year = × 100
GD last year

4. What are the differences between GDP deflator and CPI?

GDP deflator CPI (Consumer Price Index)

1. The GDP deflator measures the changes in The weighted average prices of a specific set of
prices for all of the goods and services goods and services purchased by a typical
produced in an economy. household.

2. GDP Deflator includes only domestic 2. CPI includes anything bought by consumers
goods and not anything that is imported. including foreign goods.

Nominal GDP 3. CPI =

3. GDP deflator = × 100
Real GDP Total dollar expenditure on market basket in current year
Total dollar expenditure on market basket in base year
× 100

5. Types of Inflation:

a) Demand pull inflation: When initial increase of Aggregate Demand (AD) leads to inflation,
then it is called as demand-pull inflation.
Long- run Aggregate Supply is LRAS

Initial long-run equilibrium (at -1)

a. Aggregate Demand = AD1

b. Short-run Aggregate Supply = SRAS1

c. Price level = P1

d. Output = Y1

e. Level of employment = Full

f. Equilibrium type = Long- run

Shift of AD (at – 2)

Because of either C (Consumption) or I (Investment) or G (Government spending) or Nx (Net

export) increase AD shifts rightward from AD1 to AD2.
a. Short-run Aggregate Supply =SRAS1
b. Price level increases to = P2
c. Output increases to = Y2
d. Level of employment = Over
e. Equilibrium type = Short – run
Shift of SRAS (at – 3)
a. Aggregate Demand (AD) = AD2
b. Because the price level increases without any change in wage (input price), the real wage of
the people decreases. And this is why the supply of labor decreases and as a result SRAS1 shifts
leftward to SRAS2
c. Price level increases again to = P3
d. Output decreases to = Y1
e. Level of employment = Full
f. Equilibrium type = Long – run
Final result

Finally price level increases from P1 to P3 in the long – run because of initial AD increase. Thus
the demand – pull inflation occurs.

b) Cost push inflation: Cost-push inflation occurs when overall prices increase (inflation) due to
increases in the cost of wages and raw materials. Higher costs of production can decrease
the aggregate supply (the amount of total production) in the economy.
Long- run Aggregate Supply is LRAS

Initial long-run equilibrium (at -1)

a. Aggregate Demand = AD1

b. Short-run Aggregate Supply = SRAS1

c. Price level = P1

d. Output = Y1

e. Level of employment = Full

f. Equilibrium type = Long- run

Shift of SRAS (at – 2)

a. Because of inputs (oil, raw materials, labor) price increase SRAS shifts leftward to = SRAS2

b. Aggregate Demand = AD1

c. Price level increases to = P2

d. Output decreases to = Y2

e. Level of employment = Under

f. Equilibrium type = Short – run

Shift of SRAS (again at – 1)

Economy automatically reaches to its level of output with full employment by shifting the SRAS
rightward from SRAS2 to SRAS1. But it takes a long time.

Final result:

Finally price level increases from P1 to P2 in the short – run because of initial SRAS decrease.
Thus the cost – push inflation occurs.

How inflation can be controlled?

Inflation can be controlled by fiscal policy or monetary policy.

Fiscal policy takes place when the government spending is increased (in the case of expansionary
fiscal policy where AD shifts rightward) or decreased (in the case of contractionary fiscal policy
where AD shifts leftward) or the tax is decreased (in the case of expansionary fiscal policy where
AD shifts rightward) or increased (in the case of contractionary fiscal policy where AD shifts
leftward).
Monetary policy takes place when money supply is increased (in the case of expansionary
monetary policy where AD shifts rightward) or decreased (in the case of contractionary
monetary policy where AD shifts leftward).

Demand-pull inflation control:

When the AD shifts rightward from AD1 to AD2 with the increase of price level from P1 to P2,
the contractionary fiscal or contractionary monetary policy is taken to pursue. This is how AD
shifts back to initial AD1 with zero inflation rates.
Cost-push inflation control:
When the SRAS shifts leftward from SRAS1 to SRAS2 with the increase of price level from P1 to
P2, the contractionary fiscal or contractionary monetary policy is taken to pursue. This is how
AD shifts leftward from AD1 to AD2 with zero inflation rates.

***Describe the importance of inflation.

The importance of inflation can be shown by costs and benefits of inflation as follows-
Costs of inflation:
The costs of inflation are mainly dependent whether the inflation rate is perfectly anticipated or
imperfectly anticipated. Now we demonstrate the costs of inflation if they are imperfectly
anticipated or perfectly anticipated-

A. Costs of imperfectly anticipated inflation:

If the inflation rate is imperfectly anticipated, then costs of inflation become very high. The costs
of imperfectly anticipated inflation are-

1. Shoe-leather cost of inflation: People face lower money balance and this is why they are to
go to banks frequently in order to cash small checks. The costs of these trips to banks are often
treated as the ‘shoe-leather costs of inflation’. When actual inflation rate is above than expected
inflation rate, then this cost becomes severe. If actual inflation rate is bellow than expected
inflation rate, then this cost becomes light.

2. Menu cost: Inflation allows firms to reset new prices. Because of this resetting of prices firms
have to change their prices frequently, which involves some costs. These are known as ‘menu
costs’. When actual inflation rate is above than expected inflation rate, then this cost becomes
severe. If actual inflation rate is bellow than expected inflation rate, then this cost becomes light.

3. Value of transaction: The value of the economic transactions becomes lower as the value of
money diminishes through inflation in any case of over or under expected inflation rate.
4. Fate of creditors and debtors: If the actual inflation rate is higher than expected, then
creditors loss and debtors gain and if the actual inflation rate is lower than expected, then
creditors gain and debtor loss.

5. Tax law: Tax laws remain unchanged. If the actual inflation rate is higher than expected, then
less tax revenue is collected and if the actual inflation rate is lower than expected, then tax payers
provide unnecessarily higher taxes.

6. Consumption of domestic products: If the domestic inflation rate is higher than the inflation
rates enjoyed by foreign countries, then the consumption of domestic products to domestic
consumers decreases for under expected inflation rate.

7. Fate of the people of fixed income: The purchasing power of the People of fixed income,
such as retires, diminishes for under expected inflation rate.

8. Spending decision: Because of future uncertainty about the economic conditions both the
spending initiated by consumers and producers diminish for both over or under expected
inflation rate.

B. Costs of perfectly anticipated inflation:

If the inflation rate is perfectly anticipated, then the costs of inflation become small. In this case
all the costs of inflation can be eliminated or minimized except the ‘shoe-leather costs of
inflation’ and ‘menu costs’.

The benefits of inflation:

According to James Tobin small amount of inflation is good for the economy. We know that-

𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐰𝐚𝐠𝐞
𝐑𝐞𝐚𝐥 𝐰𝐚𝐠𝐞 =
𝐏𝐫𝐢𝐜𝐞 𝐥𝐞𝐯𝐞𝐥
We see that real wage decreases if there is a cut in the nominal wage with no change in price
level or allow increase of price level without cutting the nominal wage. Cutting the nominal
wage is not realistic matter. But small inflation (that is increase of price level) without cutting the
nominal wage allows a reduction in natural rate of unemployment because price level increases
without raising the labor cost provides higher profitability, which increases the new employment
opportunities.
On the other hand, when there is high inflation, the home currency depreciates and as a result
exports increase and imports decrease and thus net export increases. When there is low inflation,
the home currency appreciates and as a result exports decrease and imports increase and thus net
export decreases.

Finally:
Inflation has both costs and benefits. So, inflation has a great importance in Economics.
Note:
Home currency is BDT and foreign currency is US$. The BDT depreciates when 1US$ = 70BDT
becomes 1US$ = 90BDT. The BDT appreciates when 1US$=70BDT becomes 1US$=50BDT.

6. Deflation: deflation is a decrease in the general price level of goods and services.

Chapter name: Unemployment

1. Unemployment: Unemployment occurs when a person who is actively searching for

employment is unable to find work. Unemployment is often used as a measure of the health of
the economy. The most frequent measure of unemployment is the unemployment rate, which is
the number of unemployed people divided by the number of people in the labor force.

2. Types of unemployment:

a) Frictional unemployment: Frictional unemployment is a kind of unemployment that occurs

when people are “between jobs” or are looking for their first jobs. It is a kind of unemployment
that occurs when the economy is trying to match people and jobs correctly. So, if you get fired
for poor work, if you quit because you dislike your job, or if you are just looking for your first
job, you are frictionally unemployed.

b) Seasonal unemployment: Seasonal unemployment occurs when people are not working
because their jobs only exist at some times of the year. Agricultural and construction workers
are examples of this type of unemployment.

c) Structural unemployment: Structural unemployment occurs when a labour market is unable

to provide jobs for everyone who wants one because there is a mismatch between the skills of the
unemployed workers and the skills needed for the available jobs. Structural unemployment is
hard to separate empirically from frictional unemployment except that it lasts longer. As with
frictional unemployment, simple demand-side stimulus will not work to abolish this type of
unemployment easily.

d) Natural Unemployment: The sum of the frictional unemployment and structural

unemployment is called as natural unemployment. This is the unemployment when economy
operates at the level of full employment. The rate of this type of unemployment is called as
natural rate of unemployment.

e) Cyclical unemployment: Cyclical unemployment exists when individuals lose their jobs as a
result of a downturn in aggregate demand (AD). If the decline in aggregate demand is persistent,
and the unemployment long-term, it is called either demand deficient, general,
or Keynesian unemployment.

f) Disguised unemployment: is a kind of unemployment in which there are people who are
visibly employed but are actually unemployed. This situation is also known as 'hidden
unemployment'. In such a situation more people are engaged in a work than required. For
example:
------In rural areas, this type of unemployment is generally found in agricultural sector like - in a
family of 9 people all are engaged in the same agricultural plot. But if 4 people are withdrawn
from it there will be no reduction in output. So, these 4 people are actually facing disguised
unemployment.
------In urban areas, this type of unemployment can be seen mostly in service sectors such as in a
family all members are engaged in one petty shop or a small business which can be managed by
less number of persons.

g) Classical unemployment: Classical, or real-wage, unemployment, occurs when real wages

for a job are set above the market-clearing level, causing the number of job-seekers to exceed the
number of vacancies.

Q. Who is employed?
Q. Who is unemployed?
Q. How can you calculate the rate of unemployment in a country?

Employed: Any person 16 years old or older worked one hour or more as a paid employee either
for someone else on in his own business or farm, he is classified as employed. A household
member is also considered employed if he worked 15 hours or more in a family enterprise, or,
who has a job but has been temporary absent due to illness, bad weather, vacation or personal
reason, with or without pay.

Unemployed: A person 16 years of age or more is considered as unemployed if he must be

available for work but is not working and have made specific efforts to find work during the
previous 4 weeks. A person not looking for work, because he/she either does not want a job or
has given up job-searching, is classified as “not in the Labor Force”.

People not in the labor force includes children, full time students, retirees and those staying
home to take care of their children or elder parents.

3. Measurement of unemployment:

Rules:

a) Total population = Labor force + People not in labor force

b) Labor force = Number of unemployed people + Number of employed people

 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐮𝐧𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝 𝐩𝐞𝐨𝐩𝐥𝐞
c) 𝐔𝐧𝐞𝐦𝐩𝐥𝐨𝐲𝐦𝐞𝐧𝐭 𝐫𝐚𝐭𝐞 = × 100
𝐋𝐚𝐛𝐨𝐫 𝐟𝐨𝐫𝐜𝐞

𝐋𝐚𝐛𝐨𝐫 𝐟𝐨𝐫𝐜𝐞
d) 𝐋𝐚𝐛𝐨𝐫 𝐟𝐨𝐫𝐜𝐞 𝐩𝐚𝐫𝐭𝐢𝐜𝐢𝐩𝐚𝐭𝐢𝐨𝐧 𝐫𝐚𝐭𝐞 = × 100
𝐓𝐨𝐭𝐚𝐥 𝐩𝐨𝐩𝐮𝐥𝐚𝐭𝐢𝐨𝐧

Problem: Find out the unemployment rate and labor force participation rate when total
population = 18000, mentally challenged= 2000, children= 2000, aged= 3000 and employed=
6000.

Answer: We know,

Total population = Labor force + People not in labor force

Or, 18000 = Labor force + (2000 + 2000 + 3000)

Or, Labor force = 18000 – 7000

Or, Labor force = 11000

Again,

Labor force = Number of unemployed people + Number of employed people

Or, 11000 = Number of unemployed people + 6000

Or, Number of unemployed people = 11000 – 6000

Or, Number of unemployed people = 5000

So,
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐮𝐧𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝 𝐩𝐞𝐨𝐩𝐥𝐞
𝐔𝐧𝐞𝐦𝐩𝐥𝐨𝐲𝐦𝐞𝐧𝐭 𝐫𝐚𝐭𝐞 = × 100
𝐋𝐚𝐛𝐨𝐫 𝐟𝐨𝐫𝐜𝐞

𝟓𝟎𝟎𝟎
= × 100
𝟏𝟏𝟎𝟎𝟎

= 45.45 %

And,
 𝐋𝐚𝐛𝐨𝐫 𝐟𝐨𝐫𝐜𝐞
𝐋𝐚𝐛𝐨𝐫 𝐟𝐨𝐫𝐜𝐞 𝐩𝐚𝐫𝐭𝐢𝐜𝐢𝐩𝐚𝐭𝐢𝐨𝐧 𝐫𝐚𝐭𝐞 = × 100
𝐓𝐨𝐭𝐚𝐥 𝐩𝐨𝐩𝐮𝐥𝐚𝐭𝐢𝐨𝐧

𝟏𝟏𝟎𝟎𝟎
= × 100
𝟏𝟖𝟎𝟎𝟎

= 61.11 %