Chapter

Unemployment - Inflation
 Chapter objectives
I. Unemployment
II. Inflation
III.The Short-Run trade-off between Inflation
and Unemployment

slide 2
 I. Unemployment
1. Definitions and method of computation
2. Unemployment classification
3. Policies to reduce unemployment

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1. Definitions and method of computation
1.1 Definitions
• Adult population: the proportion of population that
is within working – age (includes labor force and
non – labor force)
• Labor force = Number of employed + Number of
unemployed
• Employed: People who work as paid employees,
work in their own business or work as unpaid
workers in a family member’s business

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 1. Definitions and method of computation

• Unemployed: People are able, available and

actively seeking work – but not employed

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1. Definitions and method of computation

1.2 Method of computation

• Unemployment rate
– Percentage of labor force that is unemployed
Number of unemployed 100%
Unemployment rate =
Labor force
• Labor-force participation rate
– Percentage of adult population that is in the
labor force
Labor force
Labor - force participation rate = 100%
Adult population
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 QUESTION 1
The figure 1 shows the statistics on the US population in 2009.
Compute unemployment rate, employment rate and labor-force
participation rate

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 2. Unemployment classification
1. Natural rate of unemployment
2. Cyclical unemployment

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 2. Unemployment classification
2.1 Natural rate of unemployment
The natural unemployment rate that is the
rate of unemployment that the economy
experiences even during normal times. It is
estimated to prevail in the long run.
It includes frictional, structural unemployment
and classical unemployment.

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 2. Unemployment classification
• Frictional unemployment
–results because it takes time for workers
to search for the jobs
• That best suit their tastes and skills

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 2. Unemployment classification
• Structural unemployment
– occurs when a labor 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.

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 2. Unemployment classification
• Classical unemployment
• occurs when wages for a job are set above
the equilibrium level

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 Figure 4
Classical unemployment
Wage
Labor
Surplus of labor = supply
Unemployment

Real wage

WE

Labor
demand

0 LD LE LS Quantity of Labor

In this labor market, the wage at which supply and demand balance is WE. At this equilibrium
wage, the quantity of labor supplied and the quantity of labor demanded both equal LE. By
contrast, if the wage is forced to remain above the equilibrium level, the quantity of labor supplied
rises to LS, and the quantity of labor demanded falls to LD. The resulting surplus of labor, LS – LD,
represents unemployment. 13
 2. Unemployment classification
• Reasons for classical unemployment
- Minimum - wage law

- Efficiency wages

- Labor unions

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 2.Unemployment classification
2.Cyclical unemployment (deficient-demand
unemployment): unemployment occurs when
economic activity slows down as a result of a
recession.
– The demand for goods and services decreases
– More workers get laid off

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 Question 2
• Each statement below describes a type of unemployment. In
the space provided, write a “F” if the statement describes
frictional unemployment, “ST” for structural unemployment,
“C” for cyclical unemployment, or “CL” for classical
unemployment.
1. Fred was laid off from the Quarry because the nation is
suffering from a recession.
2. Ronald, who just graduated from Clown School, is
looking to find his first real job.
3. Mickey Mouse voluntarily quit his job at Disney & has
decided that he will seek a job as a truck driver.
4. Peter Pan was fired from his job at the Peanut Butter
factory because he is being replaced by RoboCop (a highly
efficient peanut butter machine)
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 3. Policies to reduce unemployment
• Demand - side policies include Fiscal policy
and Monetary policy
– Fiscal policy can decrease unemployment by
helping to increase aggregate demand. The
government will need to pursue expansionary
fiscal policy.

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 3. Policies to reduce unemployment
- Monetary policy can decrease unemployment
by helping to increase aggregate demand. The
central bank will need to pursue expansionary
monetary policy.

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 3. Policies to reduce unemployment
• Supply- side policies: aim to overcome
imperfections in the labor market and reduce
unemployment.
– Government – run employment agencies: give
out information about job vacancies in order to
match workers and jobs more quickly.
– Public training programs: ease the transition of
workers from declining to growing industries
– Reduce the power of labor unions

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 II. Inflation
• Definition of Inflation
• Causes of inflation
• Costs of Inflation
• Policies to reduce inflation

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1. Definition of Inflation
- is a sustained increase in the general price
level of goods and services in an economy
over a period of time
OR
- is a sustained decrease in the purchasing

power of money

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 2. Causes of inflation
• Demand-pull inflation occurs when
overall prices rise due to increases in
aggregate demand in the economy.

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 2. Causes of inflation
• Cost-push inflation occurs when overall
prices rise due to increases in production
costs, such as raw materials and wages.

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 2. Causes of inflation
• Inflation and Money supply growth
(Quantity theory of money)
– A simple theory linking the inflation rate to
the growth rate of the money supply.
– Begins with the concept of velocity…

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 Quantity theory of money
• definition of velocity: the number of times
the average dollar changes hands in a given
time period
• example: In 2012,
– $500 billion in transactions
– money supply = $100 billion
– The average dollar is used in ....
transactions in 2012
– So, velocity =

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 Quantity theory of money
This suggests the following definition:
• V = (P × Y) / M
– P = price level (GDP deflator)
– Y = real GDP
– M = quantity of money

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 Quantity theory of money
With slight algebraic rearrangement, this
equation can be rewritten as
M×V=P×Y

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 Quantity theory of money
• assumes V is constant
Then, quantity equation becomes:

M V = P Y

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 Quantity theory of money
• The quantity equation in growth rates:
Growth rate of M + Growth rate of V = Growth rate of
P + Growth rate of Y
Growth rate of P= Growth rate of M - Growth rate of Y

• Growth rate of Y depends on growth in the

factors of production

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 Quantity theory of money
• The quantity theory of money implies:
Countries with higher money growth rates
should have higher inflation rates
• So, the central bank, which controls the
money supply, has ultimate control over
the rate of inflation.

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 Money and prices during four
hyperinflations (a, b)

This figure shows the quantity of money and the price level during four
hyperinflations.
(Note that these variables are graphed on logarithmic scales. This means that equal
vertical distances on the graph represent equal percentage changes in the variable.)
In each case, the quantity of money and the price level move closely together. The
strong association between these two variables is consistent with the quantity theory
of money, which states that growth in the money supply is the primary cause of
inflation 31
 3. The Costs of Inflation
• Shoe leather costs
• Menu costs
• Confusion and inconvenience
• Relative-price variability & misallocation
of resources
• Inflation-induced tax distortions
• A special cost of unexpected
inflation: arbitrary redistributions of
wealth
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 3. The Costs of Inflation
Question 1: Choose one cost of inflation to
discuss and provide an example.
Question 2: If inflation is less than expected,
who is benefits – debtors or creditors?Explain.
 4. Policies to deal with inflation
• Demand - side policies include Fiscal policy
and Monetary policy
– Contractionary monetary policy – Higher
interest rates. This increases the cost of
borrowing and discourages spending. This leads
to lower economic growth and lower inflation.

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 4. Policies to deal with inflation
• Contractionary fiscal policy – Higher income tax
and/or lower government spending, will reduce
aggregate demand, leading to lower growth and
less demand-pull inflation.

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 4. Policies to deal with inflation
• Supply-side policies is concerned with shifting the
aggregate supply curve to the right to reduce cost -
push inflation.
(1) By reducing the power of trade unions
(2) By encouraging increases in productivity through
the retraining of labor or by investing in new
technologies, etc.

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III. The Short-Run trade-off between
Inflation and Unemployment
 1. Short-run Phillips Curve (SRPC)
– Shows the short-run trade-off
– Between inflation and unemployment

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 The Short-run Phillips Curve
Inflation
Rate
(percent
per year)
B
6

A
2

Phillips curve
4 7 Unemployment
Rate (percent)

The Phillips curve illustrates a negative association between the inflation rate and the
unemployment rate. At point A, inflation is low and unemployment is high. At point B, inflation
is high and unemployment is low.
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 2. The SRPC and AS-AD model

(a) The Model of AD and AS (b) The Phillips Curve

Inflation
Price Short-run
Rate
level aggregate
(percent
supply
per year)
B B
6%
106
A High aggregate
102 demand

A
Low aggregate 2
demand
Phillips curve

0 15,000 16,000 Quantity 0 4% 7% Unemployment

unemployment unemployment of output output output Rate (percent)
=7% =4% =16,000 =15,000

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 2. The SRPC and AS-AD model

• As the AD curve ...., the economy

....along the Short-Run Phillips Curve
• a rightward shift in AD curve .....
unemployment and ...... inflation (= moving
...... along SRPC),
• while a leftward shift in AD curve
.....unemployment and ..... inflation (= moving
.... along SRPC).
• Monetary and fiscal policy can ....an
economy...the Short-Run Phillips Curve