Inflation and Unemployment

Professor Abdul Bayes

(abdulbayes@yahoo.com)
01711564547

Inflation
Inflation- The rise in the general level of prices
In the long term, inflation erodes consumer purchasing

power.
That means that accumulated wealth buys less and less,
with the passage of time.
Where there is high inflation it is difficult for businesses to
plan for the future as there is uncertainty regarding the
cost of raw materials

The causes of inflation

inflation results when the macro economy has too much demand for
available production. These alternatives fall under two general
categories:
Demand-Pull Inflation: In effect, the demand side of the aggregate
market is "pulling" the price level higher.
Cost-Push Inflation: Cost-push inflation is inflation attributable to
decreases in supply, primarily due to increases in production cost.
Money supply increase

Cost Push Inflation

As costs rise it causes the
aggregate supply curve to
shift onwards so less is
supplied at each price level
Each time the aggregate
supply curve shifts inwards
the price rises causing
inflation

Demand pull inflation

As aggregate demand
increases then the general
price level rises
When total demand exceeds
total supply demand pull
inflation occurs
If the economy is close to full
capacity the effects of demand
pull inflation will be greater

COSTS OF INFLATION
Inflation is like a tax shoe leather

cost when inflation encourages

people to reduce money holdings
more frequent trips to banks.
Menu costs-costs of price
adjustment, printing new price
list,catalogs,advertisement etc.
Exaggerates capital gains and
increases tax liability. You bought
a share at $10 in 1990 and sold at
$50 in 2010. Capital gain is $40 to
be taxed. But if inflation has
doubled, then you have invested
equivalent of $20 in 2010!.

Redistributes income
Lenders loose, borrowers

gain
Distorts resource allocation
as inflation affects relative
prices

INFALTION AFFECTS GDP

The Impact of an Increase in the Price Level on the
Economy Assuming No Changes in G, T, and Ms

7 of 47

AE Y

Preventing inflation

One of the best ways to prevent inflation is through stock,

variable annuities, and variable universal life insurance.
These alternatives provide the potential for returns that
exceed inflation over the long term.

Central banks place high interest rates using

unemployment and the decline of production to prevent
price increases.

MEASURING INFLATION

The consumer price index (CPI) is a measure of the overall

cost of the goods and services bought by typical consumer
(s).

Step 1: Fix the basket by consumer survey =4 hot dogs, 2

beef burgers

Step 2:Find the price in each point in time

Year
Price of hot dogs($)
Price of burger ($)
2005
1
2
2006
2
3
2007
3
4

MESURING INFLATION
(Contd..)

Step 3: Compute the cost of the basket for each year:

2005: ($1 per HD X 4 HD) + ($2 per BB X 2 BB) = $8 per basket

2006: ($2 per HD X 4 HD) + ($3 per BB X 2 BB) = $14 per basket
2007$3 per HD) X 4 HD) + ($4 per BB) X 2BB)=$20 per basket

Step 4: Choose one as base year (2005) and compute the index)
2005: ($8/$8) X 100 = 100
2006: ($14/$8) X 100 = 175
2007: ($20/$8) X 100 = 250
Step 5: Use CPI to calculate inflation rate from previous year
2006: (175-100)/100X100 = 75%
2007: (250-175)/1175X100 = 43%

MEASURING INFLATION (Contd..)

CPI= Prices of basket of goods and services now/prices of basket in

base yearX100
Inflation rate in year 2: CPI in year 2 CPI in year 1/CPI in year
1X100
Problems with CPI: Substitution bias fixed basket; new goods;
quality
GDP deflator (Ratio of nominal GDP to real GDP) and CPI tell same
story but different on two counts:
Deflator considers all prices produced domestically while CPI all
goods bought by consumer (also imported). Thus, rise in airplanes
price shows up in deflator not in CPI; rise in price of Allion car shows
up in CPI not in deflator. Similarly oil prices.
Basket changes with deflator as GDP grows but not CPI.

Unemployment

There are a number of types of unemployment:

Structural unemployment
Cyclical unemployment
Frictional unemployment

Structural unemployment occurs when the economy

changes and industries die out
Training is needed to give the unemployed workers
new skills

Unemployment

Cyclical unemployment is caused by the business

cycle
Frictional unemployment is caused when people
are temporarily out of work as they are moving jobs

Unemployment and PPF

Unemployment means that

scarce economic
resources are being
wasted reducing the long
run potential of the
economy
Where there are high
levels of unemployment an
economy will be operating
inside the perimeters of its
PPF

HOW UNEMPLOYMENT IS
MEASURED?

Labor force = Number of employed

+ number of unemployed
Unemployment rate = Number of
unemployed/Labor forceX100
Labor force participation rate=
Labor force/Adult populationX100

Unemployment and AD / AS
As Aggregate demand increases unemployment will

decrease
Supply side policies can be used to increase
aggregate supply in the economy and thereby
reduce the level of unemployment
However if the growth in the level of aggregate
demand is less than the underlying trend growth in
output unemployment is likely to occur

Causes and Consequences of

Unemployment
Unemployment is caused by demand and supply side

factors
On the demand side if the demand curve shifts
inwards unemployment will rise
Supply side factors such as an excess of supply of
workers also means unemployment will increase

Policies that increase labour market

flexibility

A number of policies can be implemented to

increase market flexibility and reduce
unemployment
Policies can be implemented on the supply
side and the demand side by the government

Supply side policies

Supply side policies include:
Reducing the occupational mobility of labour this

can be through providing training for the

unemployed, increasing the availability and quality
of education and providing incentives for people to
work

Demand side policies

Employment subsidies can be used by the

government to encourage businesses to give jobs
to the long term unemployed

Effects of Unemployment

On an individual level unemployment reduces the level of income that

an individual earns
As their income has been reduced consumption also reduces as they
pay for necessities rather than luxuries
Goods that are income elastic will be consumed less
Quality of life will be reduced for the unemployed worker
Workers may become discouraged and give up searching for jobs
becoming part of the long term structural unemployment in the UK

Effects of Unemployment

Unemployment can have significance effects

on the performance of the economy as a whole
The effects are most marked due to long terms
unemployment
If there is unemployment in the economy
resources are not being used effectively and
the economy will be operating below any points
on the PPF curve

Economic effects of unemployment

If unemployment rates are rising their will be a negative
impact on economic growth potential
Consumption is likely to fall as consumers will have had a
decrease in income levels
Government spending will increase as the government will
be responsible for benefit payments
Taxation levels will decrease as less people are in work and
therefore paying taxes

Natural Rate of Unemployment Hypothesis

The natural rate of unemployment recognizes that

there will always be some level of unemployment in
an economy
At the natural rate all unemployment will be
voluntary
This is the employment rate when the economy is
operating at full employment

Determinants of the natural rate

The natural rate is determined by the interaction

of the demand for labour and the supply of labour

At the equilibrium wage rate all people who want a
job can get a job
However at this wage rate their will be some
people who choose not to work

Determinants of the natural rate

The natural rate of unemployment is

determined by:

Value of welfare benefits

Trade union power
Taxation system
Migration of labour
Social factors

Natural rate of unemployment and policy

If governments want to reduce the natural rate of
unemployment they need to concentrate on supply
side policies
If the benefits system is relatively high in a country
it will cause less people to want to work

The Phillips Curve

Short run phillips curve is curve shaped

The long run phillips curve the curve is vertical
At this rate the where unemployment is at its
natural rate inflation is stable
In the UK since 1997 there has been low
inflation and low unemployment

Phillips Curve