1 Unemployment & Inflation ECO 120 Macroeconomics Week 10 Lecturer Dr. Rod Duncan
2 TopicsDefinition of unemployment.Types of unemployment.Costs of unemployment.Definition of inflation.Types of inflation.Impacts of inflation.Relationship between unemployment and inflation- the Phillips Curve.
3 Unemployment A person becomes unemployed if he or she is a: Job loser Job leaverNew entrant or re-entrant into the labour forceHe or she is no longer unemployed if:Hired or recalledWithdraws from the labour force
4 Labour Force Participation Rate PopulationWorking age populationLabour Force Participation RateLabour ForceEmployed /UnemployedUnemployment Rate
5 Labour Force Participation Rate (LFPR) Proportion of country’s population that takes part in its economic activities directly (either actually taking part or willing to)(/)Labour ForceWorking Age PopulationX100LFPR In Australia, in September 2003 :( million / million ) x 100 = %
6 Unemployment Rate (UR) Proportion of country’s labour force that is unemployed.(/)Number UnemployedLabour ForceX100UR in Australia, in September 2003 :(0.591 million / million) x = 5.8%
7 Unemployment over the Business Cycle (1965- 1995) Change in GDP
8 Labour Force Participation by Sex at Ages 35-44 MalesFemales
9 Aged looking forfull-time workTotal UnemploymentAged 20 & over seekingfull-time work
10 Types of UnemploymentCyclical unemploymentFrictional (or search) unemploymentStructural (technological) unemployment
11 Cyclical Unemployment Associated with the ups and downs of the business cycleTakes place due to insufficient aggregate demand or total spending- reflects shifts in AD curve.High during recessions and low during booms.Fiscal and monetary policies can reduce cyclical unemployment - policies are relevant.
12 Frictional Unemployment Associated with the period of time in which people are searching for jobs, being interviewed and waiting to commence duties.It is inevitable and always existFiscal and monetary policies can not reduce frictional unemployment – macroeconomic policies are irrelevant.Policies that make it easier to find new jobs will affect frictional unemployment.
13 Structural Unemployment Associated with wider structural or technological changes in the economy that may make some jobs redundant.It is inevitable and always existLasts longer than frictional unemploymentFiscal and monetary policies can not reduce structural unemployment – macroeconomic policies are irrelevant.Policies that encourage workers to retrain skills or to move to a new area with more jobs will decrease structural unemployment.
14 Full EmploymentFull employment means when all productive resources in the economy are in full use - implies no cyclical unemployment - still frictional and structural unemployment exist - they can be low - but can never be zero.The full-employment rate of unemployment is called the natural rate of unemploymentequals the sum of frictional and structural unemploymentcyclical unemployment = zeroDomestic output consistent with the natural rate of unemployment is potential output or full employment level of GDP
15 Other Employment Issues Part-time employment - very high in Australia in recent years.Discouraged workers or the “hidden unemployed”Those who become discouraged and drop out of the labour force temporarily - would return if a suitable job prospect aroseDiscourage workers, participation rate and the unemployment rate
16 Cost of Unemployment Economic cost output foregone, measured in terms of the loss of potential GDP - Okun’s law quantifies the relationship between the unemployment rate and the GDP gap - for every 1% of unemployment (over the natural rate) 3.5% of GDP loss in Australia.UnderemploymentHigh budget costsSocial CostsIncrease in crime rate, abuse etc.Physical & mental illnessUnlikely to develop work ethics
17 Classical Employment Theory Economy always operates under full employment - it is automatic and self sustaining - if there is any unemployment that is only temporaryPrice-wage flexibilitythe assumption that all prices, including wages and interest rates, are flexible and will, rapidly adjust to remove disequilibriaClassical theory and laissez fairethe price system ensured that price-wage flexibility and fluctuations in the interest rate was capable of maintaining full employment
18 AD-AS in the Classical Theory Vertical aggregate supply curveexclusively determines level of real domestic outputStable down-sloping aggregate demandexclusively determines price level
20 Keynesian View of AD - AS Full employment is not automatic - unemployment exists for longer periods - the Great Depression of the 1930s - sticky wages and prices.Horizontal aggregate supply curve during recession - ‘recessionary’ or ‘Keynesian’ rangeChange in AD impacts on unemployment - not on price level.Once the full employment level is reached - vertical AS curve - change in AD affects price level only.Unstable aggregate demand - especially investment demand management and stabilisation policies by the government are essential
21 Keynesian View of Unemployment ASLRASP1Price LevelAD1AD2Q2Q1Real Domestic Output
22 Current year index - Previous year InflationWe measure the general price level through a price index such as the Consumer Price Index (CPI)Inflation is a continuous rise in the general price levelInflationrateCurrent year index - Previous yearindexPrevious year indexx100=
24 Types of InflationDemand-Pull InflationCost-Push Inflation
25 Demand-Pull Inflation Occurs when an increase in AD pulls up the price levelExcess demand for output - increase in AD - AD shifts rightward - AS does not change in the short run - movement along the AS curve - price level increases - GDP increasesIn the longer run, workers will realise their real wages have fallen and will demand and receive increased nominal wages - lower profit level - supply decreases - causing the AS to shift to the left - GDP declines - price level increases further - only inflationMay be caused by expansionary fiscal and monetary policies - can be cured by contractionary policies.
26 Demand-Pull Inflation - Short run ASLRAS1Price LevelAn increase inaggregatedemand....Increases the pricelevel and outputin the short runP2bP1aAD2AD1Real GDPoQ1
27 Demand-Pull Inflation - Long run ASLRPrice LevelAS1A decrease inaggregatesupply....Increases the pricelevel and outputreturns to originallevelP3cP2bP1aAD2AD1Real GDPoQ1Q2
28 Cost-Push InflationOccurs when an increase in the cost of production at each price level shifts the AS curve leftward resulting in increased pricesShort-run: Increased prices and decreased real output (and more unemployment)Wage push : increase in wage rate - power of trade unionsSupply shocks - increase in prices of major raw materials - oil etc.Profit push : increase in profit requirement of large monopoly businesses.
29 Cost-Push Inflation Price Level Real GDP o ASLR AS2 AS1 Cost-push inflation occurswhen aggregatesupply shifts left....Causing a higherprice levelbPrice LevelP2P1aAD1Real GDPoQ1
30 Cost-Push Inflation and Demand Management Government intervention (AD): If government intervenes to increase AD an inflationary spiral will resultNo Government intervention (AD): If government does not intervene to increase AD severe recession will result, however nominal wages will eventually decline and will restore AS to original position
31 Cost-Push Inflation Price Level Real GDP o ASLR AS2 AS1 An attempt to increase ADwill only furtherincrease theprice levelP3cbPrice LevelP2P1aAD1Real GDPoQ1Q2
32 StagflationSimultaneous experience of high and increasing unemployment and inflation - cost-push inflation.Caused by :Aggregate supply shocks such as severe increases in fuel costs, and devaluationsProductivity declineInflationary expectations and wages - expectations about the likely future path and rate of increase of the general price level
33 Types of Inflation in Australia : Cost push - caused by international oil price rise.1979 : cost-push - caused by international oil price rise.: cost push - caused by rapidly rising wages.In early 1993, RBA announced its policy of inflation targeting - 2% - 3% a year - initially caused a recession & rise in unemployment
34 Impacts of InflationAnticipated (expected) and unanticipated (unexpected) inflation.Anticipated inflation is not a big problem - economy adjusts automatically.Unanticipated inflation redistributes income between :employers and employeeslenders and borrowers
35 Phillips CurveSuggests an inverse relationship (or a trade-off) between inflation and the unemployment rateNamed after A W Phillips who originally discovered the relationship between unemployment and nominal wages, using British data in 1950s.In general, inflation is associated with economic expansion and unemployment with economic recession.During expansion : the greater the rate of growth of AD - inflation is high - unemployment is low.During recession : the slower the rate of growth of AD - inflation is low - unemployment is high.
36 The Phillips Curve Annual rate of inflation (percent) 7654321Annual rate of inflation(percent)Unemployment rate (percent)
37 Implications of Phillips Curve Trade-off suggests : a rise in inflation should lead to a decline in unemployment, and vice versa.In general, both can not be brought down to the minimum level.The society must make a choice between low inflation and low unemployment.
38 Phillips Curve in Australia 19771983197019932003
39 Shifting Phillips Curve The smooth relationship may not be valid in the long-run - Conflicts with the trade-offs embodied in the Phillips CurveVertical Phillips Curve - at full employment level, only price level changesSimultaneous high and increasing unemployment and inflation - may lead to shifts in the curve