Lesson 16-2 Inflation and Unemployment in the Long Run

The Inflation Rate in the Long Run Money growth affects inflation. Money growth is believed to be the main determinant of the inflation rate. This belief is founded upon the equation of exchange: MV = PY. P = %M – %Y p.

Since there is a limit to how fast potential output can grow (2–3 percent annual rate in the United States), if the money supply increases too fast, inflation will result. Other factors can shift the aggregate demand curve— expansionary fiscal policy or increases in investment— but they are not usually sustained and actually affect inflation on a year-to-year basis.

Inflation Rates and Economic Growth In the long run, the inflation rate is determined by the relative values of the economy’s rate of money growth and of its rate of economic growth. A money growth rate equal to the rate of economic growth will, in the absence of a change in velocity, produce a zero rate of inflation. A money growth rate that falls short of the rate of economic growth is likely to lead to deflation.

Frictional Unemployment Frictional unemployment is the time it takes an unemployed worker to find a job. The reservation wage is the lowest wage that, if offered, would be accepted by an unemployed worker and may include both the wage and benefits or conditions of employment. The reservation wage can be determined in a model of job search that includes the following: A reservation-wage curve as a negative function of the duration of the job search. A best-offer-received curve as a positive function of the duration of the job search.

Duration of unemployment will be reduced the greater the information available about job opportunities. Unemployment compensation probably increases the amount of time people will wait for a given wage, thereby shifting the reservation-wage curve to the right, raising the average duration of unemployment, and increasing the wage at which searches end

Structural Unemployment Structural unemployment occurs when there is a mismatch between unemployed worker characteristics and job requirements. Structural unemployment can be caused by many factors. Technological change Changes in demand Structural unemployment is reduced by public and private job training firms and placement firms that cross regional borders and/or supply workers with new skills.

Cyclical Unemployment and Efficiency Wages Some economists argue that equilibrium in the labor market may never occur. Efficiency wage theory holds that firms may try to maintain a wage greater than equilibrium. Firms may believe that such wages reduce job turnover. This theory is controversial, but if true, means that short-run wage rigidity could become permanent.