1. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 25 PowerPoint Lectures for Principles of Economics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

2. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 2 of 25

3. © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 22 PART IV CONCEPTS AND PROBLEMS IN MACROECONOMICS Unemployment, Inflation, and Long-Run Growth Fernando & Yvonn Quijano Prepared by:

4. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 4 of 25 11 UnemploymentMeasuring UnemploymentComponents of the Unemployment RateThe Costs of UnemploymentInflationThe Consumer Price IndexThe Costs of InflationLong-Run GrowthOutput and Productivity GrowthLooking Ahead CHAPTER OUTLINE Unemployment, Inflation, and Long-Run Growth 22 PART IV CONCEPTS AND PROBLEMS IN MACROECONOMICS

5. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster A.The unemployment rate has information about the state of the labor market. B.The inflation rate has information about the average price level. C.The long-run growth rate determines changes in our economic standard of living over long time periods.

6. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Why Unemployment Is a Problem? Unemployment results in  Lost production and incomes  Lost human capital The loss of income is devastating for those who bear it. Employment benefits create a safety net but don’t fully replace lost wages, and not everyone receives benefits. Prolonged unemployment permanently damages a person’s job prospects by destroying human capital.

7. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 25 Unemployment employed Any person 16 years old or older (1) who works for pay, either for someone else or in his or her own business for 1 or more hours per week, (2) who works without pay for 15 or more hours per week in a family enterprise, or (3) who has a job but has been temporarily absent with or without pay. Measuring Unemployment unemployed A person 16 years old or older who is not working, is available for work, and has made specific efforts to find work during the previous 4 weeks.

8. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 8 of 25 Unemployment not in the labor force A person who is not looking for work because he or she does not want a job or has given up looking. Measuring Unemployment labor force The number of people employed plus the number of unemployed. labor force = employed + unemployed population = labor force + not in labor force

9. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Employment and Unemployment Figure 5.1 shows the labor force categories. Population: 304.5 million Working-age population: 233.8 million Labor force: 154.6 million Employment: 145.8 million Unemployment: 8.8 million

10. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 10 of 25 Unemployment unemployment rate The ratio of the number of people unemployed to the total number of people in the labor force. Measuring Unemployment labor force participation rate The ratio of the labor force to the total population 16 years old or older.

11. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 11 of 25 Unemployment Measuring Unemployment TABLE 22.1 Employed, Unemployed, and the Labor Force, 1953–2007 (1)(2)(3)(4)(5)(6) Population 16 Years Old Or Over (Millions) Labor Force (Millions) Employed (Millions) Unemployed (Millions) Labor Force Participation Rate (Percentage Points) Unemployment Rate (Percentage Points) 1953107.163.061.21.858.92.9 1960117.269.665.83.959.45.5 1970137.182.878.74.160.44.9 1980167.7106.999.37.663.87.1 1982172.3110.299.510.764.09.7 1990189.2125.8118.87.066.55.6 2000212.6142.6136.95.767.14.0 2007231.9153.1146.07.166.04.6 Note: Figures are civilian only (military excluded). Source: Economic Report of the President, 2008, Table B-35.

12. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 12 of 25 Unemployment Components of the Unemployment Rate Unemployment Rates for Different Demographic Groups TABLE 22.2 Unemployment Rates by Demographic Group, 1982 and 2008 YearsNov. 1982March 2008 Total10.8 5.2 White9.6 4.5 Men20+9.04.1 Women20+8.14.1 Both sexes16–1921.313.2 African-American20.2 9.0 Men Women 20+ 19.3 16.5 8.4 7.5 Both sexes16–1949.531.3 Source: U.S. Department of Labor, Bureau of Labor Statistics. Data are not seasonally adjusted.

13. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 13 of 25 Unemployment Components of the Unemployment Rate Unemployment Rates in States and Regions TABLE 22.3 Regional Differences in Unemployment, 1975, 1982, 1991, and 2003 1975198219912003 U.S. avg.8.59.76.76.0 Cal.9.9 7.56.7 Fla.10.78.27.35.1 Ill.7.111.37.16.7 Mass.11.27.99.05.8 Mich.12.515.59.27.3 N.J.10.29.06.65.9 N.Y.9.58.67.26.3 N.C.8.69.05.86.5 Ohio9.112.56.46.1 Tex.5.66.96.66.8 Sources: Statistical Abstract of the United States, various editions.

14. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 14 of 25 Unemployment Components of the Unemployment Rate Unemployment Rates in States and Regions A Quiet Revolution:Women Join the LaborForce If you are interested in learning more about the economic history of American women, read the book Understanding the Gender Gap: An Economic History of American Women by Harvard University economist Claudia Goldin.

15. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 15 of 25 Unemployment Components of the Unemployment Rate Discouraged-Worker Effects discouraged-worker effect The decline in the measured unemployment rate that results when people who want to work but cannot find jobs grow discouraged and stop looking, thus dropping out of the ranks of the unemployed and the labor force. In the late stages of a recession the unemployment rate sometimes begins to fall. This decline is not being caused entirely by economic growth increasing. Part of the decrease in the unemployment rate is caused by more discouraged workers.

16. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 16 of 25 Unemployment Components of the Unemployment Rate The Duration of Unemployment TABLE 22.4 Average Duration of Unemployment, 1979–2007 Weeks 197910.8199318.0 198011.9199418.8 198113.7199516.6 198215.6199616.7 198320.0199715.8 198418.2199814.5 198515.6199913.4 198615.0200012.6 198714.5200113.1 198813.5200216.6 198911.9200319.2 199012.0200419.6 199113.7200518.4 199217.7200616.8 200716.8 Sources: U.S. Department of Labor, Bureau of Labor Statistics.

17. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 17 of 25 Unemployment The Costs of Unemployment Some Unemployment Is Inevitable All economies must experience some unemployment. The three types of unemployment will always be present when change is occurring and if the labor market operates with any degree of inefficiency.  Frictional unemployment  Structural unemployment  Cyclical unemployment

18. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 18 of 25 Unemployment The Costs of Unemployment Frictional, Structural, and Cyclical Unemployment frictional unemployment People currently switching jobs. Caused by imperfect information in the labor market. Frictional unemployment exists even in an economy where actual output equals potential output. Structural Unemployment: “Long-term” frictional unemployment. Caused by a mismatch in the characteristics of the unemployed and the job vacancies (skills, location). Seasonal Unemployment: Occurs in areas where production levels are dependent on weather or calendar events.A

19. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 19 of 25 Real GDP and Unemployment Over the Business Cycle Full employment does not mean that there is no unemployment. Full employment occurs when there is no cyclical unemployment or, equivalently, when all the unemployment is frictional and structural. The quantity of real GDP at full employment is potential GDP. When the economy is at full employment, the unemployment rate equals the natural unemployment rate and real GDP equals potential GDP. When the unemployment rate is greater than the natural unemployment rate, real GDP is less than potential GDP. And when the unemployment rate is less than the natural unemployment rate, real GDP is greater than potential GDP.

20. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster with jobs being created and jobs being destroyed, people entering the labor force and people leaving, people finding work and people losing work. The natural rate of unemployment varies over time for any one country, in the last three decades the rate has varied in the USA & UK from 2% to 6%, where in countries like Switzerland and Japan the rate has varied from less than 1% to 2%.

21. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Defining Inflation 1.Not all price increases are inflation. Over any time period, prices of some goods will rise and other prices will fall. 2.Inflation is an increase in the overall (average) price level. Deflation is a decrease in the overall (average) price level. Inflation happens when prices of many goods and services increase together. 3.Distinguish between deflation, disinflation and reflaion.

22. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 22 of 25 Disinflation is a decrease in the rate of inflation a slowdown in the increase of the general price level of goods and services over time. If the inflation rate is not very high to start with, disinflation can lead to deflation – decreases in the general price level of goods and services. For example if the annual inflation rate one month is 5% and it is 4% the following month, prices disinflated by 1% but are still increasing at a 4% annual rate. If disinflation continues until the inflation rate is zero, the economy enters a deflationary period. Reflation Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is the opposite of disinflation.

23. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Why Inflation Is a Problem Inflation is a problem for many reasons, but the main one is that once it takes hold, it is unpredictable. Unpredictable inflation is a problem because it  Redistributes income and wealth  Diverts resources from production

24. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 24 of 25 purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation Inflation can have positive and negative effects on an economy…..?.

25. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 25 of 25 Negative effects of inflation include 1- loss in stability in the real value of money and other monetary items over time. 2- uncertainty about future inflation may discourage investment and saving. 3- high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include 1- a mitigation of economic recessions and 2- debt relief by reducing the real level of debt.

26. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Price Level and Inflation Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index. The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer“ The inflation rate is the percentage rate of change of a price index over time. For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. an increase of 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.

27. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Price Level and Inflation Constructing the CPI Constructing the CPI involves three stages:  Selecting the CPI basket  Conducting a monthly price survey  Calculating the CPI

28. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 28 of 25 Inflation The Consumer Price Index The CPI market basket shows how a typical consumer divides his or her money among various goods and services. Most of a consumer’s money goes toward housing, transportation, and food and beverages. Source: The Bureau of Labor Statistics  FIGURE 22.1 The CPI Market Basket

29. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Price Level and Inflation Let’s work an example of the CPI calculation. In a simple economy, people consume only oranges and haircuts. The CPI basket is 10 oranges and 5 haircuts. The table also shows the prices in the base period. The cost of the CPI basket in the base period was $50. Table (b) shows the fixed CPI basket of goods. It also shows the prices in the current period. The cost of the CPI basket at current-period prices is $70.

30. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster The CPI is calculated using the formula: CPI = (Cost of basket at current-period prices ÷ Cost of basket at base-period prices)  100. Using the numbers for the simple example, CPI = ($70 ÷ $50)  100 = 140. The CPI is 40 percent higher in the current period than it was in the base period.

31. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 31 of 25 Inflation The Consumer Price Index TABLE 22.5 The CPI, 1950–2007 Percentage Change in CPICPI Percentage Change in CPICPI Percentage Change in CPICPI 19501.324.119695.536.719884.1118.3 19517.926.019705.738.819894.8124.0 19521.926.519714.440.519905.4130.7 19530.826.719723.241.819914.2136.2 19540.726.919736.244.419923.0140.3 1955  0.4 26.8197411.049.319933.0144.5 19561.527.219759.153.819942.6148.2 19573.328.119765.856.919952.8152.4 19582.828.919776.560.619963.0156.9 19590.729.119787.665.219972.3160.5 19601.729.6197911.372.619981.6163.0 19611.029.9198013.582.419992.2166.6 19621.030.2198110.390.920003.4172.2 19631.330.619826.296.520012.8177.1 19641.331.019833.299.620021.6179.9 19651.631.519844.3103.920032.3184.0 19662.932.419853.6107.620042.7188.9 19673.133.419861.9109.620053.4195.3 19684.234.819873.6113.620063.2201.6 20072.8207.3 Sources: Bureau of Labor Statistics, U.S. Department of Labor.

32. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Price Level and Inflation The Biased CPI The CPI might overstate the true inflation for four reasons:  New goods bias  Quality change bias  Commodity substitution bias  Outlet substitution bias

33. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Price Level and Inflation New Goods Bias New goods that were not available in the base year appear and, if they are more expensive than the goods they replace, they put an upward bias into the CPI. Quality Change Bias Sometimes price increases reflect quality improvements (safer cars, improved health care) and should not be counted as part of inflation..

34. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Price Level and Inflation Commodity Substitution Bias The market basket of goods used in calculating the CPI is fixed and does not take into account consumers’ substitutions away from goods whose relative prices increase. Outlet Substitution Bias When prices rise, people use discount stores more frequently and convenience stores less frequently.

35. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 35 of 25 Other widely used price indices for calculating price inflation include the following Cost-of-living indices Producer price indices Commodity price indices Core price indices Employment Cost Index

36. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 36 of 25 Inflation The Costs of Inflation real interest rate The difference between the interest rate on a loan and the inflation rate.* Debtors & creditors Shoe leather cost High inflation increases the opportunity cost of holding cash balances, people hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals. Menu costs With high inflation, firms must change their prices often in order to keep up with economy wide changes Inflation May Change the Distribution of Income

37. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Potential output *Is the output the economy would produce if both the labor force and capital stock were fully employed. What Makes Potential GDP Grow? *The potential output of an economy depends upon the quality and quantity of capital stock and labor force and existing technology, P O is not static; normally, it grows over time. *P O is a supply concept, a measure of productive capacity that may be represented diagrammatically by the PPF. 37 of 25

38. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 38 of 25 growth requires that people face incentives to: Save and invest in new capital because new capital expands production possibilities. Invest in human capital because human capital is a fundamental source of increased productivity and technological advance. Discover new technologies because technological change, the discovery and the application of new technologies and new goods, has made the largest contribution to output growth.

39. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

40. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster GDP gap The GDP gap or the output gap is the difference between potential GDP and actual GDP or actual output. The calculation for the output gap is Y-Q where Y is actual output and Q is potential output. If this calculation yields a positive number it is called an inflationary gap and indicates the growth of aggregate demand is out pacing the growth of aggregate supply--possibly creating inflation, if the calculation yields a negative number it is called a recessionary gap--possibly signifying deflation. 40 of 25

41. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster The relation between the Unemployment rate ( U ), Potential Output ( Q ) and actual Output (Y ). Here it is necessary to introduce the fourth main category of unemployment: Demand- deficient unemployment. Arises because of insufficient demand for labor. ( Reduction of such unemployment is the major interest and concern to policy makers ). It follows that the larger the gap between the Q and Y, the higher will be the rate of unemployment ; and the smaller the gap, the closer the unemployment rate will be to the full employment rate. % output gap = Q – Y Y 41 of 25

42. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Okun’s Law Okun’s law states that for each 1% by which (Y )falls short to (Q ), the U will exceed its NRU by one third of 1%. Thus if Y 6% below Q, the U will be 2% above NRU. 42 of 25

43. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Output and Inflation After understanding how the inflation rate is determined, its necessary to investigate how firms set prices. It depends on how firms form expectations about cost and demand for the coming period, in other words aggregate demand will influence firms expectations of both demand for their own products and the prices they will have to pay for inputs in the coming period. 43 of 25

44. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Since in any short-run period, AD will influence both U and INF, there will be an implied relationship between U & INF. For each possible AD, there will be corresponding combination of U & INF. When AD is high, there will be low rate of U and high rate of INF, when AD is low, there will be a high rate of Y and low rate of INF. This relationship summarized in the Philips Curve. William Phillips a New Zealand born economist, wrote a paper in 1958 titled The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861– 1957, which was published in the quarterly journal Economica 44 of 25

45. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Inflation and Unemployment: The Phillips Curve A Phillips curve is a curve that shows the relationship between the inflation rate and the unemployment rate. There are two time frames for Phillips curves:  The short-run Phillips curve  The long-run Phillips curve

46. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster The Short-Run Phillips Curve The short-run Phillips curve shows the tradeoff between the inflation rate and unemployment rate, holding constant 1. The expected inflation rate 2. The natural unemployment rate Inflation and Unemployment: The Phillips Curve

47. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Figure 12.6 illustrates a short-run Phillips curve (SRPC)—a downward-sloping curve. It passes through the natural unemployment rate and the expected inflation rate. Inflation and Unemployment: The Phillips Curve

48. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster With a given expected inflation rate and natural unemployment rate: If the inflation rate rises above the expected inflation rate, the unemployment rate decreases. If the inflation rate falls below the expected inflation rate, the unemployment rate increases. Inflation and Unemployment: The Phillips Curve

49. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Gordon's triangle model Robert J. Gordon of Northwestern University has analyzed the Phillips curve to produce what he calls the triangle model, in which the actual inflation rate is determined by the sum of 1- demand pull or short-term Phillips curve inflation, 2- cost push or supply shocks, and 3- built-in inflation 49 of 25

50. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 50 of 25

51. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Aggregate Demand increasing faster than production. Demand-pull inflation arises when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing too few goods". 51 of 25

52. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Cost-Push Inflation An inflation that starts with an increase in costs is called cost-push inflation. There are two main sources of increased costs: 1. An increase in the money wage rate 2. An increase in the money price of raw materials, such as oil Inflation Cycles

53. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster A Cost-Push Inflation Process If the oil producers raise the price of oil to try to keep its relative price higher, and the Fed responds by increasing the quantity of money, a process of cost- push inflation continues. Inflation Cycles

54. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster built-in inflation Built-in inflations induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation. 54 of 25

55. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster The Long-Run Phillips Curve The long-run Phillips curve shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate. Stagflation In the 1970s, many countries experienced high levels of both inflation and unemployment also known as stagflation. Theories based on the Phillips curve suggested that this could not happen, and the curve came under concerted attack from a group of economists headed by Milton Friedman Inflation and Unemployment: The Phillips Curve

56. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 56 of 25

57. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster The combination of a rising price level and a decreasing real GDP is called stagflation. Cost-push inflation occurred in the United States during the 1970s when the Fed responded to the OPEC oil price rise by increasing the quantity of money. Inflation Cycles

58. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster New theories, such as rational expectations arose to explain how stagflation could occur. The latter theory, also known as the "natural rate of unemployment" distinguished between the "short- term" Phillips curve and the "long-term" one. The short-term Phillips Curve looked like a normal Phillips Curve, but shifted in the long run as expectations changed. In the long run, only a single rate of unemployment. The long-run Phillips Curve was thus vertical, so there was no trade-off between inflation and unemployment. Edmund Phelpswon the Nobel Prize in Economicsin 2006 for this. 58 of 25

59. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 59 of 25 Long-Run Growth output growth The growth rate of the output of the entire economy. per-capita output growth The growth rate of output per person in the economy. productivity growth The growth rate of output per worker.

60. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 60 of 25 Long-Run Growth Output and Productivity Growth Productivity grew much faster in the 1950s and 1960s than since.  FIGURE 22.2 Output per Worker Hour (Productivity), 1952 I–2007 IV

61. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 61 of 25 Long-Run Growth Output and Productivity Growth Capital per worker grew until about 1980 and then leveled off somewhat.  FIGURE 22.3 Capital per Worker, 1952 I–2007 IV

62. CHAPTER 22 Unemployment, Inflation, and Long-Run Growth © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 62 of 25 consumer price index (CPI) cyclical unemployment discouraged-worker effect employed frictional unemployment labor force labor force participation rate natural rate of unemployment not in the labor force output growth per-capita output growth REVIEW TERMS AND CONCEPTS producer price indexes (PPIs) productivity growth real interest rate structural unemployment unemployed unemployment rate 1. Labor force = employed + unemployed 2. Population = labor force + not in labor force 3. 4.