Economics for Business I - Macroeconomics - Lecture 4

Unemployment and Inflation

Introduction

• This lecture aims to explain how unemployment and inflation are measured, examine their evolution over time, and discuss their causes and consequences.

Unemployment

Definition

• Number unemployed: Those of working age who are without work but are available for work at current wage rates.
• Labour force: The number employed plus the number unemployed.
• Unemployment rate: The number unemployed expressed as a percentage of the labour force; calculated as: Unemployment Rate = \frac{Number of Unemployed}{Labour Force} \times 100

Flows Into and Out of Unemployment

• Inflows (per period of time):
  • From jobs: People made redundant, people sacked, people temporarily laid off, people resigning.
  • From outside the labour force: School/college leavers, people returning to the labour force (e.g., after raising children).
• Outflows (per period of time):
  • To jobs: People taking new jobs, people returning to old jobs who had been temporarily laid off.
  • To outside the labour force: People who have become disheartened and give up looking for a job, people who have reached retirement age, people who temporarily withdraw from the labour force (e.g., to raise a family), people who emigrate, people who die.

Measures of Unemployment

• Claimant unemployment:
  • Those in receipt of unemployment-related benefits.
  • Understates the level of unemployment as many people are ineligible for benefits.
• Standardised unemployment:
  • People of working age who are without work, available to start work within two weeks, and actively seeking employment or waiting to take up an appointment.
  • Used by international organizations: International Labour Organisation (ILO) and Organisation for Economic Co-operation and Development (OECD).
  • Generally, standardised rate > claimant rate.

Causes of Unemployment

• Real-wage (classical).
• Demand-deficient (cyclical).
• Frictional (search).
• Structural.
• Seasonal.

Real-Wage (Classical) Unemployment

• Definition: Disequilibrium unemployment caused by real wages being driven up above the market-clearing level.
• Real wage: Nominal wage corrected for inflation.
• Occurs when trade unions use their monopoly power to drive wages above the market-clearing level or if the government sets the national minimum wage too high.
• Why: A rise in real wage rates increases firms’ labour costs (wages rates paid by firms have increased relative to the prices of their goods and services).

Demand-Deficient (Cyclical) Unemployment

• Definition: Disequilibrium unemployment caused by a fall in aggregate demand with no corresponding fall in the real wage rate.
• Cyclical unemployment rises in a recession and falls in an economic upturn.
• As aggregate demand (AD) falls, firms’ sales fall; firms then reduce production and lay off workers.
• As AD recovers, firms hire more workers, increase output and sales, and unemployment falls.
• Example: Lockdown during the Covid-19 pandemic caused demand-deficient unemployment.

Frictional (Search) Unemployment

• Definition: Equilibrium unemployment that occurs as a result of imperfect information in the labour market.
• It takes time for workers to find jobs (even though there are vacancies), and in the meantime, they are unemployed.
• Imperfect information: Employers are not fully informed about available labour; workers are not fully informed about available jobs.
• Both employers and workers have to search, hence the term ‘search’ unemployment.
• Remedy: Better job information.

Structural Unemployment

• Definition: Equilibrium unemployment that arises from changes in the pattern of demand or supply in the economy.
• People made redundant cannot easily take up new jobs.
• Changing consumer tastes may reduce demand (shift from fossil fuels to green energy).
• Technological unemployment: Result of the introduction of labour-saving technology (loss of jobs in retail due to online shopping).
• Regional unemployment: Example: former coal-mining areas.

Seasonal Unemployment

• Definition: Unemployment associated with industries or regions where the demand for labour is lower at certain times of the year.
• In agriculture, unemployment is high in the winter months.
• May also affect services; for example, in beach or ski destinations, unemployment can reach high levels in the off-season.

Composition of Unemployment

• Unemployment rates can vary enormously between countries and social groups and across different regions.
  • Age (youth unemployment rates are higher than average).
  • Males vs. females.
  • Geographical region (e.g., North vs. South; rural vs. urban).

Inflation

Definition

• Rate of inflation: The percentage increase in prices over a 12-month period.
  • Typically used to refer to the annual percentage change in consumer prices.
  • Normally a consumer prices index (CPI) is used.
• Government policy is to keep inflation low and stable.

Price Inflation

• Price inflation: the annual percentage increase in prices.
  • Consumer price inflation.
  • CPI – consumer price index.
  • RPI – retail price index (includes housing costs).
• It is possible to give rates of inflation for other prices or wages.
  • Commodity prices, food prices, house prices, import prices, etc.
  • Wages, earnings, salaries, etc.
• GDP deflator: The price index of all final domestically produced goods and services (that is all those items that contribute towards GDP).

Demand-Pull Inflation

• Definition: Inflation caused by persistent rises in aggregate demand.
• Firms respond to rising demand by raising prices and increasing output.
• Demand shock: A single increase in demand (e.g., an increase in government spending) that leads to a short-run increase in inflation.
• For inflation to persist, there must be continuing increases in aggregate demand (typically in a booming economy).

Cost-Push Inflation

• Definition: Inflation caused by persistent rises in costs of production (independently of aggregate demand).
• Firms respond to rising costs by raising prices and decreasing output.
• Supply shock: A single increase in costs (e.g., the government increases tax on petrol) that leads to a short-run increase in fuel prices.
• Sources of cost-push inflation:
  • Oil shocks periodically put upward pressure on costs and prices.
  • Trade unions pushing up wages, firms with monopoly power raising prices.

Consequences of Inflation

• Redistribution:
  • From those on fixed incomes to those who can bargain for pay, rent, or profit increases.
  • From those with savings earning interest below the inflation rate to those with assets (e.g., property).
• Uncertainty:
  • Inflation uncertainty leads firms to lower investments, which reduces economic growth.

Inflation and Unemployment

• The (original) Phillips curve suggests an inverse relationship between unemployment and inflation.
  • Lower unemployment is associated with higher inflation (and vice versa).
• Apparent policy implication: trade-off inflation against unemployment.
• The experience since the late 1960s has suggested that no such simple relationship exists beyond the short run.
• The Phillips curve broke down in the 1970s, and stagflation appeared.
• UK, and many other countries in the Western world too, began to experience falling GDP, growing unemployment, and higher rates of inflation.
• Stagflation: A combination of economic stagnation (low GDP growth and high unemployment) and high inflation.

Lecture Summary

1. Excessive real wages, deficient demand, market frictions, structural change, and seasonal fluctuations can cause unemployment to rise.
2. Rising aggregate demand causes demand-pull inflation, whereas increases in production costs lead to cost-push inflation.
3. The relationship between inflation and unemployment is more complex than it once seemed.