Unemployment and Inflation Notes

Unemployment

Identifying Unemployment

  • Natural Rate of Unemployment:

    • Unemployment that persists even in the long run.

    • It represents the normal level of unemployment experienced by an economy.

  • Cyclical Unemployment:

    • Year-to-year fluctuations in unemployment around its natural rate.

    • Associated with short-term ups and downs of the business cycle.

Measuring Unemployment

  • Employed:

    • A person who has spent most of the previous week working at a paid job.

  • Unemployed:

    • A person who is on temporary layoff, is looking for a job, or is waiting for the start date of a new job.

  • Not in the Labor Force:

    • A person who fits neither the employed nor unemployed categories (e.g., full-time student, homemaker, retiree).

  • Labor Force:

    • The total number of workers, including both the employed and the unemployed.

  • Unemployment Rate Calculation:

    • Unemployment rate is calculated as the percentage of the labor force that is unemployed.

Impact of Unemployment

  • Lost Production:

    • The largest single cost of unemployment is lost production.

  • Okun’s Law:

    • For every 2% that GDP falls relative to potential GDP, the unemployment rate rises by about 1 percentage point.

Equilibrium vs. Disequilibrium Unemployment

  • Equilibrium Unemployment:

    • Arises when people become unemployed voluntarily as they move from job to job or into and out of the labor force.

    • Workers might prefer leisure or other activities to jobs at the going wage rate.

    • May include frictionally unemployed individuals searching for their first job.

    • May include low-productivity workers who prefer retirement or unemployment insurance to low-paid work.

  • Disequilibrium Unemployment:

    • Occurs when the labor market or the macroeconomy is not functioning properly, and some qualified people willing to work at the going wage cannot find jobs.

    • Structural Unemployment:

      • A mismatch between the supply of and the demand for workers, and markets do not quickly adjust.

    • Cyclical Unemployment:

      • Exists when the overall demand for workers declines in business-cycle downturns.

Public Policy and Job Search

  • Government Programs:

    • Can affect the time it takes unemployed workers to find new jobs.

    • Government-Run Employment Agencies:

      • Provide information about job vacancies to match workers and jobs more quickly.

    • Public Training Programs:

      • Aim to ease the transition of workers from declining to growing industries and to help disadvantaged groups escape poverty.

    • Unemployment Insurance:

      • Aims to protect workers’ incomes when they become unemployed.

Why is there Structural Unemployment?

  • Minimum-wage laws

  • Unions

  • Efficiency wages

Inflation

Definition

  • Inflation is an increase in the overall level of prices.

  • Categorization of Inflation:

    • Low inflation.

    • Galloping inflation: Double-digit or triple-digit per year.

    • Hyperinflation.

The Classical Theory of Inflation

  • Quantity Theory of Money:

    • Used to explain the long-run determinants of the price level and the inflation rate.

  • Inflation:

    • An economy-wide phenomenon that concerns the value of the economy’s medium of exchange.

  • Value of Money:

    • When the overall price level rises, the value of money falls.

Money Supply, Money Demand, and the Equilibrium Price Level

  • Equilibrium is achieved where money supply and money demand intersect, determining the equilibrium value of money and the equilibrium price level.

  • An increase in the money supply decreases the value of money and increases the price level.

The Classical Dichotomy and Monetary Neutrality

  • Classical Dichotomy:

    • Economic variables should be divided into two groups:

      • Nominal variables: Measured in monetary units.

      • Real variables: Measured in physical units.

  • Monetary Neutrality:

    • Real economic variables do not change with changes in the money supply.

    • Changes in the money supply affect nominal variables but not real variables.

    • The irrelevance of monetary changes for real variables is called monetary neutrality.

Velocity and the Quantity Equation

  • Velocity of Money:

    • Refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

Velocity and the Quantity Equation Formula

  • V = (P × Y)/M

    • Where:

      • V = velocity

      • P = the price level

      • Y = the quantity of output

      • M = the quantity of money

  • Rewriting the equation gives the quantity equation: M × V = P × Y

Implications of the Quantity Equation

  • An increase in the quantity of money in an economy must be reflected in one of three other variables:

    • The price level must rise.

    • The quantity of output must rise.

    • The velocity of money must fall.

The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money

  • The velocity of money is relatively stable over time.

  • When the CB changes the quantity of money, it causes proportionate changes in the nominal value of output (P × Y).

  • Because money is neutral, money does not affect output.

The Fisher Effect

  • According to the principle of money neutrality, an increase in the rate of money growth raises the rate of inflation but does not affect any real variable.

  • Nominal interest rate = real interest rate + inflation rate

The Fisher Effect

  • The one-for-one adjustment of the nominal interest rate to the inflation rate is called the Fisher effect.

  • According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount.

  • The real interest rate stays the same.

Demand-Pull and Cost-Push Inflation

  • Demand-Pull Inflation (or demand shocks inflation):

    • Occurs when aggregate demand (AD) rises more rapidly than the economy’s productive potential, pulling prices up to equilibrate aggregate supply (AS) and AD.

  • Cost-Push Inflation (or supply shocks inflation):

    • Occurs when the costs of production rise even in periods of high unemployment and idle capacity.

The Costs of Inflation

  • The Inflation Fallacy:

    • Inflation does not in itself reduce people’s real purchasing power.

  • Shoe leather costs

  • Menu costs

  • Relative price variability

  • Tax distortions

  • Confusion and inconvenience

  • Arbitrary redistribution of wealth

Shoe Leather Costs

  • The resources wasted when inflation encourages people to reduce their money holdings.

  • Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.

  • Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.

  • The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand.

  • Also, extra trips to the bank take time away from productive activities.

Menu Costs

  • The costs of adjusting prices.

  • During inflationary times, it is necessary to update price lists and other posted prices.

  • This is a resource-consuming process that takes away from other productive activities.

Relative-Price Variability and the Misallocation of Resources

  • Inflation distorts relative prices.

  • Consumer decisions are distorted, and markets are less able to allocate resources to their best use.

Inflation-Induced Tax Distortion

  • Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.

  • With progressive taxation, capital gains are taxed more heavily.

Inflation-Induced Tax Distortion

  • The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.

  • The after-tax real interest rate falls, making saving less attractive.

Confusion and Inconvenience

  • When the CB increases the money supply and creates inflation, it erodes the real value of the unit of account.

  • Inflation causes dollars at different times to have different real values.

  • Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth

  • Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.

  • These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.

The Short-Run Tradeoff between Inflation and Unemployment

  • Society faces a short-run tradeoff between unemployment and inflation.

    • If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation.

    • If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

The Phillips Curve

  • Illustrates the short-run relationship between inflation and unemployment.

  • Shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.

The Long-Run Phillips Curve

  • In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.

  • As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.

  • Monetary policy could be effective in the short run but not in the long run.

Shifts in the Phillips Curve: The Role of Expectations

  • The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

  • Expected inflation measures how much people expect the overall price level to change.

  • In the long run, expected inflation adjusts to changes in actual inflation.

  • The CB’s ability to create unexpected inflation exists only in the short run.

  • Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.

  • Unemployment Rate = Natural Rate of Unemployment - a (Actual Inflation - Expected Inflation)

The Natural Experiment for the Natural-Rate Hypothesis

  • The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis.

  • Historical observations support the natural-rate hypothesis.

Shifts in the Phillips Curve: The Role of Supply Shocks

  • Historical events have shown that the short-run Phillips curve can shift due to changes in expectations.

  • The short-run Phillips curve also shifts because of shocks to aggregate supply.

  • Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation.

  • An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

  • A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge.

  • This shifts the economy’s aggregate supply curve and, as a result, the Phillips curve.

The Cost of Reducing Inflation

  • To reduce inflation, the CB has to pursue contractionary monetary policy.

  • When the CB slows the rate of money growth, it contracts aggregate demand.

  • This reduces the quantity of goods and services that firms produce.

  • This leads to a rise in unemployment.

The Cost of Reducing Inflation

  • To reduce inflation, an economy must endure a period of high unemployment and low output.

  • The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point.