Macroeconomics: Inflation and Unemployment Notes

Plan of Session

• Measurement of Unemployment
• Types of Unemployment
• Policies to Affect Employment
• Relationship Between Inflation and Unemployment
• Trade-Off Between Inflation and Unemployment

Why Unemployment Matters

• Impact on Output and Income: Unemployment generally reduces output and aggregate income.
• Increased Inequality: The unemployed typically suffer greater losses than employed individuals.
• Erosion of Human Capital: Skills may diminish due to prolonged unemployment.
• Psychic Costs: Feelings of self-worth and contribution diminish; leisure time cannot compensate for the pain of rejection (Layard, Nickell, and Jackman).

Measures of Unemployment

• Claimant Count:

  • Individuals claiming unemployment-related benefits.
  • Current UK Rate: 4.6% (Oct 2024 - Dec 2024).

• ILO Unemployment (LFS):

  • Individuals who are out of work, actively seeking a job in the past four weeks, and available to start within two weeks.
  • Current UK Rate: 4.4% (Oct 2024 - Dec 2024).

• Employment Definition: Includes anyone working at least one hour of paid work, in training schemes, unpaid family work, or temporarily absent from a job.

• Survey vs. Actual Count:

  • Claimant Count is a comprehensive measure.
  • Labour Force Survey is based on a sample of 40,000 people and averages results from the last three surveys.

Types of Unemployment

• Cyclical:
  • Related to demand changes in the business cycle; can be influenced by aggregate demand (AD) policies.
• Frictional:
  • Temporary unemployment from job turnover and market dynamism.
• Structural:
  • Mismatch of skills between workers and jobs available.
• Equilibrium Unemployment:
  • Combination of frictional and structural unemployment.

Policies to Affect Unemployment

• Cyclical Unemployment: Can be addressed through successful AD policies to keep GDP around potential output (Y*).
• Frictional and Structural Unemployment: Require targeted, microeconomic policies for faster adjustments, including:
  • Education and training
  • Relocation support
  • Work incentives
• Ineffective Policies:
  • Reducing workweek
  • Protectionism
  • Anti-technology measures
• Effective Flexibility: Policies facilitating easier labor market participation are beneficial.

The Phillips Curve

• Original Concept: Relates wage inflation to the levels of unemployment; adapted to relate unit cost inflation to GDP.
• Implications:
  • Identifies how demand states affect inflation, suggesting inflation is positive when GDP (Y) exceeds potential output (Y) and negative when Y < Y.
• Expectations-Augmented Phillips Curve:
  • Shows how GDP relates to unit cost inflation, influenced by expected inflation levels.

Equilibrium Unemployment and Potential GDP

• Equilibrium Unemployment: The level of unemployment that occurs when GDP is equal to potential GDP (Y*). Also known as:
  • Natural Rate of Unemployment
  • Non-accelerating inflation rate of unemployment (NAIRU).

Trade-Off Between Inflation and Unemployment

• Short Run: Yes, increased demand can lead to higher GDP, reduced unemployment, and higher inflation.
• Long Run: No, if GDP is sustained above potential output and unemployment below its natural rate, inflation accelerates unsustainably.
• Sustainable Unemployment: Achieved at the natural rate (U*), consistent with a range of expected inflation levels, supported by monetary policies.
• Inflation Targeting: Effective regimes have stabilized inflation expectations, potentially flattening the short-run Phillips curve and lowering equilibrium unemployment levels.