FE T8 - Unemployment and Inflation

Major Concerns of Macroeconomics

• Macroeconomics focuses on three primary concerns:

  • Output Growth

  • Unemployment

  • Inflation

Understanding Unemployment

• Definition: Unemployment refers to a situation where members of the labor force are without a job but are actively seeking employment.

• Significance: The unemployment rate is a vital indicator of an economy's health. The existence of unemployment implies that the aggregate labor market is not in equilibrium.

• Production Possibility Frontier (PPF) Analysis: From a PPF perspective, unemployment signifies that resources are not being fully utilized. This inefficiency causes the economy to produce at a lower combination of outputs than its potential.

Criteria for Classification as Unemployed

• Individuals are considered unemployed if they did not work, were available for work, and met at least one of the following conditions:

  • Engaged in specific job-seeking activities.

  • Waiting to be recalled to a job from which they were temporarily laid off.

  • Would have been looking for a job but were temporarily ill.

  • Waiting to report to a new job within a period of one month.

Measuring the Labor Force and Unemployment

• Labor Force Definition: The labor force includes individuals who are currently working (employed) as well as those who are unemployed and actively seeking jobs. It only encompasses persons of working age, defined as $15$ to $64$ years old.

• Out of the Labor Force: This category includes persons who fit neither the employed nor the unemployed (seeking jobs) categories. Examples include:

  • Students

  • Retirees

  • Homemakers

  • Members of the armed forces

  • Disabled individuals

  • Institutionalized persons

  • Discouraged workers

• Fundamental Equations:

  • $\text{Population} = \text{Labor Force} + \text{Not in Labor Force}$

  • $\text{Labor Force} = \text{Employed} + \text{Unemployed}$

  • $\text{Unemployed Rate} = \frac{\text{Unemployed}}{\text{Labor Force}} \times 100$

• Labor Force Participation Rate: This is the ratio of the labor force to the total population. A higher rate indicates a higher productivity rate in the economy.

  • $\text{Labor Force Participation Rate} = \frac{\text{Labor Force}}{\text{Population}} \times 100$

Specific Labor Market Phenomena

• Discouraged Workers: These are individuals who are not looking for work because they either do not want a job or have given up looking. They are classified as "Not in the Labor Force." They typically put effort into job searching initially but became discouraged due to continuous failure.

• Underemployment: This represents labor resources that are not fully utilized.

  • It includes people who, due to family responsibilities or bills, are compelled to take jobs below their capabilities.

  • These individuals remain in the labor force but work part-time or full-time while being paid less than they deserve.

  • The official unemployment rate does not count these individuals as unemployed.

Types of Unemployment

• Frictional Unemployment: The portion of unemployment caused by short-run problems in matching jobs with skills.

• Structural Unemployment: Unemployment resulting from changes in the structure of the economy, leading to significant job losses in specific industries.

• Seasonal Unemployment: Arises on the supply side of the labor market due to seasonal variations in employment or labor supply.

• Cyclical Unemployment: The increase in unemployment rates that occurs specifically during economic recessions and depressions.

Full Employment and the Natural Rate of Unemployment

• Full Employment: A basic economic goal. However, full employment does not mean zero unemployment. A certain degree of unemployment is considered inevitable and desirable for the normal functioning of the economy.

• Natural Rate of Unemployment: The normal rate around which the actual unemployment rate fluctuates. It is the sum of three components:

  • $\text{Natural Rate} = \text{Frictional} + \text{Structural} + \text{Seasonal}$

• Cyclical Unemployment Re-definition: The deviation of the actual unemployment rate from its natural rate.

Government Programs to Combat Unemployment

• Employment Agencies: Government-run agencies provide information on job vacancies to the unemployed, helping to reduce the duration of frictional unemployment.

• Public Training Programs: These programs train workers in skills suitable for the current economic structure, easing transitions from declining to growing industries and reducing both frictional and structural unemployment.

• Unemployment Insurance: This protects workers' incomes when they are laid off because their previous employers no longer required their skills. It reduces the hardship of unemployment and helps decrease the duration of structural unemployment.

Perspectives on Inflation

• Inflation: An increase in the overall price level of the economy.

• Sustained Inflation: An increase in the overall price level that continues over a significant period.

• Hyperinflation: A period characterized by very rapid increases in the overall price level.

• Deflation: A decrease in the overall price level. Prolonged deflation can be as damaging as sustained inflation.

• Stagflation: A combination of stagnation and inflation. It occurs when the price level rises rapidly (inflation) during a period of recession or high, persistent unemployment (stagnation).

Measuring Inflation

• GDP Deflator: Calculated as $\frac{\text{Nominal GDP}}{\text{Real GDP}}$. It represents the average of current-year prices expressed as a percentage of base-year prices.

• Consumer Price Index (CPI): A price index computed using a specific basket of goods purchased by a typical consumer. It is the most popular measure of inflation.

  • $\text{Inflation Rate} = \frac{CPI_{Year\,2} - CPI_{Year\,1}}{CPI_{Year\,1}} \times 100$

• Producer Price Index (PPI): Measures price changes at all three stages of production:

  1. Finished goods stage

  2. Intermediate materials stage

  3. Crude materials stage

Costs and Impacts of Inflation

• Income Distribution: Inflation changes how income is distributed. High-income groups often have flexible incomes that rise with prices, while low-income groups on fixed incomes are hurt, worsening income inequality.

• Creditors and Debtors: Inflation lower than expected benefits creditors and hurts debtors. Inflation higher than expected (unanticipated) hurts creditors and benefits debtors.

• Investment Risk: Unanticipated inflation increases investment risk because real returns cannot be accurately estimated.

• Anticipated Inflation Costs: Even if expected, inflation causes administrative and inefficiency costs (e.g., higher opportunity cost of holding cash, leading to more frequent bank trips).

• Real Interest Rate Formula:

  • $i = r - \pi$

  • Where $i$ is the real interest rate, $r$ is the nominal interest rate, and $\pi$ is the expected inflation rate.

Causes of Inflation

• Demand-Pull Inflation: Caused by continuous rises in Aggregate Demand (AD) that cannot be met by supply. This shifts the AD curve to the right (from $AD_1$ to $AD_2$), creating excess demand and pushing prices from $P_1$ to $P_2$. Causes include:

  • Increase in money supply (Expansionary Monetary Policy).

  • Increase in government purchases (Expansionary Fiscal Policy).

  • Increase in exports.

• Cost-Push Inflation: Results from factors that decrease Aggregate Supply (AS), known as a supply shock. Increasing production costs pull the price level up. This shifts the AS curve to the left (from $AS_1$ to $AS_2$), raising prices from $P_1$ to $P_2$ and falling output from $Q_2$ to $Q_1$. Sources include:

  • Wage rate increases.

  • Rising prices for raw materials.

Controlling Inflation

• Contractionary Monetary Policy: Central Bank (Bank Negara) reduces the money supply and raises interest rates.

• Contractionary Fiscal Policy: Government reduces expenditures and/or increases taxes.

• Direct Controls:

  • Price Pegging: Government fixes ceiling prices to prevent rapid increases.

  • Control of Trade Unions: Persuading unions not to demand higher wages to prevent cost-push inflation.

  • Anti-hoarding Campaigns: Reporting those who store goods unnecessarily, which causes artificial shortages.

  • Price Tagging: Labeling all goods to prevent consumer over-charging.

  • Rationing: Using coupons to buy limited quantities of goods (used as a last resort).

• Note: Effectiveness requires simultaneous implementation of all three methods (monetary, fiscal, and direct control).

The Phillips Curve

• Definition: Describes the short-run trade-off and negative association between the inflation rate and the unemployment rate.

• Dynamics:

  • Point A: Low inflation and High unemployment.

  • Point B: High inflation and Low unemployment.

  • $\uparrow \text{inflation} \rightarrow \downarrow \text{unemployment}$

• Relation to AD and AS:

  • The Phillips curve shows combinations of unemployment and inflation arising from shifts in AD moving the economy along the short-run AS curve.

  • Greater AD leads to higher output and a higher price level.

  • Higher output results in lower unemployment.

  • Low AD Scenario: Output is $7,500$, Price Level is $102$, Unemployment is $7\%$, Inflation is $2\%$.

  • High AD Scenario: Output is $8,000$, Price Level is $106$, Unemployment is $4\%$, Inflation is $6\%$.

Questions & Discussion

• Q: A person not looking for work, because he or she either does not want a job or has given up looking, is classified as:

  • A: Not in the labor force.

• Q: When an unemployed worker becomes discouraged about finding work and stops looking, the unemployment rate will:

  • A: Fall (because they are no longer counted in the labor force).

• Q: Calculation Exercise. Labor force = $159.7\text{ million}$, Employed = $152.2\text{ million}$, Unemployed = $7.5\text{ million}$. Prisoners = $1.51\text{ million}$.

  • a) Calculate official unemployment rate:

    • $\frac{7.5}{159.7} \times 100 = 4.7\%$

  • b) Calculate rate if prisoners were in the labor force and unemployed:

    • $\frac{7.5 + 1.51}{159.7 + 1.51} \times 100 = 5.6\%$

Historical Data (Malaysia: 1981-2013)