Economic Fluctuations, Unemployment, Inflation, and Fiscal Policy

Unemployment

• Lost production is the largest cost of unemployment.

• In the Philippines, a 1% increase in unemployment leads to a 2% drop in real GDP growth.

• Effects of unemployment vary across different groups.

Natural Rate of Unemployment

• Steady-state rate of unemployment.

• The rate toward which the economy gravitates in the long run.

• Unemployment rate without economic fluctuations.

• Related to potential GDP.

• Sum of frictional and structural unemployment.

• Cyclical unemployment causes deviations from the natural rate.

Cyclical Unemployment

• Layoffs caused by economic downturns.

• Fewer workers, idle capital, reinforcing the downturn.

• Slow to revert to the natural rate due to sticky wages.

• Costs:

  • Output lost during downturns.

  • Uneven effects on different groups.

  • Lost tax revenue.

  • Psychological and financial distress.

Frictional Unemployment

• Unemployment due to the time it takes for workers to find a job.

• Caused by:

  • People entering and exiting jobs.

  • Sectoral shifts in the economy.

  • Competing cheaper products from abroad.

Structural Unemployment

• Unemployment due to a mismatch between skills demanded and skills workers can offer.

• Long-term and slow to fix.

• Caused by:

  • Technological obsolescence.

  • Wage rigidities.

Structural Unemployment - Wage Rigidities

• Minimum wage laws prevent wages from falling to equilibrium.

• Unions influence wages above equilibrium.

• Efficiency wages assume high wages increase worker productivity.

Unemployment Takeaways

• Unemployment represents wasted resources.

• Cyclical unemployment impacts groups differently.

• Alleviated by expansionary fiscal and monetary policies.

• Policy goal: reduce the natural rate of unemployment.

• Address via:

  • Labor force retooling.

  • Job matching programs.

  • Unemployment insurance.

  • Consider psychological and financial distress.

Inflation

• Inflation is an increase in average prices.

• In high-inflation countries, money is not a useful medium of exchange.

Quantity Theory of Money

• Equation of exchange: M × V = P × Y, where:

  • M = Money supply

  • V = Velocity of money

  • P = Price level

  • Y = Real GDP

  • Both sides represent nominal GDP.

• In growth form: %\Delta M + %\Delta V = %\Delta P + %\Delta Y

• Inflation rate is caused by growth in the money supply in the long run.

Money Supply and Inflation

• Central bank controls inflation by managing the money supply.

• Increasing money supply faster than real output causes inflation.

• If money supply increases at the same rate as real output, prices remain stable.

Costs of Inflation

• Low, stable inflation has minimal costs.

• High and volatile inflation causes problems.

• Price confusion and money illusion.

• Inflation redistributes wealth.

• Lenders are worse off when inflation is high, borrowers are better off, and vice-versa with low inflation rates.

• Real Rate Equation: Real\ rate = Nominal\ Rate - Inflation

• Fisher effect: i = r + \pi

Costs of Inflation - Redistribution of Wealth

• Unexpected inflation (E \pi < \pi ): Harms lenders, benefits borrowers

• Unexpected disinflation (E \pi > \pi ): Benefits lenders, harms borrowers

• Expected inflation = Actual inflation (E \pi = \pi ): No redistribution of wealth

Social Costs of Inflation

• Shoe leather costs (more trips to the ATM).

• Menu costs (frequent price changes).

• Tax liabilities on nominal wages.

• Complicated financial planning.

Inflation Takeaways

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

• Caused by money supply growth exceeding real GDP growth.

• Distorts price signaling.

• Redistributes wealth unexpectedly.

• Impacts long-term financial planning.

Output Gap

• Long-run equilibrium: SRAS, LRAS, and AD intersect.

• Ensures full-employment, potential output.

• Inflationary gap: Actual output > full-employment output.

• Recessionary gap: Actual output < full-employment output.

• Government can use contractionary or expansionary fiscal policy to hasten the return to full employment.

Output Gap - Fiscal Policies

• Contractionary fiscal policy: Decreased G, Increased T, Decreased Tr

• Expansionary fiscal policy: Increased G, Decreased T, Increased Tr

Phillips’ Curve

• Negative relationship between inflation and unemployment.

• Equation: Inflation\ Rate = 8.39 − 1.07 * Unemployment\ Rate

• Suggests a short-run trade-off between inflation and unemployment.

• Sacrifice ratio: Percentage output lost for each point reduction in inflation rate.

• Misery index: Sum of unemployment and inflation rates.

• The Phillips’ curve relationship is a short-run relationship and does not hold in the long-run.

Stagflation

• Slow growth, high unemployment, and rising prices.

• Cost-push inflation over a prolonged period.

• Hard to resolve.

• Supply-side policies can help:

  • Wage cuts

  • Lower business taxes

  • Privatization and deregulation

  • Lower tariffs on imports of raw materials

Summary

• Economic fluctuations come from demand and supply shocks.

• Effects are seen in unemployment and inflation.

• Government can interfere through policies affecting supply and demand to return the economy to long-run levels.