Ch 13 - Inflation and Unemployment

(Macroeconomics)

The Evil Twins

• Inflation and Unemployment both have disastrous effects on our economy, which also affects our standard of living.

• Unemployment refers to the state of people who are able to work, willing to work, and actively looking for work, but can’t find employment.

• It indicates that an important resource is being underutilised, meaning that production is less than what it could be if were using our resources fully.

• If we were to put unemployment in economic terms, we could say that production is inside the production possibilities frontier, meaning that it is inefficient.

• Inflation is the general increase of price and decrease in the purchasing value of money.

• The effects of inflation are less obvious, and can benefit producers. The rise in prices increase the benefit on producers as they continue to produce goods and service when prices are rising, and therefore gain more.

• Inflation can negatively affect families on a fixed income, however, most incomes tend to keep up with the rising costs of goods and services.

• Inflation is able to redistribute wealth as it takes purchasing power from households and transports it in the hands of others.

• Menu Costs: The misallocation of resources because of inflation

Inflation

The Consumer Price Index

• The inflation rate is that which indicates where the prices are rising.

• The consumer price index (CPI) is an index of the variation in prices for retail goods and other items. The CPI measures the average change over time in the prices paid by urban consumer for a market basket of goods and services.

• Formula: Interest rate = CPI2 - CPI1 / CPI1

• Subtract past CPI from current CPI and divide by past CPI

• Formula: CPI = Total cost this period/total cost base period * 100

• The CPI calculated does not overstate the amount of inflation since it does not account for all quality improvements

The GDP Deflator

• The GDP deflator measures the changes in prices for all goods and services produced in an economy

• Formula: GDP Deflator = (GDP/Real GDP)*100

• GDP Deflator = Nominal GDP / Real GDP * 100

• Real GDP = Nominal GDP / GDP Deflator * 100

• Real GDP = (GDP/GDP Deflator) * 100

• The GDP deflator does not address import prices, meaning that it does not change as imports change in price.

• The most common measure of inflation is by the percentage change in the consumer price index and the percentage change in the GDP deflator

The Cost of Inflation

• Even though some households may suffer with the increase in prices and fixed income, the majority of incomes will increase to keep up with rising prices.

• To understand why this is happening, we must look at the circular flow diagram. As the prices paid for goods and services increased by firms, producers tend to gain more in revenue. This increase in prices goes back to households in the form of dividends, meaning that higher prices will almost always translate to higher levels of income.

• Inflation erodes the purchasing power of savings, meaning that any savings in a bank will have less value that before inflation. As a result, inflation discourages savings.

• Resources are misallocated as they attempt to accommodate to the new prices. For example, restaurants have to print new menus to convey the changes in price, and so on.

• Borrowing and lending becomes tricky with inflationary conditions. Lenders tend to lose out on a percentage of money as the value of money changes than at the point it used to be. Lenders who do not participate in the inflation rate will be at a loss, while borrowers will benefit.

• Nominal Interest Rate = Real interest rate + expected inflation

• Nominal interest is the rate actually paid. Interest rate is the actual return the lender receives net of inflation

• The nominal interest rate paid by banks on savings accounts is not adjusted upward for expected inflation.

Unemployment

The Types of Unemployment

• Unemployment causes serious damage to individuals who are willing to work and are looking for work. Entire households go through hardships when they experience unemployment.

• During recessions, unemployment is more prominent as the GDP is declining. As a result, fewer goods and services will be produced and the labour and resources required for production will be reduced as people find themselves out of work.

• Unemployment rate is the number of unemployed people divided by the labor force. NOTE: the labour force does not include retired citizens, underage people, and anyone not seeking employment. It only includes people who are able and willing to work, and who are actively looking for work.

• Natural Rate of Unemployment: the unemployment rate if there was no cyclical unemployment

• Formula: Unemployment rate = Number of unemployed / Civilian Labour force

Types of unemployment:

1. Hidden/discouraged unemployment: those who are able to work, but are not seeking employment as they are discouraged due to lack of jobs or lack of experience to secure a good enough job. These people are not included in the labour force, as they are not seeking employment.

2. Structural Unemployment: These people are out of work since the economy is structured in a way which is disadvantageous for them. It is often difficult for a person to relocate or retrain for a specific job, so they give up. This is not included in the official statistics of unemployment.

3. Seasonal Unemployment: people who are able to find work only for a portion of the year due to the seasonal nature of their jobs. They have to actively seek employment in the off season to be considered seasonally unemployed

4. Cyclical Unemployment: when employees lose their jobs during a recession and experience a slowdown in production. Unemployment tends to increase during the contractionary phase of the business cycle. However, these people are expected to return to work when the business cycle improves during the next expansion.

5. Frictional unemployment: people who are not working as they are in between jobs. People who are scheduled to begin a new job, however, they do not hold a job right now. People who quit a job and are looking for another fall under this category. People who are new graduates looking for employment fall under this as well.

• NOTE: people who are not looking for work will not be part of the labour force, and are not considered to be unemployed.