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ECO 120
Macroeconomics
Week 11
Unemployment &
Inflation
Lecturer
Dr. Rod Duncan
Topics
• Definition of unemployment.
• Types of unemployment.
• Costs of unemployment.
• Definition of inflation.
• Types of inflation.
• Impacts of inflation.
• Relationship between unemployment and
inflation- the Phillips Curve.
Unemployment
A person becomes unemployed if he or she is a:
•Job loser
•Job leaver
•New entrant or re-entrant into the labour force
He or she is no longer unemployed if:
•Hired or recalled
•Withdraws from the labour force
Population
Working age
population
Labour Force
Employed /
Unemployed
Labour Force
Participation
Rate
Unemployment
Rate
Labour Force Participation Rate (LFPR)
Proportion of country’s population that takes
part in its economic activities directly (either
actually taking part or willing to)
( Labour Force /
Working Age Population )
X
LFPR In Australia, in September 2003 :
( 10.237 million / 15.955 million ) x 100 = 64.2 %
100
Unemployment Rate (UR)
Proportion of country’s labour force that is
unemployed.
( Number Unemployed
/ Labour Force )
UR in Australia, in September 2003 :
(0.591 million / 10.237 million) x 100 = 5.8%
X
100
Unemployment over the Business
Cycle (1965- 1995)
12
10
Unemployment
8
6
4
2
0
Change in GDP
-2
-4
1965
1970
1975
1980
1985
1990
1995
Labour Force Participation by Sex
at Ages 35-44
100
Participation rate (%)
90
Males
80
70
60
50
Females
40
30
20
10
0
1965
1970
1975
1980
1985
1990
1994
1995
6. 1
SEP.2003
JAN.2003
MAY.2002
6. 1
SEP.2001
JAN.2001
MAY.2000
6. 1
SEP.1999
JAN.1999
MAY.1998
6. 1
SEP.1997
JAN.1997
MAY.1996
6. 2
SEP.1995
JAN.1995
MAY.1994
6. 2
SEP.1993
JAN.1993
MAY.1992
6. 2
SEP.1991
JAN.1991
u n e mp l o y e d
MAY.1990
SEP.1989
JAN.1989
MAY.1988
SEP.1987
JAN.1987
MAY.1986
5
SEP.1985
JAN.1985
35
MAY.1984
SEP.1983
JAN.1983
MAY.1982
SEP.1981
JAN.1981
MAY.1980
SEP.1979
Unemployment rate (%)
To t a l
6. 2
Unemployment Analysis - Australia : June 1979 - September 2003
40
Aged 15-19 looking for
full-time work
30
25
20
15
Total Unemployment
10
Aged 20 & over seeking
full-time work
0
Types of Unemployment
 Cyclical unemployment
 Frictional (or search) unemployment
 Structural (technological) unemployment
Cyclical Unemployment
Associated with the ups and downs of the
business cycle
• Takes place due to insufficient aggregate
demand or total spending- reflects shifts in AD
curve.
• High during recessions and low during booms.
• Fiscal and monetary policies can reduce
cyclical unemployment - policies are relevant.
Frictional Unemployment
Associated with the period of time in
which people are searching for jobs,
being interviewed and waiting to
commence duties.
•It is inevitable and always exist
•Fiscal and monetary policies can not reduce
frictional unemployment – macroeconomic
policies are irrelevant.
•Policies that make it easier to find new jobs
will affect frictional unemployment.
Structural Unemployment
Associated with wider structural or technological
changes in the economy that may make some jobs
redundant.
• It is inevitable and always exist
• Lasts longer than frictional unemployment
• Fiscal and monetary policies can not reduce
structural unemployment – macroeconomic policies
are irrelevant.
• Policies that encourage workers to retrain skills or to
move to a new area with more jobs will decrease
structural unemployment.
Full Employment
• Full employment means when all productive resources
in the economy are in full use - implies no cyclical
unemployment - still frictional and structural
unemployment exist - they can be low - but can never
be zero.
• The full-employment rate of unemployment is called
the natural rate of unemployment
• equals the sum of frictional and structural
unemployment
• cyclical unemployment = zero
• Domestic output consistent with the natural rate of
unemployment is potential output or full employment
level of GDP
Other Employment Issues
• Part-time employment - very high in Australia
in recent years.
• Discouraged workers or the “hidden
unemployed”
• Those who become discouraged and drop out
of the labour force temporarily - would
return if a suitable job prospect arose
• Discourage workers, participation rate and the
unemployment rate
Cost of Unemployment
• Economic cost
• output foregone, measured in terms of the loss of
potential GDP - Okun’s law quantifies the
relationship between the unemployment rate and the
GDP gap - for every 1% of unemployment (over the
natural rate) 3.5% of GDP loss in Australia.
• Underemployment
• High budget costs
• Social Costs
• Increase in crime rate, abuse etc.
• Physical & mental illness
• Unlikely to develop work ethics
Classical Employment Theory
Economy always operates under full employment - it
is automatic and self sustaining - if there is any
unemployment that is only temporary
Price-wage flexibility
the assumption that all prices, including wages and
interest rates, are flexible and will, rapidly adjust to
remove disequilibria
Classical theory and laissez faire
the price system ensured that price-wage flexibility
and fluctuations in the interest rate was capable of
maintaining full employment
AD-AS in the Classical Theory
•Vertical aggregate supply curve
exclusively determines level of real
domestic output
•Stable down-sloping aggregate demand
exclusively determines price level
Classical View of Unemployment
Price Level
ASLR = AS
P1
P2
AD1
AD2
Q1
Real Domestic Output
Keynesian View of AD - AS
•Full employment is not automatic - unemployment exists
for longer periods - the Great Depression of the 1930s sticky wages and prices.
•Horizontal aggregate supply curve during recession ‘recessionary’ or ‘Keynesian’ range
Change in AD impacts on unemployment - not on price level.
•Once the full employment level is reached - vertical AS
curve - change in AD affects price level only.
•Unstable aggregate demand - especially investment
demand management and stabilisation policies by the
government are essential
Keynesian View of Unemployment
Price Level
ASLR
P1
AS
AD1
AD2
Q2 Q1
Real Domestic Output
Inflation
• We measure the general price level through
a price index such as the Consumer Price
Index (CPI)
• Inflation is a continuous rise in the general
price level
Inflation
rate
=
Current year index - Previous year
index
x
Previous year index
100
Inflation in Australia (1970-2003)
18
16
14
12
10
8
6
4
2
0
-2
1970
1975
1980
1985
1990
1995
2000
Types of Inflation
• Demand-Pull Inflation
• Cost-Push Inflation
Demand-Pull Inflation
• Occurs when an increase in AD pulls up the price level
• Excess demand for output - increase in AD - AD shifts
rightward - AS does not change in the short run movement along the AS curve - price level increases GDP increases
• In the longer run, workers will realise their real wages
have fallen and will demand and receive increased
nominal wages - lower profit level - supply decreases causing the AS to shift to the left - GDP declines - price
level increases further - only inflation
• May be caused by expansionary fiscal and monetary
policies - can be cured by contractionary policies.
Demand-Pull Inflation - Short run
Price Level
ASLR
AS1
P2
b
P1
a
An increase in
aggregate
demand....
Increases the price
level and output
in the short run
AD2
AD1
o
Q1
Real GDP
Price Level
Demand-Pull Inflation - Long run
ASLR
AS1
P3
c
P2
b
P1
a
A decrease in
aggregate
supply....
Increases the price
level and output
returns to original
level
AD2
AD1
o
Q1 Q2
Real GDP
Cost-Push Inflation
• Occurs when an increase in the cost of production at
each price level shifts the AS curve leftward resulting
in increased prices
• Short-run: Increased prices and decreased real output
(and more unemployment)
• Wage push : increase in wage rate - power of trade
unions
• Supply shocks - increase in prices of major raw
materials - oil etc.
• Profit push : increase in profit requirement of large
monopoly businesses.
Cost-Push Inflation
ASLR
AS2
Price Level
AS1
b
P2
P1
a
Cost-push
inflation occurs
when aggregate
supply shifts left....
Causing a higher
price level
AD1
o
Real GDP
Q1
Cost-Push Inflation and Demand Management
• Government intervention (AD): If
government intervenes to increase AD an
inflationary spiral will result
• No Government intervention (AD): If
government does not intervene to
increase AD severe recession will result,
however nominal wages will eventually
decline and will restore AS to original
position
Cost-Push Inflation
ASLR
AS2
Price Level
AS1
P3
b
c
P2
P1
An attempt to
increase AD
will only further
increase the
price level
a
AD1
o
Real GDP
Q1 Q2
Stagflation
• Simultaneous experience of high and
increasing unemployment and inflation - costpush inflation.
• Caused by :
• Aggregate supply shocks such as severe
increases in fuel costs, and devaluations
• Productivity decline
• Inflationary expectations and wages expectations about the likely future path and
rate of increase of the general price level
Types of Inflation in Australia
• 1973-74 : Cost push - caused by international oil
price rise.
• 1979 : cost-push - caused by international oil price
rise.
• 1981-82 : cost push - caused by rapidly rising
wages.
In early 1993, RBA announced its policy of inflation
targeting - 2% - 3% a year - initially caused a
recession & rise in unemployment
Impacts of Inflation
• Anticipated (expected) and unanticipated
(unexpected) inflation.
• Anticipated inflation is not a big problem economy adjusts automatically.
• Unanticipated inflation redistributes income
between :
• employers and employees
• lenders and borrowers
Phillips Curve
• Suggests an inverse relationship (or a trade-off)
between inflation and the unemployment rate
• Named after A W Phillips who originally discovered
the relationship between unemployment and nominal
wages, using British data in 1950s.
• In general, inflation is associated with economic
expansion and unemployment with economic
recession.
• During expansion : the greater the rate of growth of
AD - inflation is high - unemployment is low.
• During recession : the slower the rate of growth of AD
- inflation is low - unemployment is high.
The Phillips Curve
Annual rate of inflation
(percent)
7
6
5
4
3
2
1
0
1
2
3
4
5
6
7
Unemployment rate (percent)
Implications of Phillips Curve
• Trade-off suggests : a rise in inflation
should lead to a decline in unemployment,
and vice versa.
• In general, both can not be brought down to
the minimum level.
• The society must make a choice between
low inflation and low unemployment.
Inflation (%)
Phillips Curve in Australia
18
16
14
12
10
8
6
4
2
0
-2 0
1977
1983
1993
1970
2003
2
4
6
Unemployment (%)
8
10
12
Shifting Phillips Curve
• The smooth relationship may not be valid in
the long-run - Conflicts with the trade-offs
embodied in the Phillips Curve
• Vertical Phillips Curve - at full employment
level, only price level changes
• Simultaneous high and increasing
unemployment and inflation - may lead to
shifts in the curve
References
Macroeconomics - Jackson
Chapters : 5, 13 & 14