Transcript Chapter 7 PPT

Chapter 7
The Anatomy of Inflation
and Unemployment
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
1
Chapter Organisation
7.1 Unemployment
7.2 Inflation
7.3 The Anatomy of Unemployment
7.4 Full Employment
7.5 The Costs of Unemployment
7.6 The Costs of Inflation
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
2
Chapter Organisation
7.7 Inflation and Indexation: InflationProofing the Economy
7.8 Is a Little Inflation Good for the
Economy?
7.9 The Prices and Incomes Accord
7.10 Political Business Cycle Theory
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
3
Chapter Organisation
7.1 Unemployment
7.2 Inflation
7.3 The Anatomy of Unemployment
7.4 Full Employment
7.5 The Costs of Unemployment
7.6 The Costs of Inflation
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
4
7.1 Unemployment

The largest cost of unemployment is lost
production

Okun’s law suggests that every extra 1% of
unemployment costs around 1.5% of GDP

The costs of unemployment are borne
unevenly with the most vulnerable being
 Workers just entering the labour force
 Teenagers
 Unskilled workers
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
5
7.2 Inflation
If inflation is extremely high money stops
being a useful medium of exchange
 The costs of low inflation are more difficult
to identify
 Unexpected inflation has a distributional
cost

 debtors benefit by repaying in cheaper real
money terms
 creditors suffer by being repaid in cheaper real
money terms
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
6
Chapter Organisation
7.1 Unemployment
7.2 Inflation
7.3 The Anatomy of Unemployment
7.4 Full Employment
7.5 The Costs of Unemployment
7.6 The Costs of Inflation
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
7
7.3 The Anatomy of
Unemployment

An unemployed person is defined as:
someone who is out of work and actively
seeking work
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
8
7.3 The Anatomy of
Unemployment

Key characteristics of unemployment in
Australia
 Unemployment has increased dramatically
since the mid-1970s
 There are large variations in unemployment
rates across different age, race and
educational attainment groups
 Cyclical changes have involved sharp increases
and slow reductions in the unemployment rate
 A large proportion of those unemployed are
classified as long-term unemployed
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
9
The Unemployment Pool
At any point in time, there is a given
number of unemployed people
 Over time there are flows into and out of
this unemployment pool
 Reasons why a person may be unemployed

 A new entrant into the labour force
 A person quits their job to look for other
employment
 A person is fired or the firm closes down
 A person may be laid off
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
10
The Unemployment Pool

Reasons why a person may leave the
unemployment pool
 A person may be hired into a new job
 Someone laid off may be reinstated
 An unemployed person may stop looking for a
job and leave the labour force

Variations in unemployment across groups
 Teenagers and indigenous Australians have
higher levels of unemployment rates
 Female unemployment was higher then males
until the early 1990s
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
11
Frictional, Structural and Cyclical
Unemployment

Frictional unemployment is
 unemployment due to the job-searching
process

Structural unemployment is
 unemployment due to problems associated
with matching the available job opportunities
with the skills and abilities available among the
unemployed

Cyclical unemployment is
 unemployment that occurs when output is
below the full-employment level
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
12
Frictional, Structural and Cyclical
Unemployment

Change in Unemployment (U)
U = EU + NU - UE - UN
Where N is ‘not in labour force’, E is ‘employed’
and U is ‘unemployed’. This defines the flows:
 EU is ‘employed to unemployed’, NU is ‘not in
labour force’ to unemployed’ and so on

Duration of unemployment is
The average length of time a person remains
unemployed
The duration of unemployment in Australia has
increased dramatically since 1980
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
13
Chapter Organisation
7.1 Unemployment
7.2 Inflation
7.3 The Anatomy of Unemployment
7.4 Full Employment
7.5 The Costs of Unemployment
7.6 The Costs of Inflation
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
14
7.4 Full Employment

Determinants of the Natural Rate of
Unemployment (NRU)
 The duration of unemployment and frequency
of unemployment affects the NRU

Factors affecting the duration of
unemployment
 Organisation of the labour market, including
employment agencies
 Demographic make-up of the labour force
 Availability of unemployment benefits
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
15
The Natural Rate of
Unemployment (NRU)

Frequency of unemployment
 Average number of times, per period, that
workers become unemployed

Determinants affecting frequency of
unemployment
 Variability of demand for labour across
different firms in the economy
 The greater the variability, the greater the
unemployment rate
 The rate at which new entrants enter the
labour force (LF)
 The faster the LF growth, the greater the NRU
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
16
The Non-Accelerating Inflation
Rate of Unemployment (NAIRU)
The NAIRU is an alternative concept of the
NRU
 It measures the unemployment rate at
which inflation is neither accelerating or
decelerating
 It derives from the Phillips curve where

 The rate of unemployment is that level where
the actual and expected inflation rates are
equal and constant

Estimates of the NAIRU are imprecise
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
17
Estimates of the NRU

Estimates of the NRU in Australia have
changed over time from 2% in the 1960s
 to 6% in the early 1980s
 to 7.5% in the early 1990s

The variation in Australia in the NRU
 is similar to that in Europe
 much larger than for the United States

There is no official estimate of the NRU
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
18
Estimates of the NRU

Equation (7.1) for the natural rate
u *  w1u1*  w2u2*  ...  wnun*
shows it as the weighted average of the
natural rates of unemployment of the
subgroups in the labour force
 Two factors affect the NRU

 Changes in the composition of the labour force
(i.e. the w weights)
 Changes in the natural rates for the different
subgroups (i.e. the u* for each group)
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
19
Hysteresis and the Rising NRU
Hysteresis claims that extended periods of
high employment raise the NRU
 How does hysteresis raise the NRU?

 The unemployed might be accustomed to not
working
 Discouraged unemployed do not try so hard to
find a job
 Long-term unemployed might signal to firms the
possibility that they are undesirable
 Therefore, firms may not employ them
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
20
Reducing the NRU
The NRU can be reduced by removing
unemployment benefits
 Unemployment benefits increase the rate of
unemployment because

 It allows longer for job searching, increasing the
duration of unemployment
 It raises the reservation wage, which is the
wage at which a person receiving
unemployment benefits is willing to take a new
job
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
21
Chapter Organisation
7.1 Unemployment
7.2 Inflation
7.3 The Anatomy of Unemployment
7.4 Full Employment
7.5 The Costs of Unemployment
7.6 The Costs of Inflation
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
22
7.5 The Costs of
Unemployment

The Costs of Cyclical Unemployment
 Is output lost because the economy is not at
full employment
 According to Okun’s law, the Australian
economy loses about 1.5% of output for each
1% that the unemployment rate exceeds NRU

During the 1990–1992 recession
 The NRU was estimated to be 7.5%
 The actual rate of unemployment was 9.5%
 There was therefore a 3% loss in GDP worth
$13 billion
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
23
Costs of Unemployment

Distributional impact of unemployment
 Unemployment generally hits poor people
harder than it hits the rich
 Unemployment benefits partially spread the
burden of unemployment
 Other costs
 Society bears the additional cost of lost tax
revenue on top of the worker’s lost wages
 Increased criminal activity
 Health status
 Decreased ‘happiness’
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
24
Chapter Organisation
7.1 Unemployment
7.2 Inflation
7.3 The Anatomy of Unemployment
7.4 Full Employment
7.5 The Costs of Unemployment
7.6 The Costs of Inflation
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
25
7.6 The Costs of Inflation

Perfectly anticipated inflation

Inflation has no real costs if it is perfectly
anticipated and is built into contracts

There are two qualifications
1.The demand for currency falls because the
opportunity cost of holding currency (interest
forgone) increases with inflation
Individuals incur ‘shoe-leather’ costs because
they must make more frequent trips to the bank
2.There are ‘menu costs’ for people having to
devote resources to marking up prices
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
26
The Costs of Inflation

Imperfectly anticipated inflation introduces
risk
 If the contract has a set nominal price and
inflation is unexpectedly high
 then buyers pay less in real terms while the
seller receives less

Inflation changes the real value of assets
fixed in nominal terms
 In 2000 the price level in Australia was 7.5
times higher than in 1970
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
27
The Costs of Inflation

Who gains from imperfectly anticipated
inflation?
 The old are more vulnerable to inflation as
they own more nominal assets
 Unanticipated inflation benefits debtors at the
expense of creditors
 Capitalists benefit at the expense of workers
because prices tend to rise faster than wages
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
28
Chapter Organisation
7.7 Inflation and Indexation: InflationProofing the Economy
7.8 Is a Little Inflation Good for the
Economy?
7.9 The Prices and Incomes Accord
7.10 Political Business Cycle Theory
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
29
7.7 Inflation and Indexation:
Inflation-proofing the
Economy
Indexation ties the terms of the contract to
the behaviour of the price level
 Long-term loan contracts and wage
contracts are most affected by inflation
 Indexation removes

 the element of risk associated with inflation
 the wealth distribution effects of inflation
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
30
Inflation and Indexation

Indexation restricts the economy’s ability to
adjust to shocks
 Suppose that real materials prices increase
and firms pass this cost increase on through
higher prices
 Indexed wages rise because prices have
increased
 This leads to further price and wage increases
feeding an inflation spiral

Indexation increases transaction costs
associated with contract negotiations
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
31
Chapter Organisation
7.7 Inflation and Indexation: InflationProofing the Economy
7.8 Is a Little Inflation Good for the
Economy?
7.9 The Prices and Incomes Accord
7.10 Political Business Cycle Theory
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
32
7.8 Is a Little Inflation
Good for the Economy?
Tobin (1972): A small amount of inflation is
good
 It reduces the NRU by lowering real wages
without cutting nominal wages
 To cut real wages, firms must hold nominal
wage increases below the rate of inflation
 It is easy to increase real wages by
increasing nominal wages faster than prices

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
33
7.9 The Prices and
Incomes Accord

Prices and Incomes Accord (1983–93)
 Indexation to control nominal wage increases
while maintaining real wage levels
 Between 1983–90, real wage growth averaged
–1.1% per year
 However, during this period, employment grew
by 3% per year
 Labour costs were lower and strike activity
diminished markedly
 Unemployment stayed high around 7.8% due
to strong labour force growth
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
34
The Prices and Incomes Accord

Long-term affects of the Indexation
 Leads over time to inefficient resource
allocation
 Labour needs to reallocate to growth sectors
 Rapid reallocation of labour will only occur if
real wages are allowed to increase in growing
sectors relative to declining sectors
 Lack of flexibility in relative wages impinges on
long-run efficiency, productivity and economic
growth
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
35
Chapter Organisation
7.7 Inflation and Indexation: InflationProofing the Economy
7.8 Is a Little Inflation Good for the
Economy?
7.9 The Prices and Incomes Accord
7.10 Political Business Cycle Theory
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
36
7.10 Political Business
Cycle Theory

Political business cycle theory
 Studies the interactions between economic
policy decisions and political considerations
 Predicts that politicians use restrictive policies
early in their term, raising unemployment to
reduce inflation
 As the election approaches, expansionary
policy takes over to ensure falling
unemployment to gain voter approval
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
37
Political Business Cycle Theory

Arguments against the political business
cycle theory
 The government has a limited ability to
finetune the economy
 There are time lags associated with policy
implementation
 The government does not control the
independent RBA
 If expectations are rational, monetary policy
expansions staged for elections will have only
small real effects and mainly produce inflation
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
38