Unemployment and Inflation: Their role in economy and their relationship

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Macro-economics


Most of the nations of the world today have a free economy. A free economy is one which operates automatically. However, this automatic regulation of the economy is actually achieved by the price level. Price level can be defined as the weighted average of all the final goods and services produced in an economy. A healthy economy is characterized by a stable price level. Fluctuations in price level affect the economy’s real domestic output (RDO), unemployment and its growth. A high increase in price level can bring down a nation’s output by affecting the aggregate demand. It will lower total spending and increase the unemployment level. Similarly a decrease in price level will increase the real income of the masses, investment will increase and unemployment will fall. This decrease and increase in price level along with the fluctuations in unemployment, interest rates and output forms the business cycle that characterizes all market economies.


The BUSINESS CYCLE is an irregular and non-repeating up-and-down movement of business activity that takes place around a generally rising trend and that shows great diversity. It is also sometimes referred to as a trade cycle. A trade cycle can be Kitchin (-4 years), Medium Term (7-11 years) or Long-run (50-55 years).


The picture below illustrates a framework in which business cycle theories were often constructed. Starting at point T, the economy grew very rapidly in a self-feeding growth. Because of this self-feeding process, the economy would develop momentum. Once started, growth would continue until the system hit a limit or boundary that would stop it. The economy would then turn around and enter a contraction that was also self-feeding. This downswing would continue until a lower boundary was encountered, which would stop the contraction and start a new upswing i.e. expansion. Notice that the nd swing is always at a higher rate and the economy is never in equilibrium, but perpetually adjusting.


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Figure 1


Typically a business cycle is divided in four phases


• Depression


• Expansion


• Contraction


• Recession


DEPRESSION


Let us assume that the economy is in depression. Depression is defined as an unusually severe recession. This is when things are at their very worst and look as if theyll never get any better. Production is falling, incomes are falling, there are fewer jobs, and there are more unemployed workers. Pessimism and hardship are widespread. Firms try to survive as they can sell off the inventory on hand. More bankruptcies are observed, but the number and the size of the bankrupt firms are bottoming out. All prices, interest rates and wages are at their lowest. Unemployment is ubiquitous. The unemployed are ready to take any job. The contraction has run its course. The economy has reached its trough. In this phase the general price level has fallen to its lowest possible point. In fact, the prices are so low that they are not remunerative.


However this does not persist for a very long time and the recovery starts. Having sold off their inventories, companies start to place orders for new supplies. Thus, effective demand is created in some industries to replenish their inventories. This will mark the beginning of the expansion phase. Consumers have postponed some purchases and made do with cars or appliance by repairing them. But this has gone long enough, it is time to buy at least the indispensable; moreover credit is cheap. Families have saved up in hard times. As new investment begins the economy begins to prosper. Bank reserves are plentiful and bankers are eager to lend anew, even at very low rates. Interest rates are indeed so low that some company projects become attractive again. New sales are observed in all sectors. Companies start rehiring at the low wages first. New businesses are started. Bankruptcies are less noticeable. This is due to the combined effect of the accelerator and the multiplier as proposed by the real theory of trade cycle.


Accelerator and Multiplier Effects


a) The multiplier effect


There is a relationship between investment and consumption. New investments have what is called a multiplier effect�that is, investment money paid to wage earners and suppliers becomes income to them and then, in turn, becomes income to others as the wage earners or suppliers spend most of their earnings. An expanding ripple effect is thus set into motion.


b) The accelerator effect


This principle says that small changes in consumer spending can cause big percentage changes in investment. The accelerator model is based on the truism that, if the capital/output ratio is held constant, an increase in output can only be achieved though an increase in the capital stock. Firms need a given quantity of capital to produce the current level of output. If the level of output changes, they will need more capital. This change in capital will be given by the equation


Change in capital = accelerator � change in output


But firms can only increase their capital stock by (positive) net investment.


Net investment = accelerator � change in output


Thus,


Accelerator = Change in Capital/Change in Output


The accelerator thus depends on capital-output ratio. It played a role in many business-cycle theories and is still used today to explain some of the fluctuation in investment. According to this principle, an increasing level of income spent by consumers has an accelerating influence on investment. Higher demand creates greater incentive to increase investment in production, to meet that demand. This increase in investment would in turn further increase the income and spur the economy.


Combined effect of multiplier and accelerator


This combined effect of the accelerator and the investment multiplier helps the economy to quickly move from depression to expansion. Both of these factors also can work in a negative way, with reduced investment greatly diminishing aggregate income, and reduced consumer demand decelerating the amount of investment spending.


However to remove depression, the accelerator and the multiplier can only come into play if investment is increasing. According to Keynes, the government can increase investment and remove depression by formulating the relevant fiscal and monetary policies.


Keynes’ analysis of depression


Keynes argued that if the aggregate demand is too low, governments should intervene to boost aggregate demand. According to him, there are two policy weapons they can use


Fiscal Policy


The fiscal policies are particularly useful for bringing an economy out of depression. It is where the govt. alters taxes and spending to control the aggregate demand. Faced with a recession, it should raise its spending and/or lower taxes. It can increase spending by investing in schools, hospitals etc. This money is injected in the economy and an accelerator-multiplier effect follows.


Govt. spending U or Taxes ͗ ͖ Injections Withdrawals ͖ National Income U


Monetary Policy


Now the government’s monetary policies regarding the supply of money bring the economy to its peak. The govt. alters the supply of money in the economy or manipulates interest rates. If it increases the supply of money, there would be more money available for spending in the economy. This would lead to a fall in interest rates and the aggregate demand would rise. However, Keynes deemed the monetary policy to be less effective than the fiscal policy since some of the extra money could be used for speculating in paper assets rather than spending on real goods and services.


It is indeed most effective if both the policies are used together e.g. if the govt. invested in a new school (fiscal policy) and financed it through increases in money supply (monetary policy), there would be a significant rise in output an employment.


These policies, together with the multiplier-accelerator effect will push the economy to the expansion phase.


EXPANSION


In an economic expansion, businesses experience record sales and profits. They can hardly keep up with demand. In anticipation of a continued sales growth, inventories are built up and production facilities are expanded. This creates demand for suppliers of raw material and equipment. The equipment takes time to be built and installed. The demand-deficient or cyclical unemployment is fairly low. Banks are willing to lend given the bright predictions of continued cash flows. A large number of loan applications push banks to raise interest rates which companies can afford to pay. Companies find it difficult to hire all the employees they need, and are forced to pay higher wages, for instance, for overtime hours. But, that is not a serious problem in light of healthy sales and profits. Furthermore, a strong consumer demand justifies raising prices for many products. With higher wages, employees are still able to buy in spite of higher prices; moreover, anticipation of continued employment encourages them to use consumer credit if their income is insufficient. The overheating of the economy is evident in shortages of employees, materials, equipment, loanable funds and products. These shortages imply inflation. Because of difficulties in obtaining resources, this is no longer a good time to start a business even if sales appear encouraging. Prices, wages and interest rates continued rise puts eventually a stop to further expanding product demand, new hiring and new lending. The economy has reached its peak.


CONTRACTION


Now the economy moves on to the next phase i.e. contraction. Sales are no longer expanding. The economy starts slowing down. The slow down is mild at first. As sales stop increasing, inventories pile up. Companies can adjust to that by reducing orders for raw materials, avoiding overtime and resorting to sales promotions. Suppliers start to feel the pinch and are forced to lay off a few workers. These lay-offs are seen as a signal of potential hard times ahead. Employees prefer to set aside some wages, and reduce their consumption. Sales start to drop as consumer demand shies away. On the other hand, when the banks become conscious that their cash reserves are falling they stop further lending and start recalling their loans. Companies are now burdened by the loans they took out to install new equipment. Their profits shrink with decreasing revenues, still high employee salaries, and a large overhead. The hardest hit are the manufacturers of equipment who see their orders dwindle. Fewer and fewer businesses are started. Often, plans to open business are canceled. Some firms go out of business. Nervousness spreads in the economy, the pressure of sale increases and prices fall.


RECESSION


The slow down becomes a serious contraction i.e. recession. Surpluses are everywhere product inventories are bulging, excess capacity causes newly purchased equipment to turn idle, banks have loanable moneys that no project justifies, raw materials are not needed, and employees are too many. Lay-offs become widespread. Shrinking revenues force companies to replace full-time employees by lower paid part time and temporary workers (if labor unions do not intervene), or even to ask for wage concessions from the existing staff. Decreasing disposable income causes even more reduction in product demand. As output falls, inflation slows down, wages and prices of services are unlikely to fall but they tend to rise less rapidly in downturns. Revenues disappear and profits turn to losses. Businesses default on their loans. Highly leverages companies close down. These are bankruptcies of large operations. In turn, these bankruptcies can cause some banks to close as well. However, prices are only cut if recession becomes severe.


As discussed above, inflation is present in almost every phase of the business cycle. A fall in price level in recession is a very important indicator of depression. On the other hand, a high increase in inflation in the economy affects the total demand and total spending forcing the economy into recession. Let us now discuss the mechanism behind the fluctuations in the economy.


BUSINESS CYCLE THEORIES


There is no simple explanation for the causes of the business cycle. However, many theories have been proposed by economists to ascertain the source and mechanism of a business cycle. We can broadly divide the business cycle theories into two main categories


1. External theories


. Internal theories


EXTERNAL/EXOGENOUS THEORIES


These theories find the root of the business cycle in the fluctuations of factors outside the economic system. The 001-0 mild recession in United States brought about by the September 11 attacks is an example. Some of these theories are


• Sunspot Theory/Climatic Theory


• Political Theory


• War Theory


INTERNAL/ENDOGENOUS THEORIES


These theories look for mechanisms within the economic system itself that give rise to self-generating business cycles. This approach relies on the theory that a business cycle is accumulative in nature and that it feeds on itself. Every expansion breeds recession and contraction and vice versa. Some of the important internal theories are


• Keynesian Theory/ Psychological Theory


The Keynesian theory of the business cycle regards volatile expectations as the main source of economic fluctuations.


Keynesian Impulse


The impulse of the business cycle is a change in expected future sales and profits. This changes the level of investment in new capital. Keynes reasoned that news or rumors of future tax changes, interest rate changes, advances in technology; global economic and political events (for example) affect expectations and investment. It is often referred to as “animal spirits”.


The Keynesian Cycle Mechanism


It is caused by changes in expectations or “animal spirits” that change direction and set off a process that ends at equilibrium e.g. businessmen’s optimism increases investment during the depression and spurs the economy into the expansion phase.


• Monetarist Theory


This theory was proposed by Milton Friedman. The monetarist theory of the business cycle regards fluctuations in the money stock as the main source of economic fluctuations.


The Monetarist Impulse


The impulse in the monetarist theory of the business cycle is the growth rate of the quantity of money. A slowdown in the growth rate brings recession while a speedup brings expansion.


The Monetarist Cycle Mechanism


Once the central bank changes the money supply a cycle mechanism begins to work that first affects aggregate demand. An increase in the money supply leads to an increase in the quantity of real money, a fall in the interest rates fall, an increase in the real money balances increase. With this the investment demand and exports increase. These initial changes in expenditure have a multiplier effect and an expansion begins. Decreases in the money supply have similar, but opposite, effects. These increases and decreases in money supply explain the trade cycle.


• Equilibrium business cycle theories/ Rational Expectations theories


Some of the proponents of this theory include R.Lucas, R. Barro and T. Sargent. These theories are based on the view that money wages are determined by a rational expectation of the price level. There are two different rational expectations theories


1) New classical theory of the business cycle It regards unanticipated fluctuations in aggregate demand as the main source of economic fluctuation.


) New Keynesian Theory of the Business Cycle It is similar to the new classical theory, but also leaves room for anticipated demand fluctuations to play a role.


Rational Expectations Impulse


The impulse in the rational expectations theories is an unanticipated change in aggregate demand. A larger than anticipated increase in aggregate demand brings expansion. A smaller than anticipated increase in aggregated demand brings recession. Unanticipated impulses include fiscal policy, monetary policy, or a change in the world economy that influences exports can change real GDP. Also, believe that money wages are influenced by rational expectations of the price level.


Rational Expectations Cycle Mechanisms


This theory works on the belief that money wages are influenced by rational expectations of the price level. Firms and workers are unable to quickly adjust real money wages to changes in aggregate demand. This leads to sticky wages. In this way the aggregate demand is affected by the misperceptions. Aggregate demand less than expected brings recession. Aggregate demand greater than expected brings expansion


• Real Business Cycle Theory /Innovation Theory/ Schumpeter Theory


Real business cycle theory (RBC) regards random fluctuations in productivity as the main source of economic fluctuations. In this classical approach cycles are primarily caused by supply shocks and aggregate demand is unimportant for business cycles.


The RBC Impulse


The impulse in RBC theory is the growth rate in productivity Rapid technological progress and productivity growth will increase quickly, slow progress and productivity will grow more moderately.


The RBC Mechanism


Two immediate effects that follow a change in productivity that affect the business cycle are investment demand changes and changes in labor demand .e.g. a technology shock decreases investment which leads to fall in interest rate and increase in savings. This will move the economy into recession.


• Multiplier and accelerator model


This internal theory of the business cycle shows a mechanism in which an external shock tends to propagate itself throughout the economy. According to this model, rapid output growth stimulates investment. High investment stimulates more output growth, and the process continues until the capacity of the economy is reached at which point the economic growth rate slows. The slower growth in turn reduces investment spending and inventory accumulation, which tends to send the economy into a recession. The process then works in reverse until the trough is reached, and the economy stabilizes and turns up again.


• Supply Shocks


Supply shocks occur when business cycles are caused by shifts in aggregate supply e.g. the oil crises of the 70’s contracted the aggregate supply and brought the economy into the recessionary phase. Similarly favorable supply shocks in the 10’s brought prosperity in the US economy.


None of the internal or external theories can completely explain trade cycles simply because no two business cycles are alike. Summarizing the trade cycle


• Depression - Unemployment severe , Price level at lowest point


• Expansion - Unemployment at lowest point, Price level(inflation) highest


• Contraction - Unemployment increasing, Price level(inflation) high


• Recession - Unemployment rapidly increasing, Price level (inflation) slows down.


• Recession (severe) Unemployment severe , Price level decreasing


Thus the major issues facing an economy during any phase of a trade cycle remain inflation and unemployment. First, let us discuss unemployment, its types and its effect on economy.


Unemployment is very closely related to the business cycle. As well as experiencing fluctuations in unemployment, most countries have experienced an increase in average unemployment rates from one cycle to another. Unemployment occurs when people are actively looking for jobs but can’t find one. The most common definition of unemployed people is those of working ages who are without work, but who are available for work at current wage rates.


Measurement of unemployment


Unemployment is measured by the following formula


Unemployment rate = unemployed/ labor force 100


Before applying this formula its important to understand what is meant by the terms employed, unemployed and the labor force.


A person is employed if he or she spent most of the previous week working at a job--as opposed to keeping house, going to school, doing something else, et cetera.


A person is unemployed if they wanted to work during that previous week, but did not--because they were temporarily laid off, because they have been hired but their new job has not yet started, or because they were looking for work but did not find any.


The employed and the unemployed both make up the labor force. The people who are not included in the labor force are


• Children under 16


• Retirees


• Home-makers


• Mentally ill or retarded persons


• Full time students


• And even, idle people who simply do not want to work.





Figure


Figure shows the labor force break-up of the US economy.


Types of Unemployment


Unemployment can occur for different reasons. It can be categorized into four types


frictional, seasonal, structural and cyclical unemployment.


• Frictional Unemployment


Frictional unemployment broadly consists of two types of unemployment


Search unemployment i.e. workers who are searching for better jobs. At any given time some workers are between jobs. Some of them will be moving voluntarily from one job to another.


Wait unemployment i.e. workers waiting to take jobs in the near future. e.g. students who have just graduated or parents reentering the labor force after having children.


There are several points to notice about frictional unemployment. First, it is voluntary. No one is making workers quit their jobs to go find another job. Second, it is relatively short-term. Workers normally expect to be unemployed for a few weeks to perhaps a few months. Third, this type of unemployment is a good thing. Workers are unemployed because they are devoting their time to an activity that will improve their life. After a short time, they will be better off. Eliminating frictional unemployment would require that no person could move to a better job. Fourth, because there will be frictional unemployment, we would not even desire an unemployment rate of zero.


• Seasonal Unemployment


Some people are unemployed because of the season of the year. They have jobs in which one does not work part of the year. So, construction workers may be unemployed when the weather is especially poor. Lifeguards may not work in the winter. Teachers and ski instructors may not work in the summer. Workers who are unemployed because of the time of the year are called seasonally unemployed. Again, this type of unemployment is not a major problem. The season will change and these people will become employed again.


• Structural Unemployment


Structural unemployment occurs when the structure of the economy changes. The change in structure of the economy occurs for the following two reasons


1. A change in pattern of demand


Some industries experience declining demand. This may be due to change in consumer tastes. In the UK many industries that were once major employers have now all but disappeared. Shipbuilding and mining are prime examples of this sort of trend.


. A contraction of particular industries in particular areas


It is also referred to as regional unemployment. Migration of industries to suburbs outside the cities might force some workers living in the city to be unemployed for some time.


. A change in methods of production


It is also called technological unemployment. It occurs because technology has moved on and labor maybe substituted by machines. This is known as labor-saving technical progress. Examples include clerical workers, typists, inventory control clerks who have been made obsolete by a computer system.


The extent of structural unemployment will depend on various things


• Mobility of labor - if people are able to quickly switch jobs from a declining industry to a rapidly growing one, then there will be less structural unemployment.


• The pace of change in the economy - the faster the changes taking place in peoples tastes and demand and supply, the more structural unemployment there may be as industry has to adapt more quickly to change.


• The regional structure of industry - if industries that are dying are heavily concentrated in one area, then this may make it much more difficult for people to find new jobs. Both the shipbuilding and mining industries were heavily concentrated and some areas have taken many years to adapt and reduce the level of structural unemployment.


Nevertheless, structural unemployment tends to be longer than either frictional or seasonal unemployment and is a serious type of problem for the economy.


• Cyclical Unemployment


It is also known as demand-deficient or Keynesian unemployment after Keynes who saw a deficiency of aggregate demand as the cause of the high unemployment between the two world wars. Demand-deficient unemployment occurs when there is not enough demand to employ all those who want to work.


It is also often known as cyclical unemployment because it will vary with the trade cycle. When the economy is booming, there will be lots of demand and so firms will be employing large numbers of workers. Demand-deficient unemployment will at this stage of the cycle be fairly low. If the economy slows down, then demand will begin to fall. When this happens firms will begin to lay workers off as they do not need to produce so much. Demand-deficient unemployment rises. The behavior of demand-deficient unemployment will exactly mirror the trade cycle.


It is by far the most dangerous kind of unemployment because it is happens due to contraction in spending. It is most often associated with economic recessions.


COSTS OF UNEMPLOYMENT


The costs of unemployment are great and have a far-reaching effect on the economy and its people. For convenience we divide them into the following two categories


Economic Costs


The major economic costs of unemployment are listed below


• Loss of output to the economy The unemployed could be producing goods and services and if they arent, then GDP is lower than it could be. This is by far the single most important cost of unemployment. To explain this however, another concept must be introduced i.e. Natural Rate of Unemployment.


Natural Rate of unemployment


Frictional and structural unemployment are largely unavoidable in a dynamic economy, full employment is something less than 100 percent employment of the labor force. Actually, full employment represents the complete utilization of available resources. The rate of unemployment that prevails when the economy is at its full-employment level of output is called the natural rate of unemployment. We may define it as The long-term sustainable rate of unemployment within an economy. This rate will always exist due to frictional and structural unemployment. At the NRU, the economy is said to be producing its potential output. Natural does not however mean that the economy will always operate at this rate and thus realize its potential output. When cyclical unemployment occurs, the economy has much more unemployment than that which would occur at the NRU. This maybe explained by the following example illustrated by a graph showing the NRU of US economy


“Most economists estimate the natural unemployment rate to be 5 or 6 percent. If we take a 5 percent unemployment rate as our working definition of full employment, anything above 5 percent would be cyclical unemployment.


Frictional .5% (Natural)


Structural .5% (Natural)


5.0% (Full unemployment)


Cyclical 1.7% (Not natural)


Unemployment Rate 6.7%


The NRU in this example is 5% and the unemployment rate is 6.7%.”





After understanding the concept of natural rate of unemployment we return to the most important cost of unemployment i.e. loss of GDP.


GDP gap and Okun’s law Total production is measured by the Real Gross Domestic Product. The amount of production we need to have full employment is called Potential Real Gross Domestic Product. In other words, if the actual amount production were sufficient to create enough jobs so that the unemployment rate was 4%, that amount of production would be called Potential Real Gross Domestic Product.


The difference between the actual Real Gross Domestic Product and the Potential Gross Domestic Product is called the Gross Domestic Product (GDP) Gap.


GDP gap = Potential GDP � Real GDP The Real Gross Domestic Product (GDP) is the amount we actually produce. The Potential Gross Domestic Product (GDP) is our goal � the amount we would like to produce (to have full employment). The GDP Gap is the difference between where we are and where we would like to be. If we are below the goal (that is, if Real Gross Domestic Product is less than Potential Real Gross Domestic Product), the gap is called a recessionary gap. If we are above the goal (that is, if Real Gross Domestic Product is greater than Potential Real Gross Domestic Product), the gap is called an inflationary gap. This gap doesn’t indicate an increase in GDP, rather it shows an increase in total spending. These gaps can be more easily understood by considering the production possibilities curve.


A production possibilities curve gives the optimal output or potential output of the resources of the economy. Thus each point on the curve indicates a potential output. This also means that NRU can be anywhere on the production possibilities curve. Now suppose, there is a recession and therefore an increase in unemployment associated with a decrease in output, this results in more scarcity. This is not good for society since it will be producing at a point inside its production possibilities curve (point D in Figure ) or at a level of output short of the full employment level.





Figure - The Production Possibilities Curve


This example clearly indicates that relationship between the unemployment rate and the GDP gap. The higher the unemployment rate, the larger is the GDP gap.


Measurement of the loss of GDP due to unemployment


Arthur Okun was the first to measure this cost of unemployment by quantifying the relationship between the unemployment rate and the GDP gap. Briefly stated, the Okun’s law is


“For every 1% by which the unemployment exceeds the natural rate approximately a % GDP Gap occurs.”


Supposing the unemployment rate is 5%, if the GDP falls from the potential GDP of 6% to 4%, the unemployment rate would increase by 1% to 6%.


This law clearly shows how important it is to control unemployment.


• Loss of tax revenue Another major loss to the economy is that unemployed people arent earning and they therefore arent paying tax. The government has lost out.


• Increase in government expenditure The government has to pay out benefits to support the unemployed. Along with the loss of tax this is a double whammy.


• Loss of profits With higher employment firms are likely to do better and make better profits. If they make less profit because of unemployment, they may have fewer funds to invest.


• Reduction of potential income The longer the people remain unemployed, the more deskilled they tend to become, thereby reducing potential as well as actual income.


NON-ECONOMIC COSTS OF UNEMPLOYMENT


Unemployment can lower the quality of life of many people. Several studies have confirmed that the incidence of many diseases increases during times of high unemployment. Everything from mental illness, to suicide, cancer, heart attack, stroke, and even the common cold occur more often when unemployment is high. Studies have shown that high rates of unemployment are also associated with increased rates of alcohol and drug addiction, as measured by admission to rehabilitation programs. This may also contribute to the increase in health problems. Studies have shown that when unemployment rates rise, the number of automobile accidents increases. People are angry, they are not concentrating, and they may not be able to afford to properly maintain their automobiles. Studies have also shown that when unemployment rates rise, crime rates increase. This is true for all kinds of crime � from murder rates to burglary rates. Finally, studies have shown that high unemployment rates are associated with many aspects of family breakdown. Child abuse and spouse abuse (both physical and psychological) tend to rise as unemployment rates rise. This clearly indicates unemployment can have adverse effects on a nation. A demotivated, deskilled pool of long term unemployed is a serious economic and social problem.


Causes of Unemployment


There are many different possible causes of unemployment, and unfortunately for governments, it is never easy to identify which is the most important and what to do about it. The causes of unemployment can be split into two main types


1. Demand-side


. Supply-side


The first cause of unemployment (demand-side) is simply a lack of aggregate demand. When there isnt enough demand employers will not need as many workers, and so demand-deficient unemployment results. Keynesian economists in particular focus on this cause.


Unemployment caused by supply-side factors results from imperfections in the labor market. A perfect labor market will always clear and all those looking for work will be working - supply will equal demand. However, if the market doesnt clear properly there may be unemployment. This may happen because wages dont fall properly or are sticky downwards to clear the market. This is shown in the diagram below





Wages are initially too high and so unemployment of labor results equal to (a � b) in the figure (supply is greater than demand). To get rid of this unemployment and clear the market wages should fall. However, if they are sticky-downwards this may not happen and the unemployment may persist.


Supply-side unemployment may also happen because there is occupational or geographical immobility. It may happen because there is poor information about job opportunities. This will lead to people taking a long time looking for jobs, increasing the level of frictional or search unemployment.


One final cause of unemployment which tends to be discussed less but is no less important, is changes in the workforce. The workforce is made up of people who are of working age and not currently in full-time education. Their number will change with the demographic (age) structure of the population. If there is a baby-boom (a rapid increase in the birth rate ) then these people will become of working age between 16 and 1 years later. They then join the work-force. If there is the same number of people retiring from the work-force at the other end, then unemployment will stay the same. However, following a baby boom there are often more people joining the work-force than leaving. This may increase unemployment, unless there are enough extra jobs created to employ the extra people in the work-force. This was one of the causes of unemployment in the early 180s when people born in the baby-boom of the 160s joined the work-force.


From this exhaustive analysis of unemployment, let us move on to the nd major economic issue i.e. inflation.


Inflation is defined as a general increase in prices across the economy. Generally, we consider inflation to be a sustained rise in the average price level over a period of years.


This however does not mean that the prices of ALL the goods and services are increasing. When the overall price level is rising, the prices of some goods and services are going down [e.g., TV prices in the 170s and the 180s, the price of VCRs, and more recently the price of cellular phones].


However it must be noted that a rise or fall in inflation is not the same as a rise or fall in prices. A rise in inflation means a faster increase in prices. A fall in inflation means a slower increase in prices (but still an increase as long as inflation is positive).


Measurement of Inflation


Inflation is measured by Consumer Price Index (CPI), a convenient measure through which the rate of inflation for any given year can be calculated. The CPI is based on what it cost an average family to live.


The formula for calculation of the rate of inflation is


Rate of inflation = Current index � Previous index


---------------------------------------- 100


Previous index


The previous index is calculated for a base year, with which you want to compare inflation rates. This base year is usually free of major disturbances within the economy such as war, epidemic etc.


Rule of Seventy


This rule provides an easy shortcut to determine doubling time of inflation. It is a mathematical approximation which tells us that we can find the number of years its will take for some measure to double, given its annual percentage increase, by dividing that percentage increase into number 70. e.g. if the annual rate of inflation is 7% and we want to determine the no. of years in which this rate will double, we’ll simply divide the inflation rate into 70 i.e. 70/10 = 7. Thus, the rule of seventy tells us that it will take 7 years to double the current rate of inflation. This rule can also be used to determine the number of years it will take to double the growth rate.


Types of Inflation


1. Inertial inflation


Some kind of inflation always prevails in the economy. This inflation which is not being noticed, but exists, is called inertial inflation. It is also called core, underlying or expected inflation rate. This rate of inflation is expected and built into contracts and informal arrangements. It can persist for a long time but history shows that inflation does not remain undisturbed for a long time. Frequents shocks from changes in aggregate demand, sharp oil price changes etc. move inflation above or below its inertial rate. The major kinds of shocks are demand-pull and cost-push which follow.


. Demand-pull inflation


Changes in investment, govt. spending or net exports can change aggregate demand and propel output beyond its potential. When there is excessive demand for goods and services, we have demand-pull inflation. Demand-pull inflation is typically associated with a booming economy. This occurs when people are willing and able to buy more output than our economy can produce because our economy is already operating at full capacity. Demand-pull inflation is often summed up as “too many dollars chasing too few goods. But the question remains”Just where did all of this money come from”? Milton Friedman, a Nobel laureate in economics, suspects the rate of growth of the money supply as the primary source. Simply put, if there is more money in the economy there will be more spending. Friedman belongs to the category of economists who attribute the rises in aggregate demand entirely on the money supply called the monetarists.


Other economists do not blame the rise in aggregate demand on money supply and argue that demand-pull inflation may well occur without any increase in money supply.


Now let us analyze the effects of demand-pull inflation on the supply curve.


Keynesian Range


In the Keynesian range, the output produced in economy is much lower as compared to the potential output i.e. the output at the full-employment level. In this range, the unemployment levels are high and there is much idle production capacity.


If the demand increases, because of, say, a decrease in the income taxes there’ll be an increase in total spending, increase in the real GDP and a fall in the unemployment level. However, the prices wont be affected because the economy is in the Keynesian range.





Intermediate Range


If there is further increase in the total output the economy would enter in the intermediate range. In this range firms will increase production to meet higher demand. But this may only be possible by incurring higher costs.


As the real GDP increases, there will be an increase in the prices as well. The reason for this increase in prices is that firms have consumed all of their idle capacity and are moving towards potential output so to increase their output, the prices must also rise and cause per-unit production cost to increase.





Classical Range


If the total spending increases above the full-employment level then the economy is in the classical range. All the firms are operating at full-employment level in this range. They cannot increase their real output beyond this point. Any increase in demand will lead to a further increase in the price levels which might lead to hyper-inflation i.e. a very high increase in the general price level.


It is important to note that we have illustrated a single increase in demand or a demand shock. The effect is to give a single rise in the price level. Although this causes inflation in the short run, once the effect has taken place inflation will fall back to zero. Thus we have only discussed demand-pull inflation in the short run.


Policies to control Demand-pull inflation


There are two types of demand-side policies


• Fiscal Policy � Fiscal policy involves altering government expenditure and/or taxation Aggregate demand can be reduced by cutting government expenditure or by raising taxes and hence reducing consumer expenditure. These are both examples of deflationary fiscal policy.


• Monetary Policy � Monetary policy involves altering the supply of money in the economy or manipulating the rate of interest Tee govt. can reduce aggregate demand (a deflationary monetary policy) by reducing the money supply, thereby making less money available for spending, or by putting up interest rates and thus making borrowing more expensive. If people borrow less, they will spend less.


Cost-push inflation


This type of inflation is caused by persistent rises in costs of production (independently of demand). Inflation resulting form rising costs during periods of high unemployment and slack resource utilization is called cost-push inflation.


There are three variants of cost-push inflation


� The wage-price spiral


� Profit-push inflation


� Supply-side cost shocks/Import price-push inflation


The wage-price spiral


� Wages constitute nearly two-thirds of the cost of doing business


� Whenever workers receive a significant wage increase, this increase is passed along to consumers in the form of higher prices


� Higher prices raise everyone’s cost of living, engendering further wage increases


Profit Push


� Because just a handful of firms dominate many industries, they have the power to administer prices rather than accept the dictates of the market forces of supply and demand


� To the degree that they are able, these firms will respond to any rise in cost by passing them on to their customers


Supply- Side Cost Shocks/ Import Price-Push Inflation


� Finally, we have supply-side shocks, most prominently the oil price shocks of 17-74 and 17


• OPEC nations raised the price of oil


• When the price of oil rises, the cost of making many other things rise as well


� Cost increases are quickly translated into price increases


Additional causes of cost-push inflation include


• Tax- push inflation � Increased taxation adds to the cost of living.


• Exhaustion of natural resources � Depletion of major natural resources such as pollution of seas due to oil-spillage.


The theory of cost-push inflation explains rising prices in terms of factors that raise per-unit production cost at each level of spending. Rising per-unit production cost squeeze profits and reduce the amount of output firms are willing to supply at the existing price level. This reduces the economy’s supply of goods and services and the price level rises. In short, increasing costs are pushing price level upward.


Policies to control Cost-Push inflation


The aim here is to reduce the rate of increase in costs. This will help reduce leftward shifts in the aggregate supply curve. This can be done either by restraining monopoly influences on prices and incomes (e.g. policies to restrict the activities of trade unions), or by designing policies to increase productivity (e.g. giving various tax incentives). The govt. may also control cost-push inflation by encouraging an appreciation of currency or reducing indirect taxation.


Deflation


It can be termed as the opposite of inflation. Deflation indicates that the prices are going down.


Disinflation


It occurs when the RATE of inflation declines.


Stagflation


It exists in the economy when it is facing stagnation i.e. unemployment and rise in prices simultaneously. It occurs when the economy is in deep depression, in the Keynesian range of the aggregate supply curve. There’ll be shortage of goods and unemployment will rise. Prices will also rise because factories are being closed and goods are insufficient. However, some kind of demand exists e.g. of consumer goods, and the lack of goods increase the prices.





Four strains of inflation


Inflation displays different levels of severity


• Low inflation/Mild inflation - In low inflation the prices rise very slowly. There is a single-digit annual inflation rate. When prices are relatively stable people trust money. They are willing to hold onto money because it will be almost as valuable in a month or a year as it is today. People are willing to write long-term contracts in money terms because they are confident that the relative prices of goods they buy and sell will not increase they will remain stable.


• Zero inflation � It leads to the growth of the economy. However, some critics say that this sort of inflation will not adjust the nominal wages with real wages.


• Galloping inflation � Inflation in the double or triple digit range is called galloping inflation. Once galloping inflation become entrenched, serious economic distortions occur. Money loses its vale very quickly so people hold only the minimum amount of money that is needed for daily transactions. People never lend money on low nominal interest rate and financial markets wither away.


• Hyperinflation � It is an extremely rapid inflation whose impact on real output and employment usually is devastating. It usually arises when governments attempt to obtain extra revenue by printing money. When inflation begins to escalate, consumers, workers and businesses assume that it will rise even further. Eventually prices rise so rapidly that the monetary system breaks down, people would rather deal in barter terms, real GDP begins to fall, the economy loses the benefits of the division of labor and in the end the currency becomes worthless.


COSTS OF INFLATION


• Debtors benefit from unanticipated inflation


They get to repay their loan in dollars that are worth less than the dollars they borrowed. The biggest debtor and gainer from unanticipated inflation is always the government as it finds that people are paying more taxes.


• Creditors, the people who lend out money, are hurt by unanticipated inflation


The ultimate creditors, or lenders, are the people who put their money in banks, life insurance, or any other financial instrument paying a fixed rate of interest


• People who live on fixed incomes, particular retired people who depend on pensions (except Social Security) and those who hold long-term bonds, are hurt by unanticipated inflation.


However, when inflation is fully anticipated there are no winners and losers. Creditors have learned to charge enough interest to take into account, or anticipate, the rate of inflation over the course of the loan. This is tacked onto the regular interest rate that the lender would charge had no inflation been expected.


• From the demand- pull side


If there is a demand-pull inflation in the vertical or classical range of the AS curve, this would lead to serious consequences for the economy. Hyperinflation might take place because the demand is increasing and the economy has reached its full potential.


• From the cost-push side


If there’s an increase in cost of production, there’ll be increase in price level. This in turn will affect the aggregate demand. The fall in aggregate demand will lead to a fall in GDP and lower spending, accompanied by a rise in unemployment level.


So far we have only discussed the demand-pull inflation and cost-push inflation in the short run. However, the real cost of inflation can only be determined if the effects of demand-pull and cost-push inflation are studied in the long run.


THE EXTENDED AS-AD MODEL


In order to understand the effects of inflation in the long run, lets first analyze the long run aggregate demand (AD) and aggregate supply (AS) curves in the long run through the extended AS-AD model.


SHORT-RUN AND LONG-RUN AGGREGATE SUPPLY


Short Run


It is the period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases.


Causes of fixed nominal wages


Workers may not immediatel y be aware of the extent that inflation or deflation has changed their real wages, and thus they may not adjust their labor supply decisions and wage demands accordingly.


Many employees are hired under fixed-wage contracts. For unionized employees their prospective wages are set for years. Other professionals too have annual contracts.


For the reasons mentioned above, price- level changes don’t immediately give rise to changes in nominal wages in the short run.


The short period can also be explained with the help of a graph. In this graph, only the intermediate range of the AS curve has been considered. In the short run, nominal wages a re fixed and based on price level P1 and the expectation that it will continue. An increase in the price level from P1 to P increases profits and output moving the economy from a1 to a; a decrease in the price level from P1 to P reduces profits and real output, moving the economy from a1 to a. The short run aggregate supply curve therefore slopes upward.





Long Run


It is the period in which nominal wages are fully responsive to previous changes in the price level. Let us illustrate this by a graph. Suppose that the economy is initially at point a1 (P1 and QF). When the price level will increase from P1 to P, the labor will press for higher nominal wages. The prices of the inputs will also increase which will lead to a rise in cost of production. In the long run the workers will realize that their real wages have declined because of this increase in the price level. They restore their previous level of real wages by gaining nominal wage increases. This will shift the supply curve leftward to AS which now reflects the higher price level P. The leftward shift in the short urn aggregate supply curve to AS moves the economy from a to b1. Real output falls back to its full employment level Qf and the unemployment rate rises tot its natural rate. Conversely, a decrease in the price level reduces nominal wages and shifts the short urn aggregate supply curve to the right. After such adjustments, the economy obtains equilibrium at points such as b1 and c1. Tracing a line between these points will give us the vertical longer un supply curve. After long run adjustments in nominal wages, real output is Qf regardless of the specific price level.


Long run equilibrium


In the long run equilibrium, the aggregate demand will be qual to the short run supply as well as the long run supply curve.





With this detailed discussion of the AS-AD model let us now move to our main topic i.e. Demand pull nad cost push inflation in the long run.


Demand pull inflation in the Extended AS- AD model


An increase in the aggregate demands from AD1 to AD drives up the price level and increase real output in the short turn. But in the long run, nominal wages rise and short run aggregate supply curve shifts leftward, as from AS1 to AS. Real output then returns to its prior level, and the price level rises even more. In this scenario, the economy moves form a to b and then eventually to c.





Cost push inflation in the extended AS-AD model


Cost push inflation occurs when the agg. Supply curve shifts leftward, as from AS1 to AS . If govt. counters the decline in real output by increasing agg. demand to the broken tine, the price level rises even more. That is, the economy moves in steps from a to b to c. In contrast if the govt. allows a recession to occur, nominal wages, eventually fall and the agg. Supply curve shifts back rightward to its original location. The economy moves from a to b and then eventually back to a.





The inflation-unemployment relationship


In 158, the well known economist A. W. H. Phillips, discovered a relationship between unemployment and inflation � The Phillips curve. The relationship was first published in an article in the academic journal ‘Economica�. Phillips� research was focused on the economic statistics between 1861 and 157. He looked at the rate of change in ages, and the level of unemployment. He found a stable, inverse relationship between these two variables. A conventional Phillips curve is shown in the diagram below.





We can give the following three propositions regarding the relationship between unemployment and inflation.


• Normally, there is a short-run trade-off between the rate of inflation and the rate of unemployment


• Aggregate supply shocks can cause both higher rates of inflation and higher rates of unemployment


• There is no significant trade-off over long periods of time


Let us discuss these three points in detail


The short run Phillips curve


The Phillips curve explains that in the short run there is a trade off between unemployment and inflation. Let us consider the following graph. From the graph we see that as we increase the agg. Demand, the price level and the RDO also increases. The level of employment also increases with the increase in RDO in the short run. But this increase in employment has occurred only at the higher rate of inflation.


Comparing the effects for various possible increases in agg. demand leads to the conclusion that the larger the increase in agg. demand, the higher the rate of inflation and the greater the increase in real output. Because real output and the unemployment rate move in the opposite directions, we can generalize that given short run agg. Supply, high rates of inflation should be accompanied by low rates of unemployment.





Aggregate supply shocks and Phillips curve


When agg supply decreases i.e. supply shocks occur, the output decreases and the price level increases. Thus unemployment reate and inflation both increase. To control this the expansionary fiscal and monetary policy is used. That is increasing the demand at this point will increase the RDO and thus decrease the unemployment but only at a higher price level.


On the contrary, restrictive fiscal and monetary policy will lead to lower level of inflation but at the cost of higher unemployment.


The long run Phillips curve


Let us consider the following graph in which the Phillips curve has been modified for simplicity . We’ll be interested in increasing the agg. Demand to bring down the level of unemployment, but the inflation rate will rise. When the actual rate of inflation will increase as compared to the expected rate of inflation, the increase in demand, the profits of the firm will increase. The prices have increased so the purchasing power of the labor will decrease. They would then like to increase their real wages. Their nominal wages had increased. When their nominal wages will coincide with the new rate of inflation, the NRU will fall back to 5%. The short run Phillips curve will be shifted to the right.


Now, if there’s a further increase in agg. Demand the things above will be repeated. The nominal wages will again rise to a point when they’ll coincide with the new rate of inflation and NRU will again be maintained at 5%., at another point a. Now if points A and D are joined, we’ll obtain the long run vertical Phillips curve.


In short, increases in aggregate demand beyond those consistent with full-employment output may temporarily boost profits, output, and employment. But nominal wages eventually will catch up so as to sustain real wages. When they do, profits will fall, negating the previous short-run stimulus to production and employment. Consequently, there is no tradeoff between the rates of inflation and unemployment in the long run, that is, the long-run Phillips Curve is roughly a vertical line of the economy’s natural rate of unemployment.








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