Principles of Economics

Session 13

Topics To Be Covered

Definition of InflationCategories of InflationClassical Theory of InflationDemand-Pull InflationCost-Push InflationImpacts of Inflation

Topics To Be Covered

Measuring UnemploymentCategories of UnemploymentVoluntary and Involuntary UnemploymentReasons for Above-Equilibrium WageImpact of UnemploymentOkun’s LawPhillips Curve

Inflation

Inflation is an increase in the overall level of prices.

The Inflation Rate

1001 Year in CPI

1 Year in CPI - 2Year in CPIYear2 inRate Inflation

The inflation rate is the percentage change in the price level from the previous period.

100GDP Real

GDP Nominal=Deflator GDP

Categories of Inflation

Low inflation is characterized by prices that rise slowly and predictably, usually by no more than 10% a year.

Galloping inflation is the rise of price level by double- or triple-digit a year.

Hyperinflation is inflation that exceeds 50 percent per month.

1975 1980 1985 1990 1995 2000-50

510

15

20

25

Inflation in China

Percentper Year

Hyperinflation

Germany

1

100 trillion

1 million

10 billion

1 trillion

100 million

10,000

100

19251924192319221921

Price level

Moneysupply

Poland

Money

supply

Price level

Index (Jan. 1921 = 100)

100

10 million

100,000

1 million

10,000

1,000

19251924192319221921

Index (Jan. 1921 = 100)

Classical Theory of Inflation

The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.

Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.

When the overall price level rises, the value of money falls.

Quantity ofMoney

Value ofMoney (1/P) Price

Level (P)Money supply

(High)

(Low)1

1.33

2

4

A

Moneydemand

Money Supply and Demand and Price Level

Eq

uili

bri

um

v

alu

e o

f m

on

ey

Eq

uilib

rium

p

rice lev

el

0

1

(Low)

(High)

1/2

1/4

3/4

Quantity ofMoney

Value ofMoney (1/P) Price

Level (P)

A

MS1

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4Moneydemand

Effects of Monetary Injection

M1

MS2

1. An increase in the money supply...

2. .

..de

cre

as

es

the

v

alu

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f m

on

ey

... 3

. …a

nd

increa

se

s th

e p

rice

lev

el

M2

B

Quantity Theory of Money

How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the

economy determines the value of money. The primary cause of inflation is the growth

in the quantity of money.

Velocity and Quantity Equation

The velocity of money refers to the speed at which the typical dollar bill travels around the

economy from wallet to wallet.

Velocity and Quantity Equation

V = (P x Y)/M

V = VelocityP = Price levelY = Quantity of outputM = Quantity of money

M x V = P x Y

Velocity and Quantity Equation

The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: the price level must rise,

the quantity of output must rise, or

the velocity of money must fall.

Quantity Theory of Money

The velocity of money is relatively stable over time.

When the central bank changes the quantity of money, it causes proportionate changes in the nominal value of output (P ×Y).

Quantity Theory of Money

When the central bank alters the money supply and induces parallel changes in the nominal value of output, these changes are also reflected in changes in the price level.

When the central bank increases the money supply rapidly, the result is a high rate of inflation.

Demand-Pull Inflation

The demand-pull inflation occurs when aggregate demand rises

more rapidly than the economy’s productive potential, pulling

prices up to equilibrate aggregate supply and demand.

Short-run AS2

AD2

AD1

Demand-Pull Inflation

Quantity ofOutput

PriceLevel

0

Short-run AS1

Long-run AS

Y1

In the long run, nominal wages rising causes AS to

decrease and the price level rises further.

AP1

An increase in AD increases the price level in the short

run

BP2

Y2

CP3

Cost-Push Inflation

The cost-push inflation originates on the supply side of markets from a sharp increase in costs.

The rise of Costs pushes AS upward and leads to a higher price level but a lower

output.

AS2

P2 B

Cost-Push Inflation

Quantity ofOutput

PriceLevel

0

Short-run AS1

AD1

Long-run AS

AP1

If the government fights the recession by increasing AD,

further inflation will occur.

P3 C

AD2

Impacts of Inflation

Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

Shoeleather Costs

Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings.

Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.

Shoeleather Costs Less cash requires more frequent trips to

the bank to withdraw money from interest-bearing accounts.

The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand.

Also, extra trips to the bank take time away from productive activities.

Menu Costs

Menu costs are the costs of adjusting prices.

During inflationary times, it is necessary to update price lists and other posted prices.

This is a resource-consuming process that takes away from other productive activities.

Relative-Price Variability

Inflation distorts relative prices. Consumer decisions are distorted,

and markets are less able to allocate resources to their best use.

Inflation-Induced Tax Distortion

Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.

With progressive taxation, capital gains are taxed more heavily.

Inflation-Induced Tax Distortion

The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.

The after-tax real interest rate falls, making saving less attractive.

Confusion and Inconvenience

When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.

Inflation causes dollars at different times to have different real values.

Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

Arbitrary Redistribution of Wealth

Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.

These redistributions occur because many loans in the economy are specified in terms of the unit of account – money.

Measuring Unemployment

Unemployment is measured by the Bureau of Labor Statistics (BLS). It surveys 60,000 randomly selected

households every month. The survey is called the Current Population

Survey.

Measuring Unemployment

Based on the answers to the survey questions, the BLS places each adult into one of three categories: Employed Unemployed Not in the labor force

Measuring Unemployment

The BLS considers a person an adult if he or she is over 16 years old.

A person is considered employed if he or she has spent most of the previous week working at a paid job.

A person is unemployed if he or she is on temporary layoff, is looking for a job, or is waiting for the start date of a new job.

Unemployed (6.2 million)

The Breakdown of the U.S. Population in 2000

Not in labor force

(67.5 million)

Employed(131.5 million)

Labor force(137.7 million)Adult

population (205.2 million)

Measuring Unemployment

The unemployment rate is calculated as the percentage of the labor force that is unemployed.

100force Labor

unemployed Number=rate ntUnemployme

Measuring Unemployment

The labor-force participation rate is the percentage of the adult population that is in the labor force.

100population Adult

force Labor=rate ionparticipatforce -Labor

Unemployment Rate Since 1960

10

8

6

4

2

1970 1975 1980 1985 1990 1995

Percent of

Labor Force

Natural rate ofunemployment

19651960 2000

0

Unemployment rate

100

80

60

40

20

01950 1955 1960 1965 1970 1975 1980 1985 1990 1995 ’98

Lab

or-

forc

e

Part

icip

ati

on

Rate

(in

p

erc

en

t)Labor-force Participation Rates

for Men and Women

Men

Women

Categories of Unemployment

Natural unemployment

Cyclical unemployment

Frictional unemployment

Structural unemployment

Natural Rate of Unemployment

The natural rate of unemployment (lowest sustainable unemployment rate, LSUR) is unemployment that does not go away on its own even in the long run.

It is the amount of unemployment that the economy normally experiences.

Cyclical Unemployment

Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate.

It occurs during recession as a result of an imbalance between AS and AD.

Frictional Unemployment

Frictional unemployment arises from the incessant movement of people between regions and jobs or through different stages of the life cycle.

It is often thought of as voluntary unemployment.

Structural Unemployment

Structural unemployment results from the regional or occupational pattern of job vacancies does not match the pattern of worker availability.

Government should offer some training programs to the unemployed.

Voluntary Unemployment vs.Involuntary Unemployment

Voluntary unemployment is a situation in which individuals are unemployed because they perceive the value of wages to be less than the opportunity use of time, say in leisure.

The vast majority of people don’t think the theory of voluntary unemployment can hold water.

Employment

A

Voluntaryunemployment

F

Voluntary Unemployment vs.Involuntary Unemployment

Labor0

WageLabor

supply

Labor demand

W*

E

Voluntary Unemployment vs.Involuntary Unemployment

Labor0

Wage

Labor demand

W*

Labor supply

E

Voluntaryunemployment

K

Involuntaryunemployment

J

Employment

HGW**

Three Possible Reasons for an Above-Equilibrium Wage

Minimum-wage laws Unions Efficiency wages

Minimum-Wage Laws

When the minimum wage is set above the level that balances supply and demand, it creates unemployment.

Unemployment from a Wage Above the Equilibrium Level

WE

Quantity of Labor

LE0

Labordemand

Wage

Surplus of labor = Unemployment

Minimum wage

LD LS

Laborsupply

Unions and Collective Bargaining

A union is a worker association that bargains with employers over wages and working conditions.

In the 1940s and 1950s, when unions were at their peak, about a third of the U.S. labor force was unionized.

A union is a type of cartel attempting to exert its market power.

Unions and Collective Bargaining

A strike makes some workers better off and other workers worse off.

Workers in unions (insiders) reap the benefits of collective bargaining, while workers not in the union (outsiders) bear some of the costs.

Unions and Collective Bargaining

By acting as a cartel with ability to strike or otherwise impose high costs on employers, unions usually achieve above equilibrium wages for their members.

Union workers earn 10 to 20 percent more than nonunion workers.

Are Unions Good or Bad

Critics argue that unions cause the allocation of labor to be inefficient and inequitable. Wages above the competitive level reduce

the quantity of labor demanded and cause unemployment.

Some workers benefit at the expense of other workers.

Are Unions Good or Bad

Advocates of unions contend that unions are a necessary antidote to the market power of firms that hire workers.

They claim that unions are important for helping firms respond efficiently to workers’ concerns.

Theory of Efficiency Wages

Efficiency wages are above-equilibrium wages paid by firms in order to increase worker productivity.

The theory of efficiency wages states that firms operate more efficiently if wages are above the equilibrium level.

Theory of Efficiency Wages

A firm may prefer higher than equilibrium wages for the following reasons: Worker Health: Better paid workers eat a

better diet and thus are more productive.

Worker Turnover: A higher paid worker is less likely to look for another job.

Theory of Efficiency Wages

A firm may prefer higher than equilibrium wages for the following reasons: Worker Effort: Higher wages motivate

workers to put forward their best effort.

Worker Quality: Higher wages attract a better pool of workers to apply for jobs.

Impact of Unemployment

Economic ImpactUnemployment is a waste of natural resources.

Social ImpactThe unemployed suffer psychologically and physically.

Okun’s Law

Okun’s Law is an empirical relationship, discovered by Arthur Okun, between cyclical movements in GDP and unemployment.

)( 11 tttt YYUU

Okun’s Law

Okun estimates that when actual GDP declines 3 percent relative to potential GDP, the unemployment rate increases by about 1 percentage point.

a = 3

However, recent studies show that:

a = 2

3

2

1

0

-1

-2

-1-2 0 1 2 3 4 5 6 7 8-3-3

Okun’s Law

Percentage Change in Real GDP

Perc

en

tag

e C

han

ge

in U

nem

plo

ym

en

t

Unemployment and Inflation

The natural rate of unemployment depends on various features of the labor market.

The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.

The misery index, one measure of the “health” of the economy, adds together the inflation rate and unemployment rate.

Unemployment and Inflation

Society faces a short-run tradeoff between unemployment and inflation.

If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation.

If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

The Phillips Curve

The Phillips curve illustrates the short-run relationship between inflation and unemployment.

The Phillips Curve

Unemployment Rate

(percent)

0

Inflation Rate

(percent per year)

6

B6

Phillips curve

A5

8

AD, AS, and the Phillips Curve

The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand

curve move the economy along the short-run aggregate supply curve.

AD, AS, and the Phillips Curve

The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.

A higher level of output results in a lower level of unemployment.

Phillips Curve and AD-AS Model

Phillips curve

0

The Phillips Curve

Inflation Rate

(percent per year)

Unemployment Rate (percent)0

The Model of AD and AS

Price Level

Low AD

High ADB

6

6

(output is 7,280)

A

8

5

(output is

7,000)

A

7,000

105

(unemployment is 8%)

B

7,280

106

(unemployment is 6%)

Short-run AS

Shifts in the Phillips Curve: The Role of Expectations

The Phillips curve seems to offer policymakers a menu of possible

inflation and unemployment outcomes.

The Long-Run Phillips Curve

In the 1960s, Friedman concluded that inflation and unemployment are unrelated in the long run.

As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.

Monetary policy could be effective in the short run but not in the long run.

The Long-Run Phillips Curve

Unemployment Rate0 Natural rate of

unemployment

Inflation Rate Long-run

Phillips curve

BHigh

inflation 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases…

2. … but unemployment remains at its natural ratein the long run.ALow

inflation

Natural rate of unemployment

Long-run Phillips curve

0

The Phillips Curve

Inflation Rate

A

Natural rate of output

0

P1

Aggregate demand, AD1

Long-run aggregate supply

The AD-AS Model

Price Level

4. …but leaves output and unemployment at their natural rates.

How the Phillips Curve is Related to the AD-AS Model

P2

2. …raises the price level…

Quantity of Output

Unemploy-ment Rate

1. An increase in the money supply increases aggregate demand…

AD2

B

3. …and increases the inflation rate…

Expectations and the Short-Run Phillips Curve

Expected inflation (inertial inflation) measures how much people expect the overall price

level to change.

Expectations and the Short-Run Phillips Curve

In the long run, expected inflation adjusts to changes in actual inflation.

The Fed’s ability to create unexpected inflation exists only in the short run. Once people anticipate inflation, the only

way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.

Expectations and the Short-Run Phillips Curve

This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation.

How much is a for the USA?

2.

Unemployment Rate

= Natural rate of unemployment

Actual Expected inflation inflation

-(a- )

How Expected Inflation Shifts the Short-Run Phillips Curve

Unemployment Rate

0 Natural rate of unemployment

Inflation Rate

B

Long-run Phillips curve

A

C

2. …but in the long-run, expected inflation rises, and the short-run Phillips curve shifts to the right.

Short-run Phillips curve with high expected inflation

Short-run Phillips curve with low expected inflation

1. Expansionary policy moves the economy up along the short-run Phillips curve...

The Cost of Reducing Inflation

To reduce inflation, the Fed has to pursue contractionary monetary policy.

When the Fed slows the rate of money growth, it contracts aggregate demand.

This reduces the quantity of goods and services that firms produce.

This leads to a rise in unemployment.

A

Short-run Phillips curvewith high expected

inflation

1. Contractionary policy moves the economy down along the short-run Phillips curve...

UnemploymentRate

0 Natural rate ofunemployment

InflationRate Long-run

Phillips curve

CB

Short-run Phillips curvewith low expected

inflation

2. ... but in the long run, expected inflation falls and the short-run Phillips curve shifts to the left.

Disinflationary Monetary Policy

The Cost of Reducing Inflation

To reduce inflation, an economy must endure a period of high unemployment and low output. When the Fed combats inflation, the

economy moves down the short-run Phillips curve.

The economy experiences lower inflation but at the cost of higher unemployment.

Unemployment of China

Year Number (million

Rate (%)

Year

Number (Million)

Rate (%)

1978 5.30 5.3 1991 3.52 2.3

1983 2.71 2.3 1992 3.64 2.3

1984 2.36 1.9 1993 4.20 2.6

1985 2.39 1.8 1994 4.76 2.8

1986 2.64 2.0 1995 5.20 2.9

1987 2.77 2.0 1996 5.53 3.0

1988 2.96 2.0 1997 5.70 3.1

1989 3.78 2.6 1998 5.71 3.1

1990 3.83 2.5 1999 5.75 3.1

Unemployment of China

Year Number (million

Rate (%)

Year

Number (Million)

Rate (%)

1978 5.30 5.3 1991 3.52 2.3

1983 2.71 2.3 1992 3.64 2.3

1984 2.36 1.9 1993 4.20 2.6

1985 2.39 1.8 1994 4.76 2.8

1986 2.64 2.0 1995 5.20 2.9

1987 2.77 2.0 1996 5.53 3.0

1988 2.96 2.0 1997 5.70 3.1

1989 3.78 2.6 1998 5.71 3.1

1990 3.83 2.5 1999 5.75 3.1

Problems With the Measurement of Chinese Unemployment

The statistics excludes the rural unemployment.The number doesn’t include the unemployed wo

rkers from the countryside.The statistics comes from the unemployment reg

istration agencies, thus the number of those who are not officially registered is not included.

Laid-off workers aren’t counted as unemployed.

Assignment

Review Chapter 29 and 30Answer questions on P576 and 601.Search for information on China’s price

level and unemployment in the recent years.

Go over Chapter 20—30.

Thanks