inflationunemployment-gmm

8/11/2019 inflationunemployment-gmm

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Inflation & unemployment


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Inflation & Phillips curve: The inflation rateis the

percentage change in the pricelevel.

The Phillips Curveshows the

relationship between the inflationrate and the unemployment rate.


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Causes of Inflation: Demand-pull inflationis inflation

initiated by an increase in aggregate

demand. Cost-push, or supply-side, inflation

is inflation caused by an increase in

costs.


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Demand pull :

Increase in AD canbe due to a fiscal ormonetary policy,thus increasingprices


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Cost push:

Upward shift of the

AS will be due toincrease in costs dueto increase in price ofinputs.


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Stagflation: Stagflationoccurs when output is

falling at the same time that prices are

rising.

One possible cause of stagflation is anincrease in costs.


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Combination of both:


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Costs of inflation: Redistribution of income and wealth-

borrowers gain and creditors lose.fixedincome earners lose.

Balance of payments effect- exports becomeexpensive. Hence exchange rate depreciates.

Uncertainty about the value of money

Resource cost of changing pricesmenucosts

Economic growth and investment suffers


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Philips Curve: It is a statistical relationship between

unemployment and money wage

inflation.

Rate of inflation= rate of wage growthless rate of productivity growth.


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Phillips Curve: 1958Professor A.W. Phillips

Expressed a statistical relationship between

the rate of growthof money wages and unemploymentfrom 18611957

Rate of growth of money wages

linked to inflationary pressure Led to a theory expressing a trade-off

between inflation and unemployment


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The Philips CurveWage growth %

(Inflation)

Unemployment (%)

The Phillips Curve shows aninverse relationship between

inflation and unemployment. It

suggested that if governments

wanted to reduce unemployment

it had to accept higher inflation as

a trade-off.

Money illusion wage rates rising

but individuals not factoring in

inflation on real wage rates.1.5%

6%4%

2.5%

PC1


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The curve crosses the horizontal axis at a positivevalue of unemployment. Hence it is not possible to

have zero inflation and zero unemployment The concave shape implies that lower the level of

unemployment higher the rate of inflation.

Govt. should be able to use demand managementpolicies to take the economy to acceptable levels of

inflation and unemployment. In order to achieve full employment, some inflation is

unavoidable.

However, this relationship broke down at the end of

1960s when Britain began to experience risinginflation and unemployment.

This raised a question on the application of Phillipscurve in the long run.


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Long run Phillips curve: dp/dt = f(1/u) + dpe/dt

To keep unemployment below the natural

rate, inflation must keep on increasing everyyear. In the long run Philips curve will bevertical at the rate of unemployment wherereal aggregate demand equals real aggregate

supply. This rate is called the natural rate ofunemployment. It is also called NAIRU orLowest sustainable unemployment rate(LSUR).


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inflation

The Philips Curve

Unemployment

Long Run PC

PC1

PC2PC3

Assume the economy starts with an inflation rate of

1% but very high unemployment at 7%.

Government takes measures to reduce

unemployment by an expansionary fiscal policy that

pushes AD to the right (see the AD/AS diagram on

slide 15)

7%

2.0%

1.0%

There is a short term fall in unemployment but at a

cost of higher inflation. Individuals now base their

wage negotiations on expectations of higher inflation in

the next period. If higher wages are granted then firms

costs rise they start to shed labour and

unemployment creeps back up to 7% again.

3.0%

To counter the rise in unemployment,

government once again injects resources

into the economy the result is a short-

term fall in unemployment but higher

inflation. This higher inflation fuels further

expectation of higher inflation and so the

process continues. The long run Phillips

Curve is vertical at the natural rate ofunemployment. This is how economists

have explained the movements in the

Phillips Curve and it is termed the

Expectations Augmented Phillips

Curve.


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7% becomes the natural rate in thiscase.

Whenever unemployment rate ispushed below natural rate , wagesincrease, pushing up costs. This leads

to a lower level of output which pushesunemployment back to the naturalrate.


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Countering inflation:

Demand -pull Reduce demand by higher taxation, lower govt.expenditure, lower govt borrowing, higher interestrates

Cost push Take steps to reduce production costs by deregulatinglabour markets, encouraging greater productivity, applycontrol over wages and prices

Import factors reduce quantity of imports or their prices via tradepolicies.


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Controlling inflation (cont)

Excessivegrowth onmoney supply

Reduce money supply by cutting down on publicsector borrowing

Funding Govt borrowing from non bank

Reduce bank lendingMaintain interest rates

Expectations ofinflation

Pursue policies which indicate Govts determination toreduce inflation


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Types of Unemployment:

Frictional Unemployment:

Unemployment caused

when people move from job to joband claim benefit in the meantime

The quality of the information available

for job seekers is crucial to the extentof the seriousness of frictionalunemployment


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Types of Unemployment:

Structural Unemployment: Unemployment caused

as a result of the decline of industries and theinability of former employees to moveinto jobs being createdin new industries

Seasonal Unemployment:

Unemployment caused because of theseasonal nature of employmenttourism,agriculture, sports etc.


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CYCLICAL UNEMPLOYMENT:

Caused by a general lack of demand inthe economythis typeof unemploymentmay be widespread across a rangeof industries and sectors

Keynes saw unemployment as primarilya lack of demand in the economy which

could be influencedby the government


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Okuns Law:

This law states that 1 extra point ofunemployment costs 2%of GDP

Consequences of unemployment:1. Loss of potential output

2. Loss of human capital

3. Increasing inequalities and distributionof income

4. Social costs

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