8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

1/18

W11 C1&2 (12th and 13th Jan, 2009)

Inflation and Unemployment

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

2/18

Inflation is an increase in the overall price level.

1. Demand-pull inflation is inflation initiated by anincrease in aggregate demand.

2. Cost-push, or supply-side, inflation is inflationcaused by an increase in costs.

Demand Pull Cost Push

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

3/18

3 of 47

Stagflation occurs whenoutput is falling at the sametime that prices are rising.

One possible cause of

stagflation is an increase incosts.

Cost shocks are bad newsfor policy makers. The only

way to counter the outputloss is by having the pricelevel increase even morethan it would without thepolicy action.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

4/18

4 of 47

If every firm expects every other firm to raise prices by 10%,every firm will raise prices by about 10%. This is howexpectations can get built into the system.

In terms of the AD/AS diagram, an increase in inflationaryexpectations shifts the AS curve to the left.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

5/18

Hyperinflation is a periodof very rapid increases inthe price level.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

6/18

An increase in G with themoney supply constantshifts the AD curve from

AD0 to AD1. This leads toan increase in the interest

rate and crowding out ofplanned investment.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

7/18

If the Fed tries to preventcrowding, it will increase the

money supply and the ADcurve will shift farther and

farther to the right. The resultis a sustained inflation,perhaps hyperinflation.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

8/18

The unemployment rate is the ratio of the number ofpeople unemployed to the total number of people in thelabor force.

Cyclical unemployment is the increase in unemploymentthat occurs during recessions and depressions.

Frictional unemployment is the portion of unemploymentthat is due to the normal working of the labor market;

used to denote short-run job/skill matching problems.

Structural unemployment is the portion of unemploymentthat is due to changes in the structure of the economythat result in a significant loss of jobs in certain industries.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

9/18

According to classical economists, the quantity of labordemanded and supplied are brought into equilibrium byrising and falling wage rates. There should be nopersistent unemployment above the frictional and

structural amount. The labor supply curveillustrates the amount of laborthat households want to supplyat each given wage rate.

The labor demand curveillustrates the amount of laborthat firms want to employ ateach given wage rate.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

10/18

Classical economists believethat the

labor market always clears.

If labor demand decreases,the equilibrium wage willfall.

Anyone who wants a job atW1 will have one. There isalways full employment inthis sense.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

11/18

The classical idea that wages adjust to clear the labormarket is consistent with the view that wages respondquickly to price changes. This means that the AS curve isvertical.

When the AS curve is vertical, monetary and fiscal policycannot affect the level of output and employment in theeconomy.

Unemployment Rate: The unemployment rate is notnecessarily an accurate indicator of whether the labormarket is working properly. The unemployment rate maysometimes seem high even though the labor market isworking well.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

12/18

The fact that people are willing to work at a wage higherthan the current wage does not mean that the labor marketis not working.

The termsticky wages refers to the downward rigidity ofwages as an explanation for the existence of

unemployment. If wages stick at W0

rather than fall to the newequilibrium wage of W*

following a shift ofdemand, the result will beunemployment equal toL0 L1.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

13/18

One explanation for downwardly sticky wages is that firmsenter into social, or implicit, contracts. These contracts areunspoken agreements between workers and firms that firmswill not cut wages.

The relative-wage explanation of unemployment holdsthat workers are concerned about their wages relative to thewages of other workers in other firms and industries.

Explicit contracts are employment contracts that stipulateworkers wages, usually for a period of one to three years.Wages set in this way do not fluctuate with economicconditions.

Cost of living adjustments (COLAs) are contract provisionsthat tie wages to changes in the cost of living. The greater the

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

14/18

The efficiency wage theory is an explanation forunemployment that holds that the productivity of workersincreases with the wage rate. If this is so, firms may havean incentive to pay wages above the market-clearingrate.

If firms have imperfect information, they may simplyset wages wrongwages that do not clear the labormarket.

Minimum wage laws set a floor for wage rates, andexplain at least a fraction of unemployment.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

15/18

In the short run, the unemployment rate (U) and aggregateoutput (income) (Y) are negatively related.

The relationship between U andP is negative. As U declines inresponse to the economymoving closer and closer tocapacity output, the overallprice level rises more andmore.

As depicted by this short runAS curve, the relationship

between Y and the pricelevel (P) is positive.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

16/18

The inflation rate is the percentage change in the pricelevel.

The Phillips Curve shows the relationship between theinflation rate and the unemployment rate.

There is a trade-offbetween inflation andunemployment. To lowerthe inflation rate, we mustaccept a higher

unemployment rate.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

17/18

Expectations are self-fulfilling. This means that wageinflation is affected by expectations of future price inflation.

Price expectations that affect wage contracts eventuallyaffect prices themselves.

Inflationary expectations shift the Phillips curve to the right.

8/14/2019 Lecture 19 & 20 (12th & 13 Jan, 2009)

18/18

When output is pushedabove potential GDP (Y0),

there is upward pressureon costs. Rising costs pushthe short-run AS curve tothe left. The quantitysupplied will end up backat Y0.

If the AS curve is vertical in the long run, so is the PhillipsCurve.