ECO 120 Macroeconomics

Week 10

Unemployment &Inflation LecturerDr. Rod Duncan

Topics• Definition of unemployment.• Types of unemployment.• Costs of unemployment.

• Definition of inflation.• Types of inflation.• Impacts of inflation.

• Relationship between unemployment and inflation- the Phillips Curve.

Unemployment

A person becomes unemployed if he or she is a:

•Job loser

•Job leaver

•New entrant or re-entrant into the labour force

He or she is no longer unemployed if:

•Hired or recalled

•Withdraws from the labour force

Population

Labour Force

Employed /

Unemployed

Labour Force Participation

Rate

Unemployment Rate

Working age population

Labour Force Participation Rate (LFPR)

Proportion of country’s population that takes part in its economic activities directly (either actually taking part or willing to)

Labour Force / Working Age Population( ) X 100

LFPR In Australia, in September 2003 :

( 10.237 million / 15.955 million ) x 100 = 64.2 %

Unemployment Rate (UR)

Proportion of country’s labour force that is unemployed.

Number Unemployed / Labour Force( ) X 100

UR in Australia, in September 2003 :

(0.591 million / 10.237 million) x 100 = 5.8%

Unemployment over the Business Cycle (1965- 1995)

-4

-2

0

2

4

6

8

10

12

1965 1970 1975 1980 1985 1990 1995

Change in GDP

Unemployment

Labour Force Participation by Sex at Ages 35-44

0

10

20

30

40

50

60

70

80

90

100

1965 1970 1975 1980 1985 1990 1994 1995

Par

tici

pati

on r

ate

(%)

Females

Males

Unemployment Analysis - Australia : June 1979 - September 2003

0

5

10

15

20

25

30

35

40

SEP

.197

9

MA

Y.1

980

JAN

.198

1

SEP

.198

1

MA

Y.1

982

JAN

.198

3

SEP

.198

3

MA

Y.1

984

JAN

.198

5

SEP

.198

5

MA

Y.1

986

JAN

.198

7

SEP

.198

7

MA

Y.1

988

JAN

.198

9

SEP

.198

9

MA

Y.1

990

JAN

.199

1

SEP

.199

1

MA

Y.1

992

JAN

.199

3

SEP

.199

3

MA

Y.1

994

JAN

.199

5

SEP

.199

5

MA

Y.1

996

JAN

.199

7

SEP

.199

7

MA

Y.1

998

JAN

.199

9

SEP

.199

9

MA

Y.2

000

JAN

.200

1

SEP

.200

1

MA

Y.2

002

JAN

.200

3

SEP

.200

3

Une

mpl

oym

ent

rate

(%

)

Aged 15-19 looking for full-time work

Aged 20 & over seeking full-time work

Total Unemployment

Types of Unemployment

Cyclical unemploymentFrictional (or search) unemploymentStructural (technological) unemployment

Cyclical Unemployment

Associated with the ups and downs of the business cycle

• Takes place due to insufficient aggregate demand or total spending- reflects shifts in AD curve.

• High during recessions and low during booms.• Fiscal and monetary policies can reduce

cyclical unemployment - policies are relevant.

Frictional Unemployment

Associated with the period of time in which people are searching for jobs,

being interviewed and waiting to commence duties.

•It is inevitable and always exist•Fiscal and monetary policies can not reduce frictional unemployment – macroeconomic policies are irrelevant.•Policies that make it easier to find new jobs will affect frictional unemployment.

Structural Unemployment

Associated with wider structural or technological changes in the economy that may make some jobs

redundant.• It is inevitable and always exist• Lasts longer than frictional unemployment• Fiscal and monetary policies can not reduce

structural unemployment – macroeconomic policies are irrelevant.

• Policies that encourage workers to retrain skills or to move to a new area with more jobs will decrease structural unemployment.

Full Employment• Full employment means when all productive resources in the

economy are in full use - implies no cyclical unemployment - still frictional and structural unemployment exist - they can be low - but can never be zero.

• The full-employment rate of unemployment is called the natural rate of unemployment

• equals the sum of frictional and structural unemployment• cyclical unemployment = zero

• Domestic output consistent with the natural rate of unemployment is potential output or full employment level of GDP

Other Employment Issues

• Part-time employment - very high in Australia in recent years.

• Discouraged workers or the “hidden unemployed”

• Those who become discouraged and drop out of the labour force temporarily - would return if a suitable job prospect arose

• Discourage workers, participation rate and the unemployment rate

Cost of Unemployment• Economic cost

• output foregone, measured in terms of the loss of potential GDP - Okun’s law quantifies the relationship between the unemployment rate and the GDP gap - for every 1% of unemployment (over the natural rate) 3.5% of GDP loss in Australia.

• Underemployment• High budget costs

• Social Costs• Increase in crime rate, abuse etc.• Physical & mental illness• Unlikely to develop work ethics

Classical Employment Theory

Economy always operates under full employment - it is automatic and self sustaining - if there is any

unemployment that is only temporaryPrice-wage flexibility

the assumption that all prices, including wages and interest rates, are flexible and will, rapidly adjust to remove disequilibria

Classical theory and laissez fairethe price system ensured that price-wage flexibility and fluctuations in the interest rate was capable of maintaining full employment

AD-AS in the Classical Theory

•Vertical aggregate supply curveexclusively determines level of real domestic output

•Stable down-sloping aggregate demandexclusively determines price level

P1

Q1

P2

Pri

ce L

evel

Real Domestic Output

ASLR = AS

AD1

AD2

Classical View of Unemployment

Keynesian View of AD - AS

•Full employment is not automatic - unemployment exists for longer periods - the Great Depression of the 1930s - sticky wages and prices.•Horizontal aggregate supply curve during recession - ‘recessionary’ or ‘Keynesian’ range

Change in AD impacts on unemployment - not on price level.•Once the full employment level is reached - vertical AS curve - change in AD affects price level only.•Unstable aggregate demand - especially investment demand management and stabilisation policies by the government are essential

P1

Q1

Pri

ce L

evel

Real Domestic Output

ASLR

AD1

AD2

Q2

Keynesian View of Unemployment

AS

Inflation

• We measure the general price level through a price index such as the Consumer Price Index (CPI)

• Inflation is a continuous rise in the general price level

InflationInflationraterate

Current year index - Previous yearCurrent year index - Previous year indexindex

Previous year indexPrevious year index

x 100100=

Inflation in Australia (1970-2003)

-202468

1012141618

1970 1975 1980 1985 1990 1995 2000

Types of Inflation

• Demand-Pull Inflation

• Cost-Push Inflation

Demand-Pull Inflation• Occurs when an increase in AD pulls up the price level• Excess demand for output - increase in AD - AD shifts rightward -

AS does not change in the short run - movement along the AS curve - price level increases - GDP increases

• In the longer run, workers will realise their real wages have fallen and will demand and receive increased nominal wages - lower profit level - supply decreases - causing the AS to shift to the left - GDP declines - price level increases further - only inflation

• May be caused by expansionary fiscal and monetary policies - can be cured by contractionary policies.

P2

AD2

An increase inAn increase inaggregateaggregatedemand....demand....

Increases the priceIncreases the pricelevel and outputlevel and outputin the short runin the short run

o

P1

AS1

ASLR

AD1

aa

Q1

Pri

ce L

evel

Real GDP

Demand-Pull Inflation - Short run

bb

P3cc

A decrease inA decrease inaggregateaggregatesupply....supply....

Increases the priceIncreases the pricelevel and outputlevel and output

returns to originalreturns to originallevellevel

P2

AD2

o

P1

AS1

ASLR

AD1

aa

Q1

Pri

ce L

evel

Real GDP

Demand-Pull Inflation - Long run

bb

Q2

Cost-Push Inflation• Occurs when an increase in the cost of production at

each price level shifts the AS curve leftward resulting in increased prices

• Short-run: Increased prices and decreased real output (and more unemployment)

• Wage push : increase in wage rate - power of trade unions

• Supply shocks - increase in prices of major raw materials - oil etc.

• Profit push : increase in profit requirement of large monopoly businesses.

P2

bb

o

P1

AS1

ASLR

AD1

aa

Cost-pushinflation occurswhen aggregate

supply shifts left....Causing a higher

price level

Q1

Pri

ce L

evel

Real GDP

Cost-Push Inflation

AS2

Cost-Push Inflation and Demand Management • Government intervention (AD): If

government intervenes to increase AD an inflationary spiral will result

• No Government intervention (AD): If government does not intervene to increase AD severe recession will result, however nominal wages will eventually decline and will restore AS to original position

P2

bb

o

P1

AS1

ASLR

AD1

aa

Q1

Pri

ce L

evel

Real GDP

Cost-Push Inflation

AS2

An attempt toincrease AD

will only furtherincrease theprice level

P3 cc

Q2

Stagflation• Simultaneous experience of high and increasing

unemployment and inflation - cost-push inflation.• Caused by :

• Aggregate supply shocks such as severe increases in fuel costs, and devaluations

• Productivity decline• Inflationary expectations and wages -

expectations about the likely future path and rate of increase of the general price level

Types of Inflation in Australia

• 1973-74 : Cost push - caused by international oil price rise.

• 1979 : cost-push - caused by international oil price rise.

• 1981-82 : cost push - caused by rapidly rising wages.

In early 1993, RBA announced its policy of inflation targeting - 2% - 3% a year - initially caused a recession & rise in unemployment

Impacts of Inflation • Anticipated (expected) and unanticipated

(unexpected) inflation.• Anticipated inflation is not a big problem -

economy adjusts automatically.• Unanticipated inflation redistributes income

between :• employers and employees• lenders and borrowers

Phillips Curve• Suggests an inverse relationship (or a trade-off) between inflation

and the unemployment rate• Named after A W Phillips who originally discovered the

relationship between unemployment and nominal wages, using British data in 1950s.

• In general, inflation is associated with economic expansion and unemployment with economic recession.

• During expansion : the greater the rate of growth of AD - inflation is high - unemployment is low.

• During recession : the slower the rate of growth of AD - inflation is low - unemployment is high.

Ann

ual r

ate

of in

flatio

n(p

erce

nt)

Unemployment rate (percent)

7

6

5

4

3

2

1

01 2 3 4 5 6 7

The Phillips Curve

Implications of Phillips Curve

• Trade-off suggests : a rise in inflation should lead to a decline in unemployment, and vice versa.

• In general, both can not be brought down to the minimum level.

• The society must make a choice between low inflation and low unemployment.

Phillips Curve in Australia

-2

0

2

4

6

8

10

12

14

16

18

0 2 4 6 8 10 12

1970

1977

2003

1983

1993

Shifting Phillips Curve

• The smooth relationship may not be valid in the long-run - Conflicts with the trade-offs embodied in the Phillips Curve

• Vertical Phillips Curve - at full employment level, only price level changes

• Simultaneous high and increasing unemployment and inflation - may lead to shifts in the curve