Download CHAPTER 8 THE ANATOMY OF INFLATION AND

CHAPTER 8
THE ANATOMY OF INFLATION AND UNEMPLOYMENT
Chapter Outline
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The Anatomy of Unemployment
The Unemployment Pool
Variation in Unemployment Across Groups
Cyclical and Frictional Unemployment
Full Employment
Determinants of the Natural Rate
Estimates of the Natural Rate of Unemployment
Hysteresis and the Rising Natural Rate of Unemployment
Reducing the Natural Rate of Unemployment
Employment Insurance
The Costs of Unemployment
Costs of Cyclical Unemployment
Distribution Impact of Unemployment
Other Costs and Benefits
The Costs of Inflation
Perfectly Anticipated Inflation
Imperfectly Anticipated Inflation
Inflation and Indexation: Inflation-Proofing the Economy
Inflation and Interest Rates
Indexation of Wages
Why Not Index?
Working With Data
Changes from the Previous Edition:
There are no major changes to Chapter 8. The cyclical cost on unemployment on page 157 has
been rewritten to include an estimate of the sacrifice ratio. Box 8-1 on Percent Change, Percentage Points
and Basis points is new.
Learning Objectives:
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Students should be aware that there are large variations in the unemployment rate across different
groups, and different geographical regions in the labour force.
Students should be aware that there is high turnover in the labour market (often cyclical in nature)
consisting of flows in and out of the labour pool.
Students should understand the importance of duration and frequency of unemployment and their
relevance to the actual rate of unemployment.
Students should know the factors that determine the natural unemployment rate.
Students should be aware that the natural rate of unemployment can vary over time.
Students should be able to distinguish between frictional and cyclical unemployment.
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Students should be able to distinguish between the effects of perfectly anticipated and imperfectly
anticipated inflation.
Students should be able to evaluate the relative costs of unemployment and inflation.
Students should be familiar with the effects of wage indexation.
Students should be able to discuss the relative merits of fixed versus variable mortgage rates.
Students should be aware that a positive rate of inflation may reduce wage rigidity.
Achieving the Objectives
Periods of either high unemployment or high inflation are undesirable and should be avoided. But
since there seems to be at least a short-run tradeoff between the two, a good understanding of the relative
costs of these two economic problems is important. There is high turnover in the labour market with
constant flows into and out of the unemployment pool. Most of this turnover is cyclical and most workers
remain unemployed for fairly short periods of time. However, there is concern that many workers do
experience long-term unemployment, which significantly reduces their earnings potential. Overall, we see
fairly large variations in unemployment rates across different groups in the labour force. Since the overall
rate of unemployment is the weighted average of the unemployment rates of these different groups, some
variation in the rate of unemployment results from the changing composition of the labour force.
Frictional unemployment is the unemployment rate that results from imperfections in the labour
market. There are always workers who are between jobs, even if the economy is at the full-employment
level of output. Unemployment in excess of this "natural" rate is called cyclical unemployment since it
occurs when output is below the full-employment level.
When looking at the implications of unemployment, it is important to distinguish between the
duration and frequency of unemployment. The duration of unemployment is the average length of time a
person remains unemployed. In the past, there was a strong correlation between the duration and severity
of unemployment but in the 1990s this relation has weakened. In addition to the cyclical factors that
determine the duration of unemployment there are also four structural characteristics:
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the organization of the labour force,
the demographic make-up of the labour force,
the availability of unemployment benefits,
the desire of some of the unemployed to continue their search for better jobs.
The frequency of unemployment is the average number of times, per period, that a worker
becomes unemployed. It depends on two factors:
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the variability of the demand for labour across employers,
the rate at which new workers enter the work force.
The factors mentioned above determine the natural rate of unemployment. Since these factors
constantly change, so does the natural rate. But while the natural rate varies over time, economists believe
that it can be estimated. For the Canada, the natural rate of unemployment is currently believed to be
around 5.5%, but nobody knows for sure.
Part of the reason that the natural unemployment rate changes over time is the changing
composition of the labour force. One possible explanation for the increase in the natural rate of
unemployment in many European countries is that their economies underwent extended periods of high
unemployment in the 1980s and 1990s. The idea that long periods of high unemployment may actually
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contribute to a higher natural unemployment rate is known as unemployment hysteresis, and there are two
possible explanations for it. The first is that workers who are unemployed may get accustomed to not
being in the work force (while maybe taking on odd jobs even as they receive unemployment benefits) or
may get discouraged. The second is that workers with a history of long and/or frequent unemployment
may convey the (often unwarranted) signal that they may not have the motivation or skills required to
ensure stable employment.
The existence of employment insurance contributes to unemployment by making it easier for
workers to extend their job searches. Employment insurance also reduces firms' incentives to create stable
employment by reducing the consequences of laying off workers. More generous unemployment benefits,
together with the inflexibility of wages (due to more powerful labour unions) and the high cost of firing
workers, are often cited as reasons for higher unemployment rates in Europe than in Canada, the U.S. or
Japan. Workers in Japan, for example, receive a large part of their annual income in bonuses that can be
easily cut, thus creating wage flexibility.
Any negative effects of an increase in the unemployment rate are borne primarily by the
unemployed themselves (through psychological and financial hardships), but the cost to society as a
whole is also quite significant. The measurable social cost of unemployment is the loss of output, which is
only minimally offset by the value placed on the increase in leisure.
The loss of output due to inflation is not as direct as the loss of output due to unemployment. The
cost of perfectly anticipated inflation is minimal, since wages, taxes, and interest rates can be indexed to
ensure that real wages and interest rates remain constant. Only the cost of periodically changing prices
(so-called menu costs) and the cost of holding cash due to the loss of purchasing power must be
considered. However, in most cases inflation is not perfectly anticipated, and a redistribution of income
and wealth results. Such distributional effects operate with respect to all assets fixed in nominal terms. If
actual inflation is higher than expected, debtors profit while creditors lose.
The government may be able to profit from the so-called "bracket creep," as inflation moves
workers into higher tax brackets, increasing the real value of tax payments. However, Canadian tax
brackets have recently been indexed, in effect reducing tax revenues. The effects of imperfectly
anticipated inflation are particularly strong in long-term mortgage contracts. Housing was a very
profitable investment in the 1970s, since the increase in housing prices was at least as great as the
increase in the mortgage interest rate; therefore the real cost of borrowing may have been close to zero.
To avoid the loss of purchasing power from inflation, some wage contracts have cost-of-living
adjustments (COLAs), which index the wage rate to the rate of inflation. Such wage indexation works
well as long as inflation is caused by an increase in aggregate demand, in which case firms can easily
afford to pay higher nominal wages. However, wage indexation prevents downward real wage flexibility,
which can be a problem in a supply shock situation. After an adverse supply shock, real wages have to
fall to bring the economy back to a full-employment equilibrium position.
Flexibility of wages is essential in getting the unemployment rate back to the natural rate, but
nominal wage cuts are rare. Some economists therefore argue that a low, positive rate of inflation is good
for the economy. This idea is in sharp contrast to the "zero inflation" goal that is popular with others.
Suggestions and Pitfalls
Reviewing the economic events in Canada over the last three decades provides a good basis for a
discussion of the relationship between inflation and unemployment. In the 1970s, supply shocks caused a
simultaneous increase in inflation and unemployment. In the early 1980s, Canada experienced doubledigit inflation and double-digit unemployment. A long-lasting expansion, when neither inflation nor
unemployment was perceived as a problem, followed the recession of 1981/82. In 1990/91 the economy
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entered another recession, followed by a fairly strong economic performance in the mid- and late-1990s,
creating some worries about renewed inflation.
The problems involved in ascertaining the actual unemployment rate arise partially from
difficulties in the determination of who is in the labour force at any given time. There is a high turnover
rate in the labour force and it is important to stress that this is not necessarily undesirable; it may simply
reflect a higher degree of labour mobility. It is also important to distinguish between frictional and
cyclical unemployment. Demand management policies can reduce cyclical unemployment, but frictional
unemployment changes only if employment policies designed to affect the organization and demographic
make-up of the labour force and the turnover rate are employed.
Instructors may want to stress the evidence that is presented in the Table of Box 8-3. Looking at
international unemployment rates and discussing differences in the way labour markets work in different
countries will create a lot of student interest. The inflexibility of labour markets, strong labour unions, and
differences in structural labour market policies can explain much of the variations in unemployment rates
in Europe. Sweden, for example, has a history of creating public sector employment when needed. On the
other side of the globe, Japan creates wage flexibility by paying workers a large part of their income in
bonuses that can be cut whenever there is a need for it. This should, on average, create a lower
unemployment rate.
A discussion of the effects of the minimum wage rate law on the unemployment rate may create a
lot of class participation, since students' opinions on this subject tend to diverge greatly. Students who
favor an increase in the minimum wage rate are often astonished to learn that the minimum wage law
could actually hurt some of those it intends to help. The minimum wage law was designed to help the
least skilled workers by raising their wage rate. But if their wage rate is above the value of their marginal
products, then these workers will not be hired and the unemployment rate may actually increase. An
increase in the minimum wage rate raises labour costs in general since it also raises the wage demands of
workers earning higher rates. Inefficiency in the form of a higher inflation rate combined with a higher
unemployment rate may result. Empirical evidence, however, indicates that such effects tend to be fairly
insignificant. Some recent studies even suggest that an increase in the minimum wage rate may actually
create more employment.
The real reason politicians often favor an increased minimum wage rate over alternative measures
(such as education or training programs) is that it can be achieved at a very low cost to the government.
The alternative measures may have higher net rates of return, but their costs are often considered
prohibitive by administrations concerned with budgetary problems. It should also be noted that increases
in the rate of inflation effectively lower the real minimum wage rate if it remains unchanged in nominal
terms.
Comparing the economic costs of unemployment with those of inflation is not always easy. While
the costs of unemployment are easily measured by the loss in output (using Okun's law), the costs of
inflation are less obvious. If inflation is perfectly anticipated, its costs are insignificant and consist
primarily of the cost of making price changes (menu costs) and costs related to lower desired currency
holdings (shoe-leather costs). The costs of imperfectly anticipated inflation at low levels are mostly
distributional in nature, since unanticipated inflation tends to hurt creditors and benefit debtors. Very high
inflation rates may create uncertainty about the future and disincentives to invest. This may result in a loss
in output. Economic agents may be preoccupied with financial speculation to protect their assets against a
loss of purchasing power, and productive activity may thus be lowered. This is particularly true in times
of hyperinflation.
The distinction between nominal and real interest rates (or wage rates) needs to be stressed, since
these may actually move in opposite directions if inflation is not perfectly anticipated. Inflation's effect on
the housing market is often of particular interest to students and they are eager to discuss the relative
merits of fixed versus variable mortgage rates. In times of rapidly rising interest rates, the cost of
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attracting new funds increases, while the real rate of return on existing long-term assets decreases. Since a
significant part of the assets of Banks were in mortgages, profitability declined. Therefore, financial
institutions tried to shift the interest rate risk onto the homeowners by offering adjustable rate mortgages.
This, however, created other problems for financial institutions. In order to make adjustable rate
mortgages attractive to home buyers, they had to offer them at a lower rate. As a result, some borrowers,
who otherwise would not have qualified, now did. But when interest rates increased, so did monthly
mortgage payments, and many of these borrowers had to default on their loans.
In the discussion of wage indexation it is important to point out that indexation works well when
inflation is caused by excessive monetary growth. However, in a supply shock situation indexation does
not work very well, since real wages must fall to get the economy back to a full-employment equilibrium
at low inflation. Governments tend to be reluctant to adopt indexation on a broad scale since it is not only
complicated in practice but may also make it harder to fight inflation.
Students often believe that any desired rate of inflation can be achieved in the long run at little
cost since the economy always will adjust at the natural rate of unemployment anyway. Many are not
aware of the significant personal and social costs that the resulting higher unemployment may impose.
Thus a discussion of the desirability of a zero inflation rate may be useful. Students are especially
intrigued by the idea that a positive rate of inflation may actually be better than a zero inflation rate, since
the former may provide the wage flexibility needed for the economy to adjust to full employment more
easily.
Solutions to the Problems in the Textbook
Discussion Questions:
1.
Many unemployed teenagers are new entrants into the labour force and their frequency of
unemployment is higher than that of adult workers. Teenagers’ frequency of entry into and exit from the
labour force indicates that few of them work at jobs with the promise of high job security. They have
little or no training and few job skills and thus tend to hold unattractive jobs. This perpetuates the
problems since the jobs they can get do not provide the skills needed to gain better jobs in the future.
2.
The rate of unemployment is affected by the frequency, that is, the number of times that workers
become unemployed in a period, and by the duration, that is, the length of the period for which workers
are unemployed. Unemployment in depressed geographical areas, such as the Atlantic provinces, tends to
be of long duration and low frequency, and is often concentrated in specific industries. For instance, in
Newfoundland there are a great number of unemployed fishermen, who are middle aged with little in the
way of transferable skills.
3.
The natural rate of unemployment is the rate of unemployment that is permanently sustainable
given the institutions of the economy. The natural unemployment rate is determined by two factors: the
duration and frequency of unemployment. The duration of unemployment depends primarily on the
organization and demographic make-up of the labour force, the availability of unemployment benefits,
and the desire of the unemployed to look for better jobs. The frequency of unemployment depends largely
on the rate at which new workers enter the work force and on the variability of the demand for labour
across different firms. Given this, an economy can be said to be at full employment even when the
unemployment rate is not zero.
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4.
It is possible to design a restrictive fiscal and monetary policy mix to bring the economy to a
long-run equilibrium situation at the natural rate of unemployment and at a zero rate of inflation.
However, this cannot be achieved without an increase in the rate of unemployment in the short run.
Therefore, a choice has to be made among adjustment paths that differ in their inflation-unemployment
mix.
In considering adjustment paths, the benefits of permanently lower inflation have to be compared
with the costs of increased short-term unemployment. The costs of unemployment are loss of output and
personal hardship. If inflation can be anticipated only imperfectly, then a redistribution of income and
wealth will take place. Some output may be lost as resources are devoted to minimizing a potential loss in
purchasing power rather than to actual production. However, the cost of perfectly anticipated inflation is
minimal. Thus it probably makes little difference whether we have a zero inflation rate or an inflation rate
of 3%, as long as a specific long-run goal is established. A positive rate of inflation may actually help in
wage and price adjustments, since it allows real wages to adjust more easily to supply shocks.
Most policy makers tend to perceive the cost of inflation as lower than the cost of an increase in
unemployment resulting from tough anti-inflation policies. However, the Canadian experience of the
early 1980s seems to indicate that tough anti-inflationary measures may be acceptable if inflation reaches
the double-digit range. One way to establish a clear inflation goal is for the Bank of Canada to follow a
monetary growth rule. However, experience with such a rule was disappointing in Canada in the latter
half of the 1970’s. Another option is to maintain discretionary monetary policy aimed directly at a target
rate of inflation.
5.
The sacrifice ratio is the percentage of output lost for each one percent reduction in the inflation
rate. It is non-zero in the short and medium runs, when output is different from the full-employment level.
However, in the long run, unemployment always returns to its natural level and therefore the sacrifice
ratio is zero, if transition costs are ignored.
6.
Okun’s law states that a reduction in the unemployment rate of 1 percent will increase the level of
output by 1.6 percent. This relationship allows us to measure the cost to society (in terms of lost
production) of a given rate of unemployment.
7.
When inflation is perfectly anticipated, then its costs consist primarily of the costs of making
price changes (menu costs) and costs related to the holding of currency, which loses purchasing power. If
there is only low to moderate inflation, these costs are very low. However, when inflation rates soar, the
costs can be substantial.
8.
The cost of imperfectly anticipated inflation can be serious. There is a redistribution of wealth
among individuals. If actual inflation is higher than expected, debtors profit while creditors lose as real
interest rates are lower than expected. Equity holders are also hurt, since the real value of dividends and
capital gains is reduced. If there is no tax-indexation, people may move into higher tax brackets and suffer
financially due to this bracket creep.
9.
Indexation is designed to make it easier to live with inflation since it eliminates the cost of
unanticipated inflation. In practice, however, indexing on a broad basis makes it more complicated to
calculate contracts. It also makes it harder for the economy to adjust to shocks if changes in relative prices
are needed. This is particularly true for supply shocks. Finally, there is some concern that indexation may
weaken political motivation to fight inflation. However, as long as inflation is low to moderate, the
benefits of indexation probably outweigh the costs.
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Application Questions:
1.a. The aggregate unemployment rate can be calculated by adding the unemployment rates of different
groups weighted by their share of the labour force. The data in the problem indicate that 10% of the
labour force are teenagers. The adult work force (the other 90%) is divided into 35% females and 65%
males. Thus we get
u = (0.1)(0.19) + (0.9)[(0.35)(0.06) + (0.65)(0.07)] = 0.019 + (0.9)(0.021 + 0.0455)
= 0.019 + 0.05985 = 0.07885 = 7.9%.
1.b.
If the labour force participation rate of teenagers increases to 15%, then the aggregate rate of
unemployment changes to:
u1 = (0.15)(0.19) + (0.85)[(0.35)(0.06) + (0.65)(0.07)]
= 0.0285 + (0.85)(0.021 + 0.0455) = 0.0285 + 0.056525 = 0.085025 = 8.5%.
2. These numbers can be found in CANSIM matrix 3451.
3. See the source for Figure 8-2.
Additional Problems:
1. Why is it possible for the number of unemployed workers to increase at the same time that the
overall unemployment rate falls?
The unemployment rate is defined as the number of people unemployed divided by the number of people
in the labour force. If the labour force grows more than the number of unemployed, the unemployment
rate falls.
2.
In the manufacturing sector many workers who have been laid off later return to their original
jobs. Does this mean that these workers failed to look for other jobs while they were
unemployed?
No. The fact that these workers return to their original jobs simply means that they did not accept other
permanent job offers. Very often, laid-off workers actively look for other jobs, but may not find
comparable jobs in their geographic area. As the demand for the goods produced by their former firm
increases again, they are called back and return to their old jobs.
3. Proposals to raise the minimum wage rate are often opposed with the argument that such a
move would not only cause an increase in unemployment but would also hurt the very people it
is intended to help. Is there any validity to that argument?
The minimum wage rate provides a price floor on nominal wages. If this wage floor is above the marketclearing equilibrium wage rate, then a surplus of labour will be created. The purpose of the minimum
wage law is to provide an adequate standard of living for less skilled workers. However, if firms believe
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that the minimum wage rate is higher than the value of the marginal product of some workers, then those
workers will not be hired. As a result, the unemployment rate among less skilled workers may actually
increase. Increasing the minimum wage rate raises the cost of production (especially since higher skilled
workers may also demand higher wages) and may result in a higher inflation combined with higher
unemployment. However, empirical evidence suggests that such effects are fairly small. Whether
politicians favor an increase in the minimum wage rate depends on more than just the efficiency and
equity arguments. An increase in the minimum wage can be enacted with little cost to the government.
Alternative programs (increasing the level of education or training of low skilled workers) may have a
higher rate of return but require a greater investment of resources and may therefore be considered
unfeasible if budget deficits are a problem.
4. True or false? Why?
"When the economy enters a recession, wages tend to adjust only slowly to a market-clearing
level, and the resulting unemployment is called frictional."
False. Frictional unemployment is the unemployment that exists when the economy is at its fullemployment level of output. Unemployment in excess of this "natural rate" of unemployment occurs
when the economy enters a recession and is called cyclical unemployment.
5. Starting in the early 1990s many U.S. firms downsized their operations. In your opinion, how
did this affect the duration of unemployment?
Normally after a recession workers either return to their old jobs or find similar jobs. However, since
many jobs were completely eliminated in this particular downsizing, workers who lost their jobs in the
recession of 1990/91 had a much tougher time finding new and comparable jobs. Therefore, the duration
of unemployment increased.
6. Comment on the following statement:
"More generous unemployment benefits create a higher unemployment rate."
The unemployment rate tends to be higher in countries with more generous unemployment insurance
programs. Unemployment benefits significantly reduce the hardships associated with loss of a job. Firms
may also be less concerned about laying off their workers if they know that the workers will receive
unemployment insurance. At the same time, the benefits decrease the cost of searching for a job and
enable those who have lost jobs to at least initially reject unsatisfactory job offers. Finally, since workers
have to officially be in the labour force to receive unemployment benefits (even if they do not want a job)
they get counted as unemployed, thus increasing the measured unemployment rate.
7. "If wages are rigid, then the government can easily reduce inflation without creating higher
unemployment." Comment on this statement.
If wages are rigid, then there is a trade-off between unemployment and inflation. In other words, if policy
makers try to reduce inflation by demand management policies (restrictive monetary policy), then
unemployment will increase at least in the short run. Only in the long run, when wages become
completely flexible, will the unemployment rate return to its natural level. Another way to lower inflation
without increasing unemployment would be through supply-side economics, that is, policies designed to
shift the AS-curve to the right. According to supply-siders, a decrease in income tax rates will increase
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the incentive to save, work and invest and this will shift the upward-sloping AS-curve to the right.
However, this is easier said than done, since tax cuts generally also affect aggregate demand.
8. Distinguish between frictional, search, seasonal, and cyclical unemployment.
Frictional unemployment exists, because labour markets do not work perfectly. At any given time, some
workers are always between jobs and therefore temporarily unemployed. Search unemployment exists
because some workers who are offered a job wait for a better opportunity; they can do this for some time
because they receive unemployment insurance benefits. Seasonal unemployment occurs, since workers
are needed at different times in different areas. (Ski instructors are only needed in winter; and college
students tend to enter the labour force temporarily during the summer time.) Cyclical unemployment
refers to the unemployment that occurs as the economy enters a downturn.
9. What kinds of policies would you suggest to reduce the natural rate of unemployment?
The answer to this question is student specific. Policies to reduce the natural rate of unemployment must
reduce the frequency or duration of unemployment and affect the composition or demographic make-up
of the labour force. Policies that make workers more mobile, make information regarding job vacancies
more accessible to the public, or reduce the variability of the demand for labour across industries can also
be considered. Some people may favor a reduction in the minimum wage rate or a reduction in
unemployment benefits, but such proposals are more controversial.
10. "Restrictive monetary policy will help to decrease inflation; the resulting increase in the natural
unemployment rate is a small price to pay." Comment on this statement. In your answer,
explain what policies the government should design to lower the natural rate of unemployment.
Restrictive monetary policy lowers the rate of inflation but at the cost of increasing the actual rate of
unemployment. However, in the long run the economy will adjust back to the natural rate of
unemployment. This natural unemployment rate is not affected by monetary policy, but only by
employment policies or changes in the composition of the labour force. Employment policies involve
educating workers or increasing their skills to make them more mobile, making information about job
opportunities more readily available to them, or reducing discrimination to allow certain groups to find
jobs faster.
11. "Unemployment hysteresis generally exists when the economy is entering a deep recession and
workers fear lay-offs." Comment on this statement.
The term unemployment hysteresis is used to describe a situation in which long periods of high
unemployment lead to an increase in the natural rate of unemployment. This phenomenon arises since
workers who are out of a job may either take advantage of unemployment benefits while doing odd jobs
or get discouraged and put less effort into finding a new job. Thus they stay unemployed longer. Since
firms may perceive long periods of unemployment as a signal that these workers are less qualified or
motivated, they may not want to hire them. Therefore, the longer the spell of unemployment, the harder it
is to get out of the unemployment pool.
12. Assume the unemployment rate among different groups in the labour force is as follows: adult
males 5%, adult females 4.5%, teenagers 12%. Teenagers account for 15% of the work force
and, among adults, women workers account for 40%. What is the actual nation-wide
unemployment rate?
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The aggregate unemployment rate can be calculated by adding the unemployment rates of the different
groups weighted by their share of the labour force. Therefore we get
u = (0.15)(0.12) + (0.85)[(0.6)(0.05) + (0.4)(0.045)] = 0.018 + (0.85)(0.03 + 0.018)
= 0.018 + 0.0408 = 0.0588 = 5.8%.
13. Demographic studies show that the proportion of teenagers and minorities in the U.S.
population is likely to increase in the near future. In your opinion, what implications, if any, would
this trend have on the natural rate of unemployment?
Teenagers and minorities tend to have a greater frequency of unemployment than the general population.
If the proportion of teenagers and minorities in the labour force increases, then we should expect an
increase in the natural rate of unemployment.
14. In Japan, a large part of a worker's annual salary comes in the form of bonuses. In your
opinion, what are the implications of this for the unemployment rate in Japan?
The fact that these bonuses can be easily reduced when a firm experiences a tough time makes wages
much more flexible. The Japanese economy can therefore adjust more easily to full employment. In bad
economic times Japanese workers are not laid off as easily as workers in the U.S., where wages are more
rigid. The implication is that the Japanese unemployment rate should, on average, be lower.
15. Given that inflation cannot be perfectly anticipated, how can lending institutions protect
themselves against the loss of purchasing power?
If inflation cannot be perfectly anticipated, then lending institutions have great uncertainty about the real
value of the nominal payments they receive on loans. For example, if a long-term mortgage has a fixed
interest rate, then the lending institution that issued the loan will lose purchasing power if the rate of
inflation is higher than expected. The homeowner, on the other hand, is better off since the real interest
rate of the mortgage loan has been effectively reduced.
Variable mortgage rates (which are generally dependent on short-term interest rates) protect the
lending institution against rising inflation, since they are adjusted periodically as inflation, and thus shortterm interest rates, increase. The unanticipated capital gains accrued by borrowers due to higher inflation
are therefore much smaller since the mortgage rate is adjusted soon after short-term interest rates increase.
Thus, the lending institution's purchasing power is essentially protected.
16. "Perfectly anticipated inflation should not affect currency holders." Comment.
Whenever there is inflation, currency becomes more costly to hold because of the loss in purchasing
power. The higher the rate of inflation, the larger the incentive for individuals to put their funds into
interest earning accounts with yields higher than the expected rate of inflation
17. "Unanticipated inflation benefits debtors." Comment on this statement.
Assume you get a 30-year fixed-rate mortgage from your local savings and loan institution. The terms of
the contract will specify the nominal interest rate for your loan, which contains a premium for expected
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inflation over the term of the contract. If the actual inflation rate is greater than was anticipated at the time
the contract was signed, then you (as the debtor) are better off. In this case, you will be able to pay back
the loan with "cheaper" dollars since money has lost some of its purchasing power. The lending
institution, on the other hand, will be hurt by the higher than anticipated interest rates. Naturally, if the
actual inflation rate is less than was anticipated, the lending institution will benefit.
18. "Wage indexation can lead to an inflation spiral." Comment on this statement.
If material prices rise and the price increases are passed on to consumers in the form of higher product
prices, then the rate of inflation will increase. If wages are indexed for inflation, then workers' nominal
wages will increase as soon as new labour contracts go into effect. But firms will again pass the higher
wage costs on to consumers in the form of higher product prices and inflation will increase even more.
This process (the so-called wage-price spiral) may continue until decisive action is taken to stop it.
19. “Broad-based indexation is a good idea, since it eliminates the hardships associated with
inflation." Comment on this statement.
Broad-based indexation eliminates the cost of unanticipated inflation, which is primarily the redistribution
of wealth. Long-term loan contracts, such as mortgages, government bonds, or wage contracts are
especially affected by imperfectly anticipated inflation since lenders and workers cannot be certain about
the real value of the nominal payments they receive. Since inflation is less predictable when it is high than
when it is low, indexation is more prevalent in countries with high inflation than in those with low
inflation. The advantage of indexation is that it keeps nominal and real rates of return (or wages) in line,
while avoiding frequent costly contract renegotiations. However, indexation is often complicated and may
weaken policy makers' will to fight inflation. Furthermore, indexation prevents real wages from falling
after a supply shock, preventing an adjustment back to full employment.
20. Briefly explain how and why each of the following changes would affect the natural rate of
unemployment: (i) a decrease in unemployment benefits; (ii) an increase in the minimum wage;
(iii) a higher number of teenagers in the work force.
A decrease in unemployment benefits would make it more urgent for the unemployed to find new jobs.
They would be more likely to accept early job offers and the length of unemployment would be reduced.
Therefore the natural rate of unemployment would decrease.
Employers who believe the minimum wage rate to be above the value of the marginal product of lowskilled workers will not hire such workers. A higher minimum wage rate might make some firms less
likely to hire low-skilled workers, increasing the natural rate of unemployment. However, low-skilled
workers who continue to be employed would receive a higher wage rate, ensuring them more spending
power and this could create jobs elsewhere.
Increased labour force participation of teenagers would at least initially increase the natural rate of
unemployment, since teenagers have a higher frequency of unemployment than older, more experienced
workers do. But as more teenagers entered the labour force and more stable jobs became available to
them, then the natural rate of unemployment would decrease again.
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21. "The natural rate of unemployment is a very helpful guide for policy makers, since most
inflation is driven by wage increases." Comment on this statement.
The true value of the natural rate of unemployment is not known for sure. So if policy makers assume this
rate is lower than it actually is, they will try to stimulate the economy through expansionary policies as
soon as unemployment rises above this assumed rate. But this will reduce the actual unemployment rate
only temporarily, since the economy has a tendency to go back to the true natural rate. Policy makers will
have to stimulate the economy again and again and this creates inflationary pressure. Since inflation
reduces real wages, workers will ask for wage increases and we will enter a wage-price spiral.
The assertion that most inflation is driven by wage increases also does not hold. Instead, global
competition has broken down the relationship between wage increases and increases in inflation. In the
long run, inflation can only persist if monetary growth is excessive.
22. "Structural unemployment is in excess of the natural rate of unemployment and can therefore
be easily lowered by expansionary fiscal policy." Comment on t his statement. In your answer,
list the different types of unemployment.
Expansionary fiscal policy will result in a temporary decrease in the actual unemployment rate, but in the
long run the economy will adjust back to the natural unemployment rate. This natural rate can only be
reduced through policies geared towards improving education, skills, information about jobs, and job
mobility. Structural unemployment (the mismatch of job openings and available skills) is part of the
natural unemployment rate. Frictional unemployment always exists since labour markets don't work
perfectly and some people are always between jobs. Search unemployment exists when people who are
offered jobs decide not to take them in hopes of getting better jobs. Only cyclical unemployment is in
excess of this natural rate and can be reduced through expansionary fiscal policy.
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