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Principles of Economics
Session 13
Topics To Be Covered
Definition of Inflation
Categories of Inflation
Classical Theory of Inflation
Demand-Pull Inflation
Cost-Push Inflation
Impacts of Inflation
Topics To Be Covered
Measuring Unemployment
Categories of Unemployment
Voluntary and Involuntary Unemployment
Reasons for Above-Equilibrium Wage
Impact of Unemployment
Okun’s Law
Phillips Curve
Inflation
Inflation is an increase in the
overall level of prices.
The Inflation Rate
The inflation rate is the percentage change in
the price level from the previous period.
Inflation Rate in Year2 
CPI in Year 2 - CPI in Year 1
 100
CPI in Year 1
Nominal GDP
GDP Deflator =
 100
Real 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.

Inflation in China
Percent
per Year
25
20
15
10
5
0
-5
1975
1980
1985
1990
1995
2000
Hyperinflation
Poland
Germany
Index (Jan.
1921 = 100)
100 trillion
1 trillion
10 billion
Index (Jan.
1921 = 100)
Price level
10 million
Price level
Money
supply
1 million
100 million
100,000
1 million
10,000
Money
supply
10,000
1,000
100
1
100
1921 1922 1923 1924 1925
1921 1922 1923 1924 1925
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.

Money Supply and Demand
and Price Level
Value of
Money (1/P)
Price
Level (P)
Money supply
(High) 1
1 (Low)
1.33
1/2
1/4
(Low) 0
A
2
Money
demand
Quantity of
Money
4
Equilibrium
price level
Equilibrium
value of money
3/4
(High)
Effects of Monetary Injection
Value of
Money (1/P)
MS1
(High) 1
1. An increase
in the money
supply...
3/4
1/2
A
Money
demand
M1
1 (Low)
1.33
2
B
1/4
(Low) 0
Price
Level (P)
MS2
M2
Quantity of
Money
4
(High)
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 = Velocity
P = Price level
Y = Quantity of output
M = Quantity of money
MxV=PxY
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.
Demand-Pull Inflation
Price
Level
In the long run, nominal wages
rising causes AS to decrease
and the price level rises further.
Short-run AS2
Long-run AS
Short-run AS1
C
P3
An increase in AD
increases the price
level in the short run
B
P2
P1
A
AD
0
Y1
Y2
1
AD
2
Quantity of
Output
Cost-Push Inflation
The cost-push inflation originates
on the supply side of markets
from a sharp increase in costs.
Cost-Push Inflation
Price
Level
The rise of Costs pushes AS upward and leads
to a higher price level but a lower output.
Long-run AS
AS2
P3
P2
C
B
Short-run AS1
If the government
fights the recession by
increasing AD, further
inflation will occur.
A
P1
AD2
AD1
0
Quantity of
Output
Impacts of Inflation
 Shoeleather
 Menu
costs
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.
The Breakdown of the U.S.
Population in 2000
Employed
(131.5 million)
Adult
population
(205.2 million)
Unemployed (6.2 million)
Not in labor force
(67.5 million)
Labor force
(137.7 million)
Measuring Unemployment
The unemployment rate is calculated
as the percentage of the labor force
that is unemployed.
Number unemployed
Unemployment rate =
 100
Labor force
Measuring Unemployment
The labor-force participation rate is
the percentage of the adult population
that is in the labor force.
Labor force
Labor - force participation rate =
 100
Adult population
Unemployment Rate Since 1960
Percent
of Labor
Force
Unemployment rate
10
8
6
4
Natural rate of
unemployment
2
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Labor-force Participation
Rate (in percent)
Labor-force Participation Rates
for Men and Women
100
80
Men
60
40
Women
20
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 ’98
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.
Voluntary Unemployment vs.
Involuntary Unemployment
Wage
Labor
supply
Voluntary
unemployment
Employment
W*
A
E
F
Labor demand
0
Labor
Voluntary Unemployment vs.
Involuntary Unemployment
Wage
Involuntary
unemployment
Employment
W**
G
J
H
Labor
supply
Voluntary
unemployment
K
W*
E
Labor demand
0
Labor
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
Wage
Surplus of labor =
Unemployment
Labor
supply
Minimum
wage
WE
Labor
demand
0
LD
LE
LS
Quantity
of Labor
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 Impact
Unemployment is a waste of natural
resources.
Social Impact
The 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.
Ut  Ut 1   (Yt  Yt 1 )
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
Okun’s Law
3
Percentage Change
in Unemployment
2
1
0
-1
-2
-3
-3 -2 -1
5
4
2
3
1
6
0
Percentage Change in Real GDP
7
8
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
Inflation
Rate
(percent
per year)
6
Phillips curve
B
A
5
0
6
8
Unemployment
Rate (percent)
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
The Model of AD and AS
Short-run
AS
Price Level
106
105
B
A
The Phillips Curve
Inflation Rate
(percent per
year)
High AD
6
5
Low AD
0
7,000
(unemployment
is 8%)
0
7,280
(unemployment
is 6%)
B
A
Phillips curve
Unemployment
6
8
Rate (percent)
(output is (output is
7,280)
7,000)
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
Inflation
Rate
1. When the
Fed increases
the growth
rate of the
money
supply, the
rate of
inflation
increases…
High
inflation
Low
inflation
0
Long-run
Phillips curve
B
A
Natural rate of
unemployment
2. … but
unemployment
remains at its
natural rate
in the long run.
Unemployment
Rate
How the Phillips Curve is
Related to the AD-AS Model
The Phillips Curve
The AD-AS Model
Price
Level
Long-run aggregate
supply
Inflation
Rate
P2
1. An increase in the
money supply increases
aggregate demand…
P1
AD2
0
2. …raises the
price level…
Natural rate of
output
Aggregate
demand, AD1
Quantity of
Output
Long-run Phillips
curve
B
3. …and
increases the
inflation rate…
A
0
Natural rate of
unemployment
4. …but leaves output and unemployment
at their natural rates.
Unemployment 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
Unemployment = Natural rate of - a Actual - Expected)
(
inflation inflation
Rate
unemployment
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.
How Expected Inflation Shifts
the Short-Run Phillips Curve
Inflation
Rate
Long-run
Phillips curve
B
1. Expansionary
policy moves
the economy up
along the shortrun Phillips
curve...
0
2. …but in the long-run,
expected inflation rises,
and the short-run Phillips
curve shifts to the right.
C
Short-run Phillips curve with
high expected inflation
A
Short-run Phillips curve with
low expected inflation
Natural rate of
unemployment
Unemployment
Rate
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.
Disinflationary Monetary Policy
Inflation
Rate
Long-run
Phillips curve
A
1. Contractionary policy
moves the economy
down along the short-run
Phillips curve...
Short-run Phillips curve
with high expected
inflation
C
B
Short-run Phillips curve
with low expected
inflation
0
Natural rate of
unemployment
Unemployment
Rate
2. ... but in the long run, expected inflation falls
and the short-run Phillips curve shifts to the left.
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
1991
Number
(Million)
3.52
Rate
(%)
2.3
2.3
1992
3.64
2.3
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
Year
1978
Number
(million
5.30
Rate
(%)
5.3
1983
2.71
1984
Unemployment of China
Year
1991
Number
(Million)
3.52
Rate
(%)
2.3
2.3
1992
3.64
2.3
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
Year
1978
Number
(million
5.30
Rate
(%)
5.3
1983
2.71
1984
Problems With the Measurement
of Chinese Unemployment
The statistics excludes the rural unemployment.
The number doesn’t include the unemployed
workers from the countryside.
The statistics comes from the unemployment
registration 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 30
Answer 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