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UNEMPLOYMENT AND
INFLATION
REVIEW
Last Week...
The Circular Flow of Income
Last week we examined the Circular Flow of Income.
This
It
is a representation of the macroeconomy
highlights the interrelations between the five
main sectors of the economy.
Last Week...
REVIEW
The Circular Flow of Income
Sectors and their Roles:
1.Household Sector:

Consumption (C) and Saving (S)
2.Firms Sector

Investment (I)
3. Financial Sector

act as a link between households’ savings and firms’ investment.
4.Government Sector

Government Expenditure (G) and Taxation (T)
5.International Sector

Exports (X) and Imports (M)
REVIEW
Last Week...
Gross Domestic Product (GDP)
 We have also outlined GDP.

GDP accounts for the economic value of final
goods and services in a given year.

We defined it, measured it, assessed it and
examined alternative ways by which a country’s
progress may be determined.
UNEMPLOYMENT
This Week...
1. We define and examine the measurement of
employment and unemployment;
2. We then outline inflation;
3. Then we introduce the Phillips curve.
UNEMPLOYMENT
Unemployment
Unemployment is a major macroeconomic variable that
is measured and analysed.
It is closely associated with the level of economic activity.
Unemployment is a serious economic, social, & personal
problem. Its consequences include:
Lost production and income;
Lost human capital (skills) & experience;
Loss of self esteem; and
Social disruption.
UNEMPLOYMENT
Defining Unemployment
The International Labour Organisation (ILO) defines
unemployment as persons who:
are between a specified age range during the reference
period;
without work: were not in paid employment or self-employed;
currently available for work; and
seeking work: had taken special steps in the specified
reference period to seek paid employment or selfemployment.
Source: www.ilo.org.
UNEMPLOYMENT
General Population
Working-age Population
Labour Force
Employed
Full-time
Not in Labour
Force
Unemployed
Part-time
(includes some
underemployed)
(includes some
discouraged workers)
UNEMPLOYMENT
Measuring Unemployment
These concepts therefore need to be examined to measure the
level of employment and unemployment in an economy.
We will use the Australian Bureau of Statistics’ overview of
employment as the basis for our measurement.
The Australian Bureau of Statistics (ABS) takes the following
concepts into account when measuring the level of
unemployment in Australia:
General population: the number of people in a country
Working Age Population: The population in the age group
15 to 69.
UNEMPLOYMENT
Measuring Unemployment
Labour Force (LF): persons who are employed plus
persons who are unemployed.
Not in the Labour Force: Persons aged 15 –69 who are not
in the labour force.
Labour Force Participation Rate (LFPR): The percentage of
the working age population who are in the labour force.
UNEMPLOYMENT
Measuring Unemployment
Employed: were in paid employment or worked in a
family business for at least one hour in the survey week.
Full-time employment: work 35+ hours a week.
Part-time employment: work less than 35 hours per week.
Unemployed (U): did not work but actively looked for
work and were available to start.
UNEMPLOYMENT
Measuring Unemployment
CONCEPT
General
Population
Working-age
Civilian
Population
Labour Force
Employed
DEFINITION
STATISTICS (As
at July, 2008)
Number of people in Australia
21,181m
Number of people in Australia aged 15 years and over
17,153m
Number of people in Australia aged 15 years and over actively
looking for work (employed and unemployed).
11,201m
All persons aged 15 years and over who:
worked for one hour or more for pay, profit, commission or payment
in kind in a job or business, or on a farm; or
worked for one hour or more without pay in a family business or on
a farm; or
Full-time
Work involving 35 hrs or more per week
Part-time
Work involving less than 35 hrs per week
Unemployed
Persons aged 15 years and over who are not employed but actively
looking for work.
Participation Rate The Labour Force expressed as a percentage of the Working-age
Civilian Population.
Unemployment
The number of unemployed persons expressed as a percentage of
Rate
the labour force in the same group (Unemployed/Labour Force)
10,719m
0.482M
65.3%
(11,201/17,153)
4.3%
(482/10,719+482)
UNEMPLOYMENT
Measuring Unemployment
The Unemployment Rate
The Unemployment Rate is the percentage of the Labour
Force who are unemployed.
Unemployment Rate (%) = (U/LF) x 100
The Participation Rate
The Participation Rate is the percentage of the Working-age
Civilian Population that is in the Labour Force.
Participation Rate (%) = (LF/WAP) x 100
UNEMPLOYMENT
Unemployment in the Asia-Pacific Region
COUNTRY
Thailand
Papua New Guinea
Singapore
Malaysia
South Korea
New Zealand
Japan
Taiwan
Brunei Darussalam
People's Republic of China
Hong Kong
Australia*
Vietnam
Russia
Philippines
Indonesia
Tonga
Source: CIA World Factbook
*Australian Bureau of Statistics
UNEMPLOYMENT RATE (%)
(2007 Estimate)
1.4
1.9
2.1
3.2
3.3
3.6
3.9
3.9
4.0
4.0
4.1
4.3
5.3
6.2
7.3
9.6
13.0
UNEMPLOYMENT
Problems Measuring Unemployment
The official unemployment rate counts those people who
wanted to work, were actively looking & were able to
start.
It ignores those people working part-time who would
have preferred more hours – the underemployed.
Discouraged workers are also omitted – those that have
been discouraged by previous unsuccessful job searches &
have stopped looking but would work if a job were
available (e.g. too old, language difficulties, lack of
training, no jobs in local area).
UNEMPLOYMENT
Problems Measuring Unemployment
Discouraged Workers
Suppose that economic growth is associated with generation
of more jobs.
 As the job market improves some discouraged workers
will re-enter the LF to seek jobs.
 Thus at the same time as jobs growth is occurring,
unemployment may also be rising.
 That is, discouraged workers re-entering will boost both
LFPR and potentially increase the unemployment rate.
 This can distort the official measurement of
unemployment.
UNEMPLOYMENT
Problems Measuring Unemployment
Example
An increase in the number of people employed AND an
increase in the unemployment rate occurs if the labour
force grows due to higher participation. Consider the
following example:
Employed
Unemployed
Labour Force
Unemployment Rate
Scenario 1
50,000
5,000
55,000
Scenario 2
54,000
1,000
55,000
Scenario 3
54,000
6,000
60,000
9%
2%
10%
UNEMPLOYMENT
Problems Measuring Unemployment
Scenario 1: base case.
Scenario 2: an increase in the number of people employed
and a fall in the number of people unemployed. This means
that the number of people in the Labour Force has not
changed from Scenario 1. This leads to an overall fall in the
unemployment rate. Mathematically, the denominator in the
unemployment rate equation has not changed in magnitude
but the numerator has, leading to a lower quotient – the
unemployment rate has gone down.
UNEMPLOYMENT
Problems Measuring Unemployment
Scenario 3: an increase in the number of people employed
and a rise in the number of people unemployed. This means
that the number of people in the Labour Force has increased
from Scenario 1 due to higher participation. This leads to an
overall rise in the unemployment rate. Mathematically, the
denominator in the unemployment rate equation has
increased in magnitude leading to a higher quotient – the
unemployment rate has gone up.
UNEMPLOYMENT
Types of Unemployment
Frictional Unemployment
Occurs due to the normal workings of the labour market.
Structural Unemployment
Arises because the skills demanded by employers do not match
the skills of the unemployed, or the unemployed with the
appropriate skills do not live where the jobs are located.
For example, in China people from the country's rural areas are
migrating to big cities such as Shanghai and Beijing in hope of
finding work. Skills in rural areas may not necessarily be readily
applied in more urban parts of the country.
UNEMPLOYMENT
Types of Unemployment
Seasonal Unemployment
Relates to unemployment associated with certain
times of the year. eg. Christmas, harvesting.
Cyclical Unemployment
Relates to changes in unemployment during the
business cycle.
UNEMPLOYMENT
Full Employment
Simple Definition of Full Employment
all those who want a job at the current (distribution of)
wages has got one.
Full Employment is difficult to achieve in reality. Therefore
it is practically defined as something less than employment of
100% of the labour force.
In fact, achieving the full employment Macroeconomic
objective is defined in terms of achieving a predetermined
rate of unemployment.
UNEMPLOYMENT
Full Employment
The full-employment rate of unemployment is called the Natural
Rate of Unemployment.
This equals the sum of frictional, structural and seasonal
unemployment:
Cyclical Unemployment is zero (i.e. no business downturns).
Frictional Unemployment
Natural Rate of
Unemployment
=
+
Structural Unemployment
+
Seasonal Unemployment
UNEMPLOYMENT
Full Employment
The Natural Rate is difficult to measure & appears to change with
the business cycle – it can lag behind changes in output.
This is called Hysteresis.
Domestic output consistent with the natural rate of
unemployment is potential output or GDP.
The Natural Rate of Unemployment is similar to the NonAccelerating Inflation rate of Unemployment (NAIRU) at which both
the rate of unemployment and inflation are stable.
UNEMPLOYMENT
Costs of Unemployment
Economic
The loss of potential output is normally considered the
major economic cost of unemployment.
GDP Gap
The amount by which the actual level of GDP falls
below the full employment (potential) level of GDP.
GDP Gap = Potential level of GDP – Actual GDP
Also unequal distribution of unemployment
UNEMPLOYMENT
Costs of Unemployment
Okun’s Law
Okun’s Law relates unemployment with the GDP Gap.
It relates to lost potential by relating unemployed resources
to loss of output.
But, must be able to determine ‘natural rate of
unemployment’ to measure it (use it as a point of
reference).
UNEMPLOYMENT
Costs of Unemployment
Okun’s Law
Specifically, Okun’s Law is a regular negative
quantified relationship between GDP and the
unemployment rate.
Q=-f(Unemployment)
As the unemployment rate increases, the level of
output decreases.
UNEMPLOYMENT
Costs of Unemployment
Okun’s Law
Why does this relationship exist?
Demand-side: loss of income leads to less demand.
Supply-side:
less resources employed, less output
generated (if productivity remains constant).
As GDP & jobs grow, so does LFPR & unemployment.
So to reduce the unemployment rate, GDP needs to grow
faster than the growth in unemployment.
UNEMPLOYMENT
Costs of Unemployment
Okun’s Law
For instance, in Australia, for every 1 percentage
point increase in unemployment, the nation’s
output of goods and services falls by 2.75
percentage points.
So if actual unemployment rate is 6% and we want
to get it down to 4% then GDP will need to grow
by 7%.
UNEMPLOYMENT
Costs of Unemployment
Non-economic Costs
Increased poverty, increased crime, loss of self
esteem, and other psychological factors.
Health
(suicide and alcohol), family (divorce and
abuse), social decay, etc.
Definition
INFLATION
Inflation is a sustained rise in the general level of prices of
all goods and services.
It is one of the 3 major macroeconomic variables (output and
unemployment being the other 2) that is of concern to
economists and policymakers.
Inflation is a problem because it causes the purchasing
power (or the ‘real’ value) of money, wages and assets that
are fixed in value to decline over time, reducing the ability of
people and businesses to spend (consumption, investment,
government expenditure and exports).
This is particularly true for inflation that is unexpected.
INFLATION
Costs of Inflation
For instance, if money is loaned to finance investment, then
inflation can reduce the amount of money that the lender
receives if they do not anticipate for the loss of purchasing
power and adjust their loan repayments accordingly.
Example
HSBC bank in Hong Kong loans $1,000,000 to a Hong Kong
business for 1 year for investment in a construction project.
Inflation is anticipated to be 0% over the term of the loan
agreement.
The business therefore must pay HSBC $1,000,000 at the
end of the loan period.
INFLATION
Costs of Inflation
If inflation turns out to be 5.4% over the loan term, then
HSBC loses money when the loan is repaid.
This is because the purchasing power of the $1,000,000 has
declined by 5.4% - the $1,000,000 is now worth $948,766.60
($1,000,000/1.054).
The business pays back $948,766.60 to HSBC instead of the
original $1,000,000.
HSBC loses out and the business gains because the business
is paying less money back to HSBC.
INFLATION
Costs of Inflation
Therefore, inflation has a tendency to redistribute wealth
from creditors to debtors if it is not anticipated.
This is also true of other items that are fixed in money
value such as wages. The real value of the item declines as
inflation rises.
This reduces the incentive of participants within the
various sectors of the macroeconomy to spend and inhibits
the operation of the Circular Flow of Income.
INFLATION
Measuring Inflation
GDP Deflator
The GDP Deflator can be used to quantify inflation:
Nominal GDP
GDP Deflator =
Real GDP
X 100
Calculating changes in the GDP Deflator is one way by
which inflation can be measured.
INFLATION
Measuring Inflation
Consumer Price Index (CPI)
The Consumer Price Index is a more common way by
which inflation is measured.
The CPI is a price index which measures the value of a
representative sample of consumer goods and services.
Inflation is measured by calculating changes in the value of
the CPI.
INFLATION
Measuring Inflation
Consumer Price Index (CPI)
The CPI measures the average level of prices of a basket of
goods & services consumed by an urban family.
CPI is defined to equal 100 for reference base period.
Like any price index, it is calculated by using the formula:
Price Index =
Price in Any Given Year
Price in Base Year
What is in the basket of goods?
X 100
INFLATION
Composition of CPI
INFLATION
Measuring Inflation
Inflation rate is the percentage change in price level from
one year to next.
Inflation formula is:
Inflation Rate = [(CPI this year – CPI last year)/CPI last
year]  100.
INFLATION
Measuring Inflation
YEAR
PRICE ($)
CPI
INFLATION (%)
2004
247
98.0
2005
252
100.0
2.0
2006
261
103.6
3.6
2007
272
107.9
4.2
Assume CPI index is 103.6 (2006) & 107.9 (2007).
Inflation rate for 2007 is [(107.9 – 103.6)/103.6]*100 = 4.2%.
Prices can also fall – deflation.
INFLATION
Constructing the CPI
Constructing the CPI involves three stages:
1.
Selecting the basket of goods & services
2.
Conducting a monthly price survey
3.
Using prices & basket to cost of basket
CPI Bias
INFLATION
The main sources of biases in the CPI are:
New
goods: new goods might not have existed in base year, e.g.
typewriters being replaced by computers.
Quality
change: an improved good is considered a better good &
some of its price increase is attributed to generating this improvement.
Commodity
substitution: a category of consumption might
experience substitution between different goods in same category due
to changes in relative prices.
Outlet
substitution: consumers search for cheaper sources of goods,
e.g., discount stores.
CPI Bias
INFLATION
Impact of bias:
Distorts
clauses
Can
wage contracts & leases with CPI price
affect government outlays (many
government pension & social security payments
are indexed to changes in CPI).
INFLATION
Inflation in the Asia-Pacific Region
COUNTRY
Japan
Brunei
Papua New Guinea
Taiwan
Hong Kong
Malaysia
Singapore
Thailand
New Zealand
Korea
Philippines
Australia*
People's Republic of
China
Indonesia
Vietnam
Russia
Source: CIA World Factbook
Australian Bureau of Statistics
INFLATION RATE (%)
2007 Estimate
0.0
0.4
1.7
1.8
2.0
2.1
2.1
2.2
2.4
2.5
2.8
4.5
4.8
6.4
8.3
9.0
THE PHILLIPS CURVE
The business cycle suggests that the
macroeconomic goals of full employment and price
stability move in opposite directions.
The New Zealand economist, A. W. Phillips used
empirical data to suggest that policy makers faced a
trade-off.
Policy makers could affect the unemployment rate
or the inflation rate but not both at the same time.
THE PHILLIPS CURVE
The Phillips Curve
The Phillips curve depicts a negative correlation
between unemployment and inflation.
It represents an inverse relationship between
unemployment and inflation – a decrease in one
variable results in an increase in the other.
THE PHILLIPS CURVE
Characteristics of the Phillips Curve
A stable and predictable relationship.
A non-linear (or curved) relationship. This results
from demand pressures not equally affecting
inflation and unemployment.
Asymptotic to the axis (impossible to achieve zero
rates of inflation or unemployment)
Governments can use fiscal and monetary policies
to select the desired combination of inflation and
unemployment.
THE PHILLIPS CURVE
The Phillips Curve
Why should there be a link between Inflation rate and
Unemployment rate?
When
GDP increases, employment increases and
Unemployment rate declines.
Increase
in GDP, all else constant, increases the price
level (and eventually the inflation rate).
Demand
pressures reduce unemployment rate but
increase inflation rate.
THE PHILLIPS CURVE
The Phillips Curve
For instance, expansionary government policy (Fiscal or Monetary) will
cause unemployment to fall (due to increased output) but will also create
higher inflation. This is depicted below by a movement along the Phillips
Curve from A to B . Unemployment declines from 6.1% to 5.0% and inflation
rises from 3.5% to 4.8%.
Inflation (%)
4.8
B
A
3.5
0
5.0
Phillips Curve
(PC)
6.1 Unemployment (%)
THE PHILLIPS CURVE
The Phillips Curve
That is, there is a trade-off between unemployment and
inflation - when unemployment increases, inflation
decreases.
This can be depicted graphically.
The relationship has implications for government policy
and its desired impact.
The Phillips curve implies that the Government can use
demand management policies to either lower the
inflation rate or to reduce the unemployment rate.
BUT NOT BOTH
THE PHILLIPS CURVE
Shifts of the Phillips Curve
The Phillips Curve shifts when there is a change in the
expectations for inflation.
For example, if people believe inflation will be higher
for all levels of output and unemployment, then this will
result in a higher Phillips Curve as depicted below.
Each level of unemployment is associated with a
higher level of inflation.
THE PHILLIPS CURVE
Shifts of the Phillips Curve
Inflation (%)
Higher inflation anticipated (4.8%)
at the original unemployment rate
(6.1%).
4.8
PC2
3.5
PC1
0
6.1
Unemployment (%)
THE PHILLIPS CURVE
The Long-run Phillips Curve
The Long Run Phillips Curve depicts the notion that the
economy will remain at a particular level of
unemployment (and output). It is represented as a
straight vertical line as seen below.
Attempts to move away from the long run level of
unemployment by implementing expansionary policy will
only result in higher prices and no reduction in
unemployment.
Suppose China’s economy is operating at an
unemployment level of 6.1% with an inflation rate of
3.5%. This inflation rate is both the actual rate of
inflation and what people expect the inflation rate to be.
THE PHILLIPS CURVE
The Long-run Phillips Curve
If the government institutes expansionary fiscal or
monetary policy there will be the typical
movement up the short run Phillips Curve from A
to B.
Unemployment declines to 5.0% and inflation rises
to 4.8%.
This rise in inflation has caused real wages to fall workers expect 3.5% inflation but are faced with
4.8% actual inflation.
THE PHILLIPS CURVE
The Long-run Phillips Curve
Workers therefore adjust their expectations of
inflation upward and demand higher money
wages to compensate them for the reduced
purchasing power of their incomes.
Once granted, these higher money wages cause
firms’ costs of production to rise and profits to fall.
Critical Assumption: wages are flexible.
THE PHILLIPS CURVE
The Long-run Phillips Curve
Firms therefore lay off workers, causing the
unemployment rate to rise back to the original
6.1%, at which actual and expected inflation is
now 4.8%.
The movement from B to C is a long run
adjustment. A long run Phillips Curve (LRPC)
results.
THE PHILLIPS CURVE
The Long-run Phillips Curve
Inflation (%)
4.8
LRPC
B
C
A
3.5
SRPC2
SRPC1
0
5.0
6.1
Unemployment (%)
THE PHILLIPS CURVE
The Long-run Phillips Curve
So, in the long run, the government’s attempt to
reduce unemployment has only resulted in higher
inflation with no change in unemployment.
The conclusion of the Long Run Phillips Curve
scenario is that government intervention does not
alter the rate of unemployment, only the level of
inflation.
REFERENCES
Textbook
 Jackson & McIver, Chapter 5, pp154-160 &
Chapter 14.
Other readings to supplement knowledge
 McTaggart Ch 22; also Ch 30.
 Kniest, Lee and Burgess, pp177-182; 184-192.
CLASS EXERCISE


Go to Asian Development Bank website.
www.adb.org
Start investigating key macroeconomic data for
your projects.