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CHAPTER 4
INFLATION &
UNEMPLOYMENT
OBJECTIVE OF LEARNING
1.
2.
3.
4.
5.
6.
define inflation
identify the different degrees of inflation
identify the causes of inflation
calculate the inflation rate
consider the various costs that inflation
imposes on society
identify ways to control inflation
INFLATION
4.1.1. Definition
Inflation can be defined as a situation where
there is a continuous increase in general price
level over time
•
•
•
•
•
generally inflation is a situation where
there is too much money chasing too few goods
cost of living has increased
there is persistent fall in the value in the economy
prices are rising
Degrees of inflation
1. Mild Inflation
• Not serious condition
• Normally the general price level would increase up to 5
%. Eg. The CPI is about 105
2. Creeping Inflation
• More serious than mild inflation
• Occurs when demand is rising but supply is constant,
hence leading to rising prices.
• the general price level would normally increase by 10%
and CPI is 110
3. Hyperinlation / galloping inflation / runaway inflation
• Very serious economics condition where the value of
money is persistently falling
• Inflation that exceeds 50% per month.
Causes of Inflation
1.
Demand Pull Inflation

Price
The basic cause of inflation comes
from the demand side, due to
factors such as



Increase in money supply
(expansionary monetary policy)
Increase in government purchases
(expansionary fiscal policy)
Increase in export
AS
P2
P1p2
p1
AD2
AD1
Output
Q1 Q2
Causes of Inflation
2. Cost push inflation ( supply
push inflation )



the basic cause is the rising costs of
production , such as an increase in
wage rates, an increase in the prices of
raw materials
when industries are faced with rising
production costs , they will push prices
up
in terms of AD-AS diagram , this is
depicted in Figure 4.2 as an upward
shift in
Price
AS2
AS1
P2
P1
Output
Q2 Q1
Causes of Inflation
3. Imported Inflation

If there is in inflation in the source countries of
imports, imported inflation comes in along with
the imported goods and services.
 E.g. as inputs or raw materials such as crude oil
are purchased at high, inflated prices from the
Middle East where the inflation originates, nonoil producers like Singapore import the inflation
as well.
Measurement if Inflation
General price level is measured using Price Index
1.
The GDP Deflator
2.
The CPI
assuming CPI is used to measure inflation , then the rate of inflation between
2 periods , say period t and period (t-1 ) is given by :
inflation rate = (CPIt – CPIt-1) / CPIt-1 x 100%
e.g. in Dec 1999, CPI was 118.9, and in Dec 1998, it was 115.7, so the inflation
rate during 1998 was = 2.77%

it is possible for inflation to be negative, but this rarely happens,
this would occur when the general price level falls and it is called
deflation
Costs of Inflation
A) Anticipated Inflation (inflation that is expected)
i) Menu costs


costs of inflation that arise from actually changing prices
restaurant owners, catalogue producers, and any other
business that must post prices will have to incur costs to change their
prices because of inflation
ii) Shoe-leather costs

costs of inflation that arise from trying to reduce holdings of cash
Costs of Inflation
B) Unanticipated Inflation (inflation that is not expected)

failure to anticipate inflation correctly imposes costs in the labour market and
the capital market
 In the labour market , unanticipated inflation causes
a) redistribution of income
b) departures from full employment
 In the capital market , unanticipated inflation causes
a) redistribution of income and too much or too little lending and borrowing
b) interest rates based on incorrectly anticipated inflation imposes a cost on
either the borrower or lender
c) inaccurate inflation expectations also create an inappropriate amount of
borrowing and lending
Ways to control inflation

3 main ways by which inflation can be controlled
i) adopt tight monetary policy undertaken by Central Bank
(Bank Negara) that use some instruments to influence
the economy by reducing money supply and higher
interest rates.
ii) contractionary fiscal policy that deals with reducing
government expenditures and increasing tax
iii) direct control - direct govt intervention in the price
mechanism of the country
Ways to control inflation

direct control
a) price pegging
- government fixed the floor and ceiling prices , so that prices will not
increase rapidly
- producers will not be able to increase prices according to their own
wishes
b) control of trade union
- demand for higher wages has caused cost-push inflation
·
persuade not to make these demands
c) anti-hoarding campaign
- done in M’sia , where reports were made against producers and
consumers who store their goods unnecessarily because such
storage could cause artificial shortage and push prices up
Ways to control inflation



b)

direct control
d) price tagging
- prices of all goods have to be labelled
- prevent producers from over-charging the consumers
e) rationing
- This is done as a last resort whereby consumers are given
coupons
to buy goods in certain quantities,
- for example, one family is only allowed to buy 10 kilograms of rice
per month. In other words, the demand for the good is
predetermined.
To be effective all 3 methods, i.e. monetary policy, fiscal policy and direct
control must be implemented simultaneously
UNEMPLOYEMENT
DEFINITION





the unemployed are those individuals who do not currently have a job but
who are looking for work
individuals who looked for work in the past but are not looking currently
are not counted as unemployed
the employed are individuals who currently have jobs
 thus,
employed + unemployed = labour force
people who are not working and are not looking for work are not
considered to be in the labour force such as a full-time student, homemaker,
or retiree is not in the labour force
discouraged workers also not included in the official count of the
unemployed as they are workers who left the labour force because they
could not find jobs
Measurement of Unemployment



Unemployment rate
the percentage of the labour force that is unemployed
it is computed as:
No. of unemployed workers
X100%
labour force
OR
Labour force - no. of employed workers
X100%
labour force
Types of unemployment

unemployment can be classified into 3 types:
1. Frictional unemployment








unemployment that occurs naturally during the normal workings of an
economy
can occur for a variety of reasons such as people change jobs, move across
the country, search for new opportunities or take their time after they enter
the labour force to find appropriate job
arises because it takes time for workers to be matched with suitable jobs
during this time , workers engaged in a job search will be registered as
unemployed
the problem is that information is imperfect
employers are not fully informed about what labour is available .
workers are not fully informed about what jobs are available .
to remedy frictional unemployment - better job information provided by
government job centers , local and national newspaper .
Types of unemployment

unemployment can be classified into 3 types:
2. Structural unemployment



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


arises from changes in the pattern of demand and supply in the economy
pattern of demand - declining demand - change in consumer tastes , goods
out of fashion , competition from other industries , etc.
pattern of supply - methods of production - new techniques of production.
Unemployment may result from labour-saving techniques of production or
a whole new technology which requires workers with different skills.
people cannot immediately take up jobs in other parts because there is
mismatch between workers skill and job requirements due to
not having sufficient education
lack of skills and training
E.g. when products such as black and white television become obsolete
workers engaged in their production may become unemployed.
Types of unemployment

unemployment can be classified into 3 types:
3. Cyclical unemployment

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
arises because the economy is in recession and there is deficiency of
demand
unemployment increases during recession and decreases during expansion
In any economy ,
actual rate of unemployment = natural rate of unemployment + cyclical
rate of unemployment
the natural rate of unemployment is defined as the rate of unemployment
that prevails when output and employment are at the full level of
employment level .
even though the economy is operating at the full employment level of
employment , there will still be people who are facing frictional and
structural unemployment
in other words ,
natural rate of unemployment = frictional + structural unemployment .
Costs of Unemployment

Costs to the unemployed

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Even though, people may have more time to pursue leisure activities,
they may be constrained in so doing by a lack of income
The unemployed also suffer a loss of status as a certain amount of
social stigma is still attached to being unemployed.
More likely to experience divorce, nervous breakdowns, bad health and
are more likely to attempt suicide than the rest of the adult population
Long periods of unemployment reduce the value of human capital.
When people are out of work, their skills can become rusty, and they
miss out on training in new methods.
Costs of Unemployment

Costs to society
 The
main cost to society is the output which is lost
 people will enjoy fewer goods and services than they could
have consumed with higher employment
 The country will be producing inside its PPF
 Whilst government revenue will fall as unemployment
rises, it will have to increase its spending on unemployment
related benefits (such as unemployment benefit)
 there has been increased evidence of a link between crime
and unemployment, particularly in the case of young
unemployed men
Policies to reduce unemployment

1.
policies to reduce unemployment depend on the type
of unemployment
Frictional unemployment



focus primarily on improving the information flows between
employers and job-seekers
employment agencies need to be set up to pool and provide
information on the type of job opportunities that are
available on the kind of workers who are searching for
employment
another much more controversial remedy is for the
government to reduce the level of unemployment benefit
Policies to reduce unemployment

structural unemployment
 encouraging
people to look more actively for jobs,
if necessary in other parts of the country

encourage people to adopt a more willing attitude
towards retraining, and if necessary to accept some
reduction in wages
 use
wage subsidy programs to encourage
employers to hire and train those who otherwise
lack the necessary skills to get the jobs
Policies to reduce unemployment

cyclical unemployment
 adopt
expansionary monetary policies by
increasing money supply and reducing interest
rates to stimulate aggregate demand or
expansionary fiscal policy by increasing
government expenditure and reducing tax
Trade-off between Inflation and
Unemployment - The Phillips Curve


a Phillips curve shows the relationship between the inflation
rate and the unemployment rate
there are 2 times frame for PC :



the short-run PC
the long-run PC
Inflation rate (%)
the short-run PC shows the
relationship between inflation
and unemployment holding
constant the expected inflation
rate and natural rate of unemployment .
SRPC
Unemployment
rate (%)