Download Causes of Inflation

Unemployment
 Full employment – Can be defined as the condition of the national economy,
where all or nearly all persons who are willing and able to work at prevailing
wages working conditions are able to do so. While underemployment is the
condition when a person is working less than what he / she needs to in order to
meet his / her necessities.
 The way in which unemployment is measured is through the unemployment
rate, the percentage of the labor force that is unemployed.
Number of employed
Unemployment rate =
x 100.
Labor force
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The reason that governments place such an importance on reducing the level of
unemployment is because unemployment poses great costs on an economy.
Some of these costs can be grouped into different categories.
- Costs of unemployment to the unemployed people themselves: Those
who are unemployed face numerous costs. For instance people will
receive less income that they would do if they were employed; this is
assuming that they receive some unemployment benefits. This
reduction of income implies lower standard of living.
- Costs of unemployment to society: The social costs of unemployment
can most clearly be seen in areas where there are high levels of
unemployment in the form of poverty, higher rates of crime and
vandalism.
- Costs of unemployment to the economy as a whole: If actual output is
less than potential output due to unemployment of the factor of labor,
production, then the economy is foregoing possible output and would
be operating at a point within its production possibility curve. This loss
of output, and income to the unemployed, has other implications such
as; the opportunity cost of the government’s spending on
unemployment benefits.
Types of unemployment
- Structural is the unemployment that results because the number of jobs
available in some labor markets is insufficient to provide a job for
everyone who wants one. Structural unemployment involves a
mismatch between the sufficiently skilled workers looking for jobs and
the vacancies available. Even though the number of vacancies may be
equal to the number of the unemployed, the unemployed workers lack
the skills needed for the jobs — or are in the wrong part of the country
or world to take the jobs offered. It is a mismatch of skills and
opportunities due to the structure of the economy changing. Structural
unemployment is a result of the dynamics of the labor market and the
fact that these can never be as flexible as, e.g., financial markets.
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Workers are "left behind" due to costs of training and moving (e.g., the
cost of selling one's house in a depressed local economy), plus
inefficiencies in the labor markets, such as discrimination or monopoly
power. Structural unemployment is hard to separate empirically from
frictional unemployment, except to say that it lasts longer. As with
frictional unemployment, simple demand-side stimulus will not work to
easily abolish this type of unemployment.
Frictional is the unemployment that results because it takes time for
workers to search for the jobs that best suit their tastes and skills. This
unemployment involves people in the midst of transiting between jobs,
searching for new ones; it is compatible with full employment. It is
sometimes called search unemployment and can be voluntary. New
entrants (such as graduating students) and re-entrants (such as former
homemakers) can also suffer a spell of frictional unemployment.
Frictional unemployment exists because both jobs and workers are
heterogeneous, and a mismatch can result between the characteristics
of supply and demand. Such a mismatch can be related to skills,
payment, work time, location, attitude, taste, and a multitude of other
factors. Workers as well as employers accept a certain level of
imperfection, risk or compromise, but usually not right away; they will
invest some time and effort to find a better match. This is in fact
beneficial to the economy since it results in a better allocation of
resources. However, if the search takes too long and mismatches are
too frequent, the economy suffers, since some work will not get done.
Therefore, governments will seek ways to reduce unnecessary frictional
unemployment.
Seasonal is a type of frictional unemployment where specific industries
or occupations are characterized by seasonal work which may lead to
unemployment. Examples include workers employed during farm
harvest times or those working winter jobs on the ski slopes or summer
jobs such as life-guarding at outdoor pools and agricultural labor.
Cyclical / demand-deficient refers to unemployment that rises during
economic downturns and falls when the economy improves. Keynesians
argue that this type of unemployment exists due to inadequate effective
aggregate demand. Some consider this type of unemployment one type
of frictional unemployment in which factors causing the friction are
partially caused by some cyclical variables. For example, a surprise
decrease in the money supply may shock participants in society. In this
case, the number of unemployed workers exceeds the number of job
vacancies, so that if even all open jobs were filled, some workers would
remain unemployed. This kind of unemployment coincides with unused
industrial capacity (unemployed capital goods). Keynesian economists
see it as possibly being solved by government deficit spending or by
expansionary monetary policy, which aims to increase non-
governmental spending by lowering interest rates. Classical economics
rejects the conception of cyclical unemployment, seeing the attainment
of full employment of resources and potential output as the normal
state of affairs. However, it accepts the theory to some extent as full
employment can never be reached.
- Real wage are higher than the market-equilibrium wage. In simple
terms, institutions such as "the minimum wage" deter employers from
hiring all of the available workers, because the cost would exceed the
technologically-determined benefit of hiring them. Some economists
theorize that this type of unemployment can be reduced by increasing
the flexibility of wages (e.g., abolishing minimum wages or employee
protection), to make the labor market more like a financial market.
 Measures to deal with unemployment: An increase in the demand for labor
will move the economy along the demand curve, increasing wages and
employment. The demand for labor in an economy is derived from the demand
for goods and services. As such, if the demand for goods and services in the
economy increases, the demand for labor will increase, increasing employment
and wages. Some of the ways that the government acts on in order to deal
with unemployment is through both fiscal and monetary policies. With these
policies the economy will be able to become more productive and it will
decrease the unemployment rate, because both of these policies encourage
consumer to demand more goods, which will affect the suppliers to be provide
and make more goods allowing more opportunities for employment. However,
the labor market is not efficient: it doesn't clear. Minimum wages and union
activity keep wages from falling, which means too many people want to sell
their labor at the going price but cannot. Supply-side policies can solve this by
making the labor market more flexible. These include removing the minimum
wage and reducing the power of unions, which act as a labor cartel. Other
supply side policies include education to make workers more attractive to
employers. Supply side reforms also increase long-term growth. This increased
supply of goods and services requires more workers, increasing employment. It
is argued that supply side policies, which include cutting taxes on businesses
and reducing regulation, create jobs and reduce unemployment.
Inflation
 Inflation can be defined as a rise in the general level of prices of goods and
services in an economy over a period of time. The term "inflation" once referred
to increases in the money supply. However, economic debates about the
relationship between money supply and price levels have led to its primary use
today in describing price inflation. Inflation can also be described as a decline in
the real value of money—a loss of purchasing power in the medium of exchange
which is also the monetary unit of account. Deflation is a sustained decrease in
the general price level of goods and services. Deflation occurs when the annual
inflation rate falls below zero percent, resulting in an increase in the real value of
money — a negative inflation rate. This should not be confused with disinflation,
a slow-down in the inflation rate (i.e. when the inflation decreases, but still
remains positive). Inflation reduces the real value of money over time;
conversely, deflation increases the real value of money.
 Costs of inflation and deflation
Inflation will not only affect individuals, but will also cause problems for
the whole economy. The costs of inflation include:
 Uncertainty - if inflation keeps varying, then firms may be reluctant to invest
in new plant and equipment as they may be unsure of what the government
will do in the future. People also may be uncertain and reluctant to spend.
Both of these factors could reduce the long-term level of economic growth.
 Income redistribution - many people have to live off fixed incomes,
particularly those on pensions. The higher the level of inflation the less their
income will be worth. This effect can also happen among people who are
working, as their incomes go up either faster or slower than inflation. These
effects can arbitrarily redistribute income.
 Menu costs - this is a general term for all the inconvenient costs that
businesses and individuals face. As prices increase they have to redo their
price lists, change price labels, reprint menus and so on. If inflation is
constant these costs can mount up.
 Competitiveness - if our prices are increasing faster than those in other
countries, then our goods will be less competitive and less in demand. This
will have a negative effect on the balance of payments.
Some of the costs of deflation include:
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Holding back on spending: Consumers may opt to postpone consumption if they
expect prices to fall further in the future.
Debts increase: The real value of household, corporate and government debt
rises when the price level is falling – another factor that might cause people to
cut back on their spending.
The real cost of borrowing increases: Real interest rates will rise if nominal rates
of interest do not fall in line with prices – another factor driving spending lower.
Lower profit margins: Company profit margins come under pressure unless costs
fall further than final prices to consumers – this can lead to higher
unemployment as firms seek to reduce their costs. Weaker profit margins can
also have a negative effect on stock markets because of a fall in expected profits
and dividends to shareholders.
Confidence and saving: Falling asset prices such as price deflation in the housing
market hit personal sector financial wealth and confidence – leading to further
declines in AD and a rise in precautionary savings (the average and marginal
propensity to save will tend to rise)
Causes of Inflation:
Demand Pull inflation: It occurs as a result of increasing aggregate demand in the
economy. This can occur when the economy is approaching full employment or when the
economy is at the full employment level of income. An increase in aggregate demand
will result in an increase in the average price level along with an increase in real output.
If the economy is already at full employment level of income, it cannot expand to meet
the outward shift in demand. In both cases, the increase in aggregate demand ‘pulls up’
the average price level. The reasons for this change can be any of the components of
aggregate demand. For example, there could be a high level of consumer confidence,
causing consumers to increase consumption. There could be a high level of demand for a
country’s exports due to the rising foreign incomes. The increase could be due to
government spending.
PL
AS
AD 1
AD
Real GDP
Cost Push: Cost push inflation occurs as a result of an increase in the costs of production.
An increase in costs results in a fall in short-run aggregate supply. This results in an
increase in the average price level and a fall in the level of real output. Increases in the
price level due to increases in the costs of labor may be referred to as wage-push
inflation. Changes in the costs of domestic raw materials will increase firms’ costs of
production, creating cost push pressures. Also, a fall in the value of a country’s currency
can cause import-push inflation. This is because a lower exchange rate makes imported
capital, components, and raw materials more expensive, thereby increasing the costs of
production to the country’s firms.
SRAS 2
SRAS 1
PL
AD
Real Output
Excess Monetary Growth: Monetarists identified excess monetary growth a cause of
inflation as well. Milton Friedman argues that excessive increases in the money supply by
government are the cause of inflation. If there is more money in the economy, then there
will be more spending, thus higher aggregate demand. Monetarists say that an increase in
the money supply results in higher aggregate demand. Because the economy rests at the
full level of employment in the long run, such increases in aggregate demand due to an
increase in the monetary supply are purely inflationary, causing price levels to rise.
LRAS
PL
AD 2
AD 1
Real Output
Methods of Measuring Inflation
Inflation can be measured by the Consumer Price Index. It is the measure of the overall
cost of the goods and services bought by a typical consumer. First one determines which
prices are most important to the consumer: if the typical consumer buys more hamburgers
than hot dogs, then the price of hamburgers is more important. Then we find the prices
of each of the goods and services in the basket for each point in time. The inflation rate
can be computed by knowing the CPI form the preceding year and the CPI form this year.
Consumer price index =
price of basket of goods and services
_______________________________ X 100
Price of basket in base year
Inflation rate in year 2 =
CPI in year 2- CPI in tear 1
______________________
CPI in year 1
X 100
Problems with Measuring Inflation:
The consumer price index is based on a small fraction of consumer goods, and if
someone’s consuming habits greatly differ from the products in the CPI basket, then that
person may experience a very different change in price. For example, if a person eats hot
dogs instead of hamburgers, drinks beer rather than soft drinks, and does not own a car,
then this person will experience a very different price index compared to what is built in
the CPI’s basket.
In addition, the CPI does not measure change in quality of a product. There might
be a change in price, but in the long run, usually the quality of goods and services
improves, therefore the CPI does not account the advanced quality which could be the
reason for a higher price.
Phillips Curve in Short Run
Inflation
Rate
6%
2%
Phillips
Curve
4%
7%
Unemployment
Rate
The Phillips Curve shows the short-run trade off between inflation and
unemployment. It simply shows the combinations of inflation and unemployment that
arise in the short run as shifts in aggregate demand curve move the economy along the
short-run aggregate- supply curve. An Increase in the aggregate demand for goods and
services leads, in the short run, to a larger output of goods and services and higher price
levels. Larger output means greater employment and thus, lower rate of unemployment.
Shifts in aggregate demand push inflation and unemployment in opposite directions in the
short run- a relationship illustrated by the Phillips Curve.
In the long run, the Phillips Curve provides no trade-off between inflation and
unemployment. Growth in the money supply determines the inflation rate. Regardless o
the inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the
long run Phillips Curve is a vertical line. The vertical long-run Phillips curve is one
expression of the classical idea of monetary neutrality. Classical theory points to growth
of the money supply as the primary determinant of inflation. But classical theory also
states that monetary growth does not affect real variables such as output and
employment; it changes all prices and nominal incomes proportionally. In particular,
money growth does not influence those factors that determine the economy’s
unemployment rate, such a market power of unions, the role of efficiency wages, or the
process of job search.
LRPC
Inflation
Natural Rate of
Unemployment
Natural Rat of Unemployment: This is the term Friedman and Phelps used to describe the
unemployment rate towards which the economy gravitates in the long run. Yet the natural
rate of unemployment is not necessarily to socially desirable rate of unemployment. Nor
is the natural rate of unemployment constant over time. For example, suppose that a
newly formed union uses its market power to raise the real wages of some workers above
the equilibrium level the result will be excess supply of workers and therefore higher
natural rate of unemployment. It is natural because it is beyond the force of monetary
policy.
Non- Accelerating Inflation Rate of Unemployment ( NAIRU)- this is an alternative term for the
natural rate of unemployment. It is the rate of unemployment at which there is neither
upward pressure on inflation (from producers taking advantage of the market power
given, and from workers using the market power) nor downward pressure on inflation
(from customers taking advantage of the market power given them by excess capacity,
and from firms using the market power provided by high unemployment to try to
decrease the rate of wage growth).
http://www.cnn.com/2009/POLITICS/03/11/stimulus.sanford/
The link above is about a document criticizing Obama’s $800 billion bailout plan. The Republican Sanford believes that the United States will experience inflation
similar to the one of Zimbabwe if the government just prints out money which the
country does not have. According to Sanford, sending money to states that need it will
only cause inflation and will not create ant new jobs. The article reinforces the short run
relationship between unemployment and inflation: “Labor Department figures released
Wednesday showed South Carolina's January unemployment rate hit 10.4 percent, second
only to Michigan's 11.6 percent.” If South Carolina turns down the money, "South
Carolina taxpayers will be taking on the debt for economic stimulus money sent
elsewhere." Just printing out paper money will cause inflation, but if the money are put
towards creating new jobs, then the bail-out plan could succeed.