ECO 120 Macroeconomics Week 11

1. ECO 120 MacroeconomicsWeek 11 Unemployment & Inflation Lecturer Dr. Rod Duncan

2. Topics • Definition of unemployment. • Types of unemployment. • Costs of unemployment. • Definition of inflation. • Types of inflation. • Impacts of inflation. • Relationship between unemployment and inflation- the Phillips Curve.

3. Unemployment • A person becomes unemployed if he or she is a: • Job loser • Job leaver • New entrant or re-entrant into the labour force • He or she is no longer unemployed if: • Hired or recalled • Withdraws from the labour force

4. Population Working age population Labour Force Participation Rate Labour Force Employed / Unemployed Unemployment Rate

5. Labour Force Participation Rate (LFPR) Proportion of country’s population that takes part in its economic activities directly (either actually taking part or willing to) ( / ) Labour Force Working Age Population X 100 LFPR In Australia, in September 2003 : ( 10.237 million / 15.955 million ) x 100 = 64.2 %

6. Unemployment Rate (UR) Proportion of country’s labour force that is unemployed. ( / ) Number Unemployed Labour Force X 100 UR in Australia, in September 2003 : (0.591 million / 10.237 million) x 100 = 5.8%

7. Unemployment over the Business Cycle (1965- 1995) Unemployment Change in GDP

8. Labour Force Participation by Sex at Ages 35-44 Males Females

9. Aged 15-19 looking for full-time work Total Unemployment Aged 20 & over seeking full-time work

10. Types of Unemployment • Cyclical unemployment • Frictional (or search) unemployment • Structural (technological) unemployment

11. Cyclical Unemployment Associated with the ups and downs of the business cycle • Takes place due to insufficient aggregate demand or total spending- reflects shifts in AD curve. • High during recessions and low during booms. • Fiscal and monetary policies can reduce cyclical unemployment - policies are relevant.

12. Frictional Unemployment • Associated with the period of time in which people are searching for jobs, being interviewed and waiting to commence duties. • It is inevitable and always exist • Fiscal and monetary policies can not reduce frictional unemployment – macroeconomic policies are irrelevant. • Policies that make it easier to find new jobs will affect frictional unemployment.

13. Structural Unemployment Associated with wider structural or technological changes in the economy that may make some jobs redundant. • It is inevitable and always exist • Lasts longer than frictional unemployment • Fiscal and monetary policies can not reduce structural unemployment – macroeconomic policies are irrelevant. • Policies that encourage workers to retrain skills or to move to a new area with more jobs will decrease structural unemployment.

14. Full Employment • Full employment means when all productive resources in the economy are in full use - implies no cyclical unemployment - still frictional and structural unemployment exist - they can be low - but can never be zero. • The full-employment rate of unemployment is called the natural rate of unemployment • equals the sum of frictional and structural unemployment • cyclical unemployment = zero • Domestic output consistent with the natural rate of unemployment is potential output or full employment level of GDP

15. Other Employment Issues • Part-time employment - very high in Australia in recent years. • Discouraged workers or the “hidden unemployed” • Those who become discouraged and drop out of the labour force temporarily - would return if a suitable job prospect arose • Discourage workers, participation rate and the unemployment rate

16. Cost of Unemployment • Economic cost • output foregone, measured in terms of the loss of potential GDP - Okun’s law quantifies the relationship between the unemployment rate and the GDP gap - for every 1% of unemployment (over the natural rate) 3.5% of GDP loss in Australia. • Underemployment • High budget costs • Social Costs • Increase in crime rate, abuse etc. • Physical & mental illness • Unlikely to develop work ethics

17. Classical Employment Theory • Economy always operates under full employment - it is automatic and self sustaining - if there is any unemployment that is only temporary • Price-wage flexibility • the assumption that all prices, including wages and interest rates, are flexible and will, rapidly adjust to remove disequilibria • Classical theory and laissez faire • the price system ensured that price-wage flexibility and fluctuations in the interest rate was capable of maintaining full employment

18. AD-AS in the Classical Theory • Vertical aggregate supply curve • exclusively determines level of real domestic output • Stable down-sloping aggregate demand • exclusively determines price level

19. Classical View of Unemployment ASLR = AS P1 Price Level P2 AD1 AD2 Q1 Real Domestic Output

20. Keynesian View of AD - AS • Full employment is not automatic - unemployment exists for longer periods - the Great Depression of the 1930s - sticky wages and prices. • Horizontal aggregate supply curve during recession - ‘recessionary’ or ‘Keynesian’ range • Change in AD impacts on unemployment - not on price level. • Once the full employment level is reached - vertical AS curve - change in AD affects price level only. • Unstable aggregate demand - especially investmentdemand management and stabilisation policies by the government are essential

21. Keynesian View of Unemployment ASLR AS P1 Price Level AD1 AD2 Q2 Q1 Real Domestic Output

22. Current year index - Previous year index Inflation rate x = 100 Previous year index Inflation • We measure the general price level through a price index such as the Consumer Price Index (CPI) • Inflation is a continuous rise in the general price level

23. Inflation in Australia (1970-2003)

24. Types of Inflation • Demand-Pull Inflation • Cost-Push Inflation

25. Demand-Pull Inflation • Occurs when an increase in AD pulls up the price level • Excess demand for output - increase in AD - AD shifts rightward - AS does not change in the short run - movement along the AS curve - price level increases - GDP increases • In the longer run, workers will realise their real wages have fallen and will demand and receive increased nominal wages - lower profit level - supply decreases - causing the AS to shift to the left - GDP declines - price level increases further - only inflation • May be caused by expansionary fiscal and monetary policies - can be cured by contractionary policies.

26. Demand-Pull Inflation - Short run ASLR AS1 Price Level An increase in aggregate demand.... Increases the price level and output in the short run P2 b P1 a AD2 AD1 Real GDP o Q1

27. Demand-Pull Inflation - Long run ASLR Price Level AS1 A decrease in aggregate supply.... Increases the price level and output returns to original level P3 c P2 b P1 a AD2 AD1 Real GDP o Q1 Q2

28. Cost-Push Inflation • Occurs when an increase in the cost of production at each price level shifts the AS curve leftward resulting in increased prices • Short-run: Increased prices and decreased real output (and more unemployment) • Wage push : increase in wage rate - power of trade unions • Supply shocks - increase in prices of major raw materials - oil etc. • Profit push : increase in profit requirement of large monopoly businesses.

29. Cost-Push Inflation ASLR AS2 AS1 Cost-push inflation occurs when aggregate supply shifts left.... Causing a higher price level b Price Level P2 P1 a AD1 Real GDP o Q1

30. Cost-Push Inflation and Demand Management • Government intervention (AD): If government intervenes to increase AD an inflationary spiral will result • No Government intervention (AD): If government does not intervene to increase AD severe recession will result, however nominal wages will eventually decline and will restore AS to original position

31. Cost-Push Inflation ASLR AS2 AS1 An attempt to increase AD will only further increase the price level P3 c b Price Level P2 P1 a AD1 Real GDP o Q2 Q1

32. Stagflation • Simultaneous experience of high and increasing unemployment and inflation - cost-push inflation. • Caused by : • Aggregate supply shocks such as severe increases in fuel costs, and devaluations • Productivity decline • Inflationary expectations and wages - expectations about the likely future path and rate of increase of the general price level

33. Types of Inflation in Australia • 1973-74 : Cost push - caused by international oil price rise. • 1979 : cost-push - caused by international oil price rise. • 1981-82 : cost push - caused by rapidly rising wages. In early 1993, RBA announced its policy of inflation targeting - 2% - 3% a year - initially caused a recession & rise in unemployment

34. Impacts of Inflation • Anticipated (expected) and unanticipated (unexpected) inflation. • Anticipated inflation is not a big problem - economy adjusts automatically. • Unanticipated inflation redistributes income between : • employers and employees • lenders and borrowers

35. Phillips Curve • Suggests an inverse relationship (or a trade-off) between inflation and the unemployment rate • Named after A W Phillips who originally discovered the relationship between unemployment and nominal wages, using British data in 1950s. • In general, inflation is associated with economic expansion and unemployment with economic recession. • During expansion : the greater the rate of growth of AD - inflation is high - unemployment is low. • During recession : the slower the rate of growth of AD - inflation is low - unemployment is high.

36. The Phillips Curve 7 6 5 4 3 2 1 0 Annual rate of inflation (percent) 1 2 3 4 5 6 7 Unemployment rate (percent)

37. Implications of Phillips Curve • Trade-off suggests : a rise in inflation should lead to a decline in unemployment, and vice versa. • In general, both can not be brought down to the minimum level. • The society must make a choice between low inflation and low unemployment.

38. Phillips Curve in Australia 1977 1983 1993 1970 2003

39. Shifting Phillips Curve • The smooth relationship may not be valid in the long-run - Conflicts with the trade-offs embodied in the Phillips Curve • Vertical Phillips Curve - at full employment level, only price level changes • Simultaneous high and increasing unemployment and inflation - may lead to shifts in the curve

40. References Macroeconomics - Jackson Chapters : 5, 13 & 14