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.
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) Index (Jan. 1921 = 100) 10 million 100 trillion Price level Price level 1 trillion 1 million Money supply 10 billion Money 100,000 100 million supply 1 million 10,000 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.
Value of Price Money supply Money (1/P) Level (P) (High) 1 1 (Low) 1.33 3/4 A 2 1/2 Equilibrium value of money Equilibrium price level 4 1/4 Money demand (Low) 0 (High) Quantity of Money Money Supply and Demand and Price Level
Value of Price MS2 Money (1/P) Level (P) 1. An increase in the money supply... 2. ...decreases the value of money ... 3. …and increases the price level B M2 Quantity of Money Effects of Monetary Injection MS1 (High) 1 1 (Low) 1.33 3/4 A 2 1/2 4 1/4 Money demand (Low) 0 (High) M1
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 Thevelocity of moneyrefers 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 M x V = P x Y
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.
Short-run AS2 C P3 B P2 AD2 Quantity of Y2 Output Demand-Pull Inflation In the long run, nominal wages rising causes AS to decrease and the price level rises further. Price Level Long-run AS Short-run AS1 An increase in AD increases the price level in the short run P1 A AD1 0 Y1
Cost-Push Inflation The cost-push inflation originates on the supply side of markets from a sharp increase in costs.
Price Level AS2 P3 C B P2 AD2 Quantity of Output Cost-Push Inflation The rise of Costs pushes AS upward and leads to a higher price level but a lower output. Long-run AS Short-run AS1 If the government fights the recession by increasing AD, further inflation will occur. A P1 AD1 0
Impacts of Inflation • Shoeleather costs • Menu 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.
Labor force (137.7 million) Adult population (205.2 million) The Breakdown of the U.S. Population in 2000 Employed (131.5 million) Unemployed (6.2 million) Not in labor force (67.5 million)
Measuring Unemployment The unemployment rate is calculated as the percentage of the labor force that is unemployed.
Measuring Unemployment The labor-force participation rate is the percentage of the adult population that is in the labor force.
Unemployment rate Natural rate of unemployment Unemployment Rate Since 1960 Percent of Labor Force 10 8 6 4 2 0 1960 1965 1970 1975 1980 1985 1990 1995 2000
Men Women Labor-force Participation Rates for Men and Women 100 Labor-force Participation Rate (in percent) 80 60 40 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)isunemployment 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 unemploymentrefers 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 unemploymentarises 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 unemploymentresults 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.
Labor supply Voluntaryunemployment Employment W* A F E Labor demand Voluntary Unemployment vs.Involuntary Unemployment Wage Labor 0
Labor supply Involuntaryunemployment Employment Voluntaryunemployment W** G J K H W* E Voluntary Unemployment vs.Involuntary Unemployment Wage Labor demand Labor 0
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.
Surplus of labor = Labor Unemployment supply Minimum wage Labor demand LD LS Unemployment from a Wage Above the Equilibrium Level Wage WE 0 LE 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.