Inflation & unemployment

Inflation & Phillips curve:

 The inflation rate is the
percentage change in the price
level.
 The Phillips Curve shows the
relationship between the inflation
rate and the unemployment rate.
Causes of Inflation:
 Demand-pull inflation is inflation
initiated by an increase in aggregate
demand.
• Cost-push, or supply-side, inflation
is inflation caused by an increase in
costs.
 Demand pull :

Increase in AD can
be due to a fiscal or
monetary policy,
thus increasing
prices
 Cost push:

Upward shift of the

AS will be due to
increase in costs due
to increase in price of
inputs.
Stagflation:
 Stagflation occurs when output is
falling at the same time that prices are
rising.
 One possible cause of stagflation is an
increase in costs.
Combination of both:
Costs of inflation:
 Redistribution of income and wealth-
borrowers gain and creditors lose.fixed
income earners lose.
 Balance of payments effect- exports become
expensive. Hence exchange rate depreciates.
 Uncertainty about the value of money
 Resource cost of changing prices – menu
costs
 Economic growth and investment suffers
Philips Curve:
 It is a statistical relationship between
unemployment and money wage
inflation.
 Rate of inflation= rate of wage growth
less rate of productivity growth.
Phillips Curve:
 1958 – Professor A.W. Phillips
 Expressed a statistical relationship between
the rate of growth
of money wages and unemployment
from 1861 – 1957
 Rate of growth of money wages
linked to inflationary pressure
 Led to a theory expressing a trade-off
between inflation and unemployment
  The Philips Curve
Wage growth %
(Inflation) The Phillips Curve shows an
inverse relationship between
inflation and unemployment. It
suggested that if governments
wanted to reduce unemployment
it had to accept higher inflation as
2.5% a trade-off.
Money illusion – wage rates rising
but individuals not factoring in
inflation on real wage rates.
1.5%

4% 6% Unemployment (%)
PC1
 The curve crosses the horizontal axis at a positive
value of unemployment. Hence it is not possible to
have zero inflation and zero unemployment
 The concave shape implies that lower the level of
unemployment higher the rate of inflation.
 Govt. should be able to use demand management
policies to take the economy to acceptable levels of
inflation and unemployment.
 In order to achieve full employment, some inflation is
unavoidable.
 However, this relationship broke down at the end of
1960s when Britain began to experience rising
inflation and unemployment.
 This raised a question on the application of Phillips
curve in the long run.
Long run Phillips curve:
 dp/dt = f(1/u) + dpe/dt
 To keep unemployment below the natural
rate, inflation must keep on increasing every
year. In the long run Philips curve will be
vertical at the rate of unemployment where
real aggregate demand equals real aggregate
supply. This rate is called the natural rate of
unemployment. It is also called NAIRU or
Lowest sustainable unemployment rate
(LSUR).
 The Philips Curve
To counter the rise in unemployment,
Long Run PC government once again injects resources
into the economy – the result is a short-
 inflation term
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AD/AS Phillips
unemployment
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Curve is vertical at the natural rate of
3.0% unemployment. This is how economists
have explained the movements in the
Phillips Curve and it is termed the
Expectations Augmented Phillips
Curve.
2.0%

1.0%
PC1
7% PC2 Unemployment
PC3
 7% becomes the natural rate in this
case.
 Whenever unemployment rate is
pushed below natural rate , wages
increase, pushing up costs. This leads
to a lower level of output which pushes
unemployment back to the natural
rate.
Countering inflation:
Demand -pull Reduce demand by higher taxation, lower govt.
expenditure, lower govt borrowing, higher interest
rates

Cost push Take steps to reduce production costs by deregulating

labour markets, encouraging greater productivity, apply
control over wages and prices

Import factors reduce quantity of imports or their prices via trade

policies.
Controlling inflation (cont)
Excessive Reduce money supply by cutting down on public
growth on sector borrowing
money supply Funding Govt borrowing from non bank
Reduce bank lending
Maintain interest rates

Expectations of Pursue policies which indicate Govt’s determination to

inflation reduce inflation
Types of Unemployment:
 Frictional Unemployment:
 Unemployment caused
when people move from job to job
and claim benefit in the meantime
 The quality of the information available
for job seekers is crucial to the extent
of the seriousness of frictional
unemployment
Types of Unemployment:
 Structural Unemployment:
 Unemployment caused
as a result of the decline of industries and the
inability of former employees to move
into jobs being created
in new industries
 Seasonal Unemployment:
 Unemployment caused because of the
seasonal nature of employment – tourism,
agriculture, sports etc.
 CYCLICAL UNEMPLOYMENT:
 Caused by a general lack of demand in
the economy – this type
of unemployment
may be widespread across a range
of industries and sectors
 Keynes saw unemployment as primarily
a lack of demand in the economy which
could be influenced by the government
Okun’s Law:
 This law states that 1 extra point of
unemployment costs 2%of GDP
 Consequences of unemployment:
1. Loss of potential output
2. Loss of human capital
3. Increasing inequalities and distribution
of income
4. Social costs