Lecture 6: Inflation and Unemployment PDF

Lecture 6 Inflation and unemployment References : Hubbard and O'Brien Chapters 20 and 28 Learning outcomes of today’s lecture Unemployment Inflation Philips Curve D R. D E B O S H R E E GHOSH 2 Can also be termed as cyclical unemployment D R. D E B O S H R E E GHOSH 3 Types of une...

Lecture 6 Inflation and unemployment References : Hubbard and O'Brien Chapters 20 and 28 Learning outcomes of today’s lecture Unemployment Inflation Philips Curve D R. D E B O S H R E E GHOSH 2 Can also be termed as cyclical unemployment D R. D E B O S H R E E GHOSH 3 Types of unemployment and their reasons Frictional : Factors contributing to frictional unemployment include voluntary job changes, geographic mobility constraints, information gaps between job seekers and employers, and the time taken for individuals to find suitable employment. Structural : Factors such as automation, globalization, changes in industry composition, and skill obsolescence. These factors lead to persistent unemployment as workers lack the necessary skills for available jobs. D R. D E B O S H R E E GHOSH 4 Types of unemployment and their reasons Real wage : caused by minimum wage laws, labour unions bargaining for higher wages, or sticky wages that do not adjust to changes in labour market conditions. Geographical : regional economic disparities, lack of transportation infrastructure, housing costs, and social ties that prevent relocation. Voluntary : can stem from various personal or lifestyle choices that prioritize non-economic activities over work, or it may reflect a decision to wait for better job prospects. D R. D E B O S H R E E GHOSH 5 Types of unemployment and their reasons Seasonal: factors such as weather conditions, agricultural cycles, holiday seasons, and tourism trends, which lead to temporary increases or decreases in labour demand. Demand deficient : stems from various factors that lead to a decrease in aggregate demand within the economy. D R. D E B O S H R E E GHOSH 6  An inflation that starts because aggregate demand increases (AD curve shifts right) is called demand-pull inflation. Demand pull inflation AD = C + I + G + (X-M) Price levels increase and real GDP also increases It can occur when the economy experiences recessionary, inflationary or even long run equilibrium. If the shift of AD leads to AD=SAS=LAS then it is a long run equilibrium. Otherwise, it is a short run equilibrium. D R. D E B O S H R E E GHOSH 7 Cost push inflation An inflation that starts with an increase in costs (of inputs) is called cost-push inflation. The SAS curve shifts to the left because it is expensive for produce products There are two main sources of increased costs: 1. An increase in the money wage rate 2. An increase in the money price of raw materials, such as oil Cost push inflation leads to stagflation i.e. a contraction in the economy (fall in real GDP or output) accompanied by a rise in the general price level unlike the effects of demand-pull inflation where the rise in general price level is along with economic expansion (a rise in real GDP or output) D R. D E B O S H R E E GHOSH 8 Inflation trends across the World Inflation in 2022 (top 10 lowest) Inflation in 2022 (top 10 highest) French Polynesia 1.7 Grenada 1.7 West Bank and Gaza Zimbabwe 50.5 Sri Lanka 48.8 Suriname 43.8 Azerbaijan 37.2 Ethiopia 34.6 Ukraine 34.3 0.3 Macao SAR,-0.4 China -2.1 Bahamas, The Seychelles -4.4 -5 -4 -3 -2 -1 0 1 2 3 D R. D E B O S H R E E 69.4 Iran, Islamic Rep. 0.6 Japan 96 Argentina 1 Djibouti 116.8 Turkiye 1.2 Marshall Islands 264.5 Sudan 1.5 Korea, Rep. Inflation is a sustained increase in the price level of goods and services. Disinflation is a decrease in the rate of inflation. Deflation is a sustained decrease in the price level of goods and services. 0 GHOSH 50 100 150 200 250 300 9 The link- GDP and unemployment Potential GDP is achieved when the economy is at full employment. Potential GDP Potential GDP is the maximum output an economy can produce without triggering inflation, assuming full employment and optimal use of resources. When the economy is at full employment, the actual unemployment rate equals the natural rate of unemployment. Full employment Full employment is the level of employment where virtually all individuals who are willing and able to work at prevailing wage rates are employed. It does not imply zero unemployment because there will always be some level of frictional, structural, and seasonal unemployment. D R. D E B O S H R E E GHOSH Natural rate of unemployment (NRU) Full employment is achieved when the actual unemployment rate equals the natural rate of unemployment. 10 Linking inflation and unemploymentPhillips Curve Phillips Curve Short run Phillips curve Long run Philips Curve Remember : Inflation is NOT just price level. Inflation is the INCREASE of price level Short run Phillips Curve : The short-run Phillips curve shows an inverse relationship between inflation and unemployment. This implies that, in the short run, lower unemployment can be achieved at the cost of higher inflation, Long run Philips Curve : The long-run Phillips curve shows that there is no trade-off between inflation and unemployment in the long run. It is typically represented as a vertical line at the natural rate of unemployment. This implies that in the long run, the economy will return to its natural rate of unemployment regardless of the inflation rate. D R. D E B O S H R E E GHOSH 11 Different school of thought – Phillips Curve Traditional Philips Curve Originates from the empirical observation by A.W. Phillips. Suggests a stable, inverse relationship between inflation and unemployment in the short run. Adaptive Expectations: Inflation expectations are based on past inflation. Early new classical theories assumed that prices adjusted freely and that expectations were formed rationally—that is, without systematic error. I.e. wages and prices adjusted simultaneously. With decrease in unemployment- wages increased simultaneously. D R. D E B O S H R E E GHOSH 12 Traditional Philips Curve BROKE DOWN In the 1970s, many advanced economies, particularly the United States, experienced stagflation (both inflation AND unemployment increased). Implication: The traditional Phillips Curve, which posited an inverse relationship between inflation and unemployment, could not explain the simultaneous rise in both. D R. D E B O S H R E E GHOSH 13 Different school of thought – Phillips Curve New Keynesian Phillips Curve (NKPC) with Sticky Wage Theory Rational Expectations: INSTEAD of only past inflation, agents form expectations about future inflation based on all available information, not just past inflation. Price and Wage Stickiness: Prices and wages are slow to adjust due to contracts, adjustment costs, and other frictions. This is the sticky wage theory. Forward-Looking Behavior: Inflation dynamics are influenced by expectations of future economic conditions. I.e. wages are set in advance (under contracts)- sticky wage theory WE FOCUS ON THIS THEORY D R. D E B O S H R E E GHOSH 14 C B A SRPC When AD increases then prices increase, this causes the suppliers increase supply due to sticky wage theory. This increases employment and decreases unemployment. Increases price level therefore causing inflation Unemployment Price level (GDP Deflator) Inflation Short Run Phillips Curve (SRPC) The short run Phillips curve (SRPC) illustrates a negative relationship between inflation and unemployment. SAS0 C B A AD2 AD1 AD0 Real GDP ($ billions) SRPC is a mirror image of movement along the SAS curve. D R. D E B O S H R E E GHOSH 15 Inflation LRPC C Expected inflation B A NRU The point where LAS exists is also corresponds to the LRPC (at natural rate of unemployment (NRU)). When a country reaches the natural rate of unemployment then output cannot be increased further but can only lead to higher prices. Price level (GDP Deflator) Long Run Phillips Curve (LRPC) The LRPC exists on the point of natural rate of unemployment (NRU). The corresponding inflation rate is the expected inflation rate Unemployment LRPC is a mirror image of the point of LAS D R. D E B O S H R E E GHOSH LAS0 SAS0 C B A AD2 AD1 AD0 Full Real GDP ($ billions) employment 16 Business cycle and Philips Curve Inflation LRPC Inflationary gap : Higher than full employment output indicated by lower than NRU unemployment C Expected inflation B A NRU Inflationary Gap Recessionary gap : Lower than full employment output indicated by higher than NRU unemployment Recessionary Gap Unemployment Remember : full employment level GDP is also known as GDP at natural rate of unemployment D R. D E B O S H R E E GHOSH 17 Impact of expansionary fiscal policy on Phillips Curve when economy in long run equilibrium Price level Inflation (%) LAS LRPC SAS2 104 100 c SAS1 b b a c 4.0 1.0 AD2 a AD1 500 Full employment Real GDP $’000m 2.5 3.0 NRU D R. D E B O S H R E E Shifting AD1 to AD2 leads to higher prices and more than potential output On AD-AS framework : movement from point a to b Based on On Philips Curve framework : anticipated movement along SRPC from a to b inflation 4%, wages rise Higher prices leads to movement along the AS curve to reach point b. At point b, wages are revised upwards (sticky wage theory) On AD-AS framework : movement SRPC2 from point b to c On Philips Curve framework : shift of SRPC1 SRPC to represent higher inflation and original level of output i.e. full Unemployment employment level output (NRU (%) output) GHOSH 18 Impact of expansionary fiscal policy on Phillips Curve when economy is in recession Price level Inflation (%) LAS 104 Shifting AD1 to AD2 leads to higher prices and output=potential output On AD-AS framework : movement from point a to b On Philips Curve framework : movement along SRPC from a to b LRPC SAS1 104 100 b a 4.0 1.0 AD2 AD1 500 Full employment Real GDP $’000m Equilibrium is stable since it is at LAS and LRPC b 3.0 NRU a SRPC1 Unemployment (%) 19