10: Macroeconomic objectives I: Low unemployment, low and stable rate of inflation

Question 1

Define unemployment:

Answer 1

Unemployment refers to people of working age who are actively looking for a job but who are not employed.

Question 2

What is underemployment?

Answer 2

People of working age with part-time jobs when they would rather work full time, or with jobs that do not make full use of their skills and education.

Question 3

What is the labour force?

Answer 3

The number of people who are employed plus the number of people of working age who are unemployed. It is only a fraction of the population because it excludes children, retired persons, students and anyone that cannot work due to an illness or disability.

Question 4

How do you measure unemployment?

Answer 4

Unemployment can be measured as a number or a percentage. If it is a percentage it is measured by the number of unemployed/labour force x 100.

Question 5

Difficulties in measuring unemployment:

Answer 5

Difficulties arise due to hidden employment:
1. Unemployment figures only include people actively searching for a job which discounts those who became discouraged and stopped.
2. Figures do not make a distinction between full time and part time employment, and count people with part time jobs as having full time jobs though in fact they are underemployed.
3, Figured make no distinction between the type of work done so if a scientist works as a water, this counts as full employment.
4. Figures do not include people on retraining programmes who previously lost their jobs.

In addition figures do not include people working in underground economies.

Question 6

Other disadvantages of national unemployment rate:

Answer 6

It does not account for differences in unemployment that arise in different population groups in a society such as regions, gender, ethnic groups, age, occupation and educational attainment.

Question 7

Economic consequences of unemployment:

Answer 7

1. A loss of real output (GDP) - inside the PPC.
2. A loss of income for unemployed workers.
3. A loss of tax revenue for the government.
4. Cost to the government of unemployment benefits, there are opportunity costs.
5. Costs to the government of dealing with social problems of unemployment.
6. Unequal distribution of income.
7. Unemployed people have difficulty finding employment in the future as they forget skills, lack experience, grow older and less desirable or new skills have been introduced that they don’t know. This is called hysteresis.

Question 8

Personal and social consequences to unemployment:

Answer 8

1. Being unemployed can lead to indebtedness as well as a loss of self-esteem. Psychological stress can lead to lower levels of health, family stress and even suicide.
2. High rates of suicide can lead to greater rates of homelessness, crime, violence and drug use.

Question 9

What are the four types of unemployment?

Answer 9

1. Structural
2. Frictional
3. Seasonal
4. Cyclical

Question 10

What is structural unemployment?

Answer 10

Structural unemployment occurs as a result of changes in demand for particular labour, or changes in geographical location of industries and therefore jobs.

Question 11

Why would there be changes in demand for particular labour skills?

Answer 11

For example, technological advancements have increased the need for computer literacy amongst workers, which the older generation have less of. The demand for computer programmers is increasing.
In addition, structural employment can occur as a result of a change in the structure of the economy. For example, as a country develops the agricultural sector takes up a smaller percentage of the economy than manufacturing or services, meaning some who have only obtained agricultural skills may become structurally unemployed.

Question 12

How does a change in geographical location of jobs lead to structural unemployment?

Answer 12

When a large firm relocates from one region to another, there is a fall in demand for labour in one region and an increase in the region it relocates.

Question 13

How can you show structural unemployment on a graph?

Answer 13

A shift of the D curve to the left. P goes down and Q goes down to P2 and Q2. Since there is a decrease in the amount of product produced employers fire those with inappropriate skills or those no longer needed due to relocation.

Question 14

What are labour market rigidities?

Give examples of labour market rigidities and explain their effects:

Answer 14

Factors preventing the forces demand and supply from operating in the labour market. They include:

1. Minimum wage legislation - leads to higher equilibrium wages and causes unemployment
2. Labour union activities and wage bargaining with employers - higher equilibrium wages and causes unemployment
3. Employment protection laws - costly for firms to fire employers due to compensation, making firms more cautious about hiring.
4. Generous unemployment benefits - increase the attractiveness of remaining unemployed and reduce incentives to work.

Question 15

Show the effect of labour market rigidities on a graph:

Answer 15

P on y, Q on x.
Labour market rigidities lead to an increase in the cost of production, shifting S to the left and causing a fall in Q produced meaning employers hire less workers.

Draw another graph.
P of labour on y
Q of labour on x
minimum wage legislation and labour union activities leads to higher than equilibrium wages (show Wm above We where D and S are supposed to meet). Show Qd is lower than Qs, labour surplus = unemployment.

Question 16

How is the government trying to reduce it?

Answer 16

Encouraging workers to retrain, or pushing firms to offer specific retraining programmes. Or encouraging workers to relocate to areas with greater employment opportunities.

Question 17

What is frictional unemployment?

Answer 17

When workers are between jobs. They may have left their previous job because they were fired, or their employer went out of business or because they wanted to search for a better job.

Question 18

Real world focus for structural unemployment:

Answer 18

Naoussa in Greece.
Used to have a booming textiles industry but employers found it was cheaper to move to other countries like Romania due to lower labour costs.
Greek government tried to lower labour costs by decreasing labour market rigidities but firms just found it easier to fire people and relocate to Romania. In 2005 unemployment reached 40% in Naoussa.

Question 19

What is seasonal unemployment?

Answer 19

When demand for labour changes on a seasonal basis due to variations in needs. For example farm workers are hired on a seasonal basis due to harvesting seasons, and laid off for the rest of the year.

Question 20

What is full employment composed of?

Answer 20

The sum of structural, frictional and seasonal unemployment. They are all naturally occurring, though this does not mean they cannot be reduced. A long term reduction in any of these types of unemployment would mean a shift right in the LRAS or Keynesian AS curves.

Question 21

Explain cyclical employment using a diagram.

Answer 21

Cyclical unemployment occurs during the downturns of the business cycle, when the economy is in a recessionary gap. It occurs as a result of a fall in AD so is also known as demand-deficient unemployment.

Show two diagrams, the neoclassicist model and the Keynesian model:

With neoclassicist show LRAS, SRAS and AD then AD1 to the left. Pl2 is lower and Yrec is lower.

With the Keynesian model draw AS (horizontal then vertical) the draw AD1 and AD2 to the left with an arrow. Y rec is lower and P2 is slightly lower (for this to be true AD1 must intersect AS on the upwards part).

Explain as AD falls, real GDP falls and firms lay off workers.

Question 22

Why then during an inflationary gap is unemployment less than the natural rate?

Answer 22

Since the natural rate of unemployment is composed of structural, seasonal and frictional unemployment, during an inflationary gap the real GDP is greater than Yp meaning some of the structurally, frictionally and seasonally unemployed are temporarily employed.

Question 23

What is inflation?

What is deflation?

What is disinflation?

Answer 23

Inflation is a sustained increase in the general price level.

Deflation is defined as a sustained decrease in the general price level.

Disinflation is a decrease in the rate of inflation.

Question 24

What is the consumer price index (CPI)?

Answer 24

A measure of the cost of living, or the cost of goods and services purchased by the typical household in the economy. It compares the value of a basket of goods and services in one year with the value of the same basket in a base year.

Question 25

Downsides of the CPI as a measure of inflation:

Answer 25

1. There are different rates of inflation for different income earners. It is difficult to have a basket of goods for the typical household when income varies so greatly within a country.
2. There are different rates of inflation depending on regional or cultural factors.
3. It does not account for changes in consumption patterns due to consumer substitutions when prices change.
4. Changes in consumption patterns due to increasing use of discount stores.
5. Changes in consumption patterns due to introduction of new products.
6. Changes in product quality are not measured.
7. International comparisons are hard as the types of goods measured and calculations vary.
8. Comparability over time are difficult because countries regularly change their basket of goods to try and address problems above, meaning over long periods of time inflation is hard to measure.

Question 26

What is the core rate of inflation and why is it necessary?

Answer 26

Certain goods have very volatile prices, such as oil. When such goods are included in the CPI they can give rise to misleading impressions regarding the rate of inflation so economists measure a core rate of inflation. They do this by construction a CPI that does not include good and energy products with highly volatile prices.

Question 27

How has the EU tried to combat the problem of international comparisons regarding the CPI?

Answer 27

The EU has devised a harmonised index of consumer prices (HICP). This determines consistent and comparable rules that must be followed by EU countries in order to calculate CPIs that are comparable.

Question 28

What is the PPI? How does it differ from the CPI? How might it be useful to predict changes in the CPI?

Answer 28

The producer price index is a composite index measuring prices received by producers of goods at various stages in the production process. They measure price changes from the point of view of the producer. They can predict changes in the CPI because they measure price changes at an earlier stages in the production process. If the wholesale prices are rising, it is likely they will eventually pass on to the consumer.

Question 29

Consequences of inflation:

Answer 29

1. Redistribution effects
2. Uncertainty
3. Menu costs
4. Money illusion
5. International competitiveness

Question 30

What are redistribution effects?

What groups are worse off due to inflation?

Answer 30

Certain groups are worse off due to inflation and some are better off due to inflation.

Those who are worse off include:

1. People who have fixed incomes or wages - the purchasing power falls
2. People who have incomes or wages that increase less rapidly than the rate of inflation.
3. Holders of cash - the purchasing power falls
4. Savers - if the interest rate is less than the rate of inflation then the value of savings will fall.
5. Lenders - if the interest rate on money lent is less than the rate of inflation then lenders will lose as when they get the same amount of money back the value has decreased.

Question 31

What groups are better off due to inflation?

Answer 31

1. Borrowers - if the interest rate is lower than the rate of inflation the amount they have to pay back has decreased in value.
2. Payers of fixed income or wages - the real value of their payments fall.

Question 32

How is uncertainty a consequence of inflation?

Answer 32

The inability to accurately predict what inflation will be in the future causes uncertainty among economic decision makers. Firms in particular become more cautious about investments which may lead to a decrease in economic growth.

Question 33

How are menu costs a consequence of inflation?

Answer 33

These are costs incurred by firms who have to frequently print out new menus due to changing prices. It also refers to advertisements and price labels in stores. The higher the rate of inflation the higher the menu costs.

Question 34

How is money illusion a consequence of inflation?

Answer 34

If wages are indexed, the nominal price increases but the real price does not. This can lead to money illusion, as people feel wealthier than they are as they have more money in the bank. If money illusion is widespread it could have negative consequences as it leads to consumers making the wrong spending decisions.

Question 35

How is export competitiveness a consequence of inflation?

Answer 35

When the PL of a country increases more rapidly than the PL in other countries with which it trades, its exports become more expensive to foreign buyers while imports become cheaper to domestic buyers. The country’s export competitiveness is reduced which may lead to a trade deficit as imports increase and exports decrease.

Question 36

Why is a zero rat of inflation not preferred?

What is the ideal rate of inflation?

Answer 36

A zero rate of inflation becomes dangerously close to deflation which can cause serious problems in an economy.

There is no fixed ideal rate of inflation but roughly 2-3% a year.

Question 37

What are the two types of inflation? Explain the first using a diagram.

Answer 37

Demand-pull inflation and cost-push inflation.

Demand-pull inflation involves an increase in AD when the economy is at full employment. AD shifts to the right and PL rises from Pl1 to Pl2 and real GDP rises from Yp to Yinf. The economy is in an inflationary gap and the demand for employment is so large that the rate of unemployment is less than the natural rate, i.e. some people who were structurally, frictionally or seasonally unemployed are not employed.

This can be shown on a Keynesian model or a neoclassical model. As long as AD shifts to the right on the Keynesian such that PL increases.

Question 38

Explain cost push inflation using a diagram:

Answer 38

Cost push inflation is caused by an increase in the cost of production or supply side shocks. Show that the economy is at full employment level of output, Yp. Show an increase in the cost of production by a shift in the SRAS curve to the left. The PL increases from Pl1 to Pl2. Real GDP decreases from Yp tp Yrec. Not that this is not a recessionary gap however as output gaps can only be changed by a change in demand.

The presence of both inflation and unemployment, as is the case here, is called stagflation.

This can only be shown on the neoclassical model because the Keynesian one is not equipt to show short run changes in supply.

Question 39

Which is worse for the economy, cost push or demand pull inflation?

Answer 39

Cost push as it leads to an increase in PL as well as a decrease in employment, leading to more indebtedness.

Question 40

Why does deflation rarely occur in the real world?

Answer 40

1. Wages of workers do not ordinarily fall due to labour market rigidities.
2. Large oligopolistic firms may fear price wars, as this negatively effects both firms.
3. Firms want to avoid incurring menu costs resulting from price changes.

Question 41

Real world examples of deflation?

Answer 41

America in the 1930s during the great depression.

Japan from 1999 - 2006.

Question 42

Consequences of deflation:

Answer 42

1. Redistribution effects
2. Uncertainty
3. Menu costs
4. Risk of a deflationary spiral with high and increasing cyclical unemployment
5. Risk of bankruptcies and a financial crisis.

Question 43

Describe redistribution effects with deflation:

Answer 43

Opposite of those with inflation.
Those on fixed incomes, lenders, savers and holders of cash benefit as the value of their money increases.
Borrowers and payers of those with fixed incomes lose as they pay out sums that have increasing real value.

Question 44

What is a deflationary spiral and what does it lead to?

Answer 44

A deflationary spiral occurs when deflation sets into motion a series of events that worsen the deflation. Deflation discourages spending because they postpone spending as they expect prices will continue to fall. It also discourages borrowing as the real value of debt increases. Consumer and business spending falls, causing AD to fall, unemployment increases and incomes and prices fall further thus repeating the cycle.

Question 45

Why would deflation lead to bankruptcy?

Answer 45

Because the real value of debt increases whilst incomes decrease mean consumers and firms may be unable to pay back debt.

Question 46

What is bad deflation? Explain using a diagram.

Answer 46

‘Bad’ deflation arises when AD decreases for a long period of time, due to business pessimism for example. The price level falls to P2. This type of deflation is associated with recession, falling output and cyclical unemployment.

Question 47

What is good deflation? Explain using a diagram:

Answer 47

Good deflation is caused by a rightward shift of the LRAS curve with the AD curve remaining constant or shifting to the right itself, less that the LRAS shift. Output increases and price decreases, increasing employment and economic growth. No deflation is ever good however as it leads to decreased consumer spending with the expectation that prices will continue to fall.

Question 48

How do you calculate the price index for a specific yeaR?

Answer 48

The value of the basket in a specific year/the value of the basket in the base year * 100.

Question 49

How do you calculate the %∆ in price level?

Answer 49

The final value of A - initial value of A / initial value of A * 100

Question 50

How do you calculate real income?

Answer 50

Nominal income / CPI * 100

Question 51

What is the relationship between unemployment and inflation?

Answer 51

The lower the rate of inflation, the higher the unemployment rate and the higher the rate of inflation the lower the unemployment rate. Thus, there is a trade off between low employment and low unemployment rate.

Question 52

Explain the relationship between unemployment and inflation using a diagram:

Answer 52

Show a SRAS curve with multiple AD shifts upwards. As the AD shifts to the right the real GDP increases, as does the PL. As the real GDP increases production increases and more labour is required for output to increase so unemployment decreases. However the price level increases, this is inflation.

You can show a phillips curve with rate of inflation on y and unemployment rate on x.
It curves downwards, starting high on y and low on x and ending high on x and low on y.

Question 53

How does stagflation break the phillips curve?

Answer 53

It causes it to shift to the right as SRAS shifts to the left with a constant AD.

Question 54

What did Friedman argue in terms of the Phillips curve?

Answer 54

Friedman argued that there is only a trade off between inflation and unemployment in the short run. Therefore the long run phillips curve is a vertical line at the natural rate of unemployment. This is the same reason that the LRAS is vertical. When the AD shifts to the right, PL will increase, causing inflation, and real GDP will increase, causing unemployment. In the short run wages cannot match this change, due to wage price stickiness. In the long run however, the supply will follow the AD shift, shifting to the left as factors of production increase in price, meaning cost of production is higher so SRAS shifts to the right. Therefore Yp is met again, and unemployment remains the same. There is a change in price level meaning inflation. This is why the LRPC is vertical.