Inflation and Unemployment Flashcards
What is the Monetarist ‘Counter Revolution’ theory?
Inflation is demand determined where monetary growth is excessive
Unemployment will settle at its ‘natural rate’ in the long- run
The natural rate will be determined by how efficiently the labour market is operating
What is the quantitiy theory of money?
Changes in the nominal money supply (M) lead to equivalent changes in the price level (and money wages) but do not have effects on output and employment.
- If the demand for real money is constant, M/P constant.
- Monetary policy can control M and extra money supply can affect the price level.
- If prices adjust slowly in the short run, higher nominal money supply M leads initially to a higher real money stock M/P since prices P have not yet adjusted.
- The excess supply of real money bids down interest rates. This boosts the demand for goods. • Gradually this bids up goods prices…
Explain what happens with an increase in inflation on unepmloyment rates
Suppose the economy begins at E, with unemployment at U*, and inflation at π1
An increase in government spending funded by an expansion in money supply takes the economy to A, with lower unemployment (U1) but inflation at π2
If the nominal money supply continues to expand at the same rate thereafter, the economy will eventually move to B on PC2.
At B, inflation expectations coincide with actual inflation and nominal wages have been renegotiated so that the real wage and hence, employment are the same as before the monetary expansion,
i.e. there is no trade-off between unemployment and inflation in the long run.
U* is known as the natural rate of unemployment
Explain the long run Phillips Curve
The vertical long-run Phillips curve implies that sooner or later, the economy will return to U*, whatever the inflation rate.
- The position of the short-run Phillips curve depends on expected inflation.
- The long-run and short-run curves intersect when actual and expected inflation are equalized.
- The long-run Phillips curve shows that in the long run there is no trade-off between unemployment and inflation.
What is inflation illusion?
People have inflation illusion when they confuse nominal and real changes.
- Welfare depends upon real variables, not nominal variables.
- If all nominal variables (prices and incomes) increase at the same rate, real income does not change.
What is the cost of fully anticipated inflation?
Limited costs if instituions adapt to known inflation:
nominal interest rates
tax rates
transfer payments
No inflation illusion but some costs remain:
- shoe-leather (people economise on money holdings)
- menu costs (firms need to alter price lists, etc.)
- Even if inflation is fully anticipated, the economy may not fully adapt
- interest rates may not fully reflect inflation
- taxes may become distorted
- fiscal drag may have unintended effects on tax liabilities •
capital and profits taxes may be distorted
What is the cost of Unanticipated Inflation?
Unintended redistribution of income
– from lenders to borrowers
– from private to public sector
– from old to young
- Uncertainty – firms find planning more difficult under inflation, which may discourage investment
- This has been seen as the most important cost of inflation.
Policy Consequences of Inflation
An inflation/unemployment trade-off in the short run only, not in the long run
Long-run equilibrium can occur at any rate of inflation, provided that the expected rate of inflation is equal to the actual
Attempting to push unemployment below the equilibrium rate of unemployment will lead to accelerating inflation
Lowering the rate of inflation requires a period of sustained unemployment above the equilibrium rate until expectations of inflation have been revised downwards
What is frictional unemployment?
– the irreducible minimum level of unemployment in a dynamic society
- people between jobs
- the ‘almost unemployable’
caused by the time it takes workers to search for a job
- occurs even when wages are flexible and there are enough jobs to go around
- occurs because – workers have different abilities, preferences
– jobs have different skill requirements
– geographic mobility of workers not instantaneous
– flow of information about vacancies and job candidates is imperfect
What is Structural Unemployment?
– unemployment arising from a mismatch of skills and job opportunities when the pattern of demand and production changes
• it takes time for ex-coal miners to retrain with other skills
Also results from real wage rigidity and job rationing
What is demand deficient unemployment
occurs when output is below full capacity
– ‘Keynesian’ unemployment occurs in the transitional period before wages and prices have fully adjusted
What is classical Unemployment?
created when the wage is deliberately maintained above the level at which labour supply and labour demand schedules intersect
Unemployment is Ac
BC is Voluntary
Ab is involuntary
note AJ is those willing to work
LF labour force
What is the Natural rate of unemployment
Natural rate of unemployment:
The average rate of unemployment around which the economy fluctuates.
- In a recession, the actual unemployment rate rises above the natural rate.
- In a boom, the actual unemployment rate falls below the natural rate.
What is the steady state condition and how is it defined?
The labour market is in steady state, or long run equilibrium, if the unemployment rate is constant
s*E=f*U
where E is #emloyed workers
U is # uneployed workers
s= rate of job seperations
f= rate of job finding
What is rate of job seperations ,s
Fraction of employed workers that become seperated from their jobs
