MACROECONOMIC INSTABILITY: UNEMPLOYMENT AND INFLATION

VILNIUS GEDIMINAS TECHNICAL UNIVERSITY

BUSINESS MANAGEMENT DEPARTMENT

INTERNATIONAL STUDIES CENTER

MACROECONOMIC INSTABILITY:

UNEMPLOYMENT AND INFLATION

Made by: Vvu-2 Aleksandra Baloban

Checked by: Asoc.prof. A.Samuliavičius

Vilnius, 2004

CONTENTS

Economic cost of unemployment; groups bearing the unequal burdens 3

GNP GAP AND OKUN’S LAW 4

INFLATION AND RATE OF INFLATION 5

INTERNATIONAL COMPARISON OF INFLATION AND UNEMPLOYMENT RATE DATA 5

DEMAND-PULL INFLATION 6

COST-PUSH (SUPPLY-SIDE) INFLATION 8

TWO TYPES OF COST-PUSH INFLATION 9

REAL AND NOMINAL INCOME 9

GROUPS THAT ARE HURT AND BENEFIT FROM UNANTICIPATED INFLATION 10

POSSIBLE EFFECTS OF INFLATION ON OUTPUT AND EMPLOYMENT 10

TOPIC SUMMARY 11

TEST 12

REFERENCES 13

ECONOMIC COST OF UNEMPLOYMENT; GROUPS BEARING THE UNEQUAL BURDENS

The pproblems associated with measuring the unemployment rate and defining the full-employment unemployment rate do not disguise an important fact: Above-normal unemployment entails great economic and social costs.

The basic economic cost of unemployment is forgone output. When the economy fails to generate enough jobs for all who are able and willing to work, potential production of goods and services is irretrievably lost.

The are three groups that bear the unequal burdens of unemployment:

First, teenagers incur much higher unemployment that do adults. This iis so because teenagers have low skill levels, more frequently discharged from jobs, and often have little geographic mobility. Many unemployed teenagers new labor-market entrants searching for their first job.

Second, the unemployment rate for blacks – both adults and teenagers –– has been roughly twice that of whites. A number of explanatory factors may be at work here including discrimination in education and in the labor market, the concentration of blacks in the less-skilled occupations, and the geographic isolation of blacks in central-city areas where the growth of employment opportunities for those first entering the labor market has been minimal.

Third, male and female unemployment rates are quite comparable. The lower unemployment rate for women in the 1982 recession years reflected the fact that the male workers are dominant in such cyclically vulnerable hard-goods industries as automobiles, steel, and construction.

GNP GAP AND OKUN’S LAW

Unemployment keeps society from moving all the way to its production possibilities curve. Economists measure this sacrificed output iin terms of GNP gap. This gap is the amount by which the actual GNP falls short of potential GNP. Potential GNP is determined by assuming that the natural rate of unemployment exists and projecting the economy’s “normal” growth rate. Figure 1 shows the GNP gap for recent years underscores the close correlation between the actual

Figure 1 Potebtial and actual GNP (a) and the unemployment rate (b)

unemployment rate (Figure 1-a) and the GNP gap (Figure 1-b) The higher the uunemployment rate, the larger the GNP gap.

The late, well-known macroeconomist A.Okun quantified the relationship between the unemployment rate and the GNP gap. This relationship, known as Okun’s law, indicates that for every 1 percent that the actual unemployment rate exceeds the natural rate, there is generated 2 percent GNP gap. This 1:2 , or 2:5, unemployment rate – GNP gap link permits one to calculate the absolute loss of output associated with any unemployment rate.

INFLATION AND RATE OF INFLATION

Now let us tern to inflation as an aspect of macroeconomic instability. The problem posed by inflation are more subtle than those of unemployment and hence are somewhat more difficult to grasp.

What is inflation? Inflation is a rising general level of prices. This does not mean, that all prices are necessarily rising. Even during periods of rather rapid inflation, some specific prices may be relatively constant and others actually falling.

Indeed, as we shall see momentarily, one of the major sore spots of inflation lies in the fact that prices tend to rise very unevenly. Some spring upward; others ascend at more leisurely pace; others do not rise at all.

Inflation is measured by price index numbers. Recall that a price index measures the ggeneral level of prices in reference to a base period.

The rate of inflation can be calculated for any given year by subtracting last year’s price index from this year’s index, dividing that difference by last year’s index, and multiplying by 100 to express it as a percentage.

Rate of this year’s index – last year’s price index

Inflation = last year’s inde * 100%

INTERNATIONAL COMPARISON OF INFLATION AND UNEMPLOYMENT RATE DATA

Table 1 presents average unemployment and inflation rates for a five-year period in nine countries.

We see that unemployment rates vary greatly among nations of the world over specific period. The major reasons for these differences is that nations have different natural rates of unemployment and also may find themselves in different phases of their business cycles. Column 2 of Table 1 lists average unemployment rates approximating U.S. measurement concept for nine industrialized nations for recent five-year period. Historically, the United States has had higher unemployment rates than most industrially advanced nations. But this general pattern changed beginning in the mid-1980s. As indicated in column 2, the average annual unemployment rate in the United States over the 1983-1987 period was lower than the unemployment rates of Canada, Australia, France, and the United Kingdom.

Table 11 Average unemployment and inflation rates for a five-year period in nine countries

Column 3 of the Table 1 notes that the average annual inflation rates in Italy, Australia, France, Sweden, and the United Kingdom were higher during the 1983-1987 period than in the United States. Some nations of the world have had double-digit – or even triple-digit – annual rates of inflation in specific years during the 1980s. (Israel, Bolivia, Brazil)

The point to be stressed is that, while U.S. inflation in the 1970s and early 1980s was both significant and troublesome, it hardly compares with that experienced by many other countries.

DEMAND-PULL INFLATION

Traditionally, changes in the price level have been attributed to an excess of total demand. The economy may attempt to spend beyond its capacity to produce; it may seek some point beyond its production possibilities curve. The business sector cannot respond to this excess demand by expanding real output because all available resources are already fully employed. Therefore, this excess demand will bid up the prices of the fixed real output, causing demand-pull inflation. The essence of demand-pull inflation is often crudely expressed in the phrase “too much money chasing too few goods”.

But the relationship between total demand, on

the one hand, and output, employment, and the price level, on the other, is more complex than these terse comments suggested. Figure 2 is helpful in unraveling these complications.

Real rational output and employment

Figure 2 The price level and the level of unemployment

In range 1 total spending – the sum of consumption, investment, government, and net export spending – is so low that the national output is far short of its maximum full-employment level. In other words, a substantial GNP ggap exists. Unemployment rates are high and business have a great deal of idle productive capacity. The net result is large output-increasing effects and no price-increasing effects.

A demand continues to rise, the economy enters range 2 wherein it is approaching full employment and is closer to fully utilizing its available resources. But we note that, before full employment is achieved, the price level may begin to rise. Why so? An production expands, supplies of idle resources do not vanish simultaneously iin all sectors and industries of economy. Bottlenecks begin to develop in some industries even though most have excess production capacity. Some industries are fully utilizing their production capacity before others and cannot respond to further increases in demand for ttheir products by increasing supply. So their price rise.

As total spending increases into range 3, full employment will be realized in all sectors of the economy. Industries in the aggregate can no longer respond to increases in demand with increases in output. Real national output is now at a maximum and further increases in demand will merely cause demand-pull inflation. Total demand in excess of society’s capacity to produce pulls the price level upward.

COST-PUSH (SUPPLY-SIDE) INFLATION

Inflation may also arise on the supply or cost side of the market. There have been several periods in our recent economic history when the price level has risen despite rather widespread evidence that aggregate demand was not excessive. We have experienced periods wherein output aand employment were both declining (evidence of deficiency of total demand), while at the same time the general price level was increasing.

The theory of cost-push inflation explains rising prices in terms of factors which raise per unit production cost. Per unit production cost is the average cost of a particular level of output. This average cost is found by dividing the total cost of the resource inputs by the amount of output produced. That is:

Total input cost

Per unit production cost ==

Units of output

Rising per unit production costs in the economy squeeze profits and reduce the amount of output that firms are willing to supply at the existing price level. As the result, the economy wide supply of goods and services declines. This decline in supply in turn drives up the price level. Hence, under this scenario, costs are pushing the price level upward, rather than demand pulling it upward, as in the case of demand-pull inflation.

TWO TYPES OF COST-PUSH INFLATION

The two most prominently mentioned sources of cost-push inflation are increases in nominal wages and increasing in the prices of nonwage inputs such as raw materials and energy.

Wage-push variant The wage-push variant of cost-push inflation theorizes that, under some circumstances, unions may be a source of inflation. According to this line of reasoning, unions exert some control over nominal wage rates through collective bargaining. Suppose that major unions demand and receive large increases in wages. Moreover, let us assume that these wage gains set the standard for wage increases paid to many nonunion workers. If the economy wide wage gains are excessive relative to any offsetting factors such as rises in output per hour, then employers will experience rising per unit pproduction costs. Producers will respond by reducing the amount of goods and services offered for sale. Assuming no change in demand, this decline in supply will result in an increase in the price level. Because the culprit is an excessive increase in nominal wages, this type of inflation is called the wage-push variant of cost-push inflation.

Supply-shock variant A second major variant of cost-push inflation, generally labeled supply shock, traces rising production cost – and therefore product prices – to abrupt, unanticipated increases in the cost of raw materials or energy inputs. The dramatic run-ups of imported oil prices in 1973-1974 and again in 1979-1980 are good illustrations. As energy prices rose during these periods, the cost of producing and transporting virtually every product in the economy increased. Rapid cost-push inflation ensued.

REAL AND NOMINAL INCOME

Assuming that the size of the national income pie is fixed, how does inflation affect the size of the slices going to different income receivers?

In answering this question it is critical to understand the difference between money or nominal income and real income. Money or nominal income consists of the number of dollars one receives as wages, rent, interest, or profits. Real income measures the amount of ggoods and services which one’s nominal income can buy. A moment’s reflection will make it clear that, if your nominal income increases faster than does the price level , then your real income will rise. Conversely, if the price level increases faster than your nominal income, then your real income will decline. The change in one’s real income can be approximated through this simple formula:

Percentage percentage percentage

Change in = change in – change in

Real income nominal income price level

Calculation of real income:

Nominal income

Real income =

Price index (in hundredsths)

GROUPS THAT ARE HURT AND BENEFIT FROM UNANTICIPATED INFLATION

• Our prior distinction between nominal and real incomes makes it clear that inflation penalizes people who receive relatively fixed nominal incomes (pensioners)

• Inflation also casts its evil eye upon savers. As prices rise, the real value, or purchasing power, of a nest egg savings will deteriorate.

• Inflation also redistributes income by altering the relationship between debtors and creditors. Specifically, unanticipated inflation tends to benefit debtors (borrowers) at the expense of creditors (lenders).

To summarize: Inflation arbitrarily “taxes” those who receive relatively fixed money incomes and “subsidizes” those who receive flexible money panelizes savers. Finally, unanticipated inflation benefits debtors at the expense of creditors.

POSSIBLE EFFECTS OF INFLATION

ON OUTPUT AND EMPLOYMENT

I would like to preset three possible effects of inflation on output and employment.

1. Stimulus of demand-pull inflation

The demand-pull theory of inflation suggests that some inflation may be necessary if the economy is to realize high levels of output and employment.

2. Cost-push inflation and unemployment

The cost-push theory of inflation indicates that inflation may be accompanied by declines in real output and employment.

3. Hyperinflation and breakdown

Hyperinflation, which is usually associated with injudicious government policy, might undermine the monetary system and precipitate eeconomic collapse.

TOPIC SUMMARY

• The basic economic cost of unemployment is forgone output. When the economy fails to generate enough jobs for all who are able and willing to work, potential production of goods and services is irretrievably lost.

Three groups that bear the unequal burdens of unemployment:

-teenagers

-blacks

-males in some industries

• Unemployment keeps society from moving all the way to its production possibilities curve. Economists measure this sacrificed output in terms of GNP gap.

Okun’s law, indicates that for every 1 percent that tthe actual unemployment rate exceeds the natural rate, there is generated 2 percent GNP gap.

• Inflation is a rising general level of prices.

Rate of this year’s index – last year’s price index

Inflation = last year’s index * 100%

• Unemployment rates and iinflation rates vary greatly among nations. Inflation and unemployment rates in the U.S. have been low over the last few years in comparison to a number of other industrial nations.

• Economists discern both demand-pull and cost-push inflation. Two variants of cost-push inflation are wage-push inflation and inflation caused by a supply shock.

• Money or nominal income consists of the number of dollars one receives as wages, rent, interest, or profits. Real income measures the amount of goods and services which one’s nominal income can buy.

Nominal income

Real income =

Price index (in hundredths)

• Inflation arbitrarily “taxes” those who receive relatively fixed money incomes and “subsidizes” those who receive flexible money panelizes savers. Finally, unanticipated inflation benefits debtors at the expense of ccreditors.

• The demand-pull theory of inflation suggests that some inflation may be necessary if the economy is to realize high levels of output and employment.

The cost-push theory of inflation indicates that inflation may be accompanied by declines in real output and employment

Hyperinflation, which is usually associated with injudicious government policy, might undermine the monetary system and precipitate economic collapse.

TEST

1. When aggregate supply is constant, higher rates of inflation are accompanied by higher rates of unemployment decreases. T F

2. Stagflation rrefers to a situation in which both the price level and unemployment rate rising T F

3. Expectations of inflation induce workers to demand a higher nominal wage and their employers to pay them higher wages. T F

4. When the nominal wage rate increases at a rate greater than the rate at which the productivity of labor increases, unit labor cost will rise. T F

5. If the nominal wage rate increases by 8% and the productivity of labor remains constant, unit labor costs will rise. T F

6. The natural rate hypothesis suggests that there is a natural rate of inflation for the economy. T F

7. Natural rate theorists conclude that demand-management policies cannot influence real output and employment in the long run, but only the price level. T F

8. The long-run aggregate supply curve is upsloping at the potential level of real national output. T F

9. New classical economists hold that price level surprises produce short-run fluctuations in the economy, but in the long-run the economy is stable at the full-employment level of output. T F

10. Demand-pull inflation will increase the price level and real output in the short-run, but in the long-run, only the price level will increase. T F

REFERENCES

1. MMc Connell & Brue. Economics.

2. Mc Connell & Brue. Macroeconomics.