UNEMPLOYMENT AND INFLATION The Circular Flow of Income Last week we examined the Circular Flow of...

UNEMPLOYMENT AND UNEMPLOYMENT AND INFLATIONINFLATION

The Circular Flow of IncomeLast week we examined the Circular Flow of Income.

This is a representation of the macroeconomy

It highlights the interrelations between the five main sectors of the economy.

Last Week...REVIEWREVIEW

Sectors and their Roles:1.Household Sector:

Consumption (C) and Saving (S)

2.Firms Sector Investment (I)

3. Financial Sector act as a link between households’ savings and firms’

investment.

4.Government Sector Government Expenditure (G) and Taxation (T)

5.International Sector Exports (X) and Imports (M)

The Circular Flow of Income

Last Week...REVIEWREVIEW

Gross Domestic Product (GDP) We have also outlined GDP.

GDP accounts for the economic value of final goods and services in a given year.

We defined it, measured it, assessed it and examined alternative ways by which a country’s progress may be determined.

Last Week...

REVIEWREVIEW

1. We define and examine the measurement of employment and unemployment;

2. We then outline inflation;

3. Then we introduce the Phillips curve.

This Week...

UNEMPLOYMENTUNEMPLOYMENT

Unemployment is a major macroeconomic variable that is measured and analysed.

It is closely associated with the level of economic activity.

Unemployment is a serious economic, social, & personal problem. Its consequences include:

Lost production and income;Lost human capital (skills) & experience;Loss of self esteem; andSocial disruption.

Unemployment


The International Labour Organisation (ILO) defines unemployment as persons who:are between a specified age range during the reference period;without work: were not in paid employment or self-employed; currently available for work; andseeking work: had taken special steps in the specified reference period to seek paid employment or self-employment.

Source: www.ilo.org.

Defining Unemployment


Working-age Population

Labour Force

Not in Labour Force

Employed

Unemployed

Full-time

Part-time(includes some

underemployed)

(includes some discouraged

workers)

General Population


These concepts therefore need to be examined to measure the level of employment and unemployment in an economy.

We will use the Australian Bureau of Statistics’ overview of employment as the basis for our measurement.

The Australian Bureau of Statistics (ABS) takes the following concepts into account when measuring the level of unemployment in Australia:

General population: the number of people in a country

Working Age Population: The population in the age group 15 to 69.

Measuring Unemployment


Labour Force (LF): persons who are employed plus persons who are unemployed.

Not in the Labour Force: Persons aged 15 –69 who are not in the labour force.

Labour Force Participation Rate (LFPR): The percentage of the working age population who are in the labour force.



Employed: were in paid employment or worked in a family business for at least one hour in the survey week.

Full-time employment: work 35+ hours a week.

Part-time employment: work less than 35 hours per week.

Unemployed (U): did not work but actively looked for work and were available to start.



CONCEPTCONCEPT DEFINITIONDEFINITION STATISTICS (As STATISTICS (As at July, 2008)at July, 2008)

General Population

Number of people in Australia 21,181m

Working-age Civilian Population

Number of people in Australia aged 15 years and over 17,153m

Labour Force Number of people in Australia aged 15 years and over actively looking for work (employed and unemployed).

11,201m

Employed

Full-time Part-time

All persons aged 15 years and over who:worked for one hour or more for pay, profit, commission or payment in kind in a job or business, or on a farm; orworked for one hour or more without pay in a family business or on a farm; orWork involving 35 hrs or more per weekWork involving less than 35 hrs per week

10,719m

Unemployed Persons aged 15 years and over who are not employed but actively looking for work.

0.482M

Participation Rate

The Labour Force expressed as a percentage of the Working-age Civilian Population.

65.3%(11,201/17,153)

Unemployment Rate

The number of unemployed persons expressed as a percentage of the labour force in the same group (Unemployed/Labour Force)

4.3%(482/10,719+482)

Measuring UnemploymentUNEMPLOYMENTUNEMPLOYMENT

The Unemployment Rate

The Unemployment Rate is the percentage of the Labour Force who are unemployed.

Unemployment Rate (%) = (U/LF) x 100

The Participation RateThe Participation Rate is the percentage of the Working-age Civilian Population that is in the Labour Force.

Participation Rate (%) = (LF/WAP) x 100



Source: CIA World Factbook*Australian Bureau of Statistics

Unemployment in the Asia-Pacific RegionCOUNTRY UNEMPLOYMENT RATE

(%)(2007 Estimate)

ThailandPapua New GuineaSingaporeMalaysiaSouth KoreaNew ZealandJapanTaiwanBrunei DarussalamPeople's Republic of ChinaHong KongAustralia*VietnamRussiaPhilippinesIndonesiaTonga

1.41.92.13.23.33.63.93.94.04.04.14.35.36.27.39.6

13.0


The official unemployment rate counts those people who wanted to work, were actively looking & were able to start.

It ignores those people working part-time who would have preferred more hours – the underemployed.

Discouraged workers are also omitted – those that have been discouraged by previous unsuccessful job searches & have stopped looking but would work if a job were available (e.g. too old, language difficulties, lack of training, no jobs in local area).

Problems Measuring Unemployment


Discouraged WorkersSuppose that economic growth is associated with generation of more jobs. As the job market improves some discouraged workers will re-enter the LF to seek jobs.Thus at the same time as jobs growth is occurring, unemployment may also be rising.That is, discouraged workers re-entering will boost both LFPR and potentially increase the unemployment rate. This can distort the official measurement of unemployment.



Scenario 1 Scenario 2 Scenario 3Employed 50,000 54,000 54,000Unemployed 5,000 1,000 6,000Labour Force 55,000 55,000 60,000

Unemployment Rate 9% 2% 10%

ExampleAn increase in the number of people employed AND an increase in the unemployment rate occurs if the labour force grows due to higher participation. Consider the following example:

UNEMPLOYMENTUNEMPLOYMENTProblems Measuring Unemployment

Scenario 1: base case.

Scenario 2: an increase in the number of people employed and a fall in the number of people unemployed. This means that the number of people in the Labour Force has not changed from Scenario 1. This leads to an overall fall in the unemployment rate. Mathematically, the denominator in the unemployment rate equation has not changed in magnitude but the numerator has, leading to a lower quotient – the unemployment rate has gone down.

UNEMPLOYMENTUNEMPLOYMENTProblems Measuring Unemployment

Scenario 3: an increase in the number of people employed and a rise in the number of people unemployed. This means that the number of people in the Labour Force has increased from Scenario 1 due to higher participation. This leads to an overall rise in the unemployment rate. Mathematically, the denominator in the unemployment rate equation has increased in magnitude leading to a higher quotient – the unemployment rate has gone up.



Frictional UnemploymentOccurs due to the normal workings of the labour market.

Structural UnemploymentArises because the skills demanded by employers do not

match the skills of the unemployed, or the unemployed with the appropriate skills do not live where the jobs are located.

For example, in China people from the country's rural areas are migrating to big cities such as Shanghai and Beijing in hope of finding work. Skills in rural areas may not necessarily be readily applied in more urban parts of the country.

Types of Unemployment


Seasonal UnemploymentRelates to unemployment associated with certain times of the year. eg. Christmas, harvesting.

Cyclical UnemploymentRelates to changes in unemployment during the business cycle.

Types of Unemployment


Simple Definition of Full Employmentall those who want a job at the current (distribution

of) wages has got one.

Full Employment is difficult to achieve in reality. Therefore it is practically defined as something less than employment of 100% of the labour force.

In fact, achieving the full employment Macroeconomic objective is defined in terms of achieving a predetermined rate of unemployment.

Full Employment


The full-employment rate of unemployment is called the Natural Rate of Unemployment.

This equals the sum of frictional, structural and seasonal unemployment:

Cyclical Unemployment is zero (i.e. no business downturns).

Full Employment

Frictional Unemployment

Seasonal Unemployment

Structural Unemployment

Natural Rate of

Unemployment

=+

+


The Natural Rate is difficult to measure & appears to change with the business cycle – it can lag behind changes in output.

This is called Hysteresis.

Domestic output consistent with the natural rate of unemployment is potential output or GDP.

The Natural Rate of Unemployment is similar to the Non-Accelerating Inflation rate of Unemployment (NAIRU) at which both the rate of unemployment and inflation are stable.

Full Employment


EconomicThe loss of potential output is normally considered

the major economic cost of unemployment.

GDP GapThe amount by which the actual level of GDP falls

below the full employment (potential) level of GDP.

GDP Gap = Potential level of GDP – Actual GDP

Also unequal distribution of unemployment

Costs of Unemployment


Okun’s LawOkun’s Law relates unemployment with the GDP Gap.

It relates to lost potential by relating unemployed resources to loss of output.

But, must be able to determine ‘natural rate of unemployment’ to measure it (use it as a point of reference).



Okun’s LawSpecifically, Okun’s Law is a regular negative quantified relationship between GDP and the unemployment rate.

Q=-f(Unemployment)

As the unemployment rate increases, the level of output decreases.



Okun’s LawWhy does this relationship exist?Demand-side: loss of income leads to less demand.

Supply-side: less resources employed, less output generated (if productivity remains constant).

As GDP & jobs grow, so does LFPR & unemployment.

So to reduce the unemployment rate, GDP needs to grow faster than the growth in unemployment.



Okun’s LawFor instance, in Australia, for every 1 percentage point increase in unemployment, the nation’s output of goods and services falls by 2.75 percentage points.

So if actual unemployment rate is 6% and we want to get it down to 4% then GDP will need to grow by 7%.



Non-economic CostsIncreased poverty, increased crime, loss of self esteem, and other psychological factors.

Health (suicide and alcohol), family (divorce and abuse), social decay, etc.



Inflation is a sustained rise in the general level of prices of all goods and services.

It is one of the 3 major macroeconomic variables (output and unemployment being the other 2) that is of concern to economists and policymakers.

Inflation is a problem because it causes the purchasing power (or the ‘real’ value) of money, wages and assets that are fixed in value to decline over time, reducing the ability of people and businesses to spend (consumption, investment, government expenditure and exports).

This is particularly true for inflation that is unexpected.

DefinitionINFLATIONINFLATION

For instance, if money is loaned to finance investment, then inflation can reduce the amount of money that the lender receives if they do not anticipate for the loss of purchasing power and adjust their loan repayments accordingly.

ExampleHSBC bank in Hong Kong loans $1,000,000 to a Hong Kong business for 1 year for investment in a construction project.

Inflation is anticipated to be 0% over the term of the loan agreement.

The business therefore must pay HSBC $1,000,000 at the end of the loan period.

Costs of InflationINFLATIONINFLATION

If inflation turns out to be 5.4% over the loan term, then HSBC loses money when the loan is repaid.

This is because the purchasing power of the $1,000,000 has declined by 5.4% - the $1,000,000 is now worth $948,766.60 ($1,000,000/1.054).

The business pays back $948,766.60 to HSBC instead of the original $1,000,000.

HSBC loses out and the business gains because the business is paying less money back to HSBC.


Therefore, inflation has a tendency to redistribute wealth from creditors to debtors if it is not anticipated.

This is also true of other items that are fixed in money value such as wages. The real value of the item declines as inflation rises.

This reduces the incentive of participants within the various sectors of the macroeconomy to spend and inhibits the operation of the Circular Flow of Income.


GDP DeflatorThe GDP Deflator can be used to quantify inflation:

Calculating changes in the GDP Deflator is one way by which inflation can be measured.

GDP Deflator =

Nominal GDPX 100Real GDP

Measuring Inflation

INFLATIONINFLATION

Consumer Price Index (CPI)The Consumer Price Index is a more common way by which inflation is measured.

The CPI is a price index which measures the value of a representative sample of consumer goods and services.

Inflation is measured by calculating changes in the value of the CPI.

Measuring Inflation

INFLATIONINFLATION

Consumer Price Index (CPI)The CPI measures the average level of prices of a basket of goods & services consumed by an urban family.

CPI is defined to equal 100 for reference base period.

Like any price index, it is calculated by using the formula:

What is in the basket of goods?

Price in Base Year

Price in Any Given YearX 100Price Index =

Measuring InflationINFLATIONINFLATION

Composition of CPIINFLATIONINFLATION

Inflation rate is the percentage change in price level from one year to next.

Inflation formula is:

Inflation Rate = [(CPI this year – CPI last year)/CPI last year] 100.

Measuring Inflation

INFLATIONINFLATION

Assume CPI index is 103.6 (2006) & 107.9 (2007).

Inflation rate for 2007 is [(107.9 – 103.6)/103.6]*100 = 4.2%.

Prices can also fall – deflation.

YEAR PRICE ($) CPI INFLATION (%)

2004 247 98.0

2005 252 100.0 2.0

2006 261 103.6 3.6

2007 272 107.9 4.2

Measuring InflationINFLATIONINFLATION

Constructing the CPI involves three stages:

1. Selecting the basket of goods & services

2. Conducting a monthly price survey

3. Using prices & basket to cost of basket

Constructing the CPI

INFLATIONINFLATION

The main sources of biases in the CPI are:

New goods: new goods might not have existed in base year, e.g. typewriters being replaced by computers.

Quality change: an improved good is considered a better good & some of its price increase is attributed to generating this improvement.

Commodity substitution: a category of consumption might experience substitution between different goods in same category due to changes in relative prices.

Outlet substitution: consumers search for cheaper sources of goods, e.g., discount stores.

CPI BiasINFLATIONINFLATION

Impact of bias:

Distorts wage contracts & leases with CPI price clauses

Can affect government outlays (many government pension & social security payments are indexed to changes in CPI).

CPI BiasINFLATIONINFLATION

Source: CIA World FactbookAustralian Bureau of Statistics

COUNTRY INFLATION RATE (%)2007 Estimate

JapanBruneiPapua New GuineaTaiwanHong KongMalaysiaSingaporeThailandNew ZealandKoreaPhilippinesAustralia*People's Republic of ChinaIndonesiaVietnamRussia

0.00.41.71.82.02.12.12.22.42.52.84.54.86.48.39.0

Inflation in the Asia-Pacific Region

INFLATIONINFLATION

The business cycle suggests that the macroeconomic goals of full employment and price stability move in opposite directions.

The New Zealand economist, A. W. Phillips used empirical data to suggest that policy makers faced a trade-off.

Policy makers could affect the unemployment rate or the inflation rate but not both at the same time.

THE PHILLIPS CURVETHE PHILLIPS CURVE

The Phillips curve depicts a negative correlation between unemployment and inflation.

It represents an inverse relationship between unemployment and inflation – a decrease in one variable results in an increase in the other.

The Phillips Curve


A stable and predictable relationship.

A non-linear (or curved) relationship. This results from demand pressures not equally affecting inflation and unemployment.

Asymptotic to the axis (impossible to achieve zero rates of inflation or unemployment)

Governments can use fiscal and monetary policies to select the desired combination of inflation and unemployment.

Characteristics of the Phillips Curve


Why should there be a link between Inflation rate and Unemployment rate?

When GDP increases, employment increases and Unemployment rate declines.

Increase in GDP, all else constant, increases the price level (and eventually the inflation rate).

Demand pressures reduce unemployment rate but increase inflation rate.

The Phillips Curve


Unemployment (%)

Inflation (%)

Phillips Curve (PC)

3.5

5.0 6.1

4.8

A

B

For instance, expansionary government policy (Fiscal or Monetary) will cause unemployment to fall (due to increased output) but will also create higher inflation. This is depicted below by a movement along the Phillips Curve from A to B . Unemployment declines from 6.1% to 5.0% and inflation rises from 3.5% to 4.8%.

0

The Phillips CurveTHE PHILLIPS CURVETHE PHILLIPS CURVE

That is, there is a trade-off between unemployment and inflation - when unemployment increases, inflation decreases.

This can be depicted graphically.

The relationship has implications for government policy and its desired impact.

The Phillips curve implies that the Government can use demand management policies to either lower the inflation rate or to reduce the unemployment rate.

BUT NOT BOTH

The Phillips CurveTHE PHILLIPS CURVETHE PHILLIPS CURVE

The Phillips Curve shifts when there is a change in the expectations for inflation.

For example, if people believe inflation will be higher for all levels of output and unemployment, then this will result in a higher Phillips Curve as depicted below.

Each level of unemployment is associated with a higher level of inflation.

Shifts of the Phillips Curve


Unemployment (%)

Inflation (%)

PC1

3.5

6.1

4.8

PC2

Higher inflation anticipated (4.8%) at the original

unemployment rate (6.1%).

0

Shifts of the Phillips Curve


The Long Run Phillips Curve depicts the notion that the economy will remain at a particular level of unemployment (and output). It is represented as a straight vertical line as seen below.

Attempts to move away from the long run level of unemployment by implementing expansionary policy will only result in higher prices and no reduction in unemployment.

Suppose China’s economy is operating at an unemployment level of 6.1% with an inflation rate of 3.5%. This inflation rate is both the actual rate of inflation and what people expect the inflation rate to be.

The Long-run Phillips Curve


If the government institutes expansionary fiscal or monetary policy there will be the typical movement up the short run Phillips Curve from A to B.

Unemployment declines to 5.0% and inflation rises to 4.8%.

This rise in inflation has caused real wages to fall - workers expect 3.5% inflation but are faced with 4.8% actual inflation.



Workers therefore adjust their expectations of inflation upward and demand higher money wages to compensate them for the reduced purchasing power of their incomes.

Once granted, these higher money wages cause firms’ costs of production to rise and profits to fall.

Critical Assumption: wages are flexible.



Firms therefore lay off workers, causing the unemployment rate to rise back to the original 6.1%, at which actual and expected inflation is now 4.8%.

The movement from B to C is a long run adjustment. A long run Phillips Curve (LRPC) results.



Unemployment (%)

Inflation (%)

SRPC

1

3.5

6.1

4.8

SRPC2

5.0

A

BC

LRPC

0



So, in the long run, the government’s attempt to reduce unemployment has only resulted in higher inflation with no change in unemployment.

The conclusion of the Long Run Phillips Curve scenario is that government intervention does not alter the rate of unemployment, only the level of inflation.



Textbook Jackson & McIver, Chapter 5, pp154-160 &

Chapter 14.

Other readings to supplement knowledge

McTaggart Ch 22; also Ch 30. Kniest, Lee and Burgess, pp177-182; 184-

192.

REFERENCESREFERENCES

Go to Asian Development Bank website. www.adb.org

Start investigating key macroeconomic data for your projects.

CLASS EXERCISECLASS EXERCISE

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