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```					      EC202A      Macroeconomics

Reading material that you may find useful:
- Abel, Bernanke and McNabb, Chapters 11
and 13
- Abel, Bernanke, 5th ed, Chapters 10 and
12.
- Dornbusch, Fisher and Startz, Chapters 5-6
(9th ed)
Objective of the lecture

Unemployment and inflation are the most
important macroeconomic problems for almost any
country in the world. Politicians try to win
consensus by promising low inflation and high
growth.

Moreover, unemployment and inflation are linked
empirically by the Phillips curve, a fact that is
missed by the IS-LM model, because of the
assumption of fixed prices. Therefore, we need
another framework.
Objective of the lecture

While keeping some of the foundations built in the
previous lectures, we will now take the analysis
further by relaxing the assumption of fixed prices,
and we will develop the AD-AS model, as a basic
macroeconomic tool for determining output,
employment and the price level.
Outline

1. The labour market ;
2. The aggregate supply curve and price
4. The Phillips curve ;
5. The expectations-augmented Phillips
curve .
The labour market

The full employment level of output is the level of
output that is produced in an economy when there
is full employment, that is, labour demand is equal
to labour supply:
LS          Given the production
Real wages

function and the current
stock of capital K, the
full employment level of
output is a function of
NF:
LD                    YF = f(NF)
NF   Labour, N
Also:   N = f-1 (Y)
The labour market

If the current level of output is persistently different
from YF and the labour supply or demand haven‟t
changed, then there is disequilibrium in the labour
market, which must be explained in some way (i.e.
imperfect information, coordination problems, efficiency
wages,…)
We call the unemployment
LS
Real wages

rate that exists when output is
at full employment level YF
the natural rate. The natural
rate exceeds zero because of
frictions in the labour market
(i.e. shifting between jobs)
LD        and lags in matching demand
with supply for labour.
NF   Labour, N
The Classical Flexible-Price model

The assumption that wages and prices are flexible
was commonly made by classical economists

Thus, this assumption is often called the classical
assumption:
- it guarantees that all markets clear
- it guarantees full employment
- it guarantees that actual output is equal to
potential output
The Classical Flexible-Price model

In the Classical Flexible-Price model:

• The Savings = Investment equilibrium determines
the real interest rate:
S = Y - C = I(r)

• The levels of potential output and real wages are
determined in the labour market:
LS(w) = MPN

•The aggregate price level is determined by the
quantity theory of money:
M ∙velocity = P ∙Y
The aggregate supply curve and price

We call the relationship between the aggregate level of
output and the price level in the economy the
Aggregate Supply Curve or AS:

Long run AS                   The short-run AS curve
P
reflects an assumption that in
the short-run the price level is
fixed and firms are willing to
supply any amount of output
Short run AS                at that price level.

But in the long run prices
adjust so that output is at
YF             Y         full employment level YF.
The aggregate supply curve and price

The horizontal short-run AS curve is exactly equivalent to
the assumption of fixed prices in the IS-LM-BP model,
which served us well to answer a certain kind of
questions. But if we want to analyse the link between
unemployment and prices, this assumption becomes too
simplistic.
LRAS
P
In practice, wages and prices
therefore the aggregate
supply is upward
sloping in the short run.
YF           Y
The aggregate supply curve and price

The theory of aggregate supply is one of the least
settled areas in macroeconomics. There is a general
consensus that prices adjust slowly to changes in
output demanded, but there are a number of
different theories used to explain this phenomenon.

Here we review 3 theories (not mutually exclusive):
1. Misperception, or imperfect information ;
2. Coordination problems ;
3. Efficiency wages.
The aggregate supply curve and price
1. Misperception, or imperfect information:
Producers have imperfect information about the general
price level. As a result, producers forecast the price
level using their imperfect information. They don't
know whether a price change is due to a change in the
overall price level or a market-specific demand, but
they have an expectation of the general price level.

When a producer sees that the price of his own product
has increased above the expected general price level,
he assumes that the relative price of his product has
increased, so he will increase production to earn more
money.
The aggregate supply curve and price
1. Misperception, or imperfect information:
In other words, producers misinterpret changes in the
general price level as changes in relative prices. This
leads to a short-run aggregate supply curve that isn‟t
vertical.
LRAS            If P > PE, producers are fooled into
P                        thinking that the relative prices of
their own goods have risen, and they
SRAS    increase their output.
PE
If P < PE, producers believe that
the relative prices of their goods
have fallen, and they reduce their
Y   output.
YF
The aggregate supply curve and price

2. Coordination problems :
Different firms within an economy cannot coordinate price
or wage changes in response to policy changes. If any
one firm increases its price but no one else does, then
the single firm that raised its price will loose business.
LRAS                 If Y > YF, producers may react
P
in 2 ways:
SRAS        1) changing prices so as to
restore full employment in
the labour market (at output
level YF) ;
2) Or, decide to accommodate
YF            Y       demand.
The aggregate supply curve and price

2. Coordination problems :

Unsure about the behaviour of competitors, individual
firms change their prices or wages only reluctantly,
preferring to accommodate demand rather than changing
prices.
LRAS
P                                       Therefore, if demand
increases prices do not rise
SRAS
enough to bring the economy
back to YF. This leads again
to a short-run aggregate
supply curve that
Y F          Y
isn‟t vertical.
The aggregate supply curve and price

3. Efficiency wages:

Employers pay above market-clearing wages to
motivate their workers to work harder, and are
reluctant to change wages because of the perceived
cost (efficiency loss) involved.

On the other hand, firms are inclined to pay higher
wages also because they can pass this cost onto
consumers, in the form of higher prices. This
happens because each firm enjoys some degree of
monopoly power in her own market.
The aggregate supply curve and price

3. Efficiency wages:

In addition, there are long-term relations between
firms and workers, that is, wages are usually set in
nominal terms and wage contracts are renegotiated
only periodically. As prices change over time, real
wages fluctuate over the length of the wage
contract.
The aggregate supply curve and price

3. Efficiency wages:
As a result of the existence of efficiency wages, at any
point in time real wages need not be at the level
needed to clear the labour market, therefore actual
output need not be equal to YF.

P
LRAS                The process of adjusting wages
and prices continues until the
SRAS      economy eventually gets back to
full employment, and the level of
output will go back to YF, but
during this process output
YF        Y                              changes.

LM                The aggregate demand
(P=P2)
LM
relationship between the
(P=P1)
quantity of goods demanded
and the price level when the
IS                 goods market and the
Y
money market are in
P
curve represents the price
levels and output levels at
P2
which the IS and LM curves
P1
intersect.
Y

r               downward because a higher
price level is associated with
lower real money supply,
shifting the LM curve up,
IS2
raising r, and decreasing Y.
IS1
Any factor that causes the
Y   intersection of the IS and LM
P               curves to shift causes the AD
curve to shift.
For example, an increase in
government expenditure
shifts the IS to the right, so
Y   right as well.

LRAS
P                         If the economy isn‟t in
general equilibrium,
SRAS        economic forces work to
restore equilibrium both in

YF       Y
The Phillips curve

Many people think there is a trade-off between
inflation and unemployment. The idea is that, to
reduce unemployment, the economy must tolerate
high inflation, or alternatively that, to reduce
unemployment, more inflation must be accepted.

The idea originated in 1958 when A.W. Phillips
showed a negative relationship between
unemployment and nominal wage growth in Britain.
Statistical studies also found a similar negative
relationship for other countries and time periods.
Since then, economists have looked at the
relationship between unemployment and inflation.
The Phillips curve

The Phillips curve shows an empirical inverse
relationship between the unemployment rate and
increases in the nominal wage rate.

This relationship can be expanded into a relationship
between inflation and unemployment, which implies
that the Phillips curve and the AS-curve can be
viewed as two alternative ways to study price
The Phillips curve

Example: The Phillips curve and the U.S.
economy during the 1960s
The Phillips curve

In the 1950s and 1960s the prevailing view was that
the economy had a negative relationship between
the two variables. This suggested that policymakers
could choose the combination of unemployment and
inflation they most desired:
 = – h(u – u)     Phillips curve

However, in the following decades the negative
relationship failed to hold. The 1970s were a
particularly bad period, with both high inflation and
high unemployment, inconsistent with the Phillips
curve.
The Phillips curve

Example: Inflation and unemployment in
the United States, 1970–2002
The Phillips curve

This experience raised at least 3 important questions:

Why was the original Phillips curve frequently
observed historically (Britain before 1958 and the US
and Europe in the 1960s) ?
Why did it seem to vanish after 1970 ?
Does the Phillips curve actually provide a menu of
unemployment and inflation rates from which
politicians can choose?

economic theory provided an answer to these
questions, even before the actual breakdown of the
Phillips curve!
The expectations-augmented Phillips
curve

During the second half of the 1960s, Friedman and
Phelps questioned the logic of the Phillips curve.
They argued that there should not be a stable
negative relationship between inflation and
unemployment.

Instead, a negative relationship should exist between
unanticipated inflation (the difference between
actual and expected inflation) and cyclical
unemployment (the difference between actual and
natural unemployment rates).
The expectations-augmented Phillips curve

How does this work in the AD-AS model?
First case: anticipated increase in money supply
LRAS               1. AD shifts up and
P
SRAS2          SRAS shifts up, with
SRAS1         no misperceptions
because the increase
in the money supply
is fully anticipated ;
AD2       2. Result: P rises, Y
unchanged ;
3. Inflation rises with no
change in
YF               Y
unemployment .
The expectations-augmented Phillips curve

Second case: unanticipated increase in money supply

LRAS               1. Money supply rises
P
2. Result: Y rises as
misperception occur ;

goes away as producers
cannot be fooled
indefinitely . P rises, Y
declines to full-
YF              Y
employment level.
The expectations-augmented Phillips curve

Thus, when the public correctly predicts aggregate
demand growth and inflation, unanticipated inflation is
zero, actual employment equals the natural rate, and
cyclical unemployment is zero. If aggregate demand goes
up unexpectedly, the economy faces a period of positive
unanticipated inflation and negative cyclical
unemployment.

The relationship between unanticipated inflation and
cyclical unemployment implied by this analysis is:
 – e = – h(u – u)
– e : unanticipated inflation
(u – u) : cyclical unemployment   h : a positive number
The expectations-augmented Phillips curve

The preceding equation expresses the idea that
unanticipated inflation will be positive (negative) when
cyclical unemployment is negative (positive).

We can re-write it as:
 = e – h(u – u)
Expectations-augmented Phillips curve
EC202A        Macroeconomics

The Phillips curve and the
aggregate supply

Reading material that you may find useful:
- Abel, Bernanke and McNabb, Chapter 13.
- Abel, Bernanke, 5th ed, Chapter 12
- Dornbusch, Fisher and Startz, Chapter 6 (9th ed).
Objective of the lecture

The Phillips curve is one of the most
controversial relationships in macroeconomics,
whose existence has been questioned several
times.

Does the original Phillips curve relationship apply
to all historical cases?
The Original Phillips Curve for the United
Kingdom

4
1991
3.5
2001
3
Inflation rate

2.5

2

1.5

1

0.5

0
4             6            8            10          12
Unem ploym ent rate
Inflation and unemployment in the UK
1978-2000

20

15
Inflation

10

5

0
3   5   7         9    11   13
Unemployment
Objective of the lecture

In this lecture we will see how economic theory
can explain these apparently illogical patterns
in the data. We will focus on the role of
expectations and credibility.
Outline:

1.   The Phillips curve and the aggregate supply;
2.   Shifts in the AS curve ;
3.   Macroeconomic policy ;
4.   Credibility ;
5.   The shifting Phillips curve in practice
6.   Supply shocks .
The Phillips curve and the aggregate supply

The original Phillips curve showed an empirical
inverse relationship between the unemployment rate
and increases in the nominal wage rate.

This relationship can be expanded into a relationship
between inflation and unemployment, which implies
that the Phillips curve and the AS-curve can be
viewed as two alternative ways to study price
The Phillips curve and the aggregate supply

Write the simple Phillips curve as:
gW = – h ∙(u – u)
Where:
gW : change in the nominal wage rate
u : actual unemployment rate
u : natural unemployment rate
(u – u) : cyclical unemployment
h : responsiveness of wages to unemployment

when u = u , gW = 0
The Phillips curve and the aggregate supply

When u = u , the labour market is in equilibrium.
Thus, the estimated Phillips curve provides a
measure of the natural rate of unemployment in a
country. For example, by looking at the previous
graph, we can see that the natural rate for Britain in
the period 1861-1913 was about 5%.

However, the simple Phillips curve fell apart in the
1960s. Friedman and Phelps showed that this
happened because the original Phillips curve lacked
an important element: inflation expectations.
The Phillips curve and the aggregate supply

When workers and firms bargain over wages, they
are concerned with the real value of wages, so they
take into account expected inflation. For example, a
wage increase of 3% with expected inflation of 0 is
quite a different thing from the same wage increase
with   e = 10%.
Thus, according to Friedman and Phelps:
gW – e = – h ∙(u – u)

Now we need 2 more steps to go from the Phillips
curve to the AS curve.
The Phillips curve and the aggregate supply

Step 1: Specify the relationship between wage growth
and prices

Assumption: firms set prices according to a mark-up
rule
P = (1+m) ∙ W
Where:
m = mark-up ; P = price ; W = wage .
As a result:
gW = 
The Phillips curve and the aggregate supply

Step 2: Specify the relationship between
unemployment and output

According to Okun‟s law:

(Y – YF )/ YF = – ω ∙ (u – u)

Where:

Y = output ; YF = full-employment or potential
output ; ω ≈ 2.5
The Phillips curve and the aggregate supply

gW – e = – h ∙(u – u)
• gW = 
• (Y – YF )/ YF = – ω ∙ (u – u)

 – e = h/ω ∙ (Y – YF )/ YF

•  = (Pt – Pt-1 )/ Pt-1
• e = (PEt – Pt-1 )/ Pt-1

(Pt – Pt-1 )/ Pt-1 – (PEt – Pt-1 )/ Pt-1 =
= h/ω ∙ (Y – YF )/ YF
The Phillips curve and the aggregate supply

Therefore, the AS curve   :
Pt – PEt= Pt-1 ∙ h/ω ∙ (Y – YF )/ YF

Pt = PEt + Pt-1 ∙ h/ω ∙ (Y – YF )/ YF

Simplification:

Pt-1 = 1
a = (h/ω) / YF

Pt = PEt + a ∙ (Y – YF )   Short-run AS curve
The Phillips curve and the aggregate supply

Pt                              Pt = PEt + a ∙ (Y – YF )

PE                   SRAS
The slope of the SRAS
depends on a, its position

Y     depends on   PEt .
YF
3 cases are possible:
If   a = 0, then the SRAS is horizontal.
If   a = infinity, then the SRAS is vertical.
If   a > 0, then the SRAS is upward-sloping.
The Phillips curve and the aggregate supply

But if the SRAS were horizontal,    Pt
prices would be fixed, which is
SRAS
unrealistic.

YF            Y
Pt           SRAS
But if the SRAS were vertical,
then Y = YF always. This can be
true only if, whenever Y ≠ YF,
firms increase their prices until
YF          Y   Y = YF again.
The Phillips curve and the aggregate supply

We know that, whenever Y ≠ YF,     W                LS
u ≠ u , so the labour market is
not in equilibrium.
Firms maximise profits only                          LD
when Y = YF and u = u .                    LF            L

If demand for output is higher than YF, firms can
quell the demand by increasing prices.
If demand for output is lower than YF, firms can
increase their sales by decreasing prices.
The Phillips curve and the aggregate supply

But we know that prices are slow to adjust to
changes in demand conditions (see previous
lecture), and Y can be away from YF. Therefore the
SRAS is upward-sloping, and a > 0 is the only
possible case.

Prices increase with the level
Pt                      of output because increased
SRAS       output implies decrease in
unemployment, and therefore
increased labour costs (Phillips
curve: when unemployment is
YF          Y   low wages increase).
Shifts in the AS curve

SRAS’
Pt    LRAS           SRAS
SRAS’’

Pt = PEt + a ∙ (Y – YF )

YF          Y

The SRAS shifts with inflation expectations.
If inflation expectations increase , then next period
the SRAS curve will shift up to SRAS’.
If inflation expectations decrease , then next period
the SRAS curve will shift down to SRAS’’.
Shifts in the AS curve

SRAS’
Pt    LRAS           SRAS
SRAS’’

Pt = PEt + a ∙ (Y – YF )

YF          Y

The SRAS shifts over time.
If output this period is above YF , then the SRAS
curve will shift up to SRAS’.
If output this period is below YF , then the SRAS
curve will shift down to SRAS’’.
Shifts in the AS curve

LRAS    LRAS’
Pt                 SRAS
SRAS’

Pt = PEt + a ∙ (Y – YF )

YF    YF ‘      Y

Both the SRAS and the LRAS shift with changes in
the natural rate of unemployment and full
employment/potential output.
If YF increases , then both the SRAS and the LRAS
curves will shift to the right.
Macroeconomic policy

Case 1: anticipated increase in money supply
LRAS               1. AD shifts up and
P
SRAS2          SRAS shifts up, with
SRAS1         no misperceptions
because the increase
in the money supply
is fully anticipated ;
AD2       2. Result: P rises, Y
unchanged ;
3. Inflation rises with no
change in
YF              Y
unemployment .
Macroeconomic policy

Case 2: unanticipated increase in money supply

LRAS               1. Money supply rises
P
2. Result: Y rises as
misperception occur ;

goes away as producers
cannot be fooled
indefinitely . P rises, Y
declines to full-
YF              Y
employment level.
Credibility

•   The speed of
LRAS
P                             the degree of flexibility
SRAS2
of prices ;
SRAS1
•   Notice that the shift
from SRAS1 to SRAS2
can be avoided if the
a reduction in money
economy goes back to
YF                Y       YF with no increase in
prices.
Credibility

The belief that the central bank is going to take
resolute action to lessen inflation would prevent the
shift from SRAS1 to SRAS2 because inflation
expectations would not change.
However, this happens only if the central bank is
credible. If the central bank is irresolute,
expectations won‟t change and inflation can be
brought down only after a recession.

This would tend to suggest that making central
banks independent and adopting statements of
principle regarding governmental or bank action in
relation to inflation are important.
The shifting Phillips curve in practice

Why did the Phillips curve disappear after 1970?

(1) Both the expected inflation rate and the
natural rate of unemployment varied considerably
more in the 1970s than they did in the 1960s ;
(2) Especially important were the oil price shocks
of 1973–1974 and 1979–1980 ;
(3) Also, the composition of the labour force
changed in the 1970s, raising the natural rate of
unemployment ;
The shifting Phillips curve in practice

(continued):

(4)     Monetary policy was
expansionary in the 1970s,
inflation. Because inflation
was volatile, expected
inflation was volatile too,
hence the Phillips curve
shifted a lot ;

(5) Plotting unanticipated inflation against cyclical
unemployment shows a fairly stable relationship since
1970.
Supply shocks

What are the effects of a supply shock, such as an
oil price increase?
• a permanent supply shock will affect potential
output YF and thus the equilibrium level of
unemployment u.
• a temporary supply shocks will leave these
measures unaffected, but will shift the short run
Phillips curve and the short run aggregate supply
schedule. The AS curve shifts up because all costs –
therefore prices – will be higher at any level of
output, due to the oil price increase.
Supply shocks

Temporary supply shock: short run effects

1. The SRAS0 curve shifts
LRAS                  up to SRAS1
P
SRAS1
2. The equilibrium of the
SRAS0         economy moves from E0
E1                          to E1
E0                    is doubly unfortunate: it
causes a simultaneous
unemployment.
YF              Y
Supply shocks

Temporary supply shock: long run effects

4. The unemployment at
LRAS                  E1 forces wages and
P
SRAS2          thus the price level
SRAS1         down.
E1                       5. The adjustment back to
the original equilibrium
E0                    is slow because prices
AD1         6. At E0 the economy is
back at full
YF              Y      employment, but real
wages have fallen
Supply shocks

Policy makers can accommodate supply shocks by
expansionary demand-side policies, but this will
accelerate inflation. On the other hand, they can
offset the price increase by implementing restrictive
demand-side policies, but this will cause output to
fall further.
A favourable supply shock shifts the upward-sloping
AS-curve to the right, leading to lower prices
combined with increased output.
Some economists believe that this is what the US
experienced in the late 1990s (technological
improvements made in the computer industry).
EC202A       Macroeconomics

Unemployment and inflation
Reading material that you may find useful:
- Abel, Bernanke and McNabb, Chapter 13.
- Abel, Bernanke, 5th ed, Chapter 12
- Dornbusch, Fisher and Startz, Chapter 7 (9th
ed).
- Begg, Fischer and Dornbusch, Chapter 27 (7th
ed).
Objective of the lecture

Unemployment and inflation are widely
perceived to be the most important economic
problems in industrialised nations.

However, compare, for example, Poland in 1990
(unemployment rate 6.3%), with the UK in
1991 (unemployment rate 7.7%). Was it better
to live in Poland in 1990 or in the UK in 1991?
Objective of the lecture

Poland: rigid labour market, reforms were still under
way, unemployment rate = 11.8% the following year.
UK: important to distinguish between frictional and
structural unemployment. Fast flows through
unemployment pool may allow better matching of
skills to jobs in a changing world.

The example shows that we need to:
• Study the classification of unemployment.
• Understand the costs of inflation and unemployment.
Outline:

1. Analysing unemployment ;
2. The costs of unemployment ;
3. Factors affecting unemployment ;
4. Policies to reduce the natural rate of
unemployment ;
5. The costs of inflation.
Analysing unemployment

Definitions:
•   labour force
•   participation rate
•   unemployment rate

Unemployment is a stock concept, measured at a
point in time (“static view”).

However, there is high turnover in the labour market,
with constant flows into and out of the
unemployment pool (“dynamic view”).
Analysing unemployment

Unemployment rate:
the percentage of the labour force without a job but
registered as being willing and available for work

Labour force:
those people holding a job or registered as being
willing and available for work

Participation rate:
the percentage of the population of working age
declaring themselves to be in the labour force.

Example: the discouraged worker effect “conceals”
unemployment.
Analysing unemployment

LABOUR FORCE
New hires
Recalls
Working                          Unemployed
Job-losers
Lay-offs
Quits
Retiring                     Discouraged
Temporarily                      workers
leaving
Non-participants          Re-entrants
Taking
New entrants
a job
Analysing unemployment

Types of unemployment:

1. Frictional = the irreducible minimum level of
unemployment in a dynamic society (time to
search for jobs, the „almost unemployable‟) ;

2. Structural = unemployment arising from a
mismatch of skills and job opportunities when the
pattern of demand and production changes (time
to acquire human capital) ;
Analysing unemployment

We call the unemployment
LS
Wages

rate that exists when the
labour market clears
equilibrium unemployment
WF                               or the natural rate.

LD
LF    Labour, L

Natural rate of unemployment =
frictional + structural unemployment
Analysing unemployment

Types of unemployment:

3. From low demand (“Keynesian unemployment”)
= when output is below the full employment level
YF ;

4. From high wages (“classical unemployment”) =
when wages are above WF ;
The costs of unemployment

There are 2 principal costs of unemployment:
1. Loss in output from idle resources ;
2. Personal or psychological cost to workers and
their families .

However, the burden of unemployment is not
equally distributed across society, since its costs
are borne mainly by the poor and disadvantaged.
The costs of unemployment

Society throws away output by failing to put
people at work.

1. Loss in output from idle resources: How to
measure it?
• Workers lose income
• Society pays for unemployment benefits and
loses tax revenue
• Okun‟s Law
The costs of unemployment

Okun’s Law :

(Y – YF )/ YF = – ω ∙ (u – u)

Where:
Y = output ; YF = full-employment or potential
output ; (u – u) : cyclical unemployment ; ω ≈
2.5

Thus Okun‟s Law allows us to measure the cost to
society (in terms of lost production) of a given rate
of unemployment.
The costs of unemployment

The natural rate of unemployment in the UK, 1956-95

12

10
8
% 6

4
2
0
56-59   60-8   69-73     74-80   81-87   88-90   91-95

Actual rate    Natural rate
The costs of unemployment

We cannot directly observe the natural rate of
unemployment, we can only rely on estimates of YF

2. Personal or psychological cost: They depend
on the average unemployment duration.

The duration of unemployment is the average length
of time a person remains unemployed.
The costs of unemployment

However, there are some factors offsetting the costs
of unemployment:
1. Unemployment leads to increased job search and
acquiring new skills, which may lead to increased
productivity and increased future output;

2. Unemployed workers have increased leisure time,
though most wouldn‟t feel that the increased
leisure compensated them for being unemployed.
Factors affecting unemployment

The problems associated with determining the
natural rate are a major issue of controversy.
Actual and natural unemployment
rates in the US

However, the
natural rate is
understood to
depend on many
factors which
vary through
time.
Factors affecting unemployment

Factors affecting the natural rate of unemployment:

• Demographic make-up of the labour force;

• Availability and duration of unemployment
benefits;

• Efficiency of the labour market in matching
workers and jobs, labour market regulation;

• Labour productivity;
Factors affecting unemployment

(continued) :

• Structural change, the variability of the demand
for labour across employers ;

• Hysteresis (= long periods of high unemployment
may actually contribute to a higher natural
unemployment rate);

• Organization of the labour force & unions.
Factors affecting unemployment

Hysteresis: There are two possible explanations. The
first is that workers who are unemployed may
become accustomed to not being in the work force
(though they may take on odd jobs while receiving
unemployment benefits) or may get discouraged.

The second is that workers with a history of long
and/or frequent unemployment may convey the
(often unwarranted) signal that they do not have the
motivation or skills required to ensure stable
employment.
Policies to reduce the natural rate of
unemployment

1. Government support for job training and
worker relocation. Firms may be reluctant to
train workers because they might leave to go to
other firms. Tax breaks or subsidies would
encourage training;

2. Increased labour market flexibility. Regulations
(like minimum wages, working conditions, fringe
benefits, etc.) increase the costs of hiring workers.
Reducing regulations whose benefits are less than
the costs would help reduce unemployment;
Policies to reduce the natural rate of
unemployment

3. Unemployment benefits reduction.
Unemployment insurance increases the time
workers spend looking for work and increases the
incentives for firms to lay off workers. ;

4. Using expansionary monetary and fiscal
policies in order to reduce the natural rate of
unemployment: useful only in the case of
hysteresis, otherwise there are inflationary
consequences. Critics suggest that there is little
evidence of hysteresis
The costs of inflation

The costs of inflation depend primarily on whether
inflation is anticipated or not.

1. Perfectly anticipated inflation
• No effects if all prices and wages keep up with
inflation

• Wages, taxes, and interest rates can be indexed

• Only shoe-leather costs & menu costs .

Shoe-leather costs: people spend resources to
economize on currency holdings, Menu costs
(the cost of periodically changing prices ).
The costs of inflation

2. Unanticipated inflation
• Realized real returns differ from expected real
returns
• Result: transfer of wealth
• From lenders to borrowers when   e
• From borrowers to lenders when  < e

• Moreover, taxpayers may loose from the "bracket
creep"
The costs of inflation

Numerical example: i = 6%, e = 4%, so expected r
= 2%. If  = 6%, actual r = 0%. If  = 2%, actual r
= 4%.
If actual inflation is higher than expected, debtors
profit while creditors lose. Homeowners who have
fixed-rate mortgages can gain substantially from
long-term unanticipated inflation, while people on
fixed incomes from pension plans may be
significantly hurt.
The costs of inflation

In most cases inflation is not perfectly anticipated
and a redistribution of income and wealth results.

Indexation is problematic: wage indexation
prevents real wage flexibility.

People want to avoid risk of unanticipated inflation.
As a result, they spend resources to forecast
inflation. Inflation causes loss of “trust” in the
government, prices provide valuable signal.

These costs are a real danger for the economy in a
pathological case: hyperinflation.

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