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Chapter 13 Unemployment and Inflation

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Page 1: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Chapter 13

Unemployment and Inflation

Page 2: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment
Page 3: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Trade off between inflation and unemployment (Phillips Curve)

• It is graph showing a trade off between unemployment and inflation; the lower the rate of unemployment, higher the rate of inflation.

• This curve presented the policy makers with a range of options from which to choose the optimal or least undesirable combination of inflation and unemployment (see fig. 13.1 on page 367).

• The figure shows that unemployment is flatter at lower rates of inflation.• An unemployed person is one who is actively seeking work but unable to

find it.• Total of those working and seeking work constitutes the labour force.

Unemployment rate expresses the number of unemployed people as a percentage of the labour force.

• Inflation is a rise in the general level of prices. Rate of inflation measures the annual percentage increase in the general level of prices.

Page 4: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Demand Pull Inflation: Sometimes an economy wants to reduce unemployment at the cost of rising inflation. Various monetary and fiscal measures are adopted for this. So unemployment falls and inflation rises. When inflation is caused by an expansion of aggregate demand is called demand pull inflation.

• Increase in demand------less supply------rise in prices• So expansion of aggregate demand raises price level and

output and reduces unemployment.

Page 5: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Cost Pull Inflation: In Phillips Curve we hold certain assumptions constant. For eg. Rise in oil prices in Britain.

• Higher oil prices feed through into higher prices in general, so that any given unemployment rate is associated with higher inflation rate.

• Increase in oil prices--------raise transport cost--------producers will pass some of the cost increase to consumers in the form of higher prices-----------so high oil prices lead to an economy wide increase in the cost of production. When inflation is caused in this way, it is called cost push inflation.

Page 6: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Costs of unemployment versus cost of inflation

• Which is more damaging for the economy: increased inflation or reduced unemployment.

• Human cost of unemployment: • Unemployment Scarring: it captures the idea that the worst effects of

unemployment are concentrated on the unemployed themselves in two ways.

• First, one period of unemployment tends to bring further periods of unemployment and reengagement tends to be associated with lower wages.• Leaving job……..loss of human capital……..unemployed person is denied

opportunities to gain further work experience……….skills deteriorate and revenue lost………employers may interpret periods of unemployment as an indication of worker’s low productivity and either refuse job offers or hire

them at lower wages.

Page 7: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Output cost of unemployment:• Unemployment causes loss of output. • Two ways to measure the loss of output• Average output method: simplest approach is to assume that everyone

who is out of work, would, if found a job, produce as much as the average person already in unemployment. But unemployed people tend to be less skilled than the labour force as a whole, so this method may exaggerate the scale of output loss.

• Output Gap method: extrapolate the trend rate of output growth under full employment through the years of unemployment, and to measure the output gap, the amount by which the actual output during the years of high unemployment falls short of full employment output.

Page 8: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Fiscal cost of unemployment:• Part of the incidence of output loss that is placed on

taxpayers, as public spending on unemployment benefits rises and income tax revenues fall.

• There is no doubt that unemployment seriously damages the health of the economy and the wellbeing of unemployed people, but economists believe that inflation is even more alarming to the economy.

Page 9: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Costs of Inflation1) Costs of anticipated inflation:• ‘Shoe leather costs’: one way of anticipating and guarding against the

inflation is to reduce cash balances and demand deposits in favor of time deposits, so that the interest earned will protect the purchasing power of their income.

The ‘shoe leather’ used up in making frequent trips to the bank is a metaphor for all the productive resources consumed, including fuel and lost output as workers leave their jobs to queue at banks.

• Menu costs: It is the sum total of the costs of changing prices and adjusting wages. Resources/time used up in revising prices/wages, involve a lengthy process of negotiation and hence a lot of management costs and time devoted to it. It is the cost/time gone in gathering information from the market.

The costs of changing prices…….menu prices…….deter firms from constant monitoring and immediate revision.

Page 10: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

2) Costs of unanticipated inflation:Most serious and affects in two ways:Through unplanned redistribution of income and wealth: estimating this is

complicated because there are many different routes through which inflation might affect income distribution, making some groups better off while others worse. For eg. Because of inflation the value of financial assets held by upper middle class may go down……upper class is seriously affected by inflation….effect of redistributing income away form the capitalist class towards the working class…………progressive impact on income distribution.

Inflationary Noise: states that without price stability markets cannot allocate resources efficiently. Inflation distorts the transmission of price signals, so it resembles ‘noise’ or background interference that distorts the transmission of radio signals.

Explain Eg.

Page 11: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Does inflation slow down economic growth?• Various studies carried out for this. Friedman (1977), Clare and

Thomas(1993) found out negative correlation between inflation and growth at higher rates of inflation--------------there is no evidence that moderate inflation inhibits growth.

• Secondly correlation does not give direction of causation…………does high inflation cause low growth or low growth cause high inflation.

• So price stability is chosen by most of the policy makers, so as to have the moderate inflation and favorable economic growth.

• There should always be price stability because even moderate inflation may step out of control and lead to unanticipated high inflation.

• Read carefully pages 376, 377, 378

Page 12: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Expectations Augmented Phillips Curve

• After 1970 the trade off between unemployment/inflation appeared to break down.

• Friedman (1968) said the phillips curve did not take into account the assumptions about the behaviour of economic agents in the labour market. He gave two premises for this.

• First: he assumed that demand and supply of labour were functions not of nominal wage rate, but of real wage rate i:e: nominal wages divided by prices, W/P.

• Second: in bargaining wage rates, workers use their experience of past inflation to predict future price rises and aim to anticipate these in wage settlements.

• He says that workers and unemployed people are rational economic agents. This implies that unemployment may occur, not simply because people are seeking work but cannot find a job, but because people are seeking work but cannot find a job that provides adequate compensation for giving up leisure or adequate rewards for skills.

Page 13: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Frictional unemployment: captures the idea that unemployment may occur because of the time it takes to find appropriate work; it underlies the natural rate of unemployment.

• Friedman believed that government intervention to try to trade off higher inflation for lower unemployment, would change agents expectations and their behavior in a way that would only make matters worse.

• See figure 13.4 on page 380.

• Figure explains that if the expectation of the rational agents are not taken into account, result is original unemployment rate at higher inflation. This is called the natural rate hypothesis of Freidman, which states that there is no permanent trade off between unemployment and inflation because in the long run, unemployment returns to it’s natural rate.

Page 14: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• How can policy makers maintain unemployment below it’s natural rate in the long run?

• This can be done by continually expanding aggregate demand, so that the rate of inflation is always accelerating.

• This is called accelerationist hypothesis which is the second of Friedman’s result. It states that unemployment can be maintained below it’s natural rate only by constantly accelerating inflation. As people's expectation chase after actual inflation, inflation must accelerate to keep ahead of those expectations.

Page 15: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Costs of reducing inflation• Sacrifice Ratio: it is the ratio of the cumulative percentage loss of GDP

incurred by the policy for each one percentage point reduction in the inflation rate thereby achieved (Ball, 1994).

• Five main influences on Sacrifice ratio:1) Initial Inflation rate: output cost of reducing the inflation rate by one

percentage point is lower if the inflation rate at the outset is higher.2) Expectations: cost of reducing the inflation depends on the speed with

which agents expectation that influence the wage and price setting process adapt to the new inflation rate.

3) Pace of adjustment: Policy makers will phase in a disinflationary policy gradually if they believe that people take time to adjust their expectations of inflation, while others believe that a ‘shock effect’ might result in rapid adjustment of expectations.

4) Policy Credibility: how much do the economic agents believe in the policies. Disinflation can be achieved at low cost to the extent that there is a consensus in favor of the policy.

5) Imperfectly competitive markets: in this there is wage bargaining between employers and trade unions. It involves costs (menu costs).

Page 16: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

UK Macro economic policy• Role of macroeconomic policy is to manage aggregate demand with the

objective of maintaining low inflation. Central Bank does this by raising interest rates.

• Bank of England is the central bank of UK. It is responsible for ensuring the effectiveness and stability of UK financial system and also for operating monetary policy.

• The sequence of events through which the central bank effects the level of national income and inflation rate is known as the transmission mechanism.

• When inflation rises, central bank raises interest rates, on the view that this will reduce aggregate demand and hence inflation.

• See figure 13.7 on page 390.• Aggregate demand/inflation curve tells us the total demand of commodities by

firms, households, govt., and foreigners at any given inflation rate. It is downward sloping, because a fall in the inflation rate would raise the demand for goods and services.

Page 17: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Output expansion and supply side:• Policy makers can also seek to increase the aggregate demand by

increasing the output growth.• Increase in investment is there when the return on investment is high.

High investment demand has a positive effect on aggregate demand/inflation curve.

• Among the events that might increase the expected returns on investment is a positive ‘productivity shock’.

• A range of supply side policies can be used to increase the productive capacity of the economy, that is, potential for supplying goods and services by increasing productivity.

Page 18: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Chapter 14

International Trade and Production

Page 19: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Objective of this chapter is to lay out the basic economics of international trade and foreign direct investment.

Page 20: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

World Trade• World trade has increased substantially.• World trade has risen because:• First, the combination of better telecommunications, air freight and faster ocean

transport has lead to substantial time savings in international transactions, which have facilitated trade growth.

• Second, import and export tariffs have gone down.• Some major developments happened:1) GATT formed by allied powers, which changed to WTO (1995)2) It promoted liberalization of trade in services3) Removal of barriers to inward investment4) Formation of numerous regional integration agreements, so as to liberalize

internal trade between member countries (EU), NAFTA (canada, mexico and USA).

5) Uptill 2000, 14 regional agreements were formed and more than 1/3rd of the world trade took place within these agreements.

Page 21: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• International trade refers to exchanges of goods and services that take place across international boundaries.

• International trade and economic growth are positively linked . Trade increases output and incomes.

Page 22: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Comparative Advantage• Why do countries go for trade? What are the gains?• Two countries (home and foreign) and two goods.• Each country can produce both the goods and consume it.• Two items i:e: bicycles and coats are taken. The country that is best in

producing bicycles, expands it’s production and exports. Same for coats.• Production Possibility frontier tells us that how much can be produced

within each country.• Autarky: a situation where there is no trade between home and foreign

country. The level of production is determined by the consumer’s demand.• The cost of production depends, on the opportunity cost: what is given up

inorder to attain the thing.• For eg. The opportunity cost of producing one bicycle is two coats, i:e: two

labour needed to produce one bicycle and one labour for coat. (see figure 14.4,a on page 401).

Page 23: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Now the country goes for trade: • 1 bicycle costs 1.5 coats; 1.5:1(ratio is important).• Cost of bicycle is 300 and coat is 200.• In home production: 1 bicycle = 2 coats• Home country closes down on the production of bicycles and specialises in

coat.• Comparative advantage: a country has a comparative advantage in the

production of good X, if the opportunity cost of producing a unit of X, in terms of other goods forgone, is lower in that country than it is abroad.

• Absolute advantage: A country enjoys an absolute advantage over another country in the production of a product when it uses fewer resources to produce that product than the other country does

Page 24: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Opportunity cost in production tells us how much of one product a country must sacrifice to produce 1 more unit of the product for which it has a comparative advantage.

Opportunity costs depend on the relative costs of producing two products, not on absolute costs.

When opportunity costs are the same in all countries, there is no comparative advantage, and there is no possibility of gains from specialization and trade.

Page 25: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Gains from Trade

• Trading results in higher living standards.• Trade among individuals allows people to specialize in

those activities they can do well.• Trade and specialization are intimately connected.

People can specialize in what they do well, and satisfy other needs by trading.

• Without trade, each country is forced to be self-sufficient. With trade, each country can specialize in products for which they acquired an advantage. This trade will result in better living standards and better products available

Page 26: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Aggregate gains and the terms of trade

• What will happen if the cost of production changes in home or foreign country?

• There will be change in the terms of trade, one country will lose and another would gain.

• The terms of trade is the quantity of imported products that can be obtained per unit of products exported. The rise in price of imports will mean a fall in the terms of trade (it will take more exports to buy imports in this case, if export price is the same).

• Terms of trade= (index of export prices/ index of import prices)*10• An increase in the terms of trade is favorable because more can be

imported per unit exported.• A decrease in the terms of trade is considered unfavorable because the

country in this case can import less per unit of exports.

Page 27: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Sources of comparative advantage1) Cross country differences in technology:2) Cross country differences in the factor endowments: • Economies differ in the relative quantities of different factors of

production, for eg. Indonesia is full of unskilled labour and USA with skilled labour.

• The production of different goods requires the usage of factors of production in different proportions: aircraft production is skilled labour intensive

• Thus the countries will have a comparative advantage in goods that are relatively users of the factors of production with which they are relatively well endowed. For eg. USA has a comparative advantage in aircraft production.

Page 28: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Trade Policy• Commercial Policy is the government’s policy towards international trade.• Free trade policy is complete freedom from interference with trade.• Protectionism is protecting domestic industries from foreign competition• Governments have put in a variety of trade policy measures both to

restrict trade volume and to raise govt. revenue. The main instruments for this are

• Tariff: they are taxes imposed on the imports of goods or services. They raise the price of the product in the country, while the world price for the product is low. It will cut the volume of imports to the economy.

• Quotas: they are quantitative limits placed on the volume of imports of specific goods or services over a specified period.

Page 29: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Effects of trade policy

• How does trade policy affect the economy?• Tariff cuts the volume the imports. Low value of

imports will improve the balance of trade, which will lead the exchange rate to be higher than it would have been otherwise, which in turn will reduce exports.

• See figure 14.5 on page 410.• In short the introduction of tariff reduces welfare in

the economy.

Page 30: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

• Is it possible that this reduction in the welfare (because of introduction of tariffs) be overturned?

• Optimal tariffs: it is the tariff rate that maximizes the net gain.• Second best tariffs: a perfectly competitive economy leads to an

efficient allocation of resource. But if there are imperfections in the economy, then the first best policy should be to reduce those imperfectionsin the economy. However, if the first best policy cannot be implemented (for whatever reason) there may be a welfare gain from using some less well targeted policy instrument, this being referred to as a ‘second best’ policy response. Trade policy may be such an instrument.

Page 31: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Pattern of trade• Most of the trade that we have studied until now is the inter industry trade.• Now we will take the intra industry trade (import and export products of the

same industry)and the benefits of it. England exports furniture to Sweden, and Sweden exports a differentiated line of furniture to England. Different countries in the EU specialize in differentiated sub-product lines. This results in bigger choice.

• Product variety effect of trade: trade gives an increased range of variety of products.

• Pro-competitive effects of trade: If there are more firms, that means more firms supplying each market, hence more intense competition, and fewer firms producing in each country, with the remaining firms larger and operating at lower average cost. This reduction in average cost is a source of efficiency gain in addition to the comparative advantage gains and variety effects.

Page 32: Chapter 13 Unemployment and Inflation. Trade off between inflation and unemployment (Phillips Curve) It is graph showing a trade off between unemployment

Foreign Direct Investment• FDI- firms have a controlling interest in the firm.• Foreign portfolio investment- when firms and individuals buy shares in

foreign companies, but have no controlling interest in the company.• In recent years FDI has increased even more rapidly than trade.• There is advantage obtained by splitting production between countries.• Firms have ‘knowledge capital’, which they want to protect, so they go for

FDI.• Market oriented or horizontal FDI: duplicating the same stage of

production in many plants in different countries.• Cost oriented or vertical FDI: production process being broken up

between different stages.• Advantages of FDI (READ PAGES 421 AND 422)