Explain how their rates are determined.

Inflation is an increase in the average level of prices, and deflation is a decrease in the average level of prices. In an economy experiencing inflation, most prices are likely to be rising, whereas in an economy experiencing deflation, most prices are likely to be falling.

There are two key points in these definitions:

1. Inflation and deflation refer to changes in the average level of prices, not to changes in particular prices. An increase in medical costs is not inflation. A decrease in gasoline prices is not deflation. Inflation means the average level of prices is rising, and deflation means the average level of prices is falling.

2. Inflation and deflation refer to rising prices and falling prices, respectively; therefore, they do not have anything to do with the level of prices at any one time. “High” prices do not imply the presence of inflation, nor do “low” prices imply deflation. Inflation means a positive rate of change in average prices, and deflation means a negative rate of change in average prices.

What difference does it make if the average level of prices changes? First, consider the impact of inflation.

Whether one regards inflation as a “good” thing or a “bad” thing depends very much on one’s economic situation. If you are a borrower, unexpected inflation is a good thing—it reduces the value of money that you must repay. If you are a lender, it is a bad thing because it reduces the value of future payments you will receive. Whatever any particular person’s situation may be, inflation always produces the following effects on the economy: it reduces the value of money and it reduces the value of future monetary obligations. It can also create uncertainty about the future.

Suppose that you have just found a $10 bill you stashed away in 1990. Prices have increased by about 50% since then; your money will buy less than what it would have purchased when you put it away. Your money has thus lost value.

Money loses value when its purchasing power falls. Since inflation is a rise in the level of prices, the amount of goods and services a given amount of money can buy falls with inflation.

Just as inflation reduces the value of money, it reduces the value of future claims on money. Suppose you have borrowed $100 from a friend and have agreed to pay it back in one year. During the year, however, prices double. That means that when you pay the money back, it will buy only half as much as it could have bought when you borrowed it. That is good for you but tough on the person who lent you the money. Of course, if you and your friend had anticipated such rapid inflation, you might have agreed to pay back a larger sum to adjust for it. When people anticipate inflation, they can adjust for its consequences in determining future obligations. But unanticipated inflation helps borrowers and hurts lenders.

Inflation’s impact on future claims can be particularly hard on people who must live on a fixed income, that is, on an income that is predetermined through some contractual arrangement and does not change with economic conditions. Retirement pensions sometimes generate fixed income. Inflation erodes the value of such payments.

Given the danger posed by inflation for people on fixed incomes, many retirement plans provide for indexed payments. An indexed payment is one whose amount changes with the rate of change in the price level. If a payment changes at the same rate as the rate of change in the price level, the purchasing power of the payment remains constant. Social security payments, for example, are indexed to maintain their purchasing power.

Uncertainty can be particularly pronounced in countries where extremely high inflation is a threat. Hyperinflation is generally defined as an inflation rate in excess of 200% per year. Inflation of that magnitude erodes the value of money very quickly. Hyperinflations occurred in Germany in the 1920s and in Yugoslavia in the early 1990s. There are stories about how people in Germany during the hyperinflation brought wheelbarrows full of money to stores to pay for ordinary items.

The inflation rate rose to an astronomical rate in 2008 in Zimbabwe. As the government printed more money and put it in circulation, prices rose. When inflation began to accelerate, the government found it “necessary” to print more and more money, causing prices to rise very fast. The inflation rate in Zimbabwe reached an astonishing 11.2 million percent in July of 2008. A loaf of bread cost 200,000 Zimbabwe dollars in February 2008. That same loaf cost 1.6 trillion Zimbabwe dollars by August 2008.

Do the problems associated with inflation imply that deflation would be a good thing? The answer is simple: no. Like inflation, deflation changes the value of money and the value of future obligations. It also creates uncertainty about the future.

If there is deflation, the real value of a given amount of money rises. In other words, if there had been deflation since 2000, a $10 bill you had stashed away in 2000 would buy more goods and services today. That sounds good, but should you buy $10 worth of goods and services now when you would be able to buy even more for your $10 in the future if the deflation continues? When Japan experienced deflation in the late 1990s and early 2000s, Japanese consumers seemed to be doing just that – waiting to see if prices would fall further. They were spending less per person and, as we will see throughout our study of macroeconomics, less consumption often meant less output, fewer jobs, and the prospect of a recession.

Unanticipated deflation hurts borrowers and helps lenders. The threat of deflation can make people reluctant to borrow for long periods. Borrowers become reluctant to enter into long-term contracts because they fear that deflation will raise the value of the money they must pay back in the future. In such an environment, firms may be reluctant to borrow to build new factories, for example. This is because they fear that the prices at which they can sell their output will drop, making it difficult for them to repay their loans.

In the 20th century, there was a period of deflation after World War I and again during the Great Depression in the 1930s.

Unit 1.4 Unemployment

Learning objectives

1. Explain how unemployment is measured.

2. Define three different types of unemployment.

3. Define and illustrate graphically what is meant by the natural level of employment. Relate the natural level of employment to the natural rate of unemployment.

4. Explain the meaning of the Okun’s law.

 

For an economy to produce all it can and achieve a solution on its production possibilities curve, the factors of production in the economy must be fully employed. Failure to fully employ these factors leads to a solution inside the production possibilities curve in which society is not achieving the output it is capable of producing.

In thinking about the employment of society’s factors of production, we place special emphasis on labor. The loss of a job can wipe out a household’s entire income; it is a more compelling human problem than unemployed capital, such as a vacant apartment.

Measuring Unemployment

We define a person as unemployed if he or she is not working but is looking for and available for work. The labor force is the total number of people working or unemployed. The unemployment rate is the percentage of the labor force that is unemployed.

The unemployment rate is computed as the number of people unemployed divided by the labor force — the sum of the number of people not working but available and looking for work plus the number of people working. The rate is expressed in percentage. For example, in October 2008, the unemployment rate in the USA was 6.5%.

The adult population can be divided into three groups. Those who have jobs are counted as employed; those who do not have jobs but are looking for them and are available for work are counted as unemployed; and those who are not working and are not looking for work are not counted as members of the labor force.

The unemployment rate is the number of people looking for work divided by the sum of the number of people looking for work and the number of people employed.

Types of Unemployment

Workers may find themselves unemployed for different reasons. Each source of unemployment has quite different implications, not only for the workers it affects but also for public policy.

Figure “The Natural Level of Employment” applies the demand and supply model to the labor market. The price of labor is taken as the real wage, which is the nominal wage divided by the price level; the symbol used to represent the real wage is the Greek letter omega, ω. The supply curve is drawn as upward sloping, though steep, to reflect studies showing that the quantity of labor supplied at any one time is nearly fixed. Thus, an increase in the real wage induces a relatively small increase in the quantity of labor supplied. The demand curve shows the quantity of labor demanded at each real wage. The lower the real wage, the greater the quantity of labor firms will demand. In the case shown here, the real wage, ω_e, equals the equilibrium solution defined by the intersection of the demand curve D ₁ and the supply curve S ₁. The quantity of labor demanded, L _e, equals the quantity supplied. The employment level at which the quantity of labor demanded equals the quantity supplied is called the natural level of employment. It is sometimes referred to as full employment.

Figure The Natural Level of Employment

 

Even if the economy is operating at its natural level of employment, there will still be some unemployment. The rate of unemployment consistent with the natural level of employment is called the natural rate of unemployment.

Frictional Unemployment

Even when the quantity of labor demanded equals the quantity of labor supplied, not all employers and potential workers have found each other. Some workers are looking for jobs, and some employers are looking for workers. During the time it takes to match them up, the workers are unemployed. Unemployment that occurs because it takes time for employers and workers to find each other is called frictional unemployment.

The case of college graduates engaged in job searches is a good example of frictional unemployment. Most of them will find jobs, but it will take time. During that time, these new graduates will be unemployed. If information about the labor market were costless, firms and potential workers would instantly know everything they needed to know about each other and there would be no need for searches on the part of workers and firms. There would be no frictional unemployment. But information is costly. Job searches are needed to produce this information, and frictional unemployment exists while the searches continue.

The government may attempt to reduce frictional unemployment by focusing on its source: information costs. Many state agencies, for example, serve as clearinghouses for job market information. They encourage firms seeking workers and workers seeking jobs to register with them. To the extent that such efforts make labor-market information more readily available, they reduce frictional unemployment.

Structural Unemployment

Another reason there can be unemployment even if employment equals its natural level stems from potential mismatches between the skills employers seek and the skills potential workers offer. Every worker is different; every job has its special characteristics and requirements. The qualifications of job seekers may not match those that firms require. Even if the number of employees firms demand equals the number of workers available, people whose qualifications do not satisfy what firms are seeking will find themselves without work. Unemployment that results from a mismatch between worker qualifications and the characteristics employers require is called structural unemployment.

Structural unemployment emerges for several reasons. Technological change may make some skills obsolete or require new ones. The widespread introduction of personal computers since the 1980s, for example, has lowered demand for typists who lacked computer skills.

Structural unemployment can occur if too many or too few workers seek training or education that matches job requirements. Students cannot predict precisely how many jobs there will be in a particular category when they graduate, and they are not likely to know how many of their fellow students are training for these jobs. Structural unemployment can easily occur if students guess wrong about how many workers will be needed or how many will be supplied.

Structural unemployment can also result from geographical mismatches. Economic activity may be booming in one region and slumping in another. It will take time for unemployed workers to relocate and find new jobs. And poor or costly transportation may block some urban residents from obtaining jobs only a few miles away.

Public policy responses to structural unemployment generally focus on job training and education to equip workers with the skills firms demand. The government publishes regional labor-market information, helping to inform unemployed workers of where jobs can be found.

Although government programs may reduce frictional and structural unemployment, they cannot eliminate it. An economy at its natural level of employment will therefore have frictional and structural unemployment.

Cyclical Unemployment

The economy may not be operating at its natural level of employment, so unemployment may be above or below its natural level. Cyclical unemployment is unemployment in excess of the unemployment that exists at the natural level of employment. During recessions, the part of unemployment that is cyclical unemployment grows. The analysis of fluctuations in the unemployment rate, and the government’s responses to them, will be discussed in later parts, where we will explore what happens when the economy generates employment greater or less than the natural level.

Consequences of cyclical unemployment for the level of production can be demonstrated using the Okun’s law. In economics, Okun’s law (named after Arthur Melvin Okun, who proposed the relationship in 1962) is an empirically observed relationship between unemployment and losses in a country’s production. The “gap version” states that for every 1% increase in the unemployment rate, a country’s GDP will be roughly an additional 2% lower than its potential GDP. The stability and usefulness of the law has been disputed.

Okun’s law states that a one-point increase in the cyclical unemployment rate is associated with two percentage points of negative growth in real GDP. The relationship varies depending on the country and time period under consideration.

Mathematical statement: The gap version of Okun's law may be written as:

Ӯ – Y / Ӯ = β (u – ū) Y ¯ − Y Y ¯ = c (u − u ¯) {\displaystyle {\frac {{\overline {Y}}-Y}{\overline {Y}}}=c(u-{\overline {u}})}, where Y Y {\displaystyle Y} is actual output, Ӯ Y ¯ {\displaystyle {\overline {Y}}} is potential GDP, u u {\displaystyle u} is actual unemployment rate, ū  u ¯ {\displaystyle {\overline {u}}} is the natural rate of unemployment and 2.5 c {\displaystyle c} is the factor relating changes in unemployment to changes in output.

For example, according to the Okun’s law, a 2% excess of the actual unemployment rate over the natural level means that the lag of the actual GDP and the potential level is 2.5 x 2 = 5%.

Key concepts

· People who are not working but are looking and available for work at any one time are considered unemployed. The unemployment rate is the percentage of the labor force that is unemployed.

· When the labor market is in equilibrium, employment is at the natural level and the unemployment rate equals the natural rate of unemployment.

· Even if employment is at the natural level, the economy will experience frictional and structural unemployment.

· Cyclical unemployment is unemployment in excess of that associated with the natural level of employment.

· Okun’s law states that a one percent increase in the cyclical unemployment rate may lead to two percentage points of negative growth in real GDP.