Inflation, Unemployment and Philip’s Curve

* Report *
Inflation, Unemployment and the
Philip’s Curve

Group # 7
Group members:-

Shehzad
6565 - Khwaja Ali Jibran
8056 - Tajdar Ahmad Hashmi
Zaid Imad
7608 - Hayat Omer Malik

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 Inflation, Unemployment and Philip’s Curve

Table of Contents
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Unemployment

Cost of Unemployment

Inflation

Cost of Inflation

Philip’s Curve

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Unemployment
By Shehzad { 7857 }

An economic condition marked by the fact that individuals actively

seeking jobs remain unhired. Unemployment is expressed as a
percentage of the total available workforce. The level of unemployment
varies with economic conditions and other circumstances.

Types of unemployment

Economists distinguish between four major kinds of unemployment, i.e.,

cyclical, frictional, structural and classical. (Another distinction, not
discussed here, is between voluntary and involuntary unemployment.)
Real-world unemployment may combine different types, while all five
might exist at one time. The magnitude of each of these is difficult to
measure, partly because they overlap and are thus hard to separate
from each other. All but cyclical unemployment can be seen as existing
at full employment, the level of employment and unemployment that
represents the inflation barrier to demand-side growth.

Cyclical unemployment

This type of unemployment exists due to inadequate effective aggregate

demand. It gets its name because it varies with the business cycle,
though it can also be persistent, as during the Great Depression of the
1930s. Gross domestic product is not as high as potential output
because of demand failure, due to (say) pessimistic business
expectations which discourages private fixed investment spending. Low
government spending or high taxes, under consumption, or low exports
net of imports may also have this result.

Some consider this type of unemployment one type of frictional

unemployment in which factors causing the friction are partially caused
by some cyclical variables. For example, a surprise decrease in the
money supply may shock participants in society. Then, we may see
recession and cyclical unemployment until expectations adjust to the
new conditions.

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In this case, the number of unemployed workers exceeds the number of

job vacancies, so that if even all open jobs were filled, some workers
would remain unemployed. This kind of unemployment coincides with

Unused industrial capacity (unemployed capital goods). Keynesian

economists see it as possibly being solved by government deficit
spending or by expansionary monetary policy, which aims to increase
non-governmental spending by lowering interest rates.

Classical economics rejects the conception of cyclical unemployment, seeing

the attainment of full employment of resources and potential output as the
normal state of affairs. However, it accepts the theory to some extent as full
employment can never be reached.

Frictional unemployment

This unemployment involves people being temporarily between jobs,

searching for new ones; it is compatible with full employment. It is
sometimes called search unemployment and can be voluntary. New
entrants (such as graduating students) and re-entrants (such as former
homemakers) can also suffer a spell of frictional unemployment.

Frictional unemployment exists because both jobs and workers are

heterogeneous, and a mismatch can result between the characteristics
of supply and demand. Such a mismatch can be related to skills,
payment, work time, location, attitude, taste, and a multitude of other
factors. Workers as well as employers accept a certain level of
imperfection, risk or compromise, but usually not right away; they will
invest some time and effort to find a better match. This is in fact
beneficial to the economy since it results in a better allocation of
resources. However, if the search takes too long and mismatches are
too frequent, the economy suffers, since some work will not get done.
Therefore, governments will seek ways to reduce unnecessary frictional
unemployment.

Policies to reduce frictional unemployment include:

• educational advice;
• schooling and training facilities;
• information on available jobs and workers;
• combating prejudice (against certain workers, jobs or locations);
• incentives and regulations (e.g. when the frictionally unemployed
receive benefits);
• relocation of industries and services;
• facilities to increase availability and flexibility (e.g. daycare
centers);
• aid or grants to overcome a specific obstacle (e.g. if a
handicapped worker is employed);
• Reduction of the gap between gross and net wages (e.g. by taxing
consumption instead).

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Frictional unemployment coincides with an equal number of vacancies.

Numerically, it is therefore maximal when the labor market is in
equilibrium. When for instance demand far exceeds supply, the
frictionally unemployed will be few as they will get many job offers.

The imperfection of the labor market is sometimes graphically presented

with a UV-curve, a hyperbolic or similarly shaped curve that shows a
fixed relationship between the unemployment rate on one axis and the
vacancy rate on the other. If the economy changes, the labor market will
move along this curve. Factors that affect friction will shift the curve
inwards or outwards. It is possible to derive this curve mathematically
by aggregating (infinitely small) submarkets of the labor market, if it is
assumed that these submarkets follow a probability distribution.
Formulae have been derived for the Normal distribution[1] and the
Weibull distribution[2]; the latter has the hyperbolic UV-curve (U x V = c)
as a special case.

Examples

One kind of frictional unemployment is called wait unemployment: it

refers to the effects of the existence of some sectors where employed
workers are paid more than the market-clearing equilibrium wage. Not
only does this restrict the amount of employment in the high-wage
sector, but it attracts workers from other sectors who wait to try to get
jobs there. The main problem with this theory is that such workers will
likely "wait" while having jobs, so that they are not counted as
unemployed. In Hollywood, for example, those who are waiting for
acting jobs also wait on tables in restaurants for pay (while acting in
"Equity Waiver" plays at night for no pay). However, these workers
might be seen as underemployed (definition 1).

Another type of frictional unemployment is seasonal unemployment,

where specific industries or occupations are characterized by seasonal
work which may lead to unemployment. Examples include workers
employed during farm harvest times or those working winter jobs on the
ski slopes or summer jobs such as life-guarding at outdoor pools and
agricultural labor.

Structural unemployment

The better the economy is doing, the lower this type of

unemployment is likely to be. This is because people will usually
be able to find jobs that suit them more quickly when the
economy is doing well This involves a mismatch between the
good workers looking for jobs and the vacancies available. Even
though the number of vacancies may be equal to the number of
the unemployed, the unemployed workers lack the skills needed
for the jobs — or are in the wrong part of the country or world to
take the jobs offered. It is a mismatch of skills and opportunities

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due to the structure of the economy changing. That is, it is very

expensive to unite the workers with jobs. One possible example in
the rich countries is the present combination of the shortage of
nurses with an excess labor supply in Information Technology.
Unemployed programmers cannot easily become nurses, because
of the need for new specialized training, the willingness to switch
into the available jobs, and the legal requirements of such
professions.

Structural unemployment is a result of the dynamic changes of a

capitalist economy (such as technological change and capital flight) —
and the fact that labor markets can never be as fluid as (say) financial
markets. Workers are "left behind" due to costs of training and moving
(e.g., the cost of selling one's house in a depressed local economy),
plus inefficiencies in the labor markets, such as discrimination.

Structural unemployment is hard to separate empirically from frictional

unemployment, except to say that it lasts longer. It is also more painful.
As with frictional unemployment, simple demand-side stimulus will not
work to easily abolish this type of unemployment.

Some sort of direct attack on the problems of the labor market — such
as training programs, mobility subsidies, anti-discrimination policies, a
Basic Income Guarantee, and/or a Citizen's Dividend — seems required.
The latter provide a "cushion" of income which allows a job-seeker to
avoid simply taking the first job offered and to find a vacancy which fits
the worker's skills and interests. These policies may be reinforced by
the maintenance of high aggregate demand, so that the two types of
policy are complementary.

Structural unemployment may also be encouraged to rise by persistent

cyclical unemployment: if an economy suffers from long-lasting low
aggregate demand, it means that many of the unemployed become
disheartened, while their skills (including job-searching skills) become
"rusty" and obsolete. Problems with debt may lead to homelessness
and a fall into the vicious circle of poverty. This means that they may not
fit the job vacancies that are created when the economy recovers. Some
economists see this scenario as occurring under British Prime Minister
Margaret Thatcher during the 1970s and 1980s. The implication is that
sustained high demand may lower structural unemployment. However, it
also may encourage inflation, so some kind of incomes policies (wage
and price controls) may be needed, along with the kind of labor-market
policies mentioned in the previous paragraph. (This theory of rising
structural unemployment has been referred to as an example of path
dependence or "hysteresis.")

Much technological unemployment (e.g. due to the replacement of

workers by robots) might be counted as structural unemployment.
Alternatively, technological unemployment might refer to the way in
which steady increases in labor productivity mean that fewer workers

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are needed to produce the same level of output every year. The fact that
aggregate demand can be raised to deal with this problem suggests that
this problem is instead one of cyclical unemployment. As indicated by
Okun's Law, the demand side must grow sufficiently quickly to absorb
not only the growing labor force but also the workers made redundant
by increased labor productivity. Otherwise, we see a jobless recovery
such as those seen in the United States in both the early 1990s and the
early 2000s.

Seasonal unemployment might be seen as a kind of structural

unemployment, since it is a type of unemployment that is linked to
certain kinds of jobs (construction work, migratory farm work). The
most-cited official unemployment measures erase this kind of
unemployment from the statistics using "seasonal adjustment"
techniques.

Hidden unemployment

Hidden, or covered, unemployment is the unemployment of potential

workers that is not reflected in official unemployment statistics, due to
the way the statistics are collected. In many countries only those who
have no work but are actively looking for work (and/or qualifying for
social security benefits) are counted as unemployed. Those who have
given up looking for work (and sometimes those who are on
Government "retraining" programmes) are not officially counted among
the unemployed, even though they are not employed. The same applies
to those who have taken early retirement to avoid being laid off, but
would prefer to be working. The statistic also does not count the
"underemployed" - those with part time or seasonal jobs who would
rather have full time jobs. Because of hidden unemployment, official
statistics often underestimate unemployment rates.

For a different meaning of hidden unemployment see Underemployment.

Classical unemployment

In this case, like that of cyclical unemployment, the number of job-

seekers exceeds the number of vacancies. However, the problem here is
not aggregate demand failure. In this situation, real wages are higher
than the market-equilibrium wage. In simple terms, institutions such as
"the minimum wage" deter employers from hiring all of the available
workers, because the cost would exceed the technologically-determined
benefit of hiring them (the marginal product of labor). Some economists
theorize that this type of unemployment can be reduced by increasing
the flexibility of wages (e.g., abolishing minimum wages or employee
protection), to make the labor market more like a financial market.

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 Inflation, Unemployment and Philip’s Curve

Full employment

In theory, it is possible to abolish cyclical unemployment by increasing

the aggregate demand for products and workers. However, eventually
the economy hits an "inflation barrier" imposed by the four other
(supply-side) kinds of unemployment to the extent that they exist.

Some economists see the inflation barrier as corresponding to the

natural rate of unemployment. The "natural" rate of unemployment is
defined as the rate of unemployment that exists when the labor market
is in equilibrium and there is pressure for neither rising inflation rates
nor falling inflation rates [1]. More scientifically, this rate is sometimes
referred to as the NAIRU or the Non-Accelerating Inflation Rate of
Unemployment

No matter what its name, this means that if the unemployment rate gets
"too low," inflation will get worse and worse (accelerate) in the absence
of wage and price controls (incomes policies). Others simply see the
possibility of inflation rising as the unemployment rate falls. This is the
famous Phillips curve.

One of the major problems with the NAIRU theory is that no-one knows
exactly what the NAIRU is (while it clearly changes over time). The
margin of error can be quite high relative to the actual unemployment
rate, making it hard to use the NAIRU in policy-making.

Another, normative, definition of full employment might be called the

ideal unemployment rate. It would exclude all types of unemployment
that represent forms of inefficiency. This type of "full employment"
unemployment would correspond to only frictional unemployment
(excluding that part encouraging the McJobs management strategy) and
would thus be very low. However, it would be impossible to attain this
full-employment target using only demand-side Keynesian stimulus
without getting below the NAIRU and suffering from accelerating
inflation (absent incomes policies). Training programs aimed at fighting
structural unemployment would help here.

To the extent that hidden unemployment exists, it implies that official

unemployment statistics provide a poor guide to what unemployment
rate coincides with "full employment".

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Costs of unemployment
By: Khawaja Ali Jibran { 6565 }

Individual

Unemployed individuals are unable to earn money to meet financial

obligations. Failure to pay mortgage payments or to pay rent may lead
to homelessness through foreclosure or eviction. The loss of health
insurance benefits that comes with unemployment increases
susceptibility to illness, mental stress, and loss of self-esteem, leading
to depression.

Some hold that many of the low-income jobs are not really a better
option than unemployment with a welfare state (with its unemployment
insurance benefits). But since it is difficult or impossible to get
unemployment insurance benefits without having worked in the past,
these jobs and unemployment are more complementary than they are
substitutes. (These jobs are often held short-term, either by students or
by those trying to gain experience; turnover in most low-paying jobs is
high, in excess of 30%/year.

Unemployment insurance keeps an available supply of workers for the

low-paying jobs, while the employers' choice of management techniques
(low wages and benefits, few chances for advancement) is made with
the existence of unemployment insurance in mind.

Combination

Another cost for the unemployed is that the combination of

unemployment, lack of financial resources, and social responsibilities
may push unemployed workers to take jobs that do not fit their skills or
allow them to use their talents. Unemployment can cause
underemployment. The fear of job loss can spur psychological anxiety.

Social

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An economy with high unemployment is not using all of the resources,

i.e. labor, available to it. This means it is operating at below its
production possibility frontier and could have higher output if the entire
workforce were usefully employed. In this view, however, those
frictionally unemployed are in fact usefully employed in looking for
work: if they accepted the first job they were offered, they would be
likely to be operating at below their skill level, reducing the economy's
efficiency. Additionally, Government programs to artificially raise
employment, for example by building totally pointless pyramids or
digging holes do not employ the workers usefully: this would make the
economy more, not less, efficient.

GOOD TO KNOW . . .

During a long period of unemployment, workers can lose their skills, causing a
loss of human capital. Being unemployed can also reduce the life expectancy
of workers by about 7 years .High unemployment can encourage
protectionism as workers fear that foreigners are 'stealing' their jobs- despite
the fact that this is not supported by economics. This means efforts to
preserve existing jobs (of the "insiders") via barriers to entry against
"outsiders" who want jobs, legal obstacles to immigration, and/or tariffs and
similar trade barriers against foreign competitors. The most developed
countries have aids for the unemployed as part of the welfare state. These
unemployment benefits include unemployment insurance, welfare,
unemployment compensation and subsidies to aid in retraining. The main
goal of these programs is to alleviate short-term hardships and, more
importantly, to allow workers more time to search for a good job.

Entity Unemployment rate Source / date of

information
(%)
Singapore 1.60 2008
Japan 3.70 2007 est.
United States 4.70 2007 est.
United Kingdom 5.30 2006 est.
India 7.10 2007 est.
Pakistan 7.50 2007
Germany 9.10 2007 est.
Iran 11.00 2001 est.
South Africa 25.40 2005
Afghanistan 30.00 2004 est.

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Inflation
By: Tajdar Ahmad Hashmi { 8056 }

Inflation is a rise in the general level of prices over

time. It may also refer to a rise in the prices of a
specific set of goods or services.

Types of inflation.
There are two major types of inflation, according to
Robert J. Gordon.
• Demand-pull inflation: inflation caused
initially by increases in aggregate demand due

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to increased private and government spending,

etc.

• Cost-push inflation: presently termed "supply

shock inflation," caused by drops in aggregate
supply due to increased prices of inputs, for
example. Take for instance a sudden decrease
in the supply of oil, which would increase oil
prices. Producers for whom oil is a part of their
costs could then pass this on to consumers in
the form of increased prices. Both the types of
inflation occurs in the long run as well as in the
short run so lets have a look at them in turn.

In the short run an initial increase in AD causes the price level

to rise with an increase in equilibrium level of output.

The increase in AD might be due to a change in MS by the

central bank or any change in the autonomous spending, A.

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Now let’s have look at the case of demand pull inflation in the
long run.
What happens here is that AD increases due to a change in MS
by the central bank or any change in the autonomous spending,
A.
This increase in the AD causes AS to decrease as in the long run
we have 100% employment level. Thus we employ more labour
and consequently the Cost of Production increases causing AS
to decrease.

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In the short run any increase in the cost of production of goods

causes a decrease inAS.

This decreases in AS causes the equilibrium price level to rise

and the output to fall.

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What happens in the long run is that AS decreases due to an

increase in the Cost of Production.
The decrease in AS results in unemployment and the economy
enters recession. To overcome unemployment government
expenditures (G) increases causing the AD to increase and due
to this the output returns back to Y1.

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The Cost of Inflation

Inflation is closely watched and widely discussed because it is thought
to be a serious problem. If you ask a person why inflation is bad he will
tell you that the answer is obvious: inflation robes him of his purchasing
power. With the rise in prices each dollar of income will buy fewer
amounts of goods and services. Thus it might seem that inflation
directly lowers the living standards. There is a fallacy in this answer.
When prices rise buyers pay more for goods and services at the same
time seller receive more for what they sell. Because most people earn
there living by selling there services. Such as there labour, inflation in
income goes hand in hand with inflation in prices. Thus, inflation not in
itself reduces people’s purchasing power.

Consider an example of a person who receives an annual raise of 10%

and the rate of inflation in that particular country is 7%. Although the
raise in purchasing power was expected to be 10% but due to the effect
of inflation, the real raise in purchasing power is only by 3%. Now in this
situation the person doesn’t realize that the raise in the salary was
adjusted for inflation. So in this situation the person believes he has
been cheated of his rightful due. What they don’t realize is that if the
inflation rate was zero then the annual raise would have been 3% rather
then 10%.

If nominal income tends to keep pace with rising prices then why is
inflation a problem? Economists have identified several costs of
inflation, which are following:

Shoeleather Costs
The cost of reducing your money holding is called the Shoeleather cost
of inflation because making more frequent trips to the bank causes your
shoes to wear out more quickly. The term is not to be taken literally: the
actual cost of inflation is the time and convenience you must sacrifice to
keep less money on hand. The resources wasted when inflation
encourages people to reduce their money holding.

Menu Cost

It is the cost of changing prices. The term is derived from a restaurants

cost of printing a new menu. Menu cost include the cost of deciding new
prices, cost of printing new price list and catalos, the cost of sending
these new prices to dealers and customers, and the cost of advertising
the new prices.

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 Inflation, Unemployment and Philip’s Curve

Tax Distortion

Tax code concludes that inflation tends to raise the tax burden on
income earned from saving:-

Tax on nominal income capital gains and on nominal interest income are
two examples of how tax affects savings. Higher burden of tax reduces
the amount of saving which in result depress the long run economic
growth by reducing the amount of investment because the savings
provide the resources of investment.

Redistribution of Wealth
In case of unexpected inflation there could be redistribution of wealth
among the debtors and creditors in a way that has nothing to do with
either merit or need. During an unexpected inflation the value of money may
rise or reduce, since many loans are in terms of unit of account (money).

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 Inflation, Unemployment and Philip’s Curve

Philip’s Curve
By: Hayat Omer Malik {7608 }

The Phillip’s curve is a historical inverse relation between the rate of

unemployment and the rate of inflation in an economy. Stated simply,
the lower the unemployment in an economy, the higher the rate of
change in wages paid to labor in that economy, in data from a number of
countries and historical periods.

A typical Philips curve looks like this. If you notice it is a negatively

sloped curve. Any move of decreasing the inflation rate will result in a
rise in the rate of unemployment.

Stagflation
In the 1970s, many countries experienced high levels of both inflation
and unemployment also known as stagflation. Theories based on the
Phillips curve suggested that this could not happen, and the curve came
under concerted attack from a group of economists headed by Milton
Friedman—arguing that the demonstrable failure of the relationship
demanded a return to non-interventionist, free market policies. The idea
that there was a simple, predictable, and persistent relationship between
inflation and unemployment was abandoned by most if not all
macroeconomists.

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NAIRU and rational expectations

Short-Run Phillips Curve before and after Expansionary Policy, with

Long-Run Phillips Curve (NAIRU)

New theories, such as rational expectations and the NAIRU (non-

accelerating inflation rate of unemployment) arose to explain how
stagflation could occur. The latter theory, also known as the "natural
rate of unemployment", distinguished between the "short-term" Phillips
curve and the "long-term" one. The short-term Phillips Curve looked like
a normal Phillips Curve, but shifted in the long run as expectations
changed. In the long run, only a single rate of unemployment (the NAIRU
or "natural" rate) was consistent with a stable inflation rate. The long-
run Phillips Curve was thus vertical, so there was no trade-off between
inflation and unemployment. Edmund Phelps won the Nobel Prize in
Economics in 2006 for this.

In the diagram, the long-run Phillips curve is the vertical red line. The
NAIRU theory says that when unemployment is at the rate defined by
this line, inflation will be stable. However, in the short-run policymakers
will face an inflation-unemployment rate tradeoff marked by the "Initial
Short-Run Phillips Curve" in the graph. Policymakers can therefore
reduce the unemployment rate temporarily, moving from point A to point
B through expansionary policy. However, according to the NAIRU,
exploiting this short-run tradeoff will raise inflation expectations,
shifting the short-run curve rightward to the "New Short-Run Phillips
Curve" and moving the point of equilibrium from B to C. Thus the
reduction in unemployment below the "Natural Rate" will be temporary,
and lead only to higher inflation in the long run.

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