Unemployment and Inflation

WORKSHOP 101

Unemployment and Inflation

1.In the equation MV = PQ, describe what is meant by each of the four terms.

M......

V......

P......

Q......

2.In an economy whose national income is £24 billion, the money supply is £8 billion.

(a)What will be the velocity of circulation?......

(b)If 12 billion units of national output are being sold in this economy, what is the average price of a unit?

......

(c)Suppose the velocity of circulation stays constant and the government decides to increase the money supply to £10 billion, what will happen to the average price if the number of units of national output sold does not increase?

......

3.If money supply rises, will the price level rise by the same percentage? It all depends on what happens to V and Q. Keynesians and monetarists differ in their analysis of whether a change in money supply will affect V and Q. Delete the wrong words in the following statements:

(a)Keynesians argue that V can change substantially / is unlikely to change much at allwhen money supply changes. (Monetarists argue the opposite.)

(b)Keynesians argue that a rise in MV (i.e. a rise in aggregate demand) will eventually lead to a rise in the price level / may or may not lead to a rise in the price level depending on the degree of slack in the economy.

Workshop

4.The following are the statistics for UK inflation and unemployment from 1970 to 2000.

Year / 1970 / 1971 / 1972 / 1973 / 1974 / 1975 / 1976 / 1977 / 1978 / 1979 / 1980 / 1981 / 1982 / 1983 / 1984 / 1985
Inflation (%) / 6.3 / 9.4 / 7.3 / 9.1 / 16.0 / 24.3 / 16.6 / 15.8 / 8.3 / 13.4 / 18.0 / 11.9 / 8.6 / 4.6 / 5.0 / 6.1
Unemployment (%) / 2.4 / 3.0 / 3.3 / 2.3 / 2.3 / 3.6 / 5.6 / 6.0 / 5.9 / 5.0 / 6.4 / 9.8 / 11.3 / 12.4 / 11.7 / 11.2
Year / 1986 / 1987 / 1988 / 1989 / 1990 / 1991 / 1992 / 1993 / 1994 / 1995 / 1996 / 1997 / 1998 / 1999 / 2000
Inflation (%) / 3.4 / 4.1 / 4.9 / 7.8 / 9.5 / 5.9 / 3.7 / 1.6 / 2.4 / 3.5 / 2.4 / 3.1 / 3.4 / 1.6 / 2.4
Unemployment (%) / 11.2 / 10.3 / 8.6 / 7.2 / 6.9 / 8.8 / 10.1 / 10.4 / 9.6 / 8.7 / 8.2 / 7.0 / 6.3 / 6.1 / 5.3

These figures are plotted on the following diagram.

(a)Try drawing the line of best fit through the points on the diagram. Does it look anything like a Phillips curve?

(b)Now try drawing four separate curves: one for the period 197079; one for 198085; one for 198693; and one for 1994–2000.

(c)(i) In which two of the four periods is there apparently a trade-off and (ii) in which one of these two is the inflation/unemployment relationship more favourable?

(i)...... (ii)......

(d)How would you describe the relationship between inflation and unemployment between 1994 and 2000?

Workshop

(e)To what extent is your diagram consistent with the Keynesian argument that the Phillips curve is downward sloping but has shifted?

......

(f)Now try connecting the points in chronological order. Describe the pattern that emerges.

......

(g)How would a monetarist account for apparent clockwise loops in the Phillips curve?

......

(h)How would you account for the relationship (or lack of it) between inflation and unemployment since 1994?

......

5.The diagram opposite shows two short run Phillips curves (PC0 and PC1). PC0 corresponds to a situation in which workers expect no inflation.

(a)What is the natural rate of unemploy-ment?

......

(b)What is the expected rate of inflation if the Phillips curve is PC1?

......

Suppose that the economy begins in long-run equilibrium with zero inflation and that the authorities adopt a policy of constant mone-tary growth because they wish to reduce unemployment below its existing level.

(c)Identify the short-run effect on unem-ployment and inflation.

Unemployment ......

Inflation

Workshop

(d)Explain why this new position for the economy is untenable in the long run.

......

(e)Towards what long-run equilibrium level of unemployment will the economy tend?

......

6.Assume that inflation depends on two things: the level of aggregate demand, indicated by the inverse of unemployment (1/U), and the expected rate of inflation (Pet). Assume that the rate of inflation (Pt) is given by the equation:

Pt = (40/U 4) + Pet

Assume initially (year 0) that the actual and expected rate of inflation is zero.

(a)What is the current (natural) rate of unemployment?......

(b)Now assume in year 1 that the government wishes to reduce unemployment to 5 per cent and continues to expand aggregate demand by as much as is necessary to achieve this. Fill in the rows for years 0 to 4 in the following table. It is assumed for simplicity that the expected rate of inflation in a given year (Pet) is equal to the actual rate of inflation in the previous year (Pt1).

Year / U / (40 / U)  4 / + / Pe / = / P

0
1
2
3
4 / ___
___
___
___
___ / ___
___
___
___
___ / +
+
+
+
+ / ___
___
___
___
___ / =
=
=
=
= / ___
___
___
___
___
5
6
7 / ___
___
___ / ___
___
___ / +
+
+ / ___
___
___ / =
=
= / ___
___
___

(c)Now assume in year 5 that the government, worried about rising inflation, reduces aggregate demand sufficiently to reduce inflation by 2 per cent in that year. What must the rate of unemployment be raised to in that year?

......

(d)Assuming that unemployment stays at this high level, continue the table for years 5 to 7.