Chapter 13 - Unemployment and Inflation: Can We Find a Balance?

Chapter 13

unemployment and inflation: Can We Find a Balance?

Can We Find A Balance?

Take your time on this one! We use it to introduce students to macroeconomic analysis.

Some of the important concepts are familiar at this point. Students are familiar with GDP and the business cycle. Demand and supply analysis are helpful in getting a working definition of unemployment established.

We find the construction of a simple set of price index numbers useful in developing the meaning of the concept of inflation and its measurement. We think it is important to stress the notion of suppressed inflation – it helps students understand the real impact of attempting to control inflation with a set of price controls.

The discussion of inflation begins with a definition of inflation and is followed by a discussion of the equity, efficiency, and output effects of inflation. The equity effects of inflation pertain to the way inflation alters the distribution of income. Some people are better off and some are worse off because of inflation. The effects of inflation on the allocation of resources are the efficiency effects of inflation. Inflation alters relative prices and, therefore, changes the pattern of resources allocation towards a less efficient allocation. Finally, inflation will have effects on the output of goods and services. These effects may be positive for a period, that is, inflation may stimulate employment and output. However, pure inflation will set in when the economy reaches full employment with serious effects on the distribution of income and allocation of resources.

We use the aggregate demand and aggregate supply framework of the preceding chapter to explain the causes of inflation and also its control. Since the impact of the money supply on aggregate demand is an important force in both causing and controlling inflation, we devote a good bit of time to the quantity theory of money and to forces that affect changes in the money supply. We examine the effects of fiscal forces, also. We try to pull these together into a relatively simple consistent framework that is logically complete and can be expanded into a full-blown macroeconomics analysis by those who continue in economics.

Documentation of the problems involved in controlling inflation is easy. Our experiences with tight-money policies, unemployment, price controls, and periods of monetary ease provide abundant examples of how difficult they are to solve.

We have obtained excellent results in our classes using the circular flow diagrams as the fundamental macroeconomic model. Then we translate the circular flow into terms of aggregate demand and aggregate supply. Changes in aggregate demand or aggregate supply that cause unemployment are brought about from changes in injections into or leakages from the circular flow. The framework is fairly simple and is one that most students can readily grasp. The discussion of measures to combat unemployment is straightforward.

TEACHING OUTLINE

  1. What is Unemployment?
  1. Labor force versus not in the labor force
  1. Institutionalization
  2. Age (over 16 years old)
  3. Labor force participation rate

B. Employment versus unemployment

1. To be unemployed

2. Unemployment rate

3. Discouragement

C. Supply and demand analysis of unemployment

  1. The Unemployment Problem
  1. Types of unemployment
  1. Frictional
  2. Structural
  3. Cyclical
  1. Full employment

C. Unemployment rates over time

III. The Inflation Problem

A. What is inflation?

B. Measurement

  1. Price indexes
  1. CPI
  2. Cost-of-living index
  3. Wholesale price index
  4. GDP deflator

2. Construction of a price index

3. Problems in measuring the cost of living

a. Typical household

b. Substitution bias

c. Introduction of new goods

d. Unmeasured quality changes

4. The rate of inflation over time

IV.Economic Effects of Inflation

  1. Equity effects
  2. Efficiency effects

C. Output effects

1. Hyperinflation

V.Economic Analysis of Unemployment and Inflation

  1. Circular flow
  2. Aggregate demand
  1. Consumption and saving
  1. MPC
  2. MPS
  3. Psychological law of consumption
  1. Investment

3. Government purchases

4. Exports and imports

5. The spending multiplier

  1. Aggregate supply

1. Short-run

2. Long-run

  1. Aggregate demand and aggregate supply

1. Deficient aggregate demand

2. Reasons for weak aggregate supply

VI.Possible trade-offs and policy options

  1. The Phillips Curve

1. Expansionary policies

2. Contractionary policies

B. Policy problems

CORE ECONOMIC PRINCIPLES

 Aggregate Supply/Aggregate Demand - The supply and demand model is expanded and applied to the macroeconomy. Aggregate supply and demand are used to introduce the causes of and policies addressing unemployment.

 Multipliers - The spending multiplier is introduced in the discussion of aggregate demand.

RESOURCES

Data Links

For employment and unemployment data, go online to the Bureau of Labor Statistics at http://www.bls.gov.

For PPI and CPI data, go online to http://www.bls.gov; look in “Economy at a Glance.” Choose “Inflation Calculator” under “Inflation & Consumer Spending” to compare dollar values in different years.

Curriculum Ideas

See “Race and Gender in a Basic Labor Force Model” in Introducing Race and Gender into Economics, edited by Bartlett. Routledge Press, 1997 (ISBN # 0-415-16283-1).

DATA SOURCES

The following data sources may be used to update and refine the statistics found in this chapter:

  • The Bureau of Labor Statistics is an agency in the U.S. Department of Labor that provides data on unemployment and other statistics. The web site for this reference is http://www.bls.gov/. Click on Economy at a Glance, and the most recent data on unemployment can be observed.
  • The Economic Report of the President is sponsored by the Executive Office of the President, and you may find it at the reference desk in your library. It contains a wealth of data, including data on population, employment, unemployment, and consumer and producer prices. Look online at their web site at http://www.access.gpo.gov/eop/, and then use the search terms box to find data of interest.

DISCUSSION QUESTIONS

1. Explain the three major types of unemployment.

2. Give examples of the forces causing aggregate demand to increase (decrease). What effects do such changes have on the employment level?

3. Explain economic activity in terms of the circular flow diagram. Explain the nature and impacts of leakages from and injections into this flow.

4. What is government fiscal policy and how can it be used to combat cyclical and structural unemployment?

5. What is Federal Reserve monetary policy and how can it be used to reduce cyclical unemployment?

6. Discuss the effects of unemployment on GDP.

7. Describe, through the use of the circular flow diagram and the AS-AD graph, how international trade conditions can influence domestic employment status.

8. Give the defining characteristics of the three major types of unemployment. Discuss appropriate policy prescriptions for effectively dealing with each type.

9. Which type of unemployment is the most serious and why? What can be done to reduce it?

10. Why can’t the market system eliminate structural unemployment?

11. Why does cyclical unemployment occur? How can we eliminate it?

12. Why does structural unemployment occur?

13. Why does frictional unemployment occur and what can we do to reduce it?

14. What is the definition of unemployment? What is meant by full employment?

15. What are the reasons for deficient aggregate demand?

16. Discuss unemployment rates according to sex, age, and ethnic background. Which demographic groups are affected most by unemployment?

17. Must there be a recession in order for unemployment to exist? Explain why or why not.

18. Discuss and illustrate with graphs how a deficient aggregate demand can result in unemployment. What can be done to remedy the problem? How would these remedies affect the aggregate demand curve?

19. Discuss and illustrate with graphs the idea of involuntary unemployment.

20. Define aggregate demand and aggregate supply. How do changes in aggregate demand affect employment? How do changes in aggregate supply affect employment? Discuss the factors that can lead to deficient aggregate demand and weak aggregate supply.

21. Discuss the aggregate supply policies in the 1980s.

22. Create an example and use it to explain the investment multiplier principle.

23. Define inflation. Explain how inflation is measured.

24. List and describe each of the major economic effects of inflation

25. Who benefits and who loses from inflation? Also explain how.

26. Use the Aggregate Demand/Aggregate Supply model to explain the current recession.

27. Give examples of the equity and efficiency effects of inflation. Explain each.

28. Discuss the conditions under which inflation may have a stimulating effect on production and employment.

29. What is meant by “inflation without rising prices?”

30. Explain how a price index is constructed.

31. What is meant by the “trade-off” between inflation and unemployment? Give the economic reasoning behind the short-run trade-off between inflation and unemployment.

32. What is a supply shock and how did the supply shocks during the 1970s affect the Phillips curve? Besides the energy crisis, what other factors might cause supply shocks?

33. What is the dilemma for aggregate demand management policies caused by supply shocks? What should policymakers do when confronted by supply shocks?

34. The supply shocks during the 1970s seemed to worsen the trade-off between inflation and unemployment. Could there be supply shocks that improved the trade-off? Explain.

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