Introduction to Economics - … of Thrift. 3.3 Definition and Measurement of Unemployment

Chapter 3 Business Cycles, Unemployment and Inflation

MACROECONOMICS

Introduction to Economics

contents

Causes of Business Cycles

Reasons for the Insufficiency of Aggregate Demand

Definition and Measurement of Unemployment

Types of Unemployment

Social Cost of Inflation

Causes of Inflation

3.1

3.2

3.3

3.4

3.5

3.6

3.1 Causes of Business Cycles

• we have seen that the equilibrium level of national income(Y*) is

determined at the intersection of aggregate demand and aggregate supply

curves

• note that the full employment level of national income is denoted by YF- full employment level of national income is the level of national

income that can be achieved if all the resources in the economy are

utilized at normal levels

• if Y*< YF as shown in the next diagram, the difference between the two is

called the recessionary gap

Recessionary Gap


Recessionary Gap and Unemployment


• Y*< YF→ a recessionary gap occurs → the economy falls into a recession and unemployment occurs

• the existence of a recessionary gap means that some of productive resources are not utilized in the production process

• unutilized resources mean they are unemployed • in contrast, if Y*> YF holds, the economy is in a boom• in this case, we don’t have to worry about unemployment but

inflation could be a problem


• business cycles occur because the equilibrium level of national

income becomes larger or smaller than the full employment

level of national income

• depending upon economic conditions, aggregate demand and

aggregate supply curves shift to the right and left,

and business cycles occur as a result

• most of the case, business cycles occur as a result of shifts in

aggregate demand

• this means that the insufficiency of aggregate demand is a

major cause of recession

Theory of Effective Demand by Keynes


• the thoughts of classical economists can be summarized by so-called

Say’s law

• Say’s law : “Supply creates its own demand.”

• as long as Say’s law holds, recessions caused by insufficient aggregate

demand would not occur

• but ‘Great Depression’ in the 1930s clearly showed Say’s law was wrong

• Keynes pointed out recessions caused by insufficient aggregate demand

are very common ⇒ Theory of Effective Demand by Keynes



•classical economists believed that the economy will return to the state of full employment through the adjustment of prices and wages even in the presence of insufficient aggregate demand

•but Keynes refuted that prices and wages lacked flexibility in reality

•he said that wages, in particular, were inflexible due to various institutional reasons

•the essence of Keynes’ theory of effective demand is that the inflexibility of prices and wages could cause insufficient aggregate demand and chronic depression



• policy implications of the theory of effective demand

- Keynes argued that we could achieve the state of full employment

by demand boosting expansionary policies

- “Demand creates supply.”

- Keynesian theory which emphasizes the demand side is appropriate

for explaining the state of recession

- world economy entered the state of full employment in the 1960s,

and since then Keynesian theory has lost some of its explanatory

power

3.2 Reasons for the Insufficiency of Aggregate Demand

Stream of national income in a simple national economy consisting of only households and firms

Leakage and Injection


• a household does not spend all its income on consumption expenditure and save some of it

• only the money spent on consumption expenditure constitutes demand for commodities produced by firms

• therefore the part of income saved has the characteristic of leakagefrom the stream of national income

• but investment by firms add to the demand for capital goods, and thus it has the characteristic of injection



- a single economic agent determines the levels of saving and investment simultaneously

- therefore saving is equal to investment always

self-sufficient economy



- different economic agents determine saving and investment independently (saving by households and investment by firms)

- if saving is larger than investment, the stream of national income will get smaller

- so the actual level of national income could be lower than the full employment level of national income and unemployment occurs

- too much saving is the cause of insufficient aggregate demand

modern economy


• if people try to save more, they might end up with less amount of saving ⇒ paradox of thrift

• more saving means more leakage ⇒ national income decreases ⇒ saving decreases as a result

- seen from the viewpoint of Keynesian theory, saving is a vice (consumption is a virtue)

• in the short-run, too much saving brings about a recession by making aggregate demand insufficient

• but in the long-run, saving is a source of capital accumulation and economic growth

Paradox of Thrift

3.3 Definition and Measurement of Unemployment

• two major problems of a national economy : unemploymentand inflation

- achieving the stability in employment and prices is the most important task for any national economy

• but the problem is that the stability in employment and the stability in prices are sometimes incompatible

ex) an expansionary policy to solve the problem of unemployment may make prices more unstable

• opinions can differ as to which of these two objectives should be given more attention

Definition of Unemployment


- people in working age population who are willing to work

economically active population

- A person who is older than 15 and does not have a job even though he/she is willing to work is considered unemployed

unemployment

- anyone who is considered able to work belong to this group

- in case of Korea, people who are older than 15

working age population

Who Are Unemployed?


Measurement of Unemployment


• unemployment rate = number of unemployed / economically active population

• economically inactive population excluded from consideration in calculating unemployment rate

• in actuality, it is difficult to judge whether a certain jobless person is unemployed or not

• discouraged workers (persons who give up searching for jobs because they get tired of fruitless job search)

• they are not counted as unemployed because they belong to economically inactive population

unemployment rate

Labor Market in Korea


working age population : P

(42.09 million)

economically active population : L

(25.87 million)

economically inactive

population : NL

(16.22 million)

employed : E

(25.06 million)

unemployed : U

(8.1 million)

rate of economic

participation

unemployment rate

3.4 Types of Unemployment

(1) cyclical unemployment

• unemployment caused by a recession

(2) frictional unemployment

• temporary unemployment due to moving of

residency or searching for better jobs

• voluntary in nature

• what we call ‘full-employment’ refers to the

state that only frictional unemployment exists

- full employment unemployment rate or

natural rate of unemployment

three types of unemployment


(3) structural unemployment• unemployment due to automation or

restructuring of industries• unemployment which is generated in the process

of the replacement of less competitive industries by more competitive industries

• inevitable when the economy grows rapidly• its social cost pretty high in the sense that it is

involuntary • that finding new jobs is very difficult for these

people is also a problem

three types of unemployment

Natural Unemployment


natural unemployment

- natural unemployment refers to the kind of unemployment which occurs in the process that workers move around to get better jobs

natural rate of unemployment

- the rate of unemployment one can observe when the number of unemployed remains at a stable level⇒ natural rate of unemployment

- natural rate of unemployment does not mean 0% of unemployment rate

- natural unemployment means full employment

Natural Unemployment


natural unemployment has a close relationship with frictional unemployment

• one of the most important factor that affects frictional unemployment is unemployment insurance

- good unemployment insurance system ⇒ pain of unemployment not so great ⇒ don’t have to search for jobs diligently ⇒ natural rate of unemployment tends to be high

• the fact that the natural rate of unemployment is relatively low in Korea means that workers are not so well protected


• involuntary unemployment : cyclical unemployment and structural unemployment are good examples of involuntary unemployment

- when the actual level of wage rate is higher than the equilibrium wage rate, excess supply of labor occurs ⇒ existence of involuntary unemployment

- since wages have a downward rigidity, excess supply of labor tends to remain the existence of minimum wage or labor

union

Involuntary Unemployment

3.5 Social Cost of Inflation

the case of expected inflation

• lenders of money asks for higher nominal interest rates to prevent a fall in real interest rates and borrowers readily accommodate this request

- Fisher hypothesis : nominal interest rate = real interest rate + expected rate of inflation Fisher hypothesis suggests that inflation adjustment is

made in the lending contract - if the adjustment for inflation is made in all sectors of the

economy like this, social cost of inflation in not that big ⇒ social cost of expected inflation is minor

Limitation of Fisher Hypothesis


(1) menu cost- cost occurs when firms try to change prices

(2) shoe leather cost- when inflation is expected, people tend to visit banks more frequently

because they try to minimize cash holdings- cost related to the visit to the banks are called the shoe leather cost

• the size of menu cost or shoe leather cost may not be that large ⇒ it means that the social cost of expected inflation is minor

Case of Unexpected Inflation


•social costs of unexpected inflation

(1) redistribution of income

- if actual inflation rate is bigger than expected inflation rate, income is redistributed from lenders to borrowers of money

- in general, business firms are most heavily indebted and they get windfall gains from unexpected inflation

- those who get pensions the nominal values of which are fixed and holders of financial assets will lose

Case of Unexpected Inflation


(2) problem of long-term contracts

- people are reluctant to sign long-term contracts when prices in future are hard to predict

- the avoidance of long-term contracts can cause the problem of efficiency

(3) spread of speculation

- in the process of inflation, relative prices also fluctuate widely, and this leads to a spread of speculation

- investments of sound nature decrease

3.6 Causes of Inflation

there are two kinds of short-term inflation

(1) demand-pull inflation

• inflation caused by an increase in aggregate demand • a rise in price level and an increase in national income can be

observed

(2) cost-push inflation

• inflation caused by a decrease in aggregate supply • a rise in price level and a decrease in national income can be

observed


Demand-pull Inflation and Cost-push Inflation

2

Short-term Inflation


demand-pull inflation

- this kind of inflation can be easily managed by reducing aggregate demand

cost-push inflation

ex) an abrupt rise in crude oil price ⇒ leftward shift of aggregate supply curve ⇒ a rise in price level and a decrease in national income - stagflation- difficult to find policy measures to manage this kind of

inflation

Long-term Inflation


•if the speed at which money supply increases is too fast compared with the pace of economic growth, inflation is inevitable

- viewed from long-run perspectives, the major cause of inflation is excessive supply of money

- “Inflation is always and everywhere a monetary phenomenon.”(M. Friedman)

Rate of Increase in Money Supply and Inflation Rate


Hyperinflation of Weimar Republic


T. Sargent. “The End of Four Big Inflation”, 1983

Long-term Inflation


• many modern states are faced with enormous needs for fiscal expenditure

• difficult to control inflation, since governments are forced to print enormous amounts of money

• in this sense, we can say that inflation caused by printing too much money is a fiscal phenomenon

• a modern example of hyperinflation caused by printing an enormous amount of money can be found in Zimbabwe

• in November 2008, its inflation rate was 89.7 x 1021%

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Introduction to Economics - … of Thrift. 3.3 Definition and Measurement of Unemployment