Exploring Inflation and Unemployment

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1 Learning Objectives Exploring Inflation and. Understand what is meant by unemployment and how it is measured.. Understand the relationship between unemployment and the state of the economy. Understand the different types of unemployment. Understand what is meant by full employment.. Understand what is meant by the Natural Rate of (NARU) and the Non-accelerating Inflation Rate of (NAIRU).. Understand what is meant by inflation and how it is measured (CPI). Understand the difference between inflation and the GDP deflator. 6. Understand what is meant by the Producer Price Index. 7. Understand the relationship between inflation and unemployment (the Philips Curve). The Consumer Price Index (CPI) The Consumer Price Index (CPI) December 0 The Consumer Price Index (CPI) rose.% in the months to December, following a.0% increase in November. The slower year-over-year rise in the CPI was mostly attributable to gasoline prices, which dropped 6.6% in the months to December, after falling.9% in November. Excluding gasoline, the CPI increased.% on a year-over-year basis in December, matching the rise in November. Friday, March 8, 0 Consumer prices rose.% in the months to February, following the.% increase posted in January. Energy prices rose 0.6% during the months to February, after posting a 9.0% increase the previous month. Gasoline prices continued to increase in February, rising.7%, after recording a.0% increase in the months to January. Excluding gasoline, the Consumer Price Index (CPI) rose.6% in the months to February, compared with a.8% increase in January. The food index rose 0.% in February, following a 0.% increase in January. The clothing and footwear index posted a decline of 0.%, after falling.% in January. The Consumer Price Index (CPI) provides a broad measure of the cost of living (i.e. inflation) in Canada. Statistics Canada tracks the retail price of a representative shopping basket of about 600 goods and services from an average household's expenditure. These include: food, shelter, household operations, transportation, furniture, clothing, recreation, tobacco and alcohol. The CPI is NOT inflation! Rather, the CPI is used to calculate inflation. Essentially, inflation is the percentage change in CPI. The percentage of the total basket that any item occupies is termed the weight and reflects typical consumer spending patterns. Since people tend to spend more on food than clothing, changes in the price of food naturally have a greater impact on the index than, for example, changes in the price of clothing and footwear.

2 Calculating Inflation through the CPI In the all-items index chart, the -month change is represented by the gap between the two curves. (.9-.)/. =.% What is the base effect? The -month variation in the CPI is calculated by comparing the current month's index with the index for the same month of the previous year. Thus, the -month variation can decrease from one month to the next merely due to the fact that the base serving as the point of comparison increased. Thus, the behaviour of the index in 00 is going to be an important factor in explaining the variations in the -month percentage changes in 00. The Base Year As of January, 0 the base year was still 00. The base year is revised every so often because the base year is associated with a cost of a given basket of goods. However, as the base year gets older it tends to present a less accurate base comparison of present spending patterns. (For example, what did an iphone cost ten years ago?) NOTE: I keep saying they ll change the base year any year now, and I ve been wrong for the last few years. Let s see what happens next year! Source: The Producer Price Index The Producer Price Index (in Canada, known as the he Industrial Product Price Index or IPPI), measures price changes for major commodities sold by manufacturers. The average price changes of inputs are tracked. Thus the PPI does not track what consumers pay for final goods and services, but what producers receive for inputs. In the US, there is a family of indexes that comprise the PPI, including: PPI Commodity Index (crude): Tracks commodities such as energy, coal, crude oil and the steel scrap. PPI Stage of Processing (SOP) Index (intermediate): Goods here have been manufactured at some level but will be sold to further manufacturers to create the finished good. Examples include lumber, steel, cotton and diesel fuel. PPI Industry Index (finished): Final stage manufacturing, and the source of the core PPI. creeping <0% galloping 0 000% Types of Inflation Not a huge problem, but it threatens to become a problem. A real threat to the economy. Although some countries deal with it. The main cause of hyperinflation is a massive imbalance between the supply and demand of a certain currency or type of money. This has most often occurred because of excessive money printing! Hyperinflation is generally associated with paper money because the means to increasing the money supply with paper money is the simplest: add more zeroes to the plates and print! hyperinflation 000% > stagflation with recession Horrible. Like dropping a bomb on the economy. Very difficult. We depend on low inflation to bring us out of recession. Germany 9-: This German woman is feeding a stove with currency notes because they will burn longer than the amount of firewood they could buy. There have been numerous episodes of hyperinflation, followed by a return to "hard money." Older economies would revert to hard currency and barter when the circulating medium became excessively devalued, generally following a "run" on the store of value.

3 Unlike inflation, which is widely considered to be normal in a healthy economy, hyperinflation is always regarded as destructive. It effectively: wipes out the purchasing power of private and public savings, provokes hoarding of real assets, causes the monetary base (ie. gold if money is based on gold standard) to flee the country ( capital flight : wealth seeks more stable or secure investments), and kills investment in the afflicted area because investments would pay off using a worthless currency. Remedies: slashing government expenditures, altering the currency basis (the amount of money that can be printed in comparison to something else, i.e. the value of the GDP, the value of a country s foreign reserves) dollarization is the use of a foreign currency (often, but not necessarily, the U.S. dollar) as a national unit of currency. These are natural. These are always occurring regardless of economic conditions. (i.e. GDP) This is related to GDP! Types of Frictional : Arises from normal labour turnover. (i.e. people leaving and entering the workforce) Generally seen as a healthy form of unemployment. At any point in time, there are firms seeking workers to fill a certain number of positions, these positions comprise the number of frictionally unemployed. [Mnemonic: between jobs Think of the job ads in any paper on any day.] Structural : Arises from technological changes or management decisions (i.e. to purchase products or hire labour overseas) that result in long-term unemployment within a given country. (Although jobs may be created in another country, jobs are still lost the country where unemployment is being measured.) [Mnemonic: downsizing Think of a blacksmith still looking for work.] Seasonal : Arises from a decrease in jobs owing to a change in season. Typically, there are less jobs in the winter because of the slowdown in construction, farming, and summer tourism jobs. Cyclical : Arises from a decrease in jobs owing to a downturn in the overall economic conditions. In other words, when the economy heads into a slow period in its economic cycle. [Mnemonic: recession ] Full Employment Full Employment: The amount of employment that results when no cyclical unemployment is present. (In other words, when the only unemployment is frictional, structural, and seasonal.) Full employment occurs when the economy is producing to its maximum capacity using labour, technology, land, capital and other factors of production to their full potential (based on normal levels of utilization). Natural Rate of : (aka NARU ) The amount of unemployment that results when no cyclical unemployment is present. (In other words, when the only unemployment is frictional, structural, and seasonal.) Full employment is generally thought of as the best condition that an economy can hope to achieve. (Realistically, one cannot hope to ever have 00% employment in a market economy.) Owing to different characteristics of a society that might impact on frictional, structural, and seasonal unemployment, different economies have different levels of what they would consider to be full employment (or, conversely, natural unemployment). Calculating Unemployed: All people who are actively seeking employment, but have not yet obtained employment. Rate: The percentage of the labour force that is unemployed. Calculating Labour Force: The total number of people who are able to work and are actively seeking work, or already have jobs, or are self-employed. Participation Rate: The percentage of the total population which is in the labour force. Another great Arthur! economic Costs of Okun s Law: For every % increase in unemployment (above full employment à % in Canada) output will drop % non-economic Note i: Data collected in the US and Canada would seem to indicate a % drop in output for every % rise in unemployment. Note ii: Full employment refers to the level of employment that is available when there is no cyclical unemployment. emotional, psychological, social, etc.

4 Theories of Changes in supply and demand for labour would create temporary unemployment. Flexible wage rates, prices, and interest rates would always adjust us back to full employment. A classical Theory à Say s Law: Supply creates it s own demand. IOW people only work to earn money, so if they re busy producing stuff, then they will earn funds with which to purchase goods! Theories of John Maynard Keynes believed that if aggregate expenditure was too low, then firms would adjust production to a reduced level. Furthermore, this new reduced level of output may remain, as there are now fewer people earning money to be spent on output. Thus, Keynes believed that the government would have to use its power of taxation and expenditure to re-adjust the economy. Inflation Rate (%) Phillips Curve SRPC See lecture by Professor Holden Illustrates the relationship between unemployment and inflation. low, inflation tends to be high. (This is because low unemployment is associated with economic prosperity, high productivity, high spending, and, ergo, inflation.) high, inflation tends to be low. (This is because high unemployment is associated with economic decline, low productivity, low spending, and, ergo, low inflation.) Phillips Curve and NAIRU Inflation Rate (%) SRPC SRPC SRPC Lecture by Professor Holden Illustrates the relationship between unemployment and inflation. When unemployment is low, inflation tends to be high. high, inflation tends to be low. In the long-run, the Phillips curve will be associated with the same level of unemployment (NAIRU) because if workers anticipate inflation and seek real wage increases, then that will raise inflation but also return unemployment to NAIRU. If workers don t anticipate inflation, then inflation will drop but unemployment will still return to NAIRU. Phillips Curve SRPC SRPC SRPC Thus, whether inflation remains constant (i.e. nonaccelerating) or whether inflation continuously increases, has a lot to do with whether workers suffer from money illusion and are happy to receive nominal wage increases that are consistent with inflation, or if they don t suffer from money illusion and demand nominal wage increases that are greater than inflation. If they ask for increases that are greater than inflation, they will cause inflation to further increase, which, ironically, will just erode their wage increase. Price Level (CPI, or better yet, GDP Deflator) (%) Range: Massive reserves of unutilized resources exist at this low level of output. Thus, average costs will remain constant as output is increased, and output can be increased for little or no increase in price.

5 Range: At this moderate level of output, average costs will begin to rise as more firms bid for scarce resources. Thus, increased output will generally require an increase in overall price levels. Range: All of society's resources are utilized at this high level of output. Thus, even increased prices could not increase productivity. 00, AP Macro Exam, Version A