Introduction to Economics. MACROECONOMICS Chapter 3 Business Cycles, Unemployment and Inflation

Transcription

1 Introduction to Economics MACROECONOMICS Chapter 3 Business Cycles, Unemployment and Inflation

2 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 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 Y F - 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 * < Y F as shown in the next diagram, the difference between the two is called the recessionary gap

4 3.1 Causes of Business Cycles Recessionary Gap

5 3.1 Causes of Business Cycles Recessionary Gap and Unemployment Y * < Y F 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 * > Y F holds, the economy is in a boom in this case, we don t have to worry about unemployment but inflation could be a problem

6 3.1 Causes of Business Cycles 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

7 3.1 Causes of Business Cycles 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

8 3.1 Causes of Business Cycles 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

9 3.1 Causes of Business Cycles Theory of Effective Demand by Keynes 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

10 3.2 Reasons for the Insufficiency of Aggregate Demand Stream of national income in a simple national economy consisting of only households and firms

11 3.2 Reasons for the Insufficiency of Aggregate Demand 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 leakage from the stream of national income but investment by firms add to the demand for capital goods, and thus it has the characteristic of injection

12 3.2 Reasons for the Insufficiency of Aggregate Demand Leakage and Injection selfsufficient economy - a single economic agent determines the levels of saving and investment simultaneously - therefore saving is equal to investment always

13 3.2 Reasons for the Insufficiency of Aggregate Demand Leakage and Injection modern 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

14 3.2 Reasons for the Insufficiency of Aggregate Demand Paradox of Thrift 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

15 3.3 Definition and Measurement of Unemployment two major problems of a national economy : unemployment and 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

16 3.3 Definition and Measurement of Unemployment Definition of Unemployment unemployment working age population 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 - anyone who is considered able to work belong to this group - in case of Korea, people who are older than 15 - people in working age population who are willing to work

17 3.3 Definition and Measurement of Unemployment Who Are Unemployed?

18 3.3 Definition and Measurement of Unemployment Measurement of Unemployment unemployment rate 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

19 3.3 Definition and Measurement of Unemployment 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) unemployment rate rate of economic participation

20 3.4 Types of Unemployment three 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

21 3.4 Types 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

22 3.4 Types of Unemployment Natural Unemployment natural unemployment natural rate of unemployment - natural unemployment refers to the kind of unemployment which occurs in the process that workers move around to get better jobs - 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

23 3.4 Types of Unemployment 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

24 3.4 Types of Unemployment Involuntary Unemployment 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

25 the case of expected inflation 3.5 Social Cost of 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

26 3.5 Social Cost of Inflation 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

27 3.5 Social Cost of Inflation 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

28 3.5 Social Cost of Inflation 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

29 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

30 3.6 Causes of Inflation Demand-pull Inflation and Cost-push Inflation 2

31 3.6 Causes of Inflation Short-term Inflation demand-pull inflation cost-push inflation - this kind of inflation can be easily managed by reducing aggregate demand 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

32 3.6 Causes 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)

33 3.6 Causes of Inflation Rate of Increase in Money Supply and Inflation Rate

34 3.6 Causes of Inflation Hyperinflation of Weimar Republic T. Sargent. The End of Four Big Inflation, 1983

35 3.6 Causes of Inflation 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 %

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