Unemployment is typically at the forefront of macroeconomics concern as it is a key variable impacting population s welfare. Concerted effort is put

Transcription

1 Unemployment is typically at the forefront of macroeconomics concern as it is a key variable impacting population s welfare. Concerted effort is put by governments in ensuring low levels of unemployment primarily by ensuring economic growth. However, in some instances unemployment can be a chronic long term problem due to structural changes in the economy. For this reason, we need to examine unemployment more closely to understand its causes and solutions. Inflation is also a central concern in the macroeconomic debate. The oversight of which is provided by the central bank. 1

2 Unemployment can be measured in different ways. In this unit we focus on the commonly used method of Labour Force Surveys which are largely based on International Labour Organisation s (ILO s) definitions. ILO defines unemployed as a person who is without a job and who is willing to start work within the next two weeks and either has been looking for work in the past four weeks or was waiting to start a job. ILO defines a person as being employed if during a specified period of time such as one week- -Performed some work for wage or salary in cash or in kind. -Had a formal attachment to their job but were temporarily not at work during the reference period. -Performed some work for profit or family gain in cash or in kind. -Were with a business, farm or service but who were temporarily not at work during the reference period. There is always some unemployment in the economy and this is referred to as natural rate of unemployment. The natural rate of unemployment is mainly composed of frictional unemployment and structural unemployment. frictional unemployment: unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills. Think of when you graduate from the University. Unless you get a job offer that is directly relevant to your field of studies, you will be reluctant to take the first job proposal that comes your way. Instead most students will take some time to look for a suitable match. 2

3 The time taken to look for a suitable match is classified as frictional unemployment. structural unemployment: unemployment that results because the number of jobs available in some labour markets is insufficient to provide a job for everyone who wants one due to wages being too high. Minimum wage laws are one such policy that can lead to structural unemployment in the economy. If the minimum wages are too high then there may be many people willing to work at higher wage but firms may not want to hire because higher wages lead to greater costs. Thus, creating unemployment. Even though the textbook does not discuss this, structural unemployment also refers to a mismatch between the skills or location of the workers and the jobs available. For example, if an economy moves from heavy manufacturing to IT sector then there will be some unemployment associated with this. Similarly mismatch may occur between skills of workers and the jobs available due to geographical location. 2

4 Cyclical (demand-deficient) unemployment arises when there is a shortage of jobs overall. This category is termed demand-deficient unemployment because it relates to a deficiency in aggregate demand. Unemployment thus varies over the economic cycle rising when aggregate demand falls below the level needed to fully employ the available workforce and falling when aggregate demand moves closer to the level needed to full employ the available supply of labour. 3

5 Since some unemployment is due to causes other than economic performance, we use the term natural rate of unemployment to refer to frictional and structural unemployment. Also frictional unemployment is inevitable due to a variety of reasons: Difficult for workers to match their skills with the appropriate job Frictional unemployment is often the result of changes in the demand for labour among different firms Workers in declining industries will find themselves looking for new jobs, and firms in growing industries will be seeking new workers People are in transition between jobs 4

6 In advanced economies most prices tend to rise over time. The increase is general price level is known as inflation. Most advanced economies aspire to a stable level of inflation, generally 2% to 3%. The theory of inflation explores the link between money supply and inflation. A moderate level of inflation is experienced by most economies. However, inflation in the range percent has been experienced in recent history by Yugoslavia and in Zimbabwe. This is referred to as hyperinflation. 5

7 Firstly we need to address what is money? Different countries have different definitions for money. Thus several different measures of the supply of money are often used and this is the case in Australia. It is not just cash (notes and coins) although all countries agree this is one component of money. To find out what should count as money we need first to determine the functions of money. The functions of money The history of money begins around 2500 years ago with the first minting of coinage in about the seventh to sixth century BC. Before that subsistence economies used some form of barter system based around exchange of goods. Now, in almost all economies, money has three important functions: A medium of exchange: as such money is therefore, something that is generally accepted in exchange for goods and services. As cash it must be light, small, appear in many denominations and be difficult to forge. Alternatively, it must be transferable through or by an acceptable mechanism (cheques, online banking, debit and credit cards, etc). A means of evaluation: money allows the value of goods, services and assets to be ascertained, including dissimilar things such as a company's assets and a person s wealth to be added up. It is a unit of account. A means of storing wealth: money is a means of allowing savings from today to be used in the future to purchase goods and services. Notes and coins satisfy all the listed functions of money. But what about the deposits with banks and other non-bank financial intermediaries? If notes and coins are money, there is no reason to exclude deposits with banks and other non-bank financial intermediaries. Economists generally use the definition of broad money to include notes, coins, current deposits with banks and deposits with non-bank sector. 6

8 With inflation we are discussion the overall price level of the economy as discussed in earlier while looking at measures such as CPI. When price level rises we have to all pay more for goods and services. Price level is therefore linked with the value of money. A rise in the price level means a lower value of money because each unit of money now buys a smaller quantity of goods and services. If P is the price level, then the quantity of goods and services that can be purchased with $1 is equal to 1/P. P is thus a measure of price level and 1/P is how much a dollar can buy in terms of a basket of goods and services. So if price level rises the value of money falls. 7

9 Monetary policy objectives Monetary policy is carried out by the central bank. It is independent of the government in western countries such as Australia and the Unites States. The main objectives of the monetary policy are: -Maintain the stability of the Australian currency; -Maintain full employment (difficult, as fiscal policy must contribute to this aim); -Ensure the prosperity and welfare of the Australia people; to which a fourth may be added, namely -Maintain the inflation rate in the range 2-3%; the principal means of achieving this is by varying interest rates or supply of money. The central bank, together with the banking system, determines the supply of money. For the purposes of our discussion we will assume the quantity of money supplied as a policy variable that the central bank controls. The stock of money in circulation depends on the behaviour of central bank. 8

10 The value of money is determined by demand and supply. We take the stock of money as fixed by the central bank. On the demand side, however, a number of factors must be considered. One factor of great importance influencing demand for money is interest rates. Money here refers to cash and deposits in bank. If interest rate is high, then holding money is less profitable as compared to holding interest bearing assets. The availability of credit as well as the level of technology also influences money demand. If credit card facilities are easily available then people have less need for money and access to internet has greatly reduced the need to hold large volumes of cash. Even though a variety of factors affect money demand, one of the foremost is price level. Money is held by households and businesses for meeting daily financial transactions. If the price level is high, then more money is needed and vice versa. To see this on a graph, we plot quantity of money on the horizontal axis and the price level on the vertical axis. The left-hand vertical axis shows the value of money 1/P, and the right-hand vertical axis shows the price level P. If the price level is high then the value of money is low. As price level goes up quantity demanded for money increases and as price level reduces the value of money increases. Since the price level is on the vertical axis, we are of course referring to movement along the demand curve rather than shift. The supply curve is a vertical line because the stock of money is held fixed. The interaction of demand and supply of money determine the price level. For example, if the price level is above the equilibrium level, businesses and people will want to hold more money than the central bank has created, so the price level must fall to balance supply and demand. If the price level is below the equilibrium level, people will want to hold less money than the central bank has created, and the price level must rise to balance supply and demand 9

11 Assume that the economy is currently in equilibrium and the central bank suddenly increases the supply of money. Lets assume that the central bank increases money supply by printing money. The stock of money changes and hence money supply shifts to the right. At point A excess supply of money is created. As there is excess supply in the economy, the extra money is generally used in the form of loans by banks to business and firms to buy goods and services. Injection of money increases demand for goods and services. However, the capacity of the economy is not fundamentally changed because of the injection of funds. So if we were at LRAS then all the injection of funds does is raise aggregate demand and then the price level. Thus, Quantity theory of money is a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. 10

12 The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). An increase in AD due to more money in the economy, creates cost pressures. This shifts the AS1 as well to the left to AS2. At this point economy has settled on its new equilibrium (B). 11

13 So why is inflation such a problem. If the price level rises in line with the wages then that should not cause any grave concerns since spending power is not eroded. However, even if nominal incomes keep pace with inflation, inflation is still viewed as a concern for a number of reasons. 1) Shoeleather costs: Inflation erodes the value of money that you carry in your pocket and therefore people/businesses avoid holding cash. Because people hold less cash, there is an increased transaction costs due to trips to the bank or because of converting interest bearing assets to cash as need arises to avoid the erosion of the value of money. 2) Menu costs: Firms do not frequently change prices as there are costs associated with changing prices. This includes things such as printing new catalogues, communicating with dealers, amending prices on websites, showrooms etc. If inflation is low and stable then firms can employ an annual price adjustment strategy. High inflation can significantly increase the cost, making a periodic adjustment in inflation impractical. 3) Relative Price Variability and the Misallocation of Resources: Some firms with high menu costs leave there costs unchanged for a significant period of time. Low inflation will not significantly impact such firms. However, higher levels of inflation will undermine the pricing structure and distort prices compared to other firms. 4) Inflation-induced tax distortions: Inflation reduces saving. This is because interest bearing assets attract a tax. But governments often fail to take into account the inflationary factors when calculating taxes. Inflationary pressures may reduce the real interest earnt on interest bearing assets to zero or less. Coupled with taxes, this provides little incentive to save. 5) Confusion and inconvenience: Money is a unit of account. If inflation is high then this causes confusion related to constantly changing prices. Thus, making it more difficult to account for such things as costs, revenues etc. 6) A Special Cost of Unexpected Inflation: An unexpected and high level of inflation can arbitrarily re-distribute wealth. For example, lets take a business that took a loan from the bank at low levels of inflation. Then inflation suddenly increases, eroding the value of money. The inflation has also eroded the value of the loan and therefore the bank loses out while the business gains. 12

14 In the short run there is a trade off between inflation and unemployment If monetary and fiscal policy makers expand aggregate demand and move the economy up along the short-run aggregate supply curve, they can lower unemployment for a while, but only at the cost of higher inflation If policy makers contract AD and move the economy down the short-run AS curve, they can lower inflation, but only at the cost of temporarily higher unemployment 13

15 Even though in the short run an increase in money supply can boost AD. However, money supply can have very little impact on the LRAS. LRAS depends on the productivity of the economy. 14

16 As discussed earlier the long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). An increase in AD due to more money in the economy temporarily increases output as AD shifts right. But this creates cost pressures. This shifts the AS1 as well to the left to AS2. At this point economy has settled on its new equilibrium (B). 15

17 Inflation can also be brought about by an increase in cost of production or commonly referred to as a supply shock. A substantial increase in the cost of production will shift the AS to the left, increasing the price level from P1 to P2. An example of such an adverse supply shock was an increase in oil prices in Whether supply shocks are going to be inflationary also depends on people s expectations. 16

18 Rational expectations: People optimally use all the information they have, including information about government policies, when forecasting the future When government policies change, people alter their expectations about inflation If the government makes a credible commitment to a policy of low inflation, people would be rational enough to lower their expectations of inflation immediately The short run aggregate supply will shift quickly without any extended period of unemployment. 17

19 1.Primary cause of inflation is simply growth in the quantity of money 2.To maintain stable prices, the central bank must maintain strict control over the money supply 3.There are costs to inflation which become bigger with hyperinflation 4.There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off 5.The temporary trade-off comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation 6.A rising rate of inflation may reduce unemployment, a high rate will not 18