MACROECONOMIC INSTABILITY: UNEMPLOYMENT AND INFLATION
incorporating inflation rate, unemployment rate, trade deficit and . there is a negative relationship between macroeconomic volatility and. Macroeconomics problems arise when the economy does not adequately achieve the goals of full employment, stability, and economic growth. As a result of. The correlation between unemployment and inflation is positive i.e. insignificant levels in the macroeconomics factors of Indian economy. .. instability, widespread corruption and lack of law enforcement hamper.
Cyclical unemployment bounces up and down according to the short-run movements of GDP. The long-term, baseline level of unemployment that occurs year in and year out, however, is called the natural rate of unemployment. The natural rate of unemployment is determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market.
Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy. On the other hand, rates of inflation generally decline during recessions. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the aggregate supply curve.
Let's look at diagram A, on the left below. In this diagram, you'll see a shift of aggregate demand to the right. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level. The two graphs show how a shift in aggregate demand or supply can cause inflationary pressure.
The graph on the left shows two aggregate demand curves to represent a shift to the right.Phillips curve - Inflation - measuring the cost of living - Macroeconomics - Khan Academy
The graph on the right shows two aggregate supply curves to represent a shift to the left. This situation can cause the aggregate supply curve to shift back to the left. In effect, the rise in input prices ends up—after the final output is produced and sold—being passed along in the form of a higher price level for outputs.
It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years. Why does inflation persist over time? One way that continual inflationary price increases can occur is if the government continually attempts to stimulate aggregate demand in a way that keeps pushing the AD curve when it is already in the steep portion of the SRAS curve.
- MACROECONOMIC INSTABILITY: UNEMPLOYMENT AND INFLATION
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- How the AD/AS model incorporates growth, unemployment, and inflation
A second possibility is that—if inflation has been occurring for several years—a certain level of inflation may come to be expected. In other words, certain characteristics and features of the economy capital, labor, and technology determine how much the economy can sustainably produce at a given time, but demand for goods and services is what actually determines how much is produced in the economy.
As actual output diverges from potential output, inflation will tend to become less stable. All else equal, when actual output exceeds the economy's potential output, a positive output gap is created, and inflation will tend to accelerate. When actual output is below potential output, a negative output gap is generated, and inflation will tend to decelerate. Within the natural rate model, the natural rate of unemployment is the level of unemployment consistent with actual output equaling potential output, and therefore stable inflation.
How the Output Gap Impacts the Rate of Inflation During an economic expansion, total demand for goods and services within the economy can grow to exceed the economy's potential output, and a positive output gap is created. As demand grows, firms rush to increase their output to meet this new demand. In the short term though, firms have limited options to increase their output. It often takes too long to build a new factory, or order and install additional machinery, so instead firms hire additional employees.
As the number of available workers decreases, workers can bargain for higher wages, and firms are willing to pay higher wages to capitalize on the increased demand for their goods and services. However, as wages increase, upward pressure is placed on the price of all goods and services because labor costs make up a large portion of the total cost of goods and services. Over time, the average price of goods and services rises to reflect the increased cost of wages.
The opposite tends to occur when actual output within the economy is lower than the economy's potential output, and a negative output gap is created. During an economic downturn, total demand within the economy shrinks. In response to decreased demand, firms reduce hiring, or lay off employees, and the unemployment rate rises. As the unemployment rate rises, workers have less bargaining power when seeking higher wages because they become easier to replace.
Firms can hold off on increasing prices as the cost of one of their major inputs—wages—becomes less expensive. This results in a decrease in the rate of inflation. As discussed earlier, the natural rate of unemployment is the rate that is consistent with sustainable economic growth, or when actual output is equal to potential output.
It is therefore expected that changes within the economy can change the natural unemployment rate. Labor market composition, 2. Labor market institutions and public policy, 3.
Macroeconomic Instability: Unemployment and Inflation Chapter ppt download
Productivity growth, and 4. Long-term—that is, longer than 26 weeks—unemployment rates. Individual worker's characteristics affect the likelihood that a worker will become unemployed and the speed or ease at which he or she can find work.
For example, younger workers tend to have less experience and therefore have higher levels of unemployment on average. Consequently, if young workers form a significant portion of the labor force, the natural rate of unemployment will be higher. Alternatively, individuals with higher levels of educational attainment generally find it easier to find work; therefore, as the average level of educational attainment of workers rises, the natural rate of unemployment will tend to decrease.
For example, apprenticeship programs provide individuals additional work experience and help them find work faster, which can decrease the natural rate of unemployment.
Alternatively, ample unemployment insurance benefits may increase the natural rate of unemployment, as unemployed individuals will spend longer periods looking for work. According to economic theory, employee compensation can grow at the same speed as productivity without increasing inflation. Individuals become accustomed to compensation growth at this speed and come to expect similar increases in their compensation year over year based on the previous growth in productivity.
A decrease in the rate of productivity growth would eventually result in a decrease in the growth of compensation; however, workers are likely to resist this decrease in the pace of wage growth and bargain for compensation growth above the growth rate of productivity. This above average compensation growth will erode firms' profits and they will begin to lay off employees to cut down on costs, leading to a higher natural rate of unemployment.
The opposite occurs with an increase in productivity growth, businesses are able to increase their profits and hire additional workers simultaneously, resulting in a lower natural rate of unemployment. Individuals who are unemployed for longer periods of time tend to forget certain skills and become less productive, and are therefore less attractive to employers. In addition, some employers may interpret long breaks from employment as a signal of low labor market commitment or worker quality, further reducing job offers to this group.
As the proportion of long-term unemployed individuals increases, the natural rate of unemployment will also increase. Understanding the relationship between the current unemployment rate and the natural rate is important when designing economic policy, and the fact that the natural rate can shift over time further complicates the design of economic policy.
How the AD/AS model incorporates growth, unemployment, and inflation (article) | Khan Academy
As shown in Figure 1the estimated natural rate of unemployment has been relatively stable over time, shifting from a high of 6. As shown in Figure 1the estimated natural rate slowly increased in the late s, s and the early s. Several economists have suggested that much of this increase in the natural rate, from about 5. A portion of this decrease in the s is likely due to baby boomers becoming more experienced and productive workers.
The sharp decrease in the s has been largely explained by an increase in the rate of productivity growth in the economy. Productivity growth, total output per hour of labor, was about 1.
Data are not seasonally adjusted. Beginning inthe natural rate began to increase sharply, as shown in Figure 1. The rapid increase in the natural rate after can largely be explained by changes in the makeup of the labor force and changes in government policy. Individuals who are unemployed for longer durations tend to have more difficulty finding new jobs, and after the recession, the long-term unemployed made up a significant portion of the labor force, which increased the natural rate of unemployment.
Macroeconomic Instability: Unemployment and Inflation Chapter 8.
In addition, some research has suggested the extension of unemployment benefits may also increase the natural rate of unemployment. Two prominent factors that also impact the rate of inflation are 1 expected inflation and 2 supply shocks. Firms will also incorporate inflation expectations when setting prices to keep the real price of their goods constant. An increase in the expected rate of inflation will be translated into an actual increase in the rate of inflation as wages and prices are set by individuals within the economy.
The classic example of a supply shock is a reduction in the supply of available oil. As the supply of oil decreases, the price of oil, and any good that uses oil in its production process, increases.
This leads to a spike in the overall price level in the economy, namely, inflation. Policymakers generally focus on negative supply shocks, which reduce the supply of a good or service, but positive supply shocks, which increase the supply of a good or service, can also occur. Positive supply shocks generally reduce inflation.
Missing Deflation Post Recession Events following the recession have again called into question how well economists understand the relationship between the unemployment gap and inflation.
As a result of the global financial crisis and the U. The natural rate model suggests that this significant and prolonged unemployment gap should have resulted in decelerating inflation during that period.
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