Lecture on Inflation and Unemployment

May 14, 2024

Lecture on Inflation and Unemployment

Inflation

Who Benefits and Who Loses

  • Beneficiaries of Inflation:
    • Individuals with Cost-of-Living Adjustments (COLA).
    • Those with significant debt (helps reduce real value of debt).
  • Losers from Inflation:
    • Banks (since it erodes the value of debts owed).
    • Individuals without wages keeping pace with inflation.
  • Historical class conflict between Farmers (who benefit from inflation due to higher product prices) and Banks (who lose due to decreased debt value).

Causes of Inflation

  • Equation Components:
    • Expected Inflation
    • Output Gap in terms of employment
    • Coefficient (measures sensitivity of inflation to the output gap)
    • Supply Shocks (e.g., oil shocks)
  • Types of Theories:
    • Adaptive Expectations (historical inflation influences future expectations)
    • Rational Expectations (uses full information set to forecast future inflation)

Theories of Inflation

Quantity Theory of Money

  • Equation: MV = PQ (Money Supply * Velocity = Price * Quantity)
  • Implications:
    • Money supply control is crucial for managing inflation.
    • Friedman's K-percent rule: Only increase money supply at the GDP growth rate.
    • Criticisms: Empirical evidence of the direct link between money supply and prices is debatable.

Institutional Theory of Inflation

  • Wage Price Inflation Spiral:
    • Workers request wage increases ➜ Firms increase prices ➜ Workers request higher wages again ➜ Continuous cycle.
    • Government intervention needed to stabilize.

Endogenous Money

  • Increase in aggregate demand/income ➜ More loans ➜ More economic activity ➜ Increase in money supply.
  • Contrasted with Quantity Theory; asserts economic activity causes money supply changes rather than vice versa.

Other Types of Inflation

  • Cost-Push Inflation: Due to increased costs of production (e.g., wages, oil prices).
  • Demand-Pull Inflation: Due to increased demand pulling prices up.

Phillips Curve

  • Depicts the inverse relationship between inflation and unemployment (trade-off).
  • Historical applicability varies:
    • 1950s: Nice clean curve.
    • 1970s: Stagflation disrupted the curve.
    • 1980s-2000s: Mixed variations.

Unemployment

Types of Unemployment

  • Frictional Unemployment: Due to time taken for workers to find jobs.
  • Structural Unemployment: When more people seek jobs than available.

Natural Rate of Unemployment

  • Sum of frictional and structural unemployment rates.
  • Estimated to be between 4.5-5%; varies historically.

Factors Affecting Natural Unemployment Rate

  1. Changes in Labor Force Characteristics: e.g., Baby Boomers entering the job market.
  2. Changes in Labor Market Institutions: e.g., reduction of labor unions in the 1980s.
  3. Changes in Government Policy: e.g., unemployment insurance, minimum wage.
  4. Changes in Productivity: Productivity slowdowns can increase natural unemployment rate.

Actual Unemployment Rate

  • Natural Rate + Cyclical Unemployment (fluctuates with business cycles).

Conclusion

  • Covered key points on inflation and employment.
  • Further details can be found in the textbook.

End of Lecture