Understanding Unemployment and Inflation: Key Concepts

Posted on Jan 20, 2025 in Economy

Understanding Unemployment

Employed, unemployed, and inactive.

  • Unemployment rate: Percentage of the active population that is unemployed.
  • Participation rate: Percentage of the adult population that belongs to the workforce.
  • Discouraged workers: People who would like to work but have given up searching.

Unemployment Rate

  • Frictional Unemployment: Unemployment that occurs because workers take time to find the job that best matches their tastes and skills.
  • Structural Unemployment: Unemployment due to the number of jobs in some markets being insufficient to provide jobs for everyone who wants to work.
  • Unemployment insurance: Public program that partially protects the income of workers who become unemployed.
  • Unemployment generated by a minimum wage above the equilibrium.

The Role of Trade Unions

  • Union: Workers’ association that negotiates with employers on wages and working conditions.
  • Collective bargaining: A process by which unions and firms agree on conditions of employment.
  • Strike: Organized withdrawal of work from a company by a union.

The Theory of Efficiency Wages

Efficiency wages: Wages above the equilibrium that are paid by companies to increase worker productivity.

  • Can lead to unemployment.
  • Causes: Health, Rotation, Quality, Effort.

Inflation: Basics

  • Money: Joint assets of the economy normally used by individuals to purchase goods and services from others.
  • Money supply: Amount of money available to the economy.
  • Monetary policy: Fixing the money supply by the Central Bank authorities.
  • Central bank: The institution responsible for supervising and regulating the banking system and the amount of money in the economy.

Creation of Money

  • Reserves: Deposits that banks have received but not paid.
  • Reserve ratios: Fraction of deposits that banks hold as reserves.
  • Money Multiplier: The reciprocal of the reserve ratio determines the amount of money that is generated in the banking system.

Control Systems

  • Open market operations: The sale of government bonds by the Central Bank.
  • Reserve Requirements: Minimum amount of reserves that banks must have to support deposits.
  • Discount rate: Interest rate of loans granted by the Central Bank to commercial banks.

Definitions

  • Inflation: Rising general price level.
  • Deflation: Descent of the general price level.
  • Hyperinflation: Unusually high inflation rate.
  • General level of prices: Prices of a basket of goods and services or to measure the value of money.

Value of Money

  • Supply and demand for money determines its value.
  • The Central Bank and the banking system determine the money supply.
  • Demand is determined by the interest rate and price level.

Balance

  • In the long run, the price level is adjusted to be at the level where demand equals supply.
  • If the general price level is above the equilibrium, the public wants more money than the Central Bank has created, so that the general price level must fall to balance supply and demand.

Quantity Theory of Money

  • The money determines the price level and the rate of growth in the amount of money available determines the rate of inflation.
  • An increase in money supply:
    • Reduces the value of money.
    • Raises the price level.
  • According to the classical analysis, variables in the money supply affect nominal variables but not real ones (neutrality of money).
  • Velocity of Money: Rate at which money changes hands (M x V = P x Y).
  • The quantity equation shows that increasing the amount of money in an economy should be reflected in the other 3 variables.

Hyperinflation

  • Generally follows this pattern:
    • The State has:
      • High costs.
      • Insufficient tax revenue.
      • Limited ability to borrow.
    • So it has to print money to finance spending.
    • The huge increase in money causes massive inflation that ends when the government introduces tax reforms that eliminate the need to resort to the inflation tax.

Fisher Effect

  • Nominal interest rate: Type that exists in an economy.
  • Real interest rate: Corrects the nominal rate to reflect inflation (Real Interest Rate = Nominal Interest Rate – Inflation Rate).
  • Fisher Effect: Smooth adjustment of the nominal interest rate to the inflation rate.

Costs of Inflation

  • Inflation itself does not reduce the real purchasing power of individuals.
  • Cost in shoe leather.
  • Menu costs.
  • The variability of relative prices and the misallocation of resources.
  • Tax distortions.
  • Arbitrary redistributions of wealth.