CHAPTER 7

INFLATION AND UNEMPLOYMENT

Inflation and unemployment are the two most talked-

about words in the contemporary society.
These two are the big problems that plague all the
economies.

1. INFLATION
1.1 Definition
vInflation is the rate at which the general level of
prices for goods and services is rising and,
consequently, the purchasing power of currency is
falling.
v General level of prices is a quantitative measure
of the rate at which the average price level of a
basket of selected goods and services in an
economy increases over a period of time.
v It is the constant rise in the general level of
prices where a unit of currency buys less than it
did in prior periods. Often expressed as a
percentage, inflation indicates a decrease in
the purchasing power of a nation’s currency
3

1
 1. INFLATION
vDeflation is the general decline in prices for
goods and services occurring when the inflation
rate falls below 0%.

1.2 Inflation Rate (CPI, annual variation in %)

• Inflation refers to an overall increase in the Consumer
Price Index (CPI), which is a weighted average of prices for
different goods.

• The set of goods that make up the index depends on

which are considered representative of a common
consumption basket.

• Depending on the country and the consumption habits of

the majority of the population, the index will comprise
different goods.

• Annual inflation, refers to the percent change of the CPI

compared to the previous year. 5

1.2 Inflation Rate (CPI, annual variation in %)

• Annual inflation, refers to the percent change of the CPI

compared to the previous year.

CPI (t) – CPI (t-1)

Inflation rate (t) =
CPI (t-1)

2
1.3 Types of inflation

•Moderate Inflation: Takes place when the prices of

goods and services rise at a single digit rate
annually.
•Moderate inflation is also termed as
creeping inflation. When an economy passes
through moderate inflation, the prices of goods
and services increase but at moderate rate.

1.3 Types of inflation

• Galloping Inflation is a type of inflation that occurs

when the prices of goods and services increase at two-
digit or three-digit rate per annum.
• Galloping inflation is also known as jumping inflation.

1.3 Types of inflation

• Hyperinflation is an extremely rapid period of inflation,

usually caused by a rapid increase in the money supply.
Usually due to unrestrained printing of fiat currency.

• Classic examples are the Hyperinflation of Weimar

Germany and the more recent Zimbabwean
Hyperinflation which reached 2.2 Million Percent.

3
 Hyperinflation

• …But as it went on, things got worse, dentists and doctors stopped
asking for currency, seeking payment in butter or eggs instead.
Prices rose not just by the day, but by the hour — or even the
minute. If you had your morning coffee in a café, and you preferred
drinking two cups rather than one, it was cheaper to order both
cups at the same time…

• During times of Hyperinflation people know the money will be

worth less tomorrow so they exchange any cash they have for any
physical good they can get their hands on (whether they need it or
not). After all, a bar of soap will still be a bar of soap tomorrow but
it may take twice as many dollars to buy it.

• In Zimbabwe, by 2008 the (hyper)inflation rate had reached 2.2

million percent. Eggs sold for a million dollars each. 10

10

1.4 Causes of Inflation

• Inflation means a sustained increase in the general price
level. However, this increase in the cost of living can be
caused by different factors. The main two types of
inflation are:
• Demand-pull inflation – this occurs when the economy
grows quickly and starts to ‘overheat’ – Aggregate
demand (AD) will be increasing faster than aggregate
supply (AS).
• Cost push inflation – this occurs when there is a rise in
the price of raw materials, higher taxes, e.t.c

11

11

1.4 Causes of Inflation

• Demand-pull inflation – this occurs when the
economy grows quickly and starts to ‘overheat’ –
Aggregate demand (AD) will be increasing faster than
aggregate supply (AS).

P AD’
AD AS

P2

P1

Q
Yp Y1

12

12

4
 Demand-pull Inflation

Demand-
Increased Additional Increase in
pull
Income Demand Price Level Inflation

13

13

1.4 Causes of Inflation

• Cost push inflation: Cost of production may rise due to an
increase in the prices of raw materials, wages, etc. Often
trade unions are blamed for wage rise since wage rate is
not completely market-determinded. Higher wage means
high cost of production. Prices of commodities are
thereby increased.
P AS’
AD AS

P2

P1

Q
Y1 Yp

14

14

Cost push Inflation

Increased cost
for Inputs and Increase in Cost push
Raw materials Price Level Inflation

15

15

5
 Consumer Price Index (CPI)

ΣP it x Q i0
CPI =
ΣP i0 x Q i0
Trong đó :
Qi0 : Quantity of goods i in base year.
Pio : Price of goods i in base year.
Pit : Pricce of goods i in year t.

16

16

The GDP deflator

The GDP deflator is a price index that measures inflation
or deflation in an economy by calculating a ratio of
nominal GDP to real GDP.

GDP nominal ΣP it x Q it
GDP def = = x 100
GDP real Σ P i0 x Q it

17

17

18

18

6
 1.4 The effects of inflation:
vEffects on Distribution of Income and Wealth:
The impact of inflation is felt unevenly by the different
groups of individuals within the national economy—some
groups of people gain by making big fortune and some others
lose.
vEffects on Production:
The rising prices stimulate the production of all goods—both
of consumption and of capital goods. As producers get more
and more profit, they try to produce more and more by
utilising all the available resources at their disposal.
The producers and the farmers would increase their stock in
the expectation of a further rise in prices. As a result
hoarding and cornering of commodities will increase.

19

1.4 The effects of inflation:

vEffects on Income and Employment:
Inflation tends to increase the aggregate money income (i.e.,
national income) of the community as a whole on account of
larger spending and greater production.

Similarly, the volume of employment increases under the

impact of increased production. But the real income of the
people fails to increase proportionately due to a fall in the
purchasing power of money.

20

Cost of Inflation

21

21

7
 2. UNEMPLOYMENT
•Unemployment occurs when a person who is
actively searching for employment is unable to find
work.
•Unemployment is often used as a measure of the
health of the economy.
•The most frequent measure of unemployment is the
unemployment rate, which is the number of
unemployed people divided by the number of
people in the labor force.

22

22

• Unemployment rate:

Unemployed people
Unemployment rate(%) = x100 %

People in the labor force

• Okun Law:
Yp – Y t 100 %
Ut = Un + ------------- x -----
Yp 2

23

23

24

24

8
 The Phillip’s curve:

•The Phillips curve is an economic concept

developed by Alban William Housego Phillips (A.
W. Phillips) stating that inflation and
unemployment have a stable and inverse
relationship.

•The theory claims that with economic growth

comes inflation, which in turn should lead to more
jobs and less unemployment.

25

25

26

26