Introduction to Economics – 11175

Week 11

Inflation and Unemployment

 Week 11 Lecture

1. Understand how the inflation rate is

measured.
2. Describe the costs of inflation.
3. Understand the labor force framework used
by the Australian Bureau of Statistics (ABS) to
classify the working age population.
4. Understand how the unemployment rate is
measured and its limitations.
5. Distinguish between different types of
unemployment.
 Inflation
• Price level: A measure of the average prices of goods and services in
the economy.

• Inflation: The sustained increase in the general level of prices in the

economy.

• Deflation: is a sustained decline in the general price level.

• Inflation rate: The percentage increase in the general price level in the
economy from one year to the next.

• Deflation rate: The percentage decrease in the general price level in

the economy from one year to the next.

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 Measuring Inflation
• GDP allows us to calculate changes in the price level
over time.
• GDP deflator: A measure of the price level, calculated
by dividing nominal GDP by real GDP and multiplying
by 100.
Nominal GDP
GDP deflator = x 100
Real GDP

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Measuring Inflation

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 Measuring Inflation
• consider a simple economy that produces only cars:
Year Quantity of Cars Price of cars Nominal GDP
2021 10 $20,000 $200,000
2022 12 $24,000 $288,000
2023 13 $26,000 $338,000

Using 2022 dollars to compute real GDP, then:

Year Quantity of Cars Price of cars Real GDP

2021 10 $24,000 $240,000
2022 12 $24,000 $288,000
2023 13 $24,000 $312,000
GDP deflator & inflation rate
Year GDP deflator
2021

2022

2023

Year Inflation rate

Between 2021 and 2022
Between 2022 and 2023
Between 2021 and 2023
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 Measuring Inflation
• Consumer price index (CPI): A measure of changes in retail
prices of a basket of goods and services representative of
consumption expenditure by typical Australian households in
capital cities.
Cost of market basket in current year
CPI = x100
cost of market basket in base year
CPI for base year is always equal to 100

• The inflation rate is calculated by taking the rate of change in

the CPI.

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The CPI Market Basket
 Measuring Inflation
• The following is a simplified example of the market basket to show how
the CPI is constructed.
Base Year (2015) 2020 2021
Product Quantity Price Expenditure Price Expenditure Price Expenditure
(on base year (on base year
quantities) quantities)
Eye 1 $50.00 $50.00 $100.00 $100.00 $85.00 $85.00
exams
Pizzas 20 10.00 200.00 15.00 300.00 14.00 280.00
Books 20 25.00 500.00 25.00 500.00 27.50 550.00
Total $750.00 $900.00 $915.00

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GDP deflator & inflation rate
Year CPI
2015 (Base)

2020

2021

Year Inflation rate

Between 2015 and 2020

Between 2020 and 2021

Between 2015 and 2021

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 Measuring inflation
• Is the CPI accurate?
• The CPI is the most widely used measure of inflation.
• Four sources of bias in the CPI may lead to it overstating
the inflation rate.

➢ Substitution bias
➢ Increase in quality bias
➢ New product bias
➢ Outlet bias

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 The Costs of Inflation
Some well known costs include:

• Inflation erodes the purchasing power of money for those holding

wealth in paper money.

• In general, loss of confidence, uncertainty, efficiency costs.

• Costs of real resources (e.g. ‘Menu’ costs, ‘Shoe leather’ costs).

• Adverse effects on incentives leading to ‘unearned’ redistributions of

wealth (e.g. Loans and wages are agreed in Nominal terms).
 The Costs of High Inflation
• Higher effective tax rates due to ‘bracket creep’ in a progressive
tax system, reducing the incentive to work. (more distortions)

➢ Why inflation causes distortion in the tax system

Taxable income Tax on this income

0 – $18,200
$18,201 – $45,000
$45,001 – $120,000
$120,001 – $180,000
$180,001 and over
Nil
19c for each $1 over $18,200
$5,092 plus 32.5c for each $1 over
$45,000
$29,467 plus 37c for each $1 over
$120,000
$51,667plus 45c for each $1 over
$180,000
 The Costs of High Inflation
Distortions in the tax system

Consider a 10 percent increase in inflation and your nominal income.

Income Tax paid
$120,000 $29,467= $0+$5,092 + $24,375
You pay $0 tax [0 – 18,200]
You pay $5,092 tax [18,201 – 45,000]
You pay $24,375 tax [45,001 – 120,000]
$132,000 $33,907= $0+$5,092 + $24,375
You pay $0 tax [0 – 18,200] +$4,440
You pay $5,092 tax [18,201 – 45,000]
You pay $24,375 tax [45,001 – 120,000]
You pay $4,440 tax [120,001 -180,000]
 What causes inflation?
• Demand-pull inflation: Inflation that is caused by an increase in
the aggregate demand for goods and services and production
levels are unable to meet this demand immediately.
• Production may be unable to meet demand particularly when the
economy is close to, or at, full employment.
• Upward pressure is put on prices and nominal wages and can lead
to a wage-price spiral.

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 Demand-pull inflation
Price level
LRAS

SRAS1

112 B
108 A

AD1 AD2
0
$1200 1300 Real GDP (billions of dollars)
 What causes inflation?
• Cost-push inflation: Inflation that arises as a result of
a negative supply shock - that is, anything that
causes a decrease in the aggregate supply of goods
and services.

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 Cost-push inflation
2. … moving
Price level short-run
equilibrium to LRAS SRAS2
point B, with
lower real GDP SRAS1
and a higher
price level.

1. An increase in
B production costs
112
shifts SRAS to the left
108 A …

AD1
0 $1100 1200 Real GDP (billions of dollars)
 What causes inflation?
• Sources of a supply shock can include:

➢ External input price shock, eg: increase in oil prices

➢ Increases in import prices
➢ Increases in wages
➢ Increases in Government charges and taxes
➢ Natural disasters, such as droughts, floods, earthquakes
➢ Depreciation of the Australian dollar.

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Labor Force Framework

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Persons not in Labor force

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 LFS February 2024
P: Working Age
Population 15+
22.21 m.

NLF: Not in Labour Force LF: Labour Force = econ.

(NLF = P – LF) active pop.
7.4 m. 14.79 m.
[Participation rate = LF/P = 66.6%]

E: U: Unemployed
Employed - actively
14.23 m. searching
+ available to
start work
0.56 m.
[Unemployment
rate = U/F =3.8%]

Source - ABS Cat No 6202.0, September 2021, - figures expressed in millions

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 Measuring the unemployment rate
• The unemployment rate the percentage of the labor force that
is unemployed.

• Unemployment rate= (Numb unemployed / Numb labor force) X100

• Unemployment rate= (562,200 / 14,794,500) X100 = 3.8%

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 Labor force participation rate
• Labor force participation rate: The percentage of the working age
population in the labor force.

• Participation rate= (Numb Labor force / working age pop) X100

• Participation rate= (14,794,500 / 22,206,203) X100 = 66.6%

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Measuring the unemployment rate and
the labour force participation rate
Problems with measuring the unemployment rate:
➢ The number of discouraged job seekers increases during a recession,
therefore, the official unemployment rate appears lower than it would
otherwise be.
❑ Feb 2023: 87,400 were discouraged job seekers.
➢ Under-employed workers—people who work part-time but would like to
work more hours.
❑ Feb 2024: 963,200 people are underemployed.
➢ People who claim to be unemployed but are not can lead to the
unemployment rate being overstated.
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 How long are people usually
unemployed?
Duration of unemployment Feb 2024

Under 4 weeks (under 1 month) 149,000

4 weeks and under 13 weeks (1 – 3 months) 197,500

13 weeks and under 26 weeks (3- 6 months) 85,600

26 weeks and under 52 weeks (6- 12 months) 59,200

52 weeks and above (long term unemployed) 113,200

Source: ABS, 6291.0.55.001 Labour Force, Australia, Detailed

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 How long are people usually
unemployed?
• Feb 2024, Australia: Around 346,500 (57%) of unemployed had
been unemployed for 3 months or less.
• Feb 2024, Australia: Around 432,100 (71.5%) of unemployed
had been unemployed for fewer than 6 months.
• Long-term unemployed: Those in the labour force who have
been continuously unemployed for a year or longer.
➢ Feb 2024, Australia: 113,200 (18.7%) were long-term
unemployed.

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 Types of Unemployment
• Frictional Unemployment

• Structural Unemployment

• Demand deficient/Cyclical Unemployment

• The natural rate of unemployment

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 Types of unemployment
• Frictional unemployment: Short-term unemployment
arising from the process of matching workers with jobs.
➢ School leavers, secondary and university graduates looking
for their first job.
➢ People re-entering the workforce after an absence.
➢ People who have lost or quit their job and are looking for
their new job.

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 Types of Unemployment
• Structural unemployment: Unemployment arising from a
persistent mismatch between the skills and characteristics of
workers and the requirements of jobs.
e.g. New technology and changes in consumer tastes may make
some workers redundant.

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 Types of unemployment
• Cyclical (Demand deficient) unemployment:
Unemployment caused by a business cycle
contraction. Also known as ‘demand deficient’
unemployment.
➢Falling sales lead to cut-backs on production and the
sacking of workers.

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 Types of unemployment
• Natural rate of unemployment: The unemployment which
occurs when the economy is operating at full employment
or producing an output at potential GDP.
• Economists say that full employment occurs where there is
no cyclical unemployment.
• There will always be some frictional and structural
unemployment.

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 The costs of unemployment
Costs to the economy
• Loss of Gross Domestic Product.
• Loss of human capital.
• Retraining costs.
• Costs to the government:
➢ Unemployment benefit payments are a net drain on the federal
budget.
➢ The opportunity cost of funds directed towards unemployment
benefits.
➢ Loss of tax revenue
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 The costs of unemployment
Costs to the individual
• Loss of income.
• Loss of skills.
• Retraining costs.
• Loss of self esteem.
• Unemployment may contribute to family break-ups, health
problems, mental illness, crime and political unrest.

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 Question 1
1. Which of the following is the best measure of
the average of the prices of the goods and
services consumed by a typical household?
A. The consumer price index.
B. The producer price index.
C. The GDP deflator.
D. None of the above.

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 Question 2
2. Suppose that the data in the following table
reflects the prices in an economy. What is the
inflation rate between 2012 and 2013? Year CPI
(2012 = 100)
2012 100
2013 120
A. 2 per cent
B. 5 per cent
C. 20 per cent
D. 10 per cent 37
 Question 3
3. Which of the following describes the accuracy of the
Consumer Price Index (CPI)?
A. Changes in the CPI accurately reflect the true rate of
inflation.
B. Changes in the CPI understate the true rate of
inflation.
C. Changes in the CPI overstate the true rate of
inflation.
D. Changes in the CPI are unrelated to the true rate of
inflation.

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 Question 4
4. When the price of petrol rises, some
consumers begin riding their bikes more frequently
or taking public transport instead of driving their
cars. The fact that the CPI does not fully account
for such changes in consumer behaviour is called
A. outlet bias.
B. increase in quality bias.
C. substitution bias.
D. discrimination bias.

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 Question 5
5. Demand-pull inflation is caused by
A. a recession.
B. high levels of aggregate demand in the short
run.
C. an increase in the costs of production, which
pulls prices higher.
D. wage increases that are higher than increases
in productivity growth.

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 Question 6

6.With cost-push inflation, initially

A. the price level and real GDP both increase.
B. only real GDP changes while the price level
remains constant.
C. the price level rises and real GDP declines.
D. All of these options are correct.

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 Question 7
7. The labour force is the sum of
A. employed workers and unemployed workers.
B. employed workers and individuals not looking for
work.
C. employed workers and the working-age
population.
D. unemployed workers and the working-age
population.
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 Question 8
8. The unemployment rate is the
A. percentage of the labour force receiving
unemployment benefits.
B. percentage of the population that is
unemployed.
C. percentage of the working-age population that
is unemployed.
D. percentage of the labour force that is
unemployed.
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 Question 9
9.A full-time student who is not working is
categorised as
A. unemployed.
B. employed.
C. not in the labour force.
D. a discouraged worker.

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 Question 10
10. Which of the following causes the official measure
of the unemployment rate to understate the true extent
of joblessness?
A. Many full-time workers really want to be part-time
workers.
B. People who collect unemployment benefits report
themselves to be searching for a job.
C. Discouraged workers are not counted as
unemployed.
D. Discouraged workers are counted as unemployed.
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