Chapter 5

Macroeconomic Problems
Unemployment as a Macroeconomic Problem፡
 Economists are always concerned with efficiency in the use of resources
Resources are used efficiently when they are devoted to their most important
or productive uses, broadly speaking.
 However, it is most clearly inefficient if resources simply are unused and go
to waste.
 The resource most likely to be under used is labor.
"Unemployment" seems to be an instance of failure to use the available labor
Con;t
This is why many economists see unemployment as an economic problem. 
The two major views on unemployment are:
The "Keynesian" view of Unemployment: Unemployment is an excess

supply of labor resulting from a failure of coordination in the market

economy.
The "Classical" view of Unemployment: Unemployment is job search --

people engaged in the productive work of looking for a better match between

worker and employer.

 In any case, the (possible) problem of unemployment is central to modern

economics
 5.1.Unemployment
Unemployment is the macroeconomic problem that affects people most directly and
severely.
 For most people, the loss of a job means a reduced living standard and psychological
distress.
It is no surprise that unemployment is a frequent topic of political debate and that
politicians often claim that their proposed policies would help create jobs.
In modern economics, the population as having three components:
those who are employed,
 those who are unemployed, and
the rest, who neither are working nor are seeking work such as a full-time student,
homemaker, or retire,
 The first two groups those who are employed and who are seeking work together
comprise the labor force:
 5.1.1. Measures of Unemployment

 The labor force: consists of all those persons who are willing to work at a market
equilibrium wage, and who either have jobs or are seeking work.
 LF= E + U

 A person who fits neither of the first two categories, such as a full-time

student, homemaker, or retiree, is not in the labor force.

 A Working Definition of Unemployment
People able, available and willing to find work and actively seeking work –
but not employed
The unemployed are included in the labour force
 Unemployed: A person is said to be "unemployed" if he or she is looking for
work, is willing to work at the prevailing wage, but is unable to find a job.
 Con;t
 Unemployment: Unemployment refers to the condition of being
unemployed, or to the number or proportion of people in the
working population who are unemployed.
 The unemployment rate is the proportion of the labor force that is
unemployed.
 To calculate the rate, you need to know the number of people
unemployed and the number of people in the labor force
Unemployment rate = number of unemployed people / labor force
 Con;t
 Labor-force participation rate the percentage of the adult
population that is in the labor force
 Labor-force participation rate= labor force/adult population*100
 This statistic tells us the fraction of the population that has chosen
to participate in the labor market
 Okun’s Law (Rule of Thumb): states that for each additional 1
percent increase in unemployment there is a corresponding 2
percent decline in output (GDP).

 The inverse relationship between the unemployment rate and

output growth (relative to potential) or the output ratio.
 5.1.2. Types of Unemployment

 The following are types of unemployment

1. Seasonal

 Seasonal unemployment is unemployment due to seasonal changes in

employment or labor supply

Regular seasonal changes in employment / labour demand

2. Frictional

Transitional unemployment due to people moving between jobs: .

 Imperfect information about available job opportunities can

lengthen the period of someone’s job search
 Con;t
 Frictional unemployment is a brief period of unemployment
experienced by people moving between jobs or into the labor
market. People have the skills and knowledge necessary to get a
job, and the jobs are available.
 Examples of frictionally unemployed people include new college
graduates and people quitting a job and looking for something
different or better.
Con;t
3. Structural unemployment
Structural unemployment is unemployment caused by a
mismatch between the skills or location of job seekers and the
requirements or location of available jobs.
Jobs may be available in other geographic areas or for individuals
with specific skills and abilities
Occupational immobility of labour
Often involves long-term unemployment
 Con;t

4. Cyclical unemployment
It is unemployment caused by a lack of job vacancies; an inadequate
level of aggregate demand.
Cyclical unemployment commonly occurs during recessions.
Companies cut back on workers due to reduced sales, fears of an
economic recession, and insufficient consumer demand.
 Related concepts
 Discouraged Workers;- Former job seekers who have given up and no
longer actively seek employment.
They drop out of the labor force.

They are no longer counted in unemployment statistics.

 Underemployment:- People who want full-time work in their field but can
find only part-time work or work at jobs below their capability.
They are counted as employed
Full employment is defined as the lowest rate of unemployment compatible

with price stability; usually between 4 – 6 percent unemployment.

 Economic and Social Costs of Unemployment

 The private costs for the unemployed

◦ Loss of income

◦ Fall in real living standards

◦ Increased health risks

 Stress

 Reduction in quality of diet

 Social exclusion because of loss of work and income

◦ Loss of marketable skills (human capital) and motivation

 The longer the duration of unemployment, the lower the chances of finding fresh

employment - the unemployed become less attractive to potential employers

 Consequences of Unemployment

 Economic Consequences for Businesses

Negative consequences
 Fall in demand for goods and services
 Fall in demand for businesses further down the supply chain
 Consider the negative multiplier effects from the closure of a major employer in a
town or city
Some positive consequences
 Bigger pool of surplus labour is available – but still a problem if there is plenty of
structural unemployment
 Less pressure to pay higher wages
 Less risk of industrial / strike action – fear of job losses – leading to reduced trade
union power
 Con;t

 Consequences for the Government (Fiscal Policy)

 Increased spending on unemployment benefits and other income –related state welfare
payments
 Fall in revenue from income tax and taxes on consumer spending
 Fall in profits – reduction in revenue from corporation tax
 May lead to rise in government borrowing (i.e. a budget deficit)
 Consequences for the economy as a whole
 Lost output (real GDP) from people being out of work – the economy will be operating
well within its production frontier
 Unemployment seen as an inefficient way of allocating resources – labour market failure?
 Some of the long-term unemployed may leave the labour force permanently – fall in
potential GDP
 Increase in the inequality – rise in relative poverty
Reasons for Unemployment
 Job leavers - They quit to seek other opportunities.
 Job losers -They are laid off or fired.
 New entrants - First-time job seekers.
 Reentrants - They had left the labor force but have returned
 5.1.3. Measures to achieve full employment
1.Demand side Policies to Reduce Unemployment
 Demand side approaches focus on raising the aggregate demand
for goods and services
 Because labour as a factor input has a derived demand, if
production and investment is increasing, so too there should be a
rise in the demand for new workers.
 Demand side Policies are mainly measures to boost total
labour demand (reduce cyclical unemployment)
 Con’t
 Include

Lower interest rates (a monetary policy stimulus)

lower exchange rate A (helps exporters)
Lower direct taxes (fiscal stimulus to spending power)
Government spending on major capital projects (e.g. improving
the transport infrastructure)
Employment subsidies (including the New Deal programme) –
designed to reduce the cost to a business of employing additional
workers
Incentives to encourage flows of foreign investment
 2.Supply-side policies to reduce Unemployment

 The labour market needs to be flexible enough to match people out

of work with the skills required by newly created jobs.
 These supply-side policies seek to provide the economy with
sufficient labour market flexibility
 Con’t
 Supply-side policies are measures to improve labour supply (reduce
frictional and structural unemployment)
– Increased spending on education & training including an emphasis
on “lifetime-learning”)
– Improved flows of information on job vacancies

– Changes to tax and benefits to improve incentives

– Measures designed to make the labour market more flexible so that
workers have the skills and education that gives them improved
employment options
 What are Consequences of falling unemployment?
 The circular flow and the multiplier:
◦ Incomes flowing into households will grow
◦ Falling unemployment adds to demand and creates a positive multiplier
effect on incomes, demand and output.
 The balance of payments:

◦ When incomes and spending are growing, there is an increase in the demand
for imports. Unless this is matched by a rise in export sales, the trade balance
in goods and services will worsen
 Government finances:

◦ With more people in work paying income tax, national insurance and value
added tax, the government can expect a large rise in tax revenues and a
reduction in social security benefits
 Inflationary effects

◦ Falling unemployment can also create a rise in inflationary pressure –

particularly when the economy moves close to operating at full capacity
◦ However this is not really a risk when the economy is coming out of
recession, since aggregate supply is likely to be highly elastic because of a
high level of spare capacity
Breakfor only 5
minutes
 5.2. Inflation
 Inflation is:
 A persistent rise in prices in an economy over a period of time
 Inflation is the rate at which the general level of prices of goods
and services is rising, and subsequently, purchasing power is falling
 To the neo-classicals, inflation is fundamentally a monetary
phenomenon.
 As Friedman, inflation is always and everywhere a monetary
phenomenon– and can be produced only by a more rapid increase
in the quantity of money than output.
 A fall in the price level is termed ‘deflation
 STAGES OF INFLATION
 Depending up on the rate of rise in price, different names have been given to inflation.

1. CREEPING INFLATION (0%-3%)

 When the rise in price is very slow like that of a snail or creeper.
 In terms of speed, a sustained rise in prices of annual increase of less than 3%
 Such an increase in price is regarded safe and essential for economic growth

2. WALKING INFLATION ( 3% - 7%)- when prices rise moderately and annual inflation rate is a single
digit.
 Inflation at this rate is a warming signal for the government to control before it turns in to running
inflation

3. RUNNING INFLATION(10% - 20 %) when prices rise rapidly as the running of the horse at a rate of
speed of 10-20% per annum.
 Such inflation affects the poor and middle class adversely
 Its control needs strong monetary and fiscal measures

4. HYPER INFLATION( 20% and above) when prices rise very fast at a double or triple digit rates- it is
usually called run away or galloping inflation .
 5.2.1. Sources and Consequences of Inflation

 The following are the main sources/causes of inflation

 Demand-Pull – where aggregate demand (AD) rises at a faster rate than

aggregate supply (AS)

 Goods may be in short supply either b/c resources are fully utilized or

 production can not be increased rapidly to meet the increasing demand

 As a result prices begin to rise in response to a situation often described

as “ too much money chasing too less goods”

 The factors which lead to increase in demand and shortage of supply are-
 Con;t

1. Increase in money supply:- inflation is caused by an increase in the

supply of money which leads to increase in AD.

 The higher the growth rate of the nominal money supply, the

higher the rate of inflation.

2. Increase in disposable income: when disposable income of the

people increases, it raises the demand for goods and services

3. Increase in public expenditure: government activities have been

expanding much with the result that government expenditure has

increasing- raising aggregate demand for goods and services

 Con;t

4. Increase in consumer Spending

 The demand for goods and services increases when consumers
expenditure increases
5. Cheap monetary Policy:- Cheap money policy or the policy of
credit expansions also leads to increase in money supply which raise
the demand for goods and services in the economy- credit induced
inflation
6. Deficit financing:- in order to meet its mounting expenses, the
government resorts to deficit financing by borrowing from the public
and even by printing more notes.
 This raises AD in relation to AS thereby leading to inflationary rise in

prices – deficit induced inflation

7. Black money- the existence of black money due to corruption, tax
evasion etc increase AD
8. Increase in Exports-when demand for domestically produced goods
increase in foreign countries
 Cost-Push Inflation
 increases in costs (labour, raw materials, imported costs, etc.) that cause a leftward
shift in AS
Causes for Increase in Cost :-
a) Increase in cost of raw materials and Shortage of Supplies
b) Artificial Scarcities
c) Natural calamities such as drought, floods
d) Industrial Disputes
e) Increase in Exports: when countries produce more for export than for domestic
consumption
f) Increase in Wages
g) Increase in Transportation Cost
h) Huge Expenditure on Advertisement
 Consequences/effects of Inflation
 Inflation can have positive and negative effects on an economy.
 Negative effects of inflation include
 loss in stability in the real value of money and other monetary
items over time;
 uncertainty about future inflation may discourage investment and
saving, and
 high inflation may lead to shortages of goods if consumers begin
hoarding out of concern that prices will increase in the future.
 Positive effects include a mitigation of economic recessions, and
debt relief by reducing the real level of debt.
Read from material for
other effects of inflation!!!
 Quiz(5%)
 1.What are sources of inflation?
 2.List and explain the stages of inflation.
 3.Discuss types of unemployment.
 4.What measures under taken to reduce unemployment?
 5.Define inflation?