Unemployment and Inflation

6/12/12
Unemployment and Inflation
Chapter 9 - Business Cycles, Unemployment, Inflation

This chapter provides an introductory look at the macroeconomic problems of unemployment and inflation. We will study economic growth in greater detail in two weeks when we study chapters 8 and 22 Web.
Review
Review: The three macroeconomic issues are: 1. UE (unemployment) 2. IN (inflation) 3. EG (economic growth)
Review: The Business Cycle Unemployment, inflation and economic growth tend to change cyclically over time.
The four phases of the business cycle: 1. A peak is when business activity reaches a temporary maximum, unemployment is low, inflation high. 2. A recession is a decline in total output, unemployment rises and inflation falls. 3. The trough is the bottom of the recession period, unemployment is at its highest, inflation is low. 4. expansion (recovery) is when output is increasing, unemployment begins to fall and later inflation begins to rise. Unemployment increases during business cycle recessions and decreases during business cycle expansions (recoveries). Inflation decreases during recessions and increases during expansions (recoveries). Review: Maximizing Satisfaction The primary reason to study unemployment is that it contributes to scarcity. Scarcity always exists since resources are limited and human wants are unlimited. There are five ways to reduce scarcity - the five Es of economics (see diagram below). Full employment is one of the five Es. We defined full employment as "using all available resources". If a society uses ALL AVAILABLE RESOURCES then more goods and services will be produced and scarcity will be reduced
www.harpercollege.edu/mhealy/eco212i/lectures/ch9-18.htm
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Another way to illustrate the effects of unemployed resources is with the production possibilities curve (see graph below). Point "D" illustrates the effect of unemployment. Points "A", "B", and "C" represent the maximum possible levels of production WITH FULL EMPLOYMENT. With unemployment, less will be produced (point "D").
Finally, we have illustrated unemployment before using the AS-AD model.
If the equilibrium level of output is less than the full employment level as illustrated on the graph above, this indicates that some available resources are unemployed and less is being produced.
What is unemployment?
The unemployment rate in the United States was 4.5% in February, 2007 and 9.8% in September, 2009. Whenever we see a "%" we have to ask "percent of what?" In February of 2007 4.5% of what was unemployed? Unemployment
US unemployment rates:
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From where do the statistics come? [The following is from: http://stats.bls.gov/cps/cps_faq.htm ]
http://stats.bls.gov/cps/prev_yrs.htm
Many people think that the unemployment rate is a measure of who is receiving an unemployment insurance check, in fact, it includes many more people than that. Because unemployment insurance records relate only to persons who have applied for such benefits, and since it is impractical to actually count every unemployed person each month, the Government conducts a monthly sample survey called the Current Population Survey (CPS) to measure the extent of unemployment in the country. The CPS has been conducted in the United States every month since 1940 when it began as a Work Projects Administration project. It has been expanded and modified several times since then. As explained later, the CPS estimates, beginning in 1994, reflect the results of a major redesign of the survey. The Unemployment Rate
http://www.cbs.nl/en/figures/keyfigures/sip_600z.htm
Year Ann Avg 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 3.8 5.9 5.3 3.3 3.0 2.9 5.5 4.4 4.1 4.3 6.8 5.5 5.5 6.7 5.5 5.7 5.2 4.5 3.8 3.8 3.6 3.5 4.9 5.9 5.6 4.9 5.6 8.5 7.7 7.1 6.1 5.8 7.1 7.6 9.7 9.6 7.5 7.2 7.0 6.2 5.5 5.3 5.6 6.8 7.5 6.9 6.1 5.6 5.4
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In September of 2000, the US unemployment rate was 3.9%
Unemployment rate, US, 1999-2009
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
What is Unemployment? OPTIONAL: How the government measures UE:

http://stats.bls.gov/cps/cps_htgm.htm http://economics.about.com/money/economics/library/chartroom/blunemplmeasure.htm
Definition
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If the unemployment rate is 3.9%, then 3.9% OF WHAT are unemployed? It is NOT 3.9% of the population, but rather 3.9% of the LABOR FORCE. What is the labor force?
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
4.9 4.5 4.2 4.0 4.7 5.8 6.0 5.5 5.1 4.6 4.6 5.8
[From http://stats.bls.gov/cps/cps_faq.htm
The basic concepts involved in identifying the employed and unemployed are quite simple: People with jobs are employed and they are in the labor force. People who are jobless, looking for jobs, and available for work are unemployed and they are also in the labor force. People who are neither employed nor unemployed are not in the labor force. About half of the US population is in the labor force. Who is counted as employed? [From http://stats.bls.gov/cps/cps_faq.htm ]
Not all of the wide range of job situations in the American economy fit neatly into a given category. For example, people are considered employed if they did any work at all for pay or profit during the survey week. This includes all part-time and temporary work, as well as regular full-time year-round employment. Persons also are counted as employed if they have a job at which they did not work during the survey week because they were: On vacation; Ill; Experiencing childcare problems; Taking care of some other family or personal obligation; On maternity or paternity leave; Involved in an industrial dispute; or Prevented from working by bad weather Basically anyone who works at least one hour a week for pay is EMPLOYED. Who is counted as unemployed? [From http://stats.bls.gov/cps/cps_faq.htm ]
Persons are classified as unemployed if they do not have a job, have actively looked for work in the prior 4 weeks, and are currently available for work.
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UNEMPLOYED then is anybody who is NOT WORKING, BUT LOOKING. Who is in the labor force? The "labor force include those who are employed plus those who are unemployed. Who is not in the labor force? [From http://stats.bls.gov/cps/cps_faq.htm ]
All members of the civilian noninstitutional population are eligible for inclusion in the labor force, and those 16 and over who have a job or are actively looking for one are classified as in the labor force. All others--those who have no job and are not looking for one--are counted as "not in the labor force." Many who do not participate in the labor force are going to school or are retired. Family responsibilities keep others out of the labor force. Still others have a physical or mental disability which prevents them from participating in labor force activities. Those not in the labor force then includes: students who are not working and not looking for a job homemakers people who are institutionalized retired people who are not working and not looking people who may be working but illegally (e.g. drug dealers) discouraged workers - people who may have had a job and were employed, they lost their jobs and looked for another and were then unemployed, and then they gave up looking so now they are not in the labor force anymore.
The authors of our textbook divide the population into three groups: those under age 16 or institutionalized, those "not in labor force", and the labor force that includes those age 16 and over who are willing and able to work, and actively seeking work (demonstrated job search activity within the last four weeks).
SUMMARY:
"Employed" includes: part-time (at least 1 hour a week for pay)
Not in the labor force: Students - not working or looking Retired - not working or looking
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underemployed
Institutionalized Homemakers - "working" and not looking Underground economy - working but not counted Discouraged workers
Employed persons consist of: [From http://stats.bls.gov/cps/cps_faq.htm
All persons who did any work for pay or profit during the survey reference week. All persons who did at least 15 hours of unpaid work in a family-operated enterprise. All persons who were temporarily absent from their regular jobs because of illness, vacation, bad weather, industrial dispute, or various personal reasons. Unemployed persons are: [From http://stats.bls.gov/cps/cps_faq.htm ]
All persons who were not classified as employed during the survey reference week, made specific active efforts to find a job during the prior 4 weeks, and were available for work. All persons who were not working and were waiting to be called back to a job from which they had been temporarily laid off. Two factors cause the official unemployment rate to understate actual unemployment. Part time workers are counted as "employed." "Discouraged workers" who want a job, but are no longer actively seeking one, are not counted as being in the labor force, so they are not part of unemployment statistic. Calculating the Unemployment Rate The unemployment rate is defined as the percentage of the labor force that is not employed. Note that it is NOT the percentage of the POPULATION. To calculate the unemployment rate: UE rate = (# unemployed / labor force) x 100 So using the data for 2007 above: the labor force = 153.1 million people those unemployed = 7.1 million people So the unemployment rate was: (7.1 / 153.1) x 100 = 4.6 % of the labor force.
What Is "Full Employment"?

Full employment equals between 4 and 5 % unemployment !!! As we discussed above, full employment results in reducing scarcity by producing the economy's potential level of output. The unemployment rate in 2007 was 4.5%, that amounts to about 71 million people unemployed. Remember that unemployed means not working but looking. So with 7.1 million people unemployed we still have FULL EMPLOYMENT!! How can 4% to 5% unemployment be considered full employment? How can 7.1 million people looking for work be called "full employment? It depends on how we define full employment. We have defined full employment as using all available resources so as to achieve the potential level of output for an economy. Full employment is achieving the potential level of output. So, with some types of unemployment an economy can still produce its potential level of output. Full employment means achieving the potential output As we learned in our AS-AD lesson "potential output" is NOT the absolute maximum, but it is the potential level of output under normal circumstances Graphically, the potential, or the full employment output can be illustrated three ways:
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1) Points A, B, and C on the production possibilities curve represent a full employment of resources.
2) Equilibrium on the short run AD - AS graph below is at the full employment level of output.
3) potential output is the level of output on the long run aggregate supply curve.
Economists estimate that about 4 %to 5% unemployment is Full Employment. This is called the "full employment rate of unemployment", or the "natural rate of unemployment" and it includes structural and frictional unemployment What? To understand how and economy with 4-5% unemployment can be achieving the potential level of output and therefore have "full" employment" , we must understand the three different types, or causes, of unemployment. Types of Unemployment To understand how we can achieve the potential level of output and still have 4.5 % unemployment we must understand the three types, or causes, of unemployment. The key to understanding what full employment means, is to consider what happens to output with each type of
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unemployment. 1. Frictional Unemployment WHAT IS FRICTIONAL UNEMPLOYMENT? Frictional unemployment is the type of unemployment caused by workers looking for their first job, voluntarily changing jobs, and by temporary layoffs. It is unemployed workers between jobs. Frictional unemployment is "good" unemployment because without it the economy could not be producing as much as possible (i.e. achieving the potential level of output). HOW DOES FRICTIONAL UNEMPLOYMENT AFFECT SCARCITY? How can the economy be achieving the potential level of output if some people are frictionally unemployed? First, frictional unemployment is NECESSARY in order for the economy is to achieve its potential level of output. For example, let's assume an engineering student has just graduated from college and is looking for a job. He/she is frictionally unemployed. Would society's scarcity be reduced as much as possible if that engineer takes the first job he/she finds? On the way home from graduation he/she sees a "HELP WANTED" sign, turns in, applies, and works the rest of his/her life at McDonald's. Is this good for society? OR would it be better for society if they NOT take that job at McDonald's and remain frictionally unemployed longer? We need some frictional unemployment to get resources to the jobs where they produce the most so some frictional unemployment actually reduces scarcity. To produce as much as possible with our limited resources we need some frictional unemployment. WHAT CAN THE GOVERNMENT DO TO REDUCE FRICTIONAL UNEMPLOYMENT? Frictional unemployment tends to be short-lived, BUT we do not want it to last too long. If that engineer is unemployed for many years looking for just the right job, then there would be more scarcity than if he/she had taken the job at McDonald's. Therefore programs to keep it low would help reduce scarcity and governments have such programs like state employment offices and career placement offices at universities. These programs help people find jobs quicker so that more can be produced. 2. Structural Unemployment WHAT IS STRUCTURAL UNEMPLOYMENT? Structural unemployment is unemployment of workers whose skills are not demanded by employers. They are unemployed because they lack sufficient skill to obtain employment, or they cannot easily move to locations where jobs are available. Structural unemployment can result from changes in the structure of demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs changes. HOW DOES STRUCTURAL UNEMPLOYMENT AFFECT SCARCITY? Structural unemployment results from people not having the necessary skills. If these people are unemployed, what happens to scarcity? Nothing! Nothing happens to scarcity is they are unemployed because they don't have the skills needed to produce anything. Therefore we can still produce our potential level of output with our available resources even if there is structural unemployment. If resources without skills were put to work, they, by definition, couldn't produce anything because they don't have the skills. WHAT CAN THE GOVERNMENT DO TO REDUCE STRUCTURAL UNEMPLOYMENT? But, do we want these workers to just do nothing? NO. We studied in the 5Es lesson that more workers or better workers results in economic growth. Economic growth is increasing out potential level of output. This is good for society since it also reduces scarcity. Therefore governments have economic growth programs to reduce structural unemployment like financial aid for school and job training programs.
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3. Cyclical Unemployment WHAT IS CYCLICAL UNEMPLOYMENT? Cyclical unemployment is a type of unemployment caused by insufficient total spending (or by insufficient aggregate demand). It is unemployment caused by the recession phase of the business cycle. If there is less aggregate demand firms respond by producing less. Output and employment are reduced. The extreme unemployment during the Great Depression (25 percent in 1933) was cyclical unemployment. HOW DOES CYCLICAL UNEMPLOYMENT AFFECT SCARCITY? If there is a recession and therefore an increase in unemployment associated with a decrease in output, this results in more scarcity. This is not good for society since it will be producing at a point inside its production possibilities curve (point D on the graph below) or at a level of output short of the full employment level.
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WHAT CAN THE GOVERNMENT DO TO REDUCE CYCLICAL UNEMPLOYMENT? Therefore, governments have policies to reduce cyclical unemployment. These are the demand management policies discussed in our lesson on the AS-AD. Expansionary fiscal policies (increasing government spending or decreasing taxes) and easy money policies (increasing the money supply) are designed to increase AD, reduce cyclical unemployment, and and move the economy back to the full employment level of output. .
It is sometimes not clear which type of unemployment describes a person's unemployment circumstances. So to repeat: economists estimate that about 4 %to 5% is Full Employment. This is called the "full employment rate of unemployment", or the "natural rate of unemployment" and it includes: the frictional unemployment and the structural unemployment, but NO cyclical unemployment. In other words, full employment is zero cyclical unemployment. If there is some frictional and structural unemployment in the economy can the potential level of output still be achieved? YES, and economists estimate that there is between 4% and 5% frictional and structural unemployment in the US economy. that is why we are currently at, or below, full employment. The "full employment rate of unemployment" is the unemployment rate occurring when there is no cyclical unemployment and the economy is achieving its potential output Changes in the Full Employment (Natural) Rate of Unemployment The natural rate of unemployment is not fixed but depends on the demographic makeup of the labor force and the laws and customs of the
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nations. in the United States in the 1060s the full employment rate of unemployment was around 4%. this was the target of President Kennedy's tax cut program In the 1970s the full employment rate of unemployment was around 5%. and it was about 6% in the 1980s. Why did the full employment rate of unemployment increase? Or, another way of saying this is "why did the amount of frictional and structural unemployment increase?" There were several cultural and demographic changes during these decades that resulted in more frictional and structural unemployment. After World War II ended in the 1940s the baby boom began. By the 1960s this large increase in population was beginning to enter the labor force. As they begin looking for their first jobs they were frictionally unemployed. Also during these decades the roles of women were changing and more women entered the labor force for the first time (frictional unemployment) and many did not have the necessary skills (structural unemployment). Recently the natural rate has dropped from 6% to 4 to 5%. This is attributed to (1) the aging of the work force with fewer new entrants reducing frictional unemployment, (2) improved job information through the internet and temporary-help agencies which also reduces frictional unemployment, (3) new work requirements passed by congress with the most recent welfare reform which encourage those who are frictionally unemployed to try to get a job quicker, and finally, (4) the doubling of the US prison population since 1985 has removed from the labor force a group of people who have a high rate of unemployment. Quick Quiz
Costs of Unemployment GDP gap As we have discussed many times, the problem with unemployed resources is that they could have been used to produce more boats - - or cars or whatever it is that society wants. With unemployment there is more SCARCITY. This loss of goods that could have been produced if we had used all of our resources is called the GDP gap and it is a measure of the cost of unemployment. The GDP gap = actual GDP - potential GDP GDP gap: The amount by which actual gross domestic product falls below potential gross domestic product. GDP stand for Gross Domestic Product. We will study how to measure GDP in chapter 6 next week. For now, GDP is a measure of how much is produced in an economy in a year. If the GDP gap is negative then the potential GDP > the actual GDP and economy is not producing as much as possible. This is how much more output could have been produced if there was full employment. The GDP gap then is the lost output caused by not having full employment.
If the GDP gap is positive then the actual GDP is > the potential GDP. It is possible to have a positive GDP gap if AD is very high and it crosses the AS curve in the classical range BEYOND the full employment level of real domestic output. The result is high inflation.
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One way to measure this cost is with Okun's Law. Economist Arthur Okun quantified the relationship between unemployment and GDP as
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follows: For every 1 percent of unemployment above the natural rate, a negative GDP gap of about 2 percent occurs. This is known as "Okun's law." What this means is for every one percentage point decrease in the unemployment rate output increases about 2%. The larger increase in output is due to more people (discouraged workers) reentering the labor force. So a 1% decrease in unemployment really means that there are more than 1% more people working. Non Economic Costs There are also many non-economic costs associated with inflation. These costs include: Unequal burdens of unemployment exist. Rates are lower for white collar workers. Teenagers have the highest rates. African-Americans have higher rates than whites. Rates for males and females are comparable, though females had a lower rate in 2002. Less educated workers, on average, have higher unemployment rates than workers with more education. "Long term" (15 weeks or more) unemployment rate is much lower than the overall rate, although it has nearly doubled from 1.1% in 1999 to 2% in 2002. Noneconomic costs include loss of self respect and social and political unrest.
What is Inflation?
Measuring Inflation http://www.bls.gov/ Inflation is the annual rate of increase in the price level. US inflation rates:
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In January of 2007 the inflation rate was 2.1 %. But what does this mean? 2.1% of what? An inflation rate of 2.1% in January of 2007 means that the price level was 2.1% higher than it was in January of 2006. In the chapter on aggregate supply and aggregate demand we learned that the price level is "the average level of prices in the economy". We find the price level on the vertical axis of the AS-AD graph.
But how is the price level measured? What numbers would one put along the vertical axis? How can we measure the average level of prices in an economy? To do this economists use a "price index". In order to calculate inflation we need to know how the price level is measured, therefore we need to learn about a price index. Measuring Inflation: Price index Our textbook defines a price index in an index number which shows how the weighted average price of a market basket of goods changes over time. What does that mean? There are two price indices that we will use this semester. We will study the GDP Price Index in the chapter on measuring GDP (or real domestic output - RDO). To learn how to measure inflation we will use the CPI, the consumer price index. The CPI is an index which measures the prices of a fixed market basket of over 200 categories of goods and services bought by a typical consumer in. It works this way: A list of over 200 items bought by the typical consumer is drawn up. The list is then "weighted" meaning that they do not include 1 car, 1, computer, 1 house, 1 pizza, one gallon of gasoline, etc. Instead they "weight" each item according to its share in the typical consumer's budget. Each month data collectors collect prices of each item in the "market basket" and an average price is calculated. The price of the market basket each month is compare to its price in a "base year". So the numbers in the CPI tell us the value of the market basket each year AS A PERCENT OF ITS VALUE IN A BASE YEAR The years 1982-1984 have been selected as "base year" and
Year CPI 1976 56.9 1977 60.6 1978 65.2 1979 72.6 1980 82.4 1981 90.9 1982 96.5
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assigned the index number of 100 (see table at right).. So, in 1988 the CPI was 118.3 which means that the price of the market basket in 1988 was 118.3% of what it was in the base year. Or the price was 18.3 % higher than in the base year. [From http://www.bls.gov/cpi/cpifaq.htm ]
1983 99.6 1984 103.9 1985 107.6 1986 109.6 1987 113.6 1988 118.3 1989 124.0 1990 130.7 1991 136.2 1992 140.3 1993 144.5 1994 148.2 1995 152.4 1996 156.9 1997 160.5 1998 163.0 1999 166.6 2000 172.2 2001 177.1 2002 179.9 2003 184.0 2004 189.9 2005 195.3 2006 201.6 2007 207.3 2008 215.3
Each month, BLS data collectors called economic assistants visit or call thousands of retail stores, service establishments, rental units, and doctors' offices, all over the United States to obtain information on the prices of the thousands of items used to track and measure price changes in the CPI. These economic assistants record the prices of about 80,000 items each month representing a scientifically selected sample of the prices paid by consumers for the goods and services purchased. During each call or visit, the economic assistant collects price data on a specific good or service that was precisely defined during an earlier visit. If the selected item is available, the economic assistant records its price. If the selected item is no longer available, or if there have been changes in the quality or quantity (for example, eggs sold in packages of 8 when they previously had been sold by the dozen) of the good or service since the last time prices had been collected, the economic assistant selects a new item or records the quality change in the current item. The recorded information is sent to the national office of BLS where commodity specialists who have detailed knowledge about the particular goods or services priced review the data. These specialists check the data for accuracy and consistency and make any necessary corrections or adjustments which can range from an adjustment for a change in the size or quantity of a packaged item to more complex adjustments based upon statistical analysis of the value of an item's features or quality. Thus, the commodity specialists strive to prevent changes in the quality of items from affecting the CPI's measurement of price change.
READ THE FOLLOWING THEN CLICK ON THE LINK BELOW AND LISTEN TO THE 5 MINUTE RADIO REPORT ON THE CPI All Things Considered National Public Radio Wed., July 19, 2006 "Shopping for the Consumer Price Index" http://www.npr.org/templates/story/story.php?storyId=5568606 All Things Considered, July 19, 2006 The Bureau of Labor Statistics today released the monthly Consumer Price Index, a key economic indicator that tracks inflation. To track prices, the Labor Department sends out hundreds of people around the country to monitor prices for everything Americans buy -- from tires to food and college tuition. Robert Siegel went shopping with Caren Gaffney to find out how the Consumer Price Index is compiled. On the outing, Gaffney, a former telecommunications executive, checked prices in two grocery stores in the Washington, D.C., area. Siegel discusses the index with economists Mark Zandy of Moody's Economy.com, the Cleveland Federal Reserve's Michael Bryan and the University of Rochester's Mark Bils. OPTIONAL- More info. on the CPI: http://stats.bls.gov/cpifaq.htm OPTIONAL - how the CPI is measured: http://stats.bls.gov/cpifact2.htm Calculating Inflation - - - - KNOW THIS !!!!!! Since a price index measures the price level as a percent of a base year and inflation measures the change in the price index from the previous year, to calculate the inflation rate we use the following formula: price index for current year - price index for previous year
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Inflation rt. for current year = price index for previous year So to calculate the inflation rate for 1999 using the CPI data above: price index for 1999 - price index for 1998 Inflation rate for 1999 = price index for 1998 166.6 - 163.0 Inflation rate for 1999 = 163.0 For fun try these online inflation calculators: Inflation Calculator CPI Calculator x 100 =
x 100
x 100
2.2 %
USING A PRICE INDEX THE PRICE OF GASOLINE: March of 1981: $1.66; CPI = 88.5 (base year: 1982-84) April of 2005: $2:30; CPI = 192 When did gasoline cost more? http://data.bls.gov/cgi-bin/cpicalc.pl http://www.westegg.com/inflation/ http://www.aier.org/colcalc.html http://www1.jsc.nasa.gov/bu2/inflateCPI.html How the Cost-of-Living Calculator Works This calculator uses the Consumer Price Index (1982-84=100) and the following simple formula to convert dollar amounts between two different years. Converted$ = (StartYear$ / StartYearCPI) * ConvertYearCPI Any time you compare dollar amounts over time, the amounts should be adjusted for price inflation. With this calculator, you can compare the real buying power of any dollar amount you enter in the box. For example, $100 in 1913 had the same buying power as $1,584.85 in 1996. http://www.aier.org/aboutcpi.html Historical CPI: http://www.inflationdata.com/inflation/Consumer_Price_Index/HistoricalCPI.aspx http://woodrow.mpls.frb.fed.us/research/data/us/calc/hist1913.cfm
The Rule of 70 - - - - KNOW THIS !!!!!! The rule of 70 is a quick way to estimate how long it will take for something (like prices) to double if you know the annual percentage increase (like inflation). To determine the number of years it will take for the price level to double; divide 70 by the annual rate of inflation.
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70 approximate number of years to double = annual percentage increase For example, if the inflation rate is 3%, it will take 23 1/3 years for prices to double. 70 approx. number of years to double = 3 This handy little rule can be used for many things. If the population of a country is growing at a rate of 1% a year (which is about the population growth rate of the United States), how many years until the population doubles? 70 approx. number of years to double = 1 What if the population growth rate is 4 % a year? 70 approx. number of years to double = 4 Types / Causes / Theories of Inflation Demand-Pull inflation = 17.5 years = 70 years = 23.33 years
Demand-pull inflation is inflation caused by too much spending (and increase in AD).
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Demand-pull inflation occurs when spending (AD) increases faster than production (AS).I There is not demand pull inflation every time AD increases. If AD crosses AS in the Keynesian range of the AS curve (AD1 and AD@ in the graph below) then an increase in AD will not cause an increase in the price level and there will be no inflation. If AD increases in the intermediate range or the Classical range the result will be a rising price level and inflation.
Cost-push (or supply-side) inflation Cost-push or supply-side inflation caused by reductions in aggregate supply. The main causes of cost-push inflation are (1) "wagepush" as result of union strength and (2) supply shocks that may occur with unexpected increases in the price of raw materials.
Effects of Inflation There are two major effects of inflation. "Redistributive effects" means that inflation affects different groups differently. Some people are hurt by inflation and some people are helped by inflation. The "output effects" of inflation include its impact on how much is produced in an economy. Redistributive effects of inflation: A. Fixed-income groups will be hurt by inflation because their real income suffers. Their nominal income (the size of their paychecks) does not rise with prices, but if their is inflation the purchasing power of their paycheck, or their real income, would decrease. Note "flexible income receivers" like those who receive social security payments avoid being hurt by inflation. Social security payments are not fixed since they have a cost-of-living-adjustment or COLA. This is an automatic increase in the incomes when inflation occurs. Some union contracts also have COLA clauses. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power. Debtors (borrowers) can be helped by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive "dear" money and are paying back "cheap" dollars that have less purchasing power for the lender. Creditors (lenders) are hurt by unanticipated inflation since they will charge an interest rate that is "too low" since they did not expect to be paid back with dollars that are less valuable.
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A. If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders. 1. "Inflation premium" is amount that interest rate is raised to cover effects of anticipated inflation. "Real interest rate" is defined as nominal rate minus inflation premium. (See Figure 8-6) anticipated: Increases in the price level (inflation) which occur at the expected rate unanticipated: Increases in the price level (inflation) at a rate greater than expected.
Output Effects of Inflation Demand-pull inflation has a stimulus effect on the economy resulting in greater output. See graph below.
Cost-push inflation has a contractionary effect resulting in less output.
Hyperinflation is a very rapid rise in the price level. It results in LESS OUTPUT because: people no longer will accept money since it is losing its value very quickly they will therefore either barter, or produce everything for themselves Therefore, society will not benefit from the gains in output caused by specialization and exchange (trade) and LESS WILL BE PRODUCED.
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Unemployment and Inflation

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