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Business cycle, unemployment,

inflation and Philip curve


Level of
real Peak
output
Sustainable growth
trend

Expansion
Peak

Recovery
Recession

Trough/
Slump

0 Time
 Is a period of time containing a single boom and
contraction in sequence.
 Peak/ Boom
 It is the peak of the business cycle. Highest point of current
economic growth. Inflation pressure is high with low
unemployment.

 Recession
 A period of decline in output, income and employment.

 Trough/slump
 Is the opposite of boom. Reach the lowest production in
recent time. Unemployment is high.
 Recovery
 Is a time when the economy becomes stronger and there is an
upturn in the business cycle.
 More jobs are created and more goods and services are supplied
by businesses.

 Expansion
 Economy growth at a faster rate.
 Output growth higher than sustainable level.
 Unemployment occurs when those who are labour
force are without jobs and is actively seeking jobs

 Let L denote the total labour forces, E the number


of employed workers and U the number of
unemployed workers:
L=E+U

 The total labour forces are those who's age is


between 16 to 64 years old (productive age) and
willing to find a jobs
 Unemployment rate:

U/L x 100 = Unemployment rate

 Example: If the unemployment rate is


Malaysia is 3%, this mean that there are 3%
of total labour force that willing to work but
cannot find jobs
 Frictional unemployment
 Is unemployment caused by the time it takes workers to
search for job
 This type of unemployment is temporary
 Frictional unemployment might causes by:
 Sectoral shift
 Unemployment causes by workers that intend to
change sector

 Workers preference
 Flows of information in labour market is imperfect
 Hence, workers need time to match jobs that they
prefer and suit their abilities
 Frictional unemployment
 Remedies
 There will always be individuals between jobs
but measures to cut the search time involved
will invariably reduce frictional
unemployment.
 Improving the flow of information with regards
to the availability of particular employment is
one such measure as is a reduction in
unemployment benefit.
 Structural unemployment
 Is unemployment caused by structural
change in economy that eliminate some
jobs in the economy and created some
jobs that unemployed are unqualified
 Long-term unemployment
 Example: Change in Malaysia economy
structure from agriculture to industrial in
1980s had causes structural
unemployment
 Structural unemployment
 Remedies
 The remedy for structural
unemployment involves retraining those
made redundant in the skills required
by the developing industry and
possible relocation to other areas.
 Natural unemployment
 Natural unemployment rate is referred to as that part of
unemployment viewed as being unavoidable and exists
when the economy is operating at the full employment
level of real GDP

 It is the sum of frictional unemployment and structural


unemployment rates

Natural unemployment (UN) = Frictional unemployment


(FU) + Structural unemployment (SU)

 Economists think the natural unemployment rate currently


is between 5 to 7%.
 Deficient unemployment/ Cyclical unemployment
 This often referred to as Keynesian unemployment or
cyclical unemployment.
 It occurs when aggregate demand is too small, there being
a deficiency of demand for good and services.
 Since labour is derived demand, the lack of demand for
goods and services will also lead to a deficiency of
demand for labour.
 There may be reduction in investment, perhaps because of
a fall in business confidence.
 Aggregate demand will fall resulting in a reduction in
national income.
 This is due to increase in the numbers of unemployed, i.e.
demand deficient unemployment.
 Deficient unemployment/ Cyclical
unemployment
 Remedies
 It is possible to use fiscal policy and
monetary policy in order to reduce
demand deficient unemployment.
 Fiscal policy can increase aggregate
demand either through the increase in
government expenditure (G) or by
reduction of taxes (T).
 Real wages unemployment
 This is often referred to as Classical
unemployment after the economists in the
1930s who believed that unemployment
was the result of real wages being too
high.
 Real wages unemployment
 Remedies
 It is not easy to cure this type of unemployment
for it involves the reduction of real wages
which would require agreement between the
government’s trade unions and employers.
 An added problem is that a cut in real wages
would reduce aggregate demand since real
wages influence consumer expenditure.
 A reduction in aggregate demand would lead
to a reduction in equilibrium national income
and therefore create deficient unemployment.
 The economic cost
 The economic cost refers to the lost of output.
 The unemployed labour represents a loss of
resources and with it resulting lower standard of
living.

 The social cost


 Individuals who are unemployed for long
periods of time will be less attractive to
prospective employers and less optimistic about
their employment prospects.
 The cost of exchequer
 Benefits such as unemployment benefit,
social security and housing benefit are
paid to those who are unemployed.
 At the same time, those who become
unemployed no longer pay income tax.
 Therefore, represents a reduction in tax
revenue to the government.
 Is a sustained increase in the general price
level of goods and services in an economy
over a period of time

 Example: If inflation is 3% this year, it mean


in general, general price of good and
services in the economy increased by 3%
 Is a measure of the overall cost of the goods and services bought
by a typical consumer

 Is a statistical estimate constructed using prices of a sample of


representative items whose prices are collected periodically

 The list of item that uses to track the progress of inflation is


known as market basket

 The frictional basket of good must include goods that accurately


represent the needs for an individual to sustain a standard of
living

 Normally, CPI take the value of 100 for base year


 Defined as a sustained increase in the
general level of prices for goods and
services

 Measure by annualized percentage


changes in a general price index (CPI)

 it = CPI t – CPIt-1/ CPI t-1 X 100


 Inflation in the economy can be causes by:
 Demand-pull inflation

 Cost-push inflation
 Import-induced inflation
 Profit push inflation
 Currency inflation
 Happens when the level of aggregate demand grows faster
than the underlying level of supply

 Too much money chasing too few goods, prices are forced
up, therefore causing inflation

 As result, AD curve shift to the right and aggregate price


level increases in the economy
 Causes of demand-pull inflation
 Increase in money supply

 When money supply increase, consumption


and investment increase
 Increase in government expenditure

 Increase in investment

 Decrease in income tax

 Disposable income increase, more money to


spend
 Happens when there was an increase in
cost of production which is independently
of aggregate demand

 When cost of production increase, AS curve


shift to the left resulting an increase in
aggregate price level
 If firms gain more power and are able to push up
prices independently of demand to make more
profit, then this is considered to be cost-push
inflation

 This is most likely when markets become more


concentrated and move towards monopoly or
perhaps oligopoly
 Inflation due to an increase in the price of imports

 When price of imports increase, the cost for firms


that import a significant proportion of their raw
materials or semi-finished products will increase

 The increase in prices of import are due to:


 Exchange rate changes

 Commodity price changes


 Inflation in the economy also can causes by too
much money in the economy

 The causes of inflation on the excessive money


supply

 For an example; excess money supply will result in


too much money chasing after too few goods
 Anticipated inflation is where people predict correctly the
level of inflation and so are able to build it into their
behaviour

 Example: If expected inflation is 5%, worker will ask for


wages increase by 5%

 In this case the effects are not so great as people aren't


surprised by price increases and they can allow for it in their
bids for higher wages. However, there are still costs for the
economy
 Menu cost
 These are the costs to firms of having to
constantly revise their price lists, or price labels
 Higher inflation means more frequent revision of
prices and this can be costly as all your
customers have to be notified
 The more customers you have the more
expensive this is
 Shoe-leather cost
 If the value of money is falling because of
inflation, then people will want to keep their
money in a form earning interest for as long as
possible
 This means more trips to the bank to get cash,
and hence the term 'shoe-leather costs'
 Unanticipated inflation is where people unable to
predict correctly the level of inflation and so are
not able to build it into their behaviour

 Hence, people won’t able to adjust their economic


decision consistent with future price changes

 Hence, the cost of unanticipated inflation will be


more serious than anticipated inflation
 Uncertainty
 Higher inflation tends to fluctuate more and be less
predictable
 This makes life very difficult for firms who want to plan
ahead as much as possible. This uncertainty may
particularly affect their investment plans. Many investment
projects take a long time before they generate returns
 If the level of inflation is unpredictable, then firms will find
it more difficult to work out if the investment will be
profitable. In that case they may simply not bother to take
the risk
 Hence, higher inflation may adversely affect investment,
and this will slow down economic growth in the long run
 Redistribution of income
 Inflation creates an arbitrary redistribution of
income, and is basically unfair
 People who have borrowed money will be better
off as they have less to pay back in real terms.
Savers, on the other hand, will be worse off as
inflation is eroding the value of their savings
 People who own physical assets will also be
better off as their assets price increased with
inflation
 Loss of purchasing power
 Inflation causes the value of an individual dollar
to decrease over time
 Each dollar has less purchasing power with
inflation. Thus, individuals who have the same
wage next year as this year will be able to
purchase less
 Purchasing power can be maintained if wages
increase exactly at the rate of inflation, but this is
not always the case. When wages increase less
than the rate of inflation, people lose purchasing
power
 Is a historical inverse (negative) relationship
between rates of unemployment and
corresponding rates of inflation that result in an
economy.

 It state that there is a tradeoff between inflation


and unemployment.

 This is because when unemployment is low, firms


need to compete for fewer worker by raising
nominal wages. As result, wages cost will increase
and firms have to increase product price as cost
increased.
 In contrast, when unemployment is high, lesser
consumer competing to buy goods and services in
the market, hence price will decrease.

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