Macroeconomic Variables - relating inflation and unemployment.pptx

A slideshow making it easy to understand the relation between inflation and unemployment.

1. Macroeconomics – Relating inflation and unemployment

2. Background information Macroeconomics → The branch of economics that studies the behavior, performance, and structure of the whole economy rather than individual markets. Economic Growth → Increase in the production of goods and services over time, usually measured by GDP. Economic Development → Improvements in living standards, education, healthcare, and reduction of poverty. Economic Stability → Avoidance of sharp fluctuations in output, employment, and prices, ensuring predictable economic conditions. Full Employment → Operating at maximum productive capacity, meaning full employment of labor and resources, discounting natural rate of unemployment. Balance of Payments Stability → Maintaining equilibrium in trade, services, and financial flows with other countries to prevent long-term deficits or surpluses.

3. Core understanding Inflation refers to a sustained general increase in the prices of goods and services in an economy. Unemployment refers to percentage of labour force that are actively looking for jobs but are unemployed. The recurring sequence of growth and decline in an economy’s overall activity over time. It shows how production, employment, and income rise and fall in a predictable pattern, moving through four main phases: 1. Expansion – The economy grows, jobs increase, and incomes rise. 2. Peak – Growth reaches its highest point before slowing. 3. Contraction (Recession) – Economic activity slows, unemployment rises, and production drops. 4. Trough – The economy hits its lowest point before starting to recover.

4. Types of inflation Demand-Pull Inflation – Arises when aggregate demand exceeds aggregate supply, at full employment level of output. Cost-Push Inflation – Triggered by rising production costs (e.g., wages, raw materials), mostly by supply shocks. Built-In Inflation – Results from a wage–price spiral, where higher wages push up prices, prompting demands for higher wages again. Hyperinflation – Extremely rapid and uncontrollable price rises, inflation rates exceed 50% a month. Stagflation – Inflation coexisting with stagnant growth and high unemployment. Deflation – Persistent fall in prices of goods and services, harmful for growth.

5. Types of unemployment Frictional Unemployment – Temporary, due to job transitions or new entrants to the labor force. Structural Unemployment – Mismatch between skills and job requirements. Cyclical Unemployment – Linked to downturns in the business cycle. Seasonal Unemployment – Occurs in industries with seasonal demand (e.g., agriculture, tourism). Disguised Unemployment – More workers are employed than actually needed, common in developing economies. Long-Term/Chronic Unemployment – Persistent, often tied to deep economic inefficiencies.

6. Why inflation and unemployment matter? Erode Purchasing Power: High inflation lowers the value of money, hurting fixed-income groups. Reduce Real Income & Profits: Inflation cuts household income and firm revenues → weaker aggregate demand → lower GDP. Distort Savings & Investment: Inflation discourages saving and creates uncertainty for investors. Cause Inequality: Inflation hits the poor hardest; unemployment reduces income security for all. Waste Human Capital: Unemployment leads to lost output, skill erosion, and long-term productivity decline. Undermine Policy Credibility: Persistent inflation or joblessness weakens trust in government and central banks.

7. The Phillips curve As seen in the curve, as the rate of inflation rises the rate of unemployment falls, in a linear manner. The relation is: low unemployment –> lower labour force to choose from –> higher competition for labour among firms –> higher wages –> higher inflation –> higher cost of production for firms –> higher prices to recover profits

8. However, the relationship is more nuanced The Philips curve only proves true in the short term. In the long term, as unemployment always returns to natural rate, attempts to lower it further accelerate inflation without reducing unemployment permanently. Basically, inflation depends on cost of prices of goods and services, and cost of prices of goods depend on firm cost of production, consisting of labour wages and raw material costs of obtaining and logistics. In case of high unemployment, there is higher competition amongst unemployed candidates, and they are ready to work at lower wages – lowering firms cost of production. Alternatively, in case of low unemployment workers receive higher wages since firms compete. This affects inflation rates. In the short term, wages are sticky and production costs are constant – due to wage contracts. But, in the long term, workers, due to inflation, demand higher wages, adjusting cost of production to inflation rate, lowering firm profits again, causing firms to fire workers to maintain margins, leading to the unemployment resetting to the natural rate.

9. Short term analogy Short term: Think of unemployment and inflation as two sides of a seesaw. One goes up, other goes down, or vice versa. Both are linearly inverse related. Inflation Unemployment

10. Long term analogy Long term: The rocking chair is unemployment, whereas its motion represents inflation rate fluctuations. Consider the swing rocking – inflation rate changing, in the case of recording the position after a short time period the rocking chair might be in an unstable position, however, in a long time period, the rocking chair always returns and stabilises at the original position – in the long term the unemployment always returns to the natural rate. Natural rate of unemployment Inflation rate fluctuation