INFLATION AND UNEMPLOYMENT

LECTURE NOTES
 Definition of Inflation
 Inflation is usually defined as a sustained increase in
the general price level. This implies that:
‒ Inflation is not a rise in the prices of one or just few
goods, and
‒ it is also not a just one-time rise in the prices of most
commodities.
 Thus, for inflation to be taking place, it is necessary
that the general price level be rising continuously over
a fairly long period of time (several months, year).
 Inflation can also be defined as a decline in the value
or purchasing power of money.
 Definition of Inflation……
 e.g. If general prices increase by 10% in 2011 it also
means that money can buy 10% fewer goods than in
the previous year.
 Therefore inflation leads to a fall in the purchasing
power of money, because prices keep on rising.
 Anticipated and Hyperinflation
 The expected inflation rate is the inflation rate that
people forecast and use to set the money wage rate
and other money prices.
 People use data about past inflation and other
relevant variables to predict inflation.
 On the other hand hyperinflation is a run-away or “out
of control” inflation, a very rapid and high growth rate
of prices.
 Is an extraordinarily high rate of inflation.
 There is no universally accepted cut-off rate of
inflation for hyperinflation.
 Some economists consider 50 percent or higher
monthly inflation as hyperinflation, whereas some
other economists consider an annual inflation rate of
200% or more as hyperinflation.
 Anticipated and Hyperinflation……
 Germany experienced hyperinflation in the 1923
where the price level increased by more than 10
billion fold in just over one year.
 From 2002-2009 Zimbabwe suffered from the second
worst hyperinflation in history ( see table 1).
 Anticipated and Hyperinflation……
 Table 1: Hyperinflation in Zimbabwe
Year Inflation Rate
2002 198.93
In 2009 Zimbabwe
2003 598.75%
abandoned its currency.
2004 132.75% At present in 2012 a
2005 585.84% new currency has yet to
be introduced, so
currencies from other
2006 1,281.11%
countries are used
(source: Wikipedia)
2007 66,212.3%
2008 231,150,888.87%
 If you want to eat in restaurant, please prepare the
money.........
 Hyperinflation in Zimbabwe
Inflation Rate in Tanzania
 The inflation rate in Tanzania was last reported at
19.4 percent in February of 2012.
 Tanzania's inflation rate slowed to 19% in March from
19.4 % a month earlier due to a fall in food and fuel
costs.
 Poor rains across much of Tanzania regions for most of
last year hit food security and electricity output,
triggering spikes in the level of inflation and threatening
economic growth.
 According to the National Bureau of Statistics (NBS),
food prices edged down to 25.7% in March from 26.7 a
month ago, helping push inflation lower.
 Food and alcoholic beverages account for almost half
the total weighting in the consumer price index in
Tanzania.
 Falling food and energy costs are the main reasons for
the decline of the inflation rate in the year to March
2012.
 Retail Price Index
 The retail price index (RPI) is a monthly survey
carried out by the government which measures
price changes.
 The following procedure is used in calculating RPI:
1. A basket of goods and services consumed by the
average family is listed. For example, food,
clothing and transport are included in the basket.
2. The price of items in the basket in the base (first)
year is noted.
3. Each item in the basket is given a number value
(weighted) to reflect its importance to the average
family. For example, food has a higher weighting
than transport.
 Retail Price Index……
3. The price of goods in the basket is recorded every
month compared with base year as a percentage
(price relative) using the equation
Price relative = Current price x 100
Base price
5. The price relative of each item is then multiplied by
its weighting.
 Retail Price Index……
 The new RPI is found using the equation:
 RPI = ∑ (Weightings x Price relative)
Total weightings
 Retail Price Index……
 Table 1. Calculation of the RPI

Basket Weighting Price relative Weighting x price

relative
Food 60 125 7500
Housing 30 120 3600
Transport 10 100 1000

Total 100 12100

 Retail Price Index……
 The value of the price relative in the base year is
always 100.
 Table 1 reveals that, after 12 months the price of food
items have risen by 25% and that of housing by 20%
while the cost of transport is unchanged.
 Table 1 shows how the RPI might then be calculated.
 Retail Price Index……
 The RPI = ∑ (Weightings x Price relative)
Total weightings
= 12100
100
= 121
 Calculating the Rate of Inflation
 The index that measures inflation is called the retail
price index.
 Inflation can be measured as a monthly change, but
the most often quoted figure is the annual change.
 The rate of inflation is the percentage change in the
RPI over the last twelve months and is calculated
using the equation:
 Rate of inflation = Current RPI - Last RPI x 100
Last RPI
 Calculating the Rate of Inflation….
 The value of the RPI in the base year is always 100.
 At the beginning of year two the rate of inflation is:
(121 – 100) x 100 = 21 per cent
100
Problems in Using the Retail Price Index
1. Because the RPI is based on consumption for
average consumer, it does not measure accurately
the change in the cost of living for each and every
individual.
2. The more an individual’s consumption pattern match
to that of the typical pattern used to create a price
index, the better the index will reflect changes in
that person’s cost of living
3. Which items should be included in or excluded from
the basket of goods?
4. Different families have different tastes hence
different weightings. How is an average family
found?
 Problems in Using the Retail Price
Index……
5. Not all regions in the country experience identical
price changes.
6. For a while new products (eg mobile phones) may
not be included in the index (slow to recognize new
products).
7. Hard to measure quality improvements
 Causes of Inflation
 There are various causes of inflation, but the two
main ones are demand pull and cost push.
1. Demand- Pull Inflation
 This occurs if the demand for goods and services
continuously rises faster than their supply.
 Demand-pull inflation occurs when there is 'too much
money chasing too few goods' that is, if demand for
current output exceeds supply.
 Causes of Demand pull inflation
 Excess Money supply
 Many economists argue that one of the main causes of
inflation is excessive money supply growth.
 The origins of this theory is from Monetarist Economists
(Milton Friedman).
 The Monetarists believe that inflation is caused by the
increase in aggregate demand which is influenced by
the amount of money in the economy, namely the
money supply.
 In particular when the monetary authorities permit an
excessive growth of the supply of money in circulation
beyond that needed to finance the volume of transactions
produced in the economy.
 They argue that excess money supply cause spending
power of the population to exceed the capacity of the
country to produce goods and services which in turn
causes inflation.
 Causes of Demand pull inflation….
 This is shown by the shift of the short-run
aggregate demand curve diagram1.
 Causes of Demand Pull inflation….
Quantity theory of money
 The Monetarists view of inflation can also be stated in
the following equation:
MV = PT
Where M = Money supply
V = the velocity of circulation (the
number of times each shilling changes
hands)
P = the average price of goods
T = the number of goods bought
(transactions)
 Causes of Demand pull inflation….
 Monetarists believe that the value of V and T are
fixed so that any increase in M (money supply),
must raise P (the level of prices) i.e. inflationary.
 Causes of Demand pull inflation….
 The role of the budget deficit
 The Monetarists identify the budget deficit as one of
the main cause of inflation.
 If government spending exceeds government revenue
printing more money or borrowing are inevitable.
 Both result in increases in the amount of money
supplied.
 The Non- Monetarist View of Inflation
 The non-monetarists (Keynesians) put forward two
possible explanations of inflation.
 First, they recognize that increases in aggregate
demand may lead to demand pull inflation.
 Increases in spending in excess of the full employment
level of output will create shortages and firms will
raise their prices.
 The Non- Monetarist View of Inflation
 2. Cost Push Inflation
 The second cause of inflation is knows as cost push
inflation.
 The non- monetarists also suggest that one of the
main causal factors of inflation is an increase in the
costs of the factors of production.
 Cost-push inflation happens when firms' costs go up.
 To maintain their profit margins, firms then need to
put their prices up.
 There are many reasons why production costs might
rise:
1. Rising imported raw materials costs
‒ Exchange rate changes can affect firms' costs, particularly
if they import many of their raw materials.
‒ Exchange rate depreciation will increase import prices and
may therefore increase firms’ costs.
2. Rising labour costs - caused by wage increases which
exceed any improvement in productivity.
‒ This cause is important in those industries which are
‘labour-intensive’.
‒ Firms may decide to pass these higher costs to their
customers by rising prices of goods and services
3. Higher indirect taxes imposed by the government –
for example a rise in the rate of excise duty on alcohol
and cigarettes, an increase in fuel duties or perhaps a
rise in the Value Added Tax.
‒ These taxes are levied on producers (suppliers) who,
depending on the price elasticity of demand and supply
for their products, can opt to pass on the burden of the
tax to consumers.
 Causes of Cost-push inflation……
4. Changes in interest rates can also affect firms costs
if they have borrowed significant amounts.
 Interest rate increases will increase the cost of
borrowing.
5. The removal of subsidies.

 Cost push inflation can be shown using the aggregate

demand and aggregate supply curves.
 Note that: In this case it is not the aggregate demand
that increases; it is the aggregate supply curve that
shifts to the left, as shown in the diagram.
Cost-push inflation……
 The Problems Associated with Inflation
 High or unpredictable inflation rates are regarded as
harmful to an overall economy
 High inflation rate will not only affect individuals, but
will also cause problems for the whole economy.
 The costs of inflation include:
1. Rising prices creates uncertainty.
 In a climate of uncertainty both domestic and
foreign entrepreneurs will be reluctant to invest.
This will slow down the potential for economic
growth.
 The Problems Associated with
Inflation…….
2.Low savings is a factor contributing to the cycle of
poverty.
 During periods of inflation households that do have
surplus funds are reluctant to save.
 Inflation erodes the real value of saving and hence
there is less incentive to forego current
consumption.
 Decreasing levels of savings and hence of
investment will lead to a decline in economic
growth and development.
 The Problems Associated with
Inflation…….
3. Inflation will lead to increases in nominal interest
rates.
 The real value of interest payments will be eroded
with inflation and thus banks and financial
institutions will have to raise their nominal interest
rates in order to try to persuade people to keep
their money deposited with banks.
 Increases in interest rates will make the cost of
acquiring credit higher.
 This will cause firms to cut back on investment.
 The Problems Associated with
Inflation…….
4. Income redistribution
 Many people who have fixed incomes, particularly
those on pensions will suffer.
 The higher the level of inflation the less their
income will be worth.
 This effect can also happen among people who are
working, as their incomes go up slower than
inflation. These effects can arbitrarily redistribute
income.
 The Problems Associated with
Inflation…….
5. Menu costs - this is a general term for all the
inconvenient costs that businesses and individuals
face.
 As prices increase they have to redo their price
lists, change price labels, reprint menus and so on.
6. Competitiveness - if our prices are increasing faster
than those in other countries, then our goods will be
less competitive and less in demand. This will have a
negative effect on the balance of payments.
Benefits of Inflation: Is it always bad?
 Not everyone suffers from inflation.
 Low level of inflation (no more than 5% per annum)
may bring the following benefits to the society:
1. Firms are able to increase prices and profits before
they pay out wages.
2. Low levels of inflation will often result in firms
experiencing increases in profitability. This will
provide funds for investment purposes.
3. Inflation will erode the real value of loans that have
been taken out and therefore may make repayment
of existing loans easier.
 Remedies of Inflation
 Demand-pull Remedies
1. To counter this and keep inflation down, you may
need to reduce the level of demand. You can do this
by using deflationary policies. These could include:
 Reduce government spending.
 Increase income tax to reduce consumer
spending.
 Reduce people’s ability to borrow money by
increasing interest rates and tightening credit
regulations.
 Remedies of Inflation…..
 Cost-push Remedies
1. To reduce cost of production such as:
 Reduce indirect taxation, oil price etc.
 Increase production
 Providing subsidies
 Seminar Questions
1. What are the causes of inflation?
2. Briefly list and explain the six most important
consequences of inflation.
3. Is inflation a necessary evil? Discuss
4. Assignment (5 marks): Visit the web site of BOT,
World Bank and other sources :
a) Find the trend of Inflation rate in Tanzania for the past
10 years
b) Discuss the major causes of inflation in Tanzania
c) Based on the causes in part (b), what do you consider
to be the remedies for inflation
 UNEMPLOYMENT
1. Definition of unemployment
2. Measurement of unemployment
3. Causes of unemployment
4. Phillips curve (inflation and unemployment)
 The Concept of Unemployment
 Unemployment as defined by the International Labour
Organization (ILO) is the number of people (of working age)
who are willing and available to work at current wage rates,
but not currently employed.
 To be unemployed one must be looking for work
 In a 2011 news story, English Business Week reported that
more than 200 million people globally are out of work.
 Almost two-thirds of advanced economies and half of
developing countries are experiencing a slowdown in
employment growth.
 How is Unemployment Measured?
 The unemployment rate is a measure of the prevalence of
unemployment and it is calculated as a percentage by dividing
the number of unemployed individuals by all individuals
currently in the labour force
 Unemployment Rate = Number of unemployed X 100
Total Labour Force
 In calculating unemployment rate data from Labour Force
Sample Surveys are used:
 These data are chosen in calculating unemployment rate since
they give the most comprehensive results and enables
calculation of unemployment by different categories such as
race and gender.
 These data are the most internationally comparable.
Unemployment Rate in Tanzania
 The unemployment rate in Tanzania was estimated at 10.7
percent in January 2012.
 In Tanzania, unemployment rate is defined as a number of
unemployed people divided by the labour force.
 The labour force is defined as the number of people employed
plus the number unemployed but seeking work.
Types of Unemployment
 Economists categorize unemployment in
the following Groups:
 Demand-deficient or Cyclical unemployment
(Keynesian Economists)
 Frictional or Search unemployment
 Structural unemployment
 Seasonal unemployment
 Classical Unemployment
  Demand-deficient or cyclical unemployment
 Demand-deficient unemployment occurs when there is not
enough demand to employ all those who want to work.
 It is a type that Keynesian economists focus on, as they believe
it happens when there is a disequilibrium in the labour market
(demand for labour exceeds supply of labour)
 It is not a matter of workers engaging in normal job search or
lacking the correct skills; in this case, the number of
unemployed people exceed the number of job vacancies
 It is also often known as cyclical unemployment because it
varies with the trade cycle.
 When the economy is booming, there will be more
demand and so firms will be employing large
numbers of workers.
 Demand-deficient unemployment will at this stage of
the cycle be fairly low.
 If the economy slows down, then demand will begin
to fall.
 When this happens firms will begin to lay workers off
as they do not need to produce so much.
  Frictional or search unemployment
 Frictional Unemployment is associated with the normal
turnover of people and jobs in the labour market and can be
thought of as unemployment that would prevail even in a well-
functioning labour market
 In modern economies; young people enter the labour force
each year while others retire or leave the labour force; new
jobs open up in some firms and disappear in other firms
 As a consequence, unemployed workers and unfilled job
vacancies will coexist at any point in time
 It takes time for an unemployed person to find a suitable job
and for an employer to find a suitable employee to fill a job
vacancy
 On average it will take everybody a reasonable period of time
as they search for the right job.
 This creates unemployment while they look for other
jobs.
 The more efficiently the job market is matching
people to jobs, the lower this form of unemployment
will be.
 However, if there is imperfect information and people
don't get to hear of jobs available that may suit them
then frictional unemployment will be higher.
 The better the economy is doing, the lower this type
of unemployment is likely to be.
  Structural unemployment
 Structural Unemployment arises when the unemployed do not
have the skills, training, work experience, or geographic
preferences to fit into any of the existing job vacancies in the
economy
 The problem of structural unemployment is always present in a
dynamic economy as technological progress and changing
demand patterns cause different rates of employment growth
in different occupations, industries and regions
 The remedies for structural unemployment often require the
unemployed worker to retrain and acquire new skills, to
change occupations, or to relocate to find a job (all of which
are costly and time-consuming)
 For instance in the developed countries such as UK, USA and
Canada, many industries (mining and shipping) that were once
major employers have now disappeared.
 The extent of structural unemployment will depend on various
things:

 Mobility of labour - if people are able to quickly switch

jobs from a declining industry to a rapidly growing one,
then there will be less structural unemployment.
 The pace of change in the economy - the faster the changes
taking place in people's tastes and demand and supply, the
more structural unemployment there may be as industry has
to adapt more quickly to change.
 The regional structure of industry - if industries that are
dying are heavily concentrated in one area, then this may
make it much more difficult for people to find new jobs.
  Seasonal unemployment
 Seasonal unemployment is fairly self explanatory.
 It tends to include people who are demanded for a short period
of the year, and the rest of the year would certainly be
classified as seasonally unemployed.
 Industries that suffer particularly are: hotel and catering,
tourism and agriculture
 Seasonal unemployment resembles demand-deficient
unemployment except that the shortage of jobs is restricted to
a certain season in the year
 Seasonal unemployment can also resemble structural
unemployment as some seasonally unemployed workers may
not have the skills or training to qualify for available jobs
during the off-season and may be unwilling to move to another
region to find a non-seasonal job
  Classical Unemployment
 Classical or real-wage unemployment occurs when real wages
for a job are set above the market-clearing level, causing the
number of job-seekers to exceed the number of vacancies.
 For example, minimum wage laws raise the cost of labourers
above the market equilibrium, resulting in more people who
wish to work at the going rate than the actual demand.
 Laws restricting layoffs made businesses less likely to hire in
the first place, as hiring becomes more risky, leaving many
young people unemployed and unable to find work.
 However, this argument is criticized for ignoring numerous
external factors and overly simplifying the relationship
between wage rates and unemployment
 Natural Rate of Unemployment
 Natural rate of unemployment — This is the
summation of frictional/search and structural
unemployment.
 It is the lowest rate of unemployment that a stable
economy can expect to achieve.
 Economists do not agree on the natural rate, with
estimates ranging from 1% to 5%
 The estimated rate varies from country to country and
from time to time.
Voluntary and Involuntary Unemployment
 Voluntary unemployment is attributed to the individuals
decisions, whereas involuntary unemployment exists because
of the socio-economic environment (including the market
structure, government intervention, and the level of aggregate
demand) in which individuals operate.
 In these terms, much or most of frictional/search
unemployment is voluntary, since it reflects individual search
behaviour.
 Voluntary unemployment includes workers who reject low
wage jobs
 Involuntary unemployment includes workers fired due to an
economic crisis, industrial decline, company bankruptcy, or
organizational restructuring.
 Therefore, cyclical unemployment, structural unemployment,
and classical unemployment are largely involuntary in nature.
 Causes of Unemployment
 Given the diverse nature of unemployment, there is no single
explanation of why the unemployment rate should be at a
particular level and there is no single policy prescription that
will yield "full employment"
 There are many different possible causes of unemployment,
and unfortunately for governments, it is not easy to identify
which is the most important and what to do about it.
 The causes of unemployment can be split into two main types:
1. Demand-side
2. Supply-side
 Demand side
 The first cause of unemployment (demand-side) is simply a
lack of aggregate demand.
 When there isn't enough demand employers will not need as
many workers, and so demand-deficient unemployment results.
 Keynesian economists in particular focus on this cause.

 Supply side
 Unemployment caused by supply-side factors results from
imperfections in the labour market.
 It may happen because there is poor information about job
opportunities.
 This will lead to people taking a long time looking for jobs,
increasing the level of frictional or search unemployment.
 In a situation of perfect information, labour market will always
clear and all those looking for work will be working - supply
will equal demand.
 Unemployment caused by supply-side factors may
also happen if the market doesn't clear properly.
 This occurs when wages don't fall properly to clear
the market. This is shown in the diagram below:

Q3
 Wages are initially too high and so unemployment of
ab results (supply is greater than demand).
 To get rid of this unemployment and clear the market
wages should fall.
 Costs of Unemployment
 Micro-effects
 Perhaps the main costs of unemployment are personal to those
who are unemployed.
1. Individuals may become dispirited by unemployment, they
may lose their self-esteem and confidence.
2. The longer they are unemployed the more they may lose
their skills and this may be bad for the economy as well.
3. On top of that these problems (and financial ones) often
lead to the unemployed being less healthy
 Macro effects
 The whole economy suffers from people being unemployed
such as:
1. Loss of output to the economy - the unemployed could be
producing goods and services and if they aren't, then GDP
will be lower than it could be.
2. Loss of tax revenue – Since unemployed people are not
earning and they therefore are not paying tax. It is the
government that lost out.
3. Increase in government expenditure - the government has
to pay out benefits to support the unemployed.
4. Loss of profits - with higher employment firms are likely to
do better and make better profits. If they make less profit
because of unemployment, they may have less funds to
invest.
 INFLATION, UNEMPLOYMENT AND
PHILIPS CURVE
 Macroeconomic policies are implemented in order to achieve
government’s main objectives of full employment and stable
economy through low inflation.
 Philips Curve is used as a tool to explain the trade-off between
these two objectives.
 You already know that the Inflation is defined by increase in
the average price level of goods and services over time.
 When there is inflation, value of money falls. A low inflation
rate indicates that average price of goods would not rise as
high.
 Unemployment exist when someone is actively seeking for job
but unable to find any despite their willingness to accept the
going market wage rate
 Inflation and Unemployment

Inflation (%)

Phillips Curve
8%

2%

2% 8% Unemployment
 Phillip curve demonstrates the inverse relationship
between unemployment rates and inflation rates
 Inflation rate ↑ → Unemployment ↓ (when AD
increases, there is a upward pressure on prices and
unemployment therefore decreases)
 Inflation rate ↓ → Unemployment ↑ (when AD
decreases, there is a downward pressure on prices and
unemployment therefore increases)
 Thus, the relationship is inverse as shown by the
graph