Macroeconomics lecture week 1 Macroeconomics and trade-off of between
unemployment and inflation
Macroeconomics
What is macroeconomics
Macros (big), the bigger picture. “Study of (the laws that govern) big household”.
Macroeconomic is about aggregated variables: unemployment, inflation, interest rates, exchange rates,
economics growth etc of a country.
When was macroeconomics invented?
Discovery of macro economy in 1930s by John Maynard Keynes
Keynes: during a time of recession, a government should spend more money, not cut budgets
Problems: (concepts hard to measure)
Gross national product (GDP) (Discussed in the Workgroup) see page 6 of the document), Unemployment,
Inflation, Aggregated demand, Business cycle
What is unemployment?
• Definition:
According to Krugman & Wells, unemployment means: jobless, looking for a job and available for
work.
• How to measure unemployment:
- Survey’s (sample)
- Claimant count (number receiving benefits)
➢ Unemployment rate= number of unemployed workers x 100
labour force
Labour force= sum of workers and unemployed between 16 and 65
• Explanations for unemployment:
- laziness
- no incentive to work (benefits are too high)
- wages are too high – excessive wage demands unions
- credit crisis (building sector declines)
- emerging competitor countries (China through outsourcing, de-industrialisation in EU and
USA)
- budget cuts government (Greece)
- overrated currency (Italy)
- covid lock down
2 theories on unemployment
1. Microeconomic Theory
Neoclassical theory
• Unemployment= balancing utility of work (wage) and disutility work (fatigue, giving up leisure)
Optimum: where marginal benefit equals marginal cost: MB=MC
Neoclassicals on unemployment:
If labour market works well: “no” unemployment.
,Kinds of unemployment according to the Neoclassicists:
1) Frictional unemployment: i.e. ‘matching’ in the labour market takes time.
➔ Unemployment is short term problem and therefore no government intervention is needed.
2) Structural unemployment: when there are more people seeking jobs in a particular labour market
than there are jobs available at the current wage rate.
(that is = the economy is not in a recession or crisis)
➔ Wage rate persistently above WE
Why is the wage rate too high?
- Unions
- Minimum wages
- Employment protection legislation
- Unemployment benefits
- Wedge (difference gross – nett salary)
➔ Unemployment is voluntary
Do machines cause persistent unemployment?
In the short term, yes. In the long term, no because new jobs will be created.
Summery neoclassical theory:
If there is unemployment, it consists of:
- Frictional unemployment (can’t be solved)
- Unemployment due to too high wages (accept lower wages)
Cause of unemployment is the worker / trade union (better accept lower wages)
The business cycle
Another cause of unemployment is the business cycle.
A business cycle has a peak and a through, but overall it’s a rising line.
➔ The increasing rise in output over the years is possible through technological progress
,2. Macroeconomic Theory
Keynesian theory
In 1936, there was a Keynesian revolution.
Problem of unemployment, according to Keynes:
Insufficient effective demand (aggregate demand)
• Products remain unsold (there is overproduction)
• Companies lay off workers
• Even less demand for products
• Government cuts budget
• Even less demand for products
Keynes: the economy is not working at full capacity
- Cyclical unemployment (caused by the business cycle)
- Involuntary unemployment
- Government can actively combat unemployment
How to fight unemployment according to Keynes?
➔ Expansionary fiscal policy (stimulate economy)
Kinds of unemployment according to Keynes:
• Frictional unemployment
• Structural unemployment
• Cyclical unemployment (business cycle)
Natural rate of unemployment (according to Friedman):
=Frictional unemployment + Structural unemployment
Inflation
CPI
Inflation
Inflation is the average raise in prices of goods and services consumer buy.
How to measure it?
You can measure the rise in the Consumer Price Index (CPI) in a certain time period. In the CPI are the
consumer goods for a daily living.
How to calculate inflation?
➢ Price index= cost of market basket in given year x 100
cost of market basket in base year
➢ Inflation = price index year 2 - price index year 1 x 100
price index year 1
Other price indexes
Producer price index (PPI) GDP deflator CPI-index (most often used)
No explanation given in the Measures average prices of all Measures average prices of the
lecture. new, domestically produced typical expenditure basket of an
final goods and services in the (urban) consumer
economy
Winners and losers of inflation:
If inflation is higher than expected, debt becomes less: inflation is beneficial for borrowers ->
governments
inflation= ‘tax on having money’, the rich pay more ‘taxes’.
, Philips curve (Unemployment and Inflation)
A graph that resembles the unemployment and inflation.
➔ The Phillips curve states that inflation and unemployment have an inverse relationship.
Higher inflation is associated with lower unemployment and vice versa.
Short-run Philips curve (SRPC)
Suggests a trade-off between unemployment and inflation.
Why is there a negative short-run relationship between the unemployment rate and the inflation rate?
The short-run aggregate supply curve shows that when a rightward shift of the aggregate demand curve
leads to an increase in the aggregate price level, real GDP increases as well.
➔ There is a positive relationship between the aggregate price level and the real GDP.
How is this related to unemployment?
There is a negative relationship between real GDP and the unemployment rate; Okun’s law states that
when the real GDP is higher than potential output, the unemployment rate will be lower than when real
GDP is below potential output.
➔ Increases in the aggregate price level are associated with increases in real GDP, which in turn
tend to lead to lower unemployment rates.
Friedman (1968):
• No trade-off between unemployment and inflation
• Inflation only determined by money supply
• Money supply has no effect on real variables (Employment, output growth, etc).
Expected inflation and Phillips Curve
- People and firms have expectations about future inflation and act according to these expectations
Workers:
Expected inflation > current inflation
Raise wage demands
Firms:
Expected inflation > current inflation
Raise prices of their products
➔ Higher expectations raises current inflation
