Chapter 12: Inflation and Unemployment

Maintaining stable prices and a low unemployment rate are key policy goals for every nation. This chapter covers the causes of unemployment and inflation and their correlation.

1. Unemployment

(1) Types of Unemployment

Frictional Unemployment: Temporary unemployment occurring during job transitions or job searches (Voluntary).
Structural Unemployment: Occurs when there is a mismatch between the skills of job seekers and the skills required by employers due to changes in industry structure or technological innovation.
Cyclical Unemployment: Unemployment caused by a recession (lack of aggregate demand).

(2) Natural Rate of Unemployment

The rate of unemployment that exists when cyclical unemployment is zero (Frictional + Structural unemployment).
The normal level of unemployment that an economy maintains in the long run.

(3) Okun’s Law

Describes the inverse relationship between unemployment and real GDP. An empirical law stating that for every 1% point increase in the unemployment rate, GDP falls by approximately 2-3% points.

2. Inflation

A continuous increase in the general price level.

Demand-Pull Inflation: Caused by aggregate demand exceeding aggregate supply (Economic overheating).
Cost-Push Inflation: Caused by rising raw material prices or wages (The cause of stagflation).
Expected vs. Unexpected Inflation: In the case of the latter, an unfair redistribution of wealth and income occurs (Lenders lose, Borrowers gain).

3. Phillips Curve

A curve representing the relationship between the unemployment rate and the inflation rate.

Short-Run Phillips Curve: An inverse (trade-off) relationship exists between the unemployment rate and the inflation rate. (To curb inflation, one must accept higher unemployment)
Long-Run Phillips Curve: In the long run, as people’s expectations reflect in prices, the Phillips curve becomes a vertical line at the natural rate of unemployment. Thus, in the long run, unemployment cannot be reduced through monetary policy.

Key Checklist

What is the term for temporary unemployment that occurs while moving between jobs? (Answer: Frictional Unemployment)
If unexpected inflation occurs, who benefits more: the lender (creditor) or the borrower (debtor)? (Answer: Debtor)
Why is the Long-Run Phillips curve vertical? (Answer: Because people fully anticipate changes in the price level)
What is the name of the law that explains the relationship between unemployment and GDP? (Answer: Okun’s Law)

Inflation and Unemployment