Business Cycles, Unemployment, and Inflation Notes
9.1 Phases of the Business Cycle
Four phases of the business cycle are identified as follows
- A peak is when business activity reaches a temporary maximum with
full employment and near-capacity output. - A recession
is a decline in total output, income, employment, and trade lasting six months or more. - The trough is the bottom of the recession period.
- Recovery is when output and employment are expanding toward full
employment level.
9.2What is Unemployment:
Unemployment generally refers to a state/situation where factors of
production (resources) are readily available and capable of being
utilized at the ruling market returns/rewards but they are either
underemployed or completely unengaged. When referring to labour,
unemployment is considered to be a situation where there are people
ready, willing and able to work at the going market wage rate but they
cannot get jobs. This definition focuses only on those who are
involuntarily not employed. It is noteworthy to mention here that all
countries suffer unemployment but most developing countries experience
it at relatively higher degree, and the following can be some of the causes.
9.2.1 Types and Causes of Unemployment
- Transitional unemployment: Transitional unemployment is that
situation which prevails due to some temporary reasons. The main reason
for this type of unemployment are:
Turnover unemployment: Some individuals leave their present jobs and
make efforts to secure better ones and in this way, they remain
unemployed for some time.
Casual unemployment: Casual workers are employed for a specific job and
when the job is competed, such workers become eventually unemployed.
E.g. shipping or building construction workers.
Seasonal unemployment: Some industries, for instance have seasonal
demand and their produce is manufactured for a specific period of time
(a specific period of the year). The workers of such industries remain
unemployed for that time e.g. ice factories may remain closed during winter.
- Structural unemployment: Caused by structural changes such that there
exist:
Cyclical unemployment: During depression, prices are too low and profit
margins remain distinctively low. In this case, investment decreases and
unemployment increases.
Technological unemployment: Due to inappropriate technology. Technology
is not inappropriate per se but in relation to the environment in which
it is applied. In most developing countries, most production structures
tend to be labour saving (capitalintensive), which is not appropriate as
these countries experience high labour supply. Capital – labour ratios
tend to be high in these countries implying that less labour is absorbed
compared to capital in production undertakings causing unemployment.
Industrial change: The establishment of new industries decreases the
demand for the products of existing industries e.g. the rapid increase
in the demand for Japanese industrial products is one reason for greater
unemployment in some European countries.
Keynesian unemployment: According to Keynesian theory of income and
employment, unemployment occurs due to lack of effective demand. If
effective demand is less, production of goods and services will fall
which will further result in the unemployment of labour. Another feature
of Keynesian unemployment is that unemployment of labour is associated
with unemployed capital such as plant and
machinery which tend to be idle during depression.
Urban unemployment: Due to availability of more facilities in urban
areas, more and more people tend to move to these areas. The employment
opportunities are not sufficient to absorb all those people who settled
in the urban areas. This kind of unemployment is therefore due to
rural-urban migration.
Disguised unemployment: Situation where some people are employed
apparently, but if they are withdrawn form this job, total production
remains the same. In most developing countries this type of unemployment
is estimated at 20 to 30% and measures should be taken to employ such
people in other sectors of the economy.
- Insufficient Capital: Shortage of capital is a hindrance in the
establishment of more industries and other productive installations, and
due to this reason, more employment opportunities are not created. - Nature of education system: Education systems for most developing
countries are whitecollar oriented, yet the nature of productive
capacities of these economies are not sufficiently supportive. Moreover,
inadequate education and training facilities render(s)
most people unable to secure those job opportunities that require high
skills and specialized training. - Rapidly increasing population: The rate of growth in population
exceeds the amount of job opportunities that the economy can generate.
Thus in summary, of the causes of unemployment in developing countries
can be said to include:
- Rapidly increasing population
- Inappropriate technology
- Insufficient capital base
- Demand deficiency/structural changes
- Presence of expatriates
- Education Systems – white-collar orientation
- Rural-urban migration
- One person for more than one job
- Corruption and general mismanagement
- Inadequate knowledge on market opportunities
Cost of Unemployment
Unemployment is a problem because it imposes costs on society and the
individual. The cost of unemployment to a nation can be categorized
under three headings: the social costs, the cost to the exchequer and
the economic cost.
The Social Cost of Unemployment
- For the individual, there is the demoralizing effect which can be
devastating particularly when they are old. This is because as some
job seekers become more and more pessimistic about their chances of
finding a job, so their motivation is reduced and their changes of
succeeding in finding jobs become even more remote. - Many of the longer-term unemployed become bored, idle, lose their
friends and suffer from depression - There is also evidence of increased family tension leading in some
cases to violence, infidelity, divorce and family breakups. - Unemployment may also lead to homelessness, as in some circumstances
building societies may foreclose on a mortgage if the repayments are
not kept up. - Long-term unemployment may also lead to vandalism, football,
hooliganism and increases in the crime rate and insecurity in general.
The cost to the exchequer (Ministry of Finance)
- There is increasing dependency ratio on the few who are employed in
the form of: - The loss of tax revenues which would otherwise have been received:
This consists mostly of lost income tax but also includes lost
indirect taxes because of the reduction in spending. - The loss of national insurance contributions which would otherwise
have been received
The economic cost
Unemployment represents a terrible waste of resources and means that the
economy is producing a lower rate of output than it could do if there
were full employment. This leads to an output gap or the loss of the
output of goods and services as a result of unemployment.
REMEDIES FOR UNEMPLOYMENT
The measures appropriate as remedies for unemployment will clearly
depend on the type and cause of unemployment. Broadly they can be
divided into:
- Demand management or demand side policies
- Supply side policies.
Demand Management policies
These policies are intended to increase aggregate demand and, therefore
the equilibrium level of national income. They are sometimes called
fiscal and monetary policies. The principal policy instruments
are:
- Supporting declining industries with public funds
- Instituting proper demand management policies that increase
aggregate demand including
exploiting foreign and regional export markets. This can be done by
increasing government expenditure, cutting taxation or expanding the
money supply. - Promoting the location of new industries in rural areas which will
require an improvement of rural infrastructure.
Supply-side policies
Supply-side policies are intended to increase the economy‘s potential
rate of output by increasing the supply of factor inputs, such as labour
inputs and capital inputs, and by increasing productivity. They include:
- Increasing information dissemination on market opportunities.
- Reversing rural-urban migration by making rural areas more
attractive and capable of providing jobs. This particularly is the
case in developing countries where rural-non-farm opportunities
offer the longest employment opportunities. - Changing attitude towards work i.e. eliminating the white-collar
mentality and creating positive attitudes towards agriculture and
other technical vocational jobs. - Provision of retraining schemes to keep workers who want to acquire
new skills to improve their mobility. - Assistance with family relocation to reduce structural unemployment.
This is done by giving recreational facilities, schools, and the
quality of life in general in other parts of the country even the
provision of financial help to cover moving costs and assist with
home purchase. - Special employment assistance for teenagers many of them leave
school without having studied work-related subjects and with little
or no work experience. - Subsidies to firms which reduce working hours rather than the size
of the workforce. - Reducing welfare payments to the unemployed. There are many
economists who believe that welfare payments have artificially
increased the level of unemployment. - Reduction of employee and trade union rights.
9.3 What is Inflation?
Definition: Inflation is a rising general level of prices (not all
prices rise at the same rate, and some may fall).
Causes and Theories of inflation:
- Demand-pull inflation: Spending increases faster than production. It
is often described as ―too much spending chasing too few goods.‖ - Cost-push or supply-side inflation: Prices rise because of rise in
per-unit production costs (Unit cost = total input cost/units of output).
- Output and employment decline while the price level is rising.
- Supply shocks have been the major source of cost-push inflation.
These typically occur with dramatic increases in the price of raw
materials or energy.
Complexities: It is difficult to distinguish between demand-pull and
cost-push causes of inflation, although cost-push will die out in a
recession if spending does not also rise.
Redistributive effects of inflation:
The price index is used to deflate nominal income into real income.
Inflation may reduce the real income of individuals in the economy, but
won‘t necessarily reduce real income for the economy as a whole (someone
receives the higher prices that people are paying). Unanticipated
inflation has stronger impacts; those expecting inflation may be able to
adjust their work or spending activities to avoid or lessen the effects.
Fixed-income groups will be hurt because their real income suffers.
Their nominal income does
not rise with prices. Savers will be hurt by unanticipated inflation,
because interest rate returns may not cover the cost of inflation. Their
savings will lose purchasing power. Debtors (borrowers) can be helped
and lenders hurt by unanticipated inflation. Interest payments may be
less than the inflation rate, so borrowers
receive ―dear‖ money and are
paying back ―cheap‖ dollars that have less purchasing power for the lender.
If inflation is anticipated, the effects of inflation may be less
severe, since wage and pension contracts may have inflation clauses
built in, and interest rates will be high enough to cover the cost of
inflation to savers and lenders. ―Inflation premium‖ is amount that
interest rate is raised to cover effects of anticipated inflation. ―Real
interest rate‖ is defined as nominal rate minus inflation premium. (See
Figure 26.5)
Output Effects of Inflation
- Cost-push inflation, where resource prices rise unexpectedly, could
cause both output and employment to decline. Real income falls. - Mild inflation (<3%) has uncertain effects. It may be a healthy
by-product of a prosperous economy, or it may have an undesirable
impact on real income. - Danger of creeping inflation turning into hyperinflation, which can
cause speculation, reckless spending, and more inflation (see
examples in text of Japan following World War II, and Germany
following World War I).
9.4 Inflation and Unemployment
For many years it was believed that there was a trade-off between
inflation and unemployment i.e. reducing inflation would cause more
unemployment and vice versa. This relationship was explained using a
simple Keynesian model using a diagram as follows:
The model was developed in the 1930s when there was large-scale
unemployment which led Keynes to focus on the problem of the
―deflationary gap‖. This situation in which aggregate spending is less
than that required to employ all those who wish to work at the
prevailing wage level. This is illustrated in the figure above by the
aggregate demand function AD1. Here the equilibrium level of national
income is Y. If aggregate demand is increased by an additional injection
or reduced by fewer withdrawals the aggregate demand function can be
shifted upwards. This extra demand encourages investment and via the
multiplier additional demand
and hence employment until aggregate demand reaches AD2 and helps to
produce full employment YF.
Beyond the point of full employment where all resources are committed,
any increase in aggregate demand to say AD3 cannot increase real output
and thus an inflationary gap occurs which can only be filled by using
prices. If there are unemployed resources in the economy and aggregate
demand increases then unemployment will be reduced and prices will
remain steady. If whenever the economy is already at the full employment
level, any additional increase in aggregate demand will force up prices
but have little effect on the level of real output and employment. In
the 1950s the nature of the relationship between inflation and unemployment
was stated in more precise form by Prof. A. W. Philips. He studied the
relationships between the variables over the period 1862 and 1958 for
the UK. The statistical relationship he found can be represented in
diagrammatic form as in the figures below.
The negatively sloped curve indicates that the lower the rate of
unemployment, the higher the rate of inflation. At a lower rate of
unemployment like U1, when aggregate demand is high and there are
inflationary pressures, the Philips curve suggests there will be a high
rate of inflation R1. When unemployment rise to U2 the inflation falls
to R2. Finally when unemployment falls to U3 the rate of inflation has
fallen to zero and any further increase in unemployment is predicted by
this model to give negative inflation/falling prices.
Because of the empirical evidence in support of this relationship over a
long period, in most countries, politicians and their economic advisors
felt confident during the 1950s and 1960s thatthey could by appropriate demand management exercise a degree of control over unemployment. They could then trade off lower unemployment for a little more inflation. The behaviour of inflation and unemployment in the 1970s however, casts doubts on what had seemed to be a well established relationship. In contrast with previous experience both inflations and unemployment increased during the 1970s giving rise to the phenomena labeled ―stagflation‖. Though inflation came down in many countries in the 1980s and 1990s, the level of unemployment remains alarmingly high. In brief, the relationship predicted by the Philips model no longer held. A new theory, or at least a significant amendment to the existing theory
was required to explain the relationship between the variables. This was
supplied by monetarists and the neo-classical. This amended theory
attributes a major role to expectations which various key groups within
the economy have about future levels of inflation and redefines the
concept of full employment from the Keynesian one of demand deficient or
involuntary unemployment to the rate at which there exists no
inflationary pressure on wages. This ‗natural rate of unemployment‘
exists where the demand and supply of labour are in rough overall
balance in the labour market. The magnitude of this natural rate of
unemployment depends, it is claimed, on such factors as the
effectiveness of the labour market, the strength of trade unions, the
level of social security benefits and the extent of competition or
monopoly. The amended model of the relationships between inflation and
unemployment can be elaborated upon more easily by the use of a diagram
similar to that below and widely referred to as the
‗expectations-augmented Philips
curve‘.
