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    Unemployment and Inflation: Implications for Policymaking

    The unemployment rate is a vital measure of economic performance. A falling unemployment rate generally occurs alongside rising gross...

    Unemployment and Inflation: Implications for Policymaking

    October 25, 2016 R44663

    The unemployment rate is a vital measure of economic performance. A falling unemployment rate generally occurs alongside rising gross domestic product (GDP), higher wages, and higher industrial production. The government can generally achieve a lower unemployment rate using expansionary fiscal or monetary policy, so it might be assumed that policymakers would consistently target a lower unemployment rate using these policies. Part of the reason policymakers do not revolves around the relationship between the unemployment rate and the inflation rate.

    In general, economists have found that when the unemployment rate drops below a certain level, referred to as the natural rate, the inflation rate will tend to increase and continue to rise until the unemployment rate returns to its natural rate. Alternatively, when the unemployment rate rises above the natural rate, the inflation rate will tend to decelerate. The natural rate of unemployment is the level of unemployment consistent with sustainable economic growth. An unemployment rate below the natural rate suggests that the economy is growing faster than its maximum sustainable rate, which places upward pressure on wages and prices in general leading to increased inflation. The opposite is true if the unemployment rate rises above the natural rate, downward pressure is placed on wages and prices in general leading to decreased inflation. Wages make up a significant portion of the costs of goods and services, therefore upward or downward pressure on wages pushes average prices in the same direction.

    Two other sources of variation in the rate of inflation are inflation expectations and unexpected changes in the supply of goods and services. Inflation expectations play a significant role in the actual level of inflation, because individuals incorporate their inflation expectations when making price-setting decisions or when bargaining for wages. A change in the availability of goods and services used as inputs in the production process (e.g., oil) generally impacts the final price of goods and services in the economy, and therefore changing the rate of inflation.

    The natural rate of unemployment is not immutable and fluctuates alongside changes within the economy. For example, the natural rate of unemployment is affected by

    changes in the demographics, educational attainment, and work experience of the labor force;

    institutions (e.g., apprenticeship programs) and public policies (e.g., unemployment insurance);

    changes in productivity growth; and

    contemporaneous and previous level of long-term unemployment.

    Following the 2007-2009 recession, the actual unemployment rate remained significantly elevated compared with estimates of the natural rate of unemployment for multiple years. However, the average inflation rate decreased by less than one percentage point during this period despite predictions of negative inflation rates based on the natural rate model. Likewise, inflation has recently shown no sign of accelerating as unemployment has approached the natural rate. Some economists have used this as evidence to abandon the concept of a natural rate of unemployment in favor of other alternative indicators to explain fluctuations in inflation.

    Some researchers have largely upheld the natural rate model while looking at broader changes in the economy and the specific consequences of the 2007-2009 recession to explain the modest decrease in inflation after the recession. One potential explanation involves the limited supply of financing available to businesses after the breakdown of the financial sector. Another explanation cites changes in how inflation expectations are formed following changes in how the Federal Reserve responds to economic shocks and the establishment of an unofficial inflation target. Others researchers have cited the unprecedented increase in long-term unemployment that followed the recession, which significantly decreased bargaining power among workers.

    Download PDF Download EPUB Revision History Oct. 25, 2016 HTML · PDF Metadata Topic areas Economic Policy

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    Unemployment and Inflation: Implications for Policymaking

    October 25, 2016 (R44663)

    Jump to Main Text of Report

    Contents

    The Phillips Curve

    Rebuttal to the Phillips Curve

    The Natural Rate Model and Inflation

    How the Output Gap Impacts the Rate of Inflation

    Time Varying Natural Rate of Unemployment

    How Has the Natural Rate Shifted Over Time?

    Other Factors Impacting Inflation

    Missing Deflation Post 2007-2009 Recession

    Globalization and the Global Output Gap

    Financial Frictions in the Wake of Crisis

    Increased Inflation Anchoring

    Long-Term Versus Short-Term Unemployment and Inflation

    Alternative Measures of Economic Slack

    Concluding Thoughts on Missing Deflation

    Policy Implications of the Natural Rate Model

    Limitations to Fiscal and Monetary Policies

    Inflation's Impact on Economic Growth

    A Weakened Relationship Between Inflation and Unemployment?

    Changing the Natural Rate of Unemployment

    Figures

    Figure 1. Natural Rate of Unemployment and Actual Unemployment Rate

    Source : www.everycrsreport.com

    MACRO FLVS Flashcards

    Start studying MACRO FLVS. Learn vocabulary, terms, and more with flashcards, games, and other study tools.

    MACRO FLVS

    18 studiers in the last hour

    What would be the effect of a large increase in labor productivity on the real GDP and the price level?

    Click card to see definition 👆

    Real GDP=increase; Price Level= Decrease

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    An increase in which of the following will increase the value of the spending multiplier?

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    The Marginal Propensity to consume

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    1/45 Created by SD1965

    Terms in this set (45)

    What would be the effect of a large increase in labor productivity on the real GDP and the price level?

    Real GDP=increase; Price Level= Decrease

    An increase in which of the following will increase the value of the spending multiplier?

    The Marginal Propensity to consume

    Which of the following will result in the greatest increase in AD?

    A $100 increase in governement expenditures, coupled with a $100 decrease in taxes

    If private investment of $100 is added to the economy the equlibrium levels of incomes and consumption will change of the following ways?

    Equ. Level of income=Increase; Eq. Level of Consumption=Increase

    If the FED wishes to use monetary policy to reinforce Congress' fiscal policy changes, it should

    increase the money supply when gov't spending DECREASES

    Which of the following relationships is illustrated by a short-run Phillips Curve?

    A decrease in the rate of inflation is accompanied by an increase in the rate of unemployment

    If other things are held constant, an increase in the United States imports will

    tend to cause the dollar to depreciate because the world supply of dollars will rise

    Which of the following will most likely result from a decrease in government spending?

    A decrease inAD

    Which of the following is most likely to increase if the public decides to increase its holdings of currency?

    The interest rate

    During a mild recession, if policymakers want to reduce unemployment by increasing investment, which of the following policies would be most appropriate?

    Purchase of government securities by the FED

    Which of the following is true of supply shocks?

    they tend to change both relative prices and the general price level in the economy

    Suppose that, from 1985-1986, unemployment fell from 7.2-7.0% and inflation fell from 3.8-1.1%. An explanation for these changes might be that

    AS curve shifted right

    The table indicates the number of labor hours required in countries X and Y to produce one unit of food or one unit of clothing (X: Food 20 hrs.; Clothing: 50 hrs; Y: Food10 hrs; Clothing 20hrs)

    Which of the following staements is correct?

    X has a comparative advantage in food production, whereas Y has a comparative advantage in clothing production

    Which of the following is a key feature of Keynesian economics?

    Macroeconomic equilibrium can occur at less than full employment

    According to Keynesian theory, the most important determinant of saving and consumption is the

    Level of income

    Under which of the following circumstances would increasing the money supply be most effective in increasing GDP?

    Interest rate is high, Employment is less than full, Business Optimism is High

    Faced with a large federal budget deficit, the government decides to decrease expenditures and tax revenues by the same amount. this action will affect output and interest rate in which of the following ways?

    Output=Decrease; Interest rate= Decrease

    If crowing out only partially offsets the effects of a tax cut; which of the following changes in interest rates and GDP are most likely to occur?

    Interest rates= Increase; GDP=Increase

    An increase in which of the following is most likely to increase the long-run growth rate of an economy's real per capita income?

    the educational attainement of the population

    An increase in the money supply will have the greatest effect on Real GDP if

    The quantity of money demanded is not very sensitive to interest rates

    Which of the following best explains why equilibrium income will rise by more than $100 in response to a %100 increase in government spending?

    Incomes will rise, resulting in higher consumption--Multiplier

    The money-creating ability of the banking system will be less than the maximum amount indicated by the money multiplier when

    people hold a portion of their money in the form of currency

    Decline in Potential GDP

    Negative Net Investment

    As nations specialize in production and trade in internationak markets, they can expect which of the following domestic improvements

    Allocation of domestic resources and standard of living

    As a measure of economic welfare, GDP underestimates a country's production of goods and services when there is an increase in

    Household Production

    Unexpected increase in inventories usually preced

    Decreases in production

    Which of the following best explains how an economy could simultaneously experience high inflation and high unemployment?

    Negative Supply Shock cause factor prices to increase

    Crowding out due to government borrowing occurs when

    Higher interest rates decrease private sector investment

    Compared to expansionary monetary policies adopted to counteract a recession, expansionary fiscal policies tend to result in

    Source : quizlet.com

    30.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation – Principles of Economics

    30.4 USING FISCAL POLICY TO FIGHT RECESSION, UNEMPLOYMENT, AND INFLATION

    Learning Objectives

    By the end of this section, you will be able to:

    Explain how expansionary fiscal policy can shift aggregate demand and influence the economy

    Explain how contractionary fiscal policy can shift aggregate demand and influence the economy

    We need to emphasize that fiscal policy is the use of government spending and tax policy to alter the economy. Fiscal policy does not include all spending (such as the increase in spending that accompanies a war).

    Graphically, we see that fiscal policy, whether through change in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. Figure 1 illustrates the process by using an aggregate demand/aggregate supply diagram in a growing economy. The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90.

    One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) is an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.

    Figure 1. A Healthy, Growing Economy. In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. But if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.

    Aggregate demand and aggregate supply do not always move neatly together. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes. For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand.

    Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. If recession threatens, the central bank uses an expansionary monetary policy to increase the supply of money, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the supply of money, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.

    EXPANSIONARY FISCAL POLICY

    Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in taxes. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investments by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased spending by the federal government on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investments, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.

    Consider first the situation in Figure 2, which is similar to the U.S. economy during the recession in 2008–2009. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP as indicated by the LRAS curve. At the equilibrium (E0), a recession occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP.

    Source : opentextbc.ca

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