Macroeconomics

Unemployment and Inflation

Tran Nam Quoc∗, PhD.

∗E-mail: [email protected]
Big Questions

► How is unemployment measured?

► Why are there always some people unemployed?

► How is inflation measured?

► What problems does inflation bring?

► What is the cause of inflation?

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Labor Force Statistics (1)

► Produced by the Bureau of Labor Statistics (BLS), in the U.S. Dept. of

Labor.
► Vietnam: Produced by the General Statistics Office of Vietnam
(GSO).

► Based on a regular survey of 100,000 persons.

► Based on “adult population” (15 years or older).

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Labor Force Statistics (2)

GSO divides the population into 3 groups:

► Employed: paid employees, self-employed, and unpaid workers in a
family business.
► Unemployed: people not working who have looked for work during the
previous 4 weeks.
► Not in the labor force: everyone else.
The labor force is the total # of workers, including the employed and
unemployed.

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Labor Force Statistics (3)

Unemployment rate (“u-rate”):

% of the labor force that is unemployed

u-rate = 100 x # of unemployed

labor force

Labor force participation rate:

% of the adult population that is in the labor force
labor force labor force
= 100 x
participation rate adult population
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Practice What You Know
Q1. Which of the following people is considered to be in the labor force?
A. Tham, who is waiting for a new job to start.
B. Huong, who has become discouraged from looking for a job and has given up
searching.
C. Hoa, an unpaid homemaker.
D. All of them are not in the labor force.

Q2. Which of the following is classified as unemployed?

A. Full-time students (1)
B. Homemakers (2)
C. Demobilized soldiers, who are able to work and are looking for a job (3)
D. (1), (2) and (3) are all incorrect

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What Does the U-Rate Really Measure?

► The u-rate is not a perfect indicator of joblessness or the health of the labor
market:
► It excludes discouraged workers.
► It does not distinguish between full-time and part-time work, or
people working part-time because full-time jobs are not available.
► Some people misreport their work status in the survey.

► Despite these issues, the u-rate is still a very useful barometer of the labor
market & economy.

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Structural unemployment
► Structural Unemployment: This is a type of
unemployment that occurs when the economy
undergoes structural changes. In this situation,
some people are unable to find jobs because
they lack the skills needed by the labor market.
► This can be due to:
► Changes in the economic structure
► Technological advances
► International competition
► There are workers who lose their jobs and find
that their skills are no longer needed by the
market in the long term (from 6 months or
more). These workers need to be retrained or
move to another place to find work. This is a
long-term problem. 8
Causes of Structural Unemployment

► Minimum wage: Determined by the government.

► Labor unions: Labor unions can negotiate higher wages than individual workers.

► Efficiency wages: Wages paid by employers that are higher than the market rate to
encourage workers to be more productive.

► Side effects of government policies: Some policies intended to support unemployed

workers (reducing the burden of unemployment costs) can have the side effect of
encouraging unemployment.

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Natural Unemployment and Cyclical Unemployment

► Natural Rate of Unemployment: This is the normal level of unemployment that an

economy experiences. It includes frictional and structural unemployment, but does not
include cyclical unemployment.

► Frictional Unemployment: This type of unemployment occurs when workers change jobs
and need time to find a job that suits their skills and preferences.

► Cyclical Unemployment: This is the deviation of the unemployment rate from the natural
rate, and it occurs due to economic cycles.

10
Natural Unemployment and Cyclical Unemployment

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Why Unemployment Always Exists

► The natural unemployment rate consists of 2 components:

► Frictional Unemployment: This type of unemployment is caused by
► Workers needing time to find suitable jobs. (Job searching, interviewing, etc.)
► Changes in the labor demands of businesses, which also require time to find
workers.

► Structural unemployment: This type of unemployment is caused by

► An insufficient number of jobs (for each type of work) in the labor market.
► Some industries having a surplus of workers, while others have a shortage, due
to the structure of labor training not matching the labor market demand.

12
Practice What You Know
Q1. Unemployment due to an insufficient number of jobs available in certain
industries to accommodate all those who want to work is called:
A. Natural unemployment
B. Cyclical unemployment
C. Structural unemployment
D. Frictional unemployment

Q2. Unemployment due to workers needing time to find jobs that match their
desires and skills is called:
A. Natural unemployment
B. Cyclical unemployment
C. Structural unemployment
D. Frictional unemployment
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The Phillips Curve

► The Phillips Curve demonstrates the inverse

relationship between inflation and unemployment. It
suggests that there is a trade-off between the two,
where lower unemployment is associated with
higher inflation, and vice versa.

► This curve shows that in order to reduce inflation

(from 5% to 3%), the unemployment rate must
increase (from 4% to 5%).

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Phillips curve

► The Phillips Curve: It is a curve that shows the trade-off between inflation and
unemployment.

► Origin of the Phillips Curve:

► The initial idea was proposed by A. W. Phillips in 1958 based on observations of data
from the United Kingdom during the period 1861 – 1957.
► Phillips examined the relationship between wages and unemployment.
► By the 1960s, Paul Samuelson and Robert Solow used the relationship between
inflation and unemployment.

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Short-Run and Long-Run Phillips Curve

► Short-Run and Long-Run Phillips Curve

► Short-run Phillips Curve is a downward-sloping curve.
► In the short run, when inflation increases, unemployment decreases.

► Long-run Phillips Curve is a vertical line.

► In the long run, changes in nominal variables like inflation do not affect real
variables like the unemployment rate.
► The unemployment rate always adjusts back to the natural rate in the long run.

16
AS-AD model and Short-run Phillips curve

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AS-AD model and Long-run Phillips curve

18
How expectations about inflation can affect the
Phillips Curve

19
Is the Phillips Curve Still Correct?

20
Practice What You Know
Q1. The short-run Phillips curve shows the combination of:
A. Unemployment and inflation in the short run when aggregate demand causes the
economy to move along the short-run aggregate supply curve.
B. Unemployment and inflation in the short run when short-run aggregate supply causes
the economy to move along the aggregate demand curve.
C. Real GDP and the price level in the short run when short-run aggregate supply causes
the economy to move along the aggregate demand curve.
D. All of the above are incorrect.
Q2. According to the Phillips curve, when the central bank increases the money supply, in
the short run:
A. Both unemployment and inflation decrease.
B. Both unemployment and inflation increase.
C. Unemployment decreases and inflation increases.
D. Unemployment increases and inflation decreases.
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Summary

► Unemployment rate is the percentage of those who would like to work who do not
have jobs.
► Natural rate of unemployment is the normal rate of unemployment around which
the actual rate fluctuates.
► Cyclical unemployment is the deviation of unemployment from its natural rate and
is connected to short-term economic fluctuations.
► The natural rate includes frictional unemployment and structural unemployment.
► Frictional unemployment occurs when workers take time to search for the right
jobs.
► Structural unemployment occurs when above-equilibrium wages result in a surplus
of labor.

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Big Questions

► How is inflation measured?

► What problems does inflation bring?

► What is the cause of inflation?

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The Price Level and Inflation

Inflation CPI
• What is inflation? • What is CPI?
• Problems • How to calculate
it
• What causes
inflation? • Concerns 24 / 50
The Price Level and Inflation

► Inflation: The growth in the overall level of

prices in an economy.

► Hyperinflation: An extremely high rate of

inflation.

► Deflation: Occurs when overall prices fall.

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Inflation in Vietnam, 1980-2023
The Đổi Mới (Renovation) economic reforms, initiated in the late 1980s,
were instrumental in reducing inflation from its peak of 81.8% in 1991
to single digits by 1996.

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Consumer Price Index (1)

► Consumer Price Index (CPI): A measure of the price level based on the
consumption pattern of a typical consumer.

► Goal: Measure the cost of living.

► Calculated by the Bureau of Labor Statistics (BLS).

► VN: calculated by GSO.

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Consumer Price Index (2)

The weights are based on the spending patterns of a typical consumer in

Vietnam.

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General Statistics Office (GSO) of Vietnam
The General Statistics Office (GSO) measures and reports inflation in Vietnam.

Its goals are:

► Determine the prices of all the goods and services a typical Vietnamese
consumer buys.
► Identify how much of a typical consumer’s budget is spent on these particular
items.

Each month, the GSO collects price information

► On thousands of goods and services each month.
► Across major consumption categories.
► For various regions and provinces within Vietnam. 29 / 50
Computing the CPI (1)

Calculating the price index:

𝑏𝑎𝑠𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 = × 100
𝑏𝑎𝑠𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟

Using the price levels, we can find inflation with the percentage change
formula:

𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥1 − 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥0

𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 =
𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥0
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Computing the CPI (2)

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CPI and Inflation rate (1980 – 2023)

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RECAP: GDP Deflator Index

► GDP deflator index:

► It is an index that measures the price level of all goods and services produced within a
country's economy, compared to the base year.

► Formula
Nominal GDP
GDP deflator (index) = × 100
Real GDP

33
Differences Between CPI and GDP Deflator

► CPI (Consumer Price Index) includes all goods and services bought by consumers. It does
not include goods purchased by businesses for investment (which are included in the GDP
deflator).

► GDP Deflator includes all goods and services produced domestically. It does not include
imported goods (which are part of the CPI).

► CPI uses a fixed basket of goods and services for comparison across all years. This means
that quantities remain constant over time, and only prices change.

► GDP Deflator uses all products of the economy produced in a given year, meaning that the
composition of the basket can change over time. Prices and quantities are variable across years.

34
Practice What You Know
Q1. Inflation can be a consequence of:
A. Increasing the money supply
B. Increasing government spending
C. Increasing wages and prices of factors of production
D. All of the above are correct
Q2. The nature of the consumer price index is:
A. The price index of the basket of goods produced in the current year compared to the
base year.
B. The coefficient reflecting the deflation rate in the current year compared to the base
year.
C. The price index of the basket of consumer goods in the base year calculated at
current prices compared to base year prices.
D. The price index of goods produced in the base year. 35 / 61
Price Movements

Clearly, most prices rise over time (see the previous figure)
► Travel
► Education
► Health care

However, some prices fall over time

► Consumer electronics
► Usually due to a result of great technological advancements
► Tube TV 1997: $7,000
► Flat panel TV 2012: $500
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Using the CPI to Compare Dollar Values across Time

Prices from different time periods can be misleading.

• In 1924, you could buy a fully constructed house for $1,969.
• To compare prices over time, we can transform past prices into a
price in today’s dollars.

𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 𝑇𝑜𝑑𝑎𝑦

𝑃𝑟𝑖𝑐𝑒 𝑇𝑜𝑑𝑎𝑦 = 𝑃𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑙𝑖𝑒𝑟 ×
𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 𝐸𝑎𝑟𝑙𝑖𝑒𝑟

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Concerns about CPI Accuracy

CPI overstates true inflation (upward bias) for three possible reasons:

1. Substitution bias
2. Changes in quality
3. New products and locations

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Substitution Bias

• When the price of item A increases, consumers tend to buy more

of item B. This means that consumers shift their spending towards
relatively cheaper alternatives.

• Since 1999, the Bureau of Labor Statistics (BLS) has used a

method to adjust for price changes and shifts in consumer
preferences. BLS is the agency responsible for calculating the CPI in
the United States.

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Changes in Quality

Prices may increase because the quality of goods has improved. This
means that part of the price increase could be due to the product being
upgraded, offering more value to consumers.

Example:

• Early 1990s: tube TVs

• Now: flat-screen HD TVs

Since 1999, the BLS has used a careful adjustment method to account
for quality changes.
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New Products and Location

Previously, the BLS updated CPI after long delays, causing upward bias
for two reasons:

• New product prices often drop after a couple of years.

• New retail outlets (such as online stores) offer better prices than
traditional retail stores.

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STOP AND THINK

So, is Vietnam's CPI adjusted by the GSO according to the above 3

issues or not?

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Cost of Inflation

1. Shoe-leather costs
2. Money illusion
3. Others
• Menu costs
• Uncertainty over future price levels
• Wealth redistribution
• Price confusion
• Tax distortions

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Shoe-Leather Costs

► As prices go up, it becomes more costly to hold money.

► Shoe-leather costs: Resources are wasted when people change behavior to

avoid holding money.

► People bear time, effort, and fuel costs when they try to use more money.

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Money Illusion (1)

► Money illusion: People interpret nominal wage or price changes as real

changes.

► If prices and wages all go up by 2%, there is no real change in purchasing

power. People with money illusion think they are richer in this case.

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Money Illusion (2)

► Nominal wage: The wage in current dollars.

► Real wage: Nominal wage adjusted for inflation.

► Another money illusion example:

► Suppose nominal wages increase by 3% and prices go up by 5%.
► Money illusion may cause you to think of yourself as wealthier, but your
real wages have actually decreased!

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Other costs (1)
► Menu costs: The costs of changing prices.
► Example: A restaurant will have to print new menus for price changes.

► Future Price Uncertainty: Wage and other input contracts often have long-term
commitments.
► Example: Would you be willing to sign a contract and be paid the same for the
next five years?

► Wealth redistribution: Inflation can redistribute wealth between borrowers and

lenders.
► Example: Suppose you borrow $50,000, if inflation was expected the bank would
have required more in return for the loan (i.e., repay $75,000 in five years).
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Other costs (2)

► Price confusion: If prices go up because of inflation but producers misinterpret this, their
businesses can fail.
► Example: If the price of bread increases due to inflation, the actual demand does not
change. Producing more bread will lead to surplus and losses.
Increase in Buy new resources
Increase
demand? Build factories
output
Hire workers
Price
increase
No change in output
Inflation? All prices affected

► Tax distortions: Tax distortions: Inflation can distort the tax system, especially capital gains
tax
► Example: Selling a house at a higher price than the purchase price, but this price increase
is mainly due to inflation. 48 / 61
Government policy aimed at a low unemployment rate
causes inflation

► A high employment rate (low unemployment rate) is the goal of most governments.

► When the government aims for this goal, it often causes inflation.
► In that case, the government causes one of the following two types of inflation:
► Cost-push inflation
► Demand-pull inflation

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Demand-pull inflation

► Demand-pull inflation occurs in the following situation: The government sets an

unemployment target lower than the natural rate
► The government increases aggregate demand.
► Output increases beyond the natural level, prices increase, unemployment falls
below the natural rate.
► Aggregate supply adjusts downward in the long run.
► Output falls back to the natural level, prices continue to increase, unemployment
rises back to the initial level.

► The name 'demand-pull' is because the government pulls aggregate demand up, causing
output to be higher than the long-run equilibrium.

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Demand-pull inflation
► The government sets an excessively low unemployment
target.
► Policy to stimulate demand
► Aggregate demand increases (AD shifts to the
right)
► Output increases, price increases
► More jobs --> Labor shortage
► Wages increase
► Businesses' input costs increase
► Aggregate supply adjusts downward (AS shifts
to the left)
► Output falls back to the natural level, price
increases again
► Conclusion: With an excessively low unemployment target,
the government stimulates demand unnecessarily, causing
inflation. 51
Cost-push inflation

► Cost-push inflation occurs in the following situation: A decrease in aggregate supply

causes output to decrease and prices to increase.
► Instead of waiting for aggregate supply to adjust itself in the long run, the
government increases aggregate demand through expansionary monetary policy or
fiscal policy.
► Output increases, and prices increase again (inflation).

► The name 'cost-push' comes from the fact that aggregate supply usually decreases due to an
increase in input costs.

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Cost-push inflation

► Decrease in aggregate supply

► AS shifts to the left
► Output decreases, price
increases
► Policy to increase aggregate
demand
► AD shifts to the right
► Output increases, price
increases again
► Conclusion: A decrease in aggregate
supply combined with a policy to
stimulate demand causes inflation in
the long run.
53
Cause of Inflation

► No debate on the cause of inflation.

► Inflation is caused by expansions in

the nation’s money supply.

► Milton Friedman:“Inflation is
always and everywhere a monetary
phenomenon.”

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Equation of Exchange (1)

Equation of exchange: Specifies the long-run relationship between the

money supply, the price level, real GDP, and the velocity of money.

𝑀×𝑉 = 𝑃×𝑌

M: quantity of money
V: velocity of money
P: price level
Y: real GDP
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Equation of Exchange (2)

In growth rates:

%ΔM + %ΔV =%ΔP + %ΔY

If we assume that the velocity of money is constant:

• %ΔP > 0 if %ΔM > %ΔY
• %ΔP < 0 if %ΔY > %ΔM
• %ΔP = 0 if %ΔM = %ΔY

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Inflation and Money Growth Rates, 1996 - 2016

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Why Governments Inflate the Money Supply

Inflation can have significant costs but there are two reasons why
governments inflate their money supply:
► Large government debts often spur governments to choose to increase
the money supply rapidly so they can pay off the debts.
► Surprise increases in the money supply can temporarily stimulate an
economy toward more rapid growth rates.

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Practice What You Know
Q1. In the short run, if the central bank decreases the money supply, then the price level will:
A. Increase and unemployment will decrease.
B. Decrease and unemployment will increase.
C. Increase and unemployment will increase.
D. Decrease and unemployment will decrease.

Q2. Suppose expected inflation and actual inflation are both high, and unemployment is at its natural rate.
If the central bank implements contractionary monetary policy, which of the following outcomes is expected
in the short run?
A. Expected inflation will be higher than actual inflation, and the unemployment rate will be higher than the
natural rate.
B. Expected inflation will be higher than actual inflation, and the unemployment rate will be lower than the
natural rate.
C. Actual inflation will be higher than expected inflation, and the unemployment rate will be higher than the
natural rate.
D. Actual inflation will be higher than expected inflation, and the unemployment rate will be lower than the
natural rate. 59 / 61
Practice What You Know
Q3. The left graph shows the short-run aggregate supply curve (SRAS) and two aggregate
demand curves (AD). In the right graph, U(%) represents the unemployment rate, and
P(%) represents the inflation rate. The Phillips Curve depicted in the right graph provides
policymakers with a menu of combinations:

A. that apply in both the short run and long run.

B. of choices related to fiscal policy, not choices related to monetary policy.
C. of unemployment and inflation.
D. All of the above are correct.
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Conclusions

CPI is the foundation of inflation calculations.

► Computation can be difficult because the typical basket of consumer goods
changes over time.
► The BLS tries to adjust for this.

The macroeconomic costs of continued price rises include:

► future price level uncertainty
► menu costs
► others: money illusion, …

Inflation is caused by expansions in the nation’s money supply. 61 / 50