IB HL ECONOMICS
UNIT 10: MACROECONOMIC OBJECTIVES 1
NOTES
10.1: Low Unemployment
Unemployment and its measurement
● Unemployment refers to people of working age who are actively looking for a
job but are not employed
● Underemployment refers to people of working age with part-time jobs, or with
jobs that do not make full use of their skills
● Economy is wasting scarce labour resources by not using them fully
Calculating unemployment
● The labour force is defined as the number of people who are employed plus the
number of people of working age who are unemployed
● Unemployment can be a number or percentage
o As a number, unemployment is total number of unemployed people
number of unemployed
o As a percentage, unemployment rate = ×100
labour force
Difficulties in measuring unemployment
● Unemployment figures include unemployed persons actively looking for work.
This excludes discouraged workers, who are unemployed workers who gave up
looking for a job and are effectively out of the labour force
● Does not make a distinction between full time and part time employment →
part time are counted as full time although technically underemployed
● Does not include people working in the underground economy – unregistered,
legally unregulated and not reported to tax authorities
● It is an average value and does not account for differences in population groups
such as region, gender, ethnic groups and age.
Costs of unemployment
● Economic costs
o Loss of real GDP → fewer people working, less output produced,
economy is producing inside the PPC
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o Loss of income → unemployed people do not earn income, and are
financially worse off
o Larger budget deficit and smaller surplus → loss of tax revenues, and
greater expenditure for unemployment benefits
o Unequal distribution of income → disadvantaged sections of the
population who experience persisting unemployment will have lower
incomes
● Personal and social costs
o Personal problems → indebtedness, psychological stress
o Greater social problems → crime, violence, drug use, homelessness
o Unable to find jobs in the future → lose skills from being unemployed
for too long
Types and causes of unemployment
Structural unemployment
● Changes in demand for labour skills
o Due to technological change → replaces a lot of low skilled labour jobs
Structural changes in the economy → demand for labour skills will change
→ in declining industries such as agriculture, there will be lower demand
● Changes in geographical location of jobs → if a large firm moves its physical
location, there is a fall for demand of labour in one region and increase in
another
● Labour market rigidities → factors preventing the forces of supply and demand
from operating in the labour market
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o Minimum wage legislation → higher than equilibrium wages
o Labour union activities → costly for firms to fire workers
o Generous unemployment benefits → increase attractiveness of being
unemployed
● Structural unemployment is long term unemployment → some structural
unemployment is unavoidable, but it can still be lowered → e.g. encouraging
workers to obtain new skills, reduce labour market rigidities, provide incentives
to hire workers
Frictional unemployment
● Occurs when workers are between jobs → fired, in search of better job or waiting
to start a new job
● Tends to be short term and does not involve lack of skills that are in demand
● Inevitable in any growing, changing economy due to differing growth of firms
and industries
Seasonal unemployment
● Demand for labour in certain industries changes on a seasonal basis due to
variation in needs
● E.g. farm workers only in peak harvesting season, or people working in the
tourism sector who are needed during peak selling seasons
Natural rate of unemployment
● When economy produces at full employment level of output, or potential
output, it has unemployment equivalent to natural rate of unemployment
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● Natural rate refers to sum of structural, frictional and seasonal unemployment
Cyclical (demand-deficient) unemployment
● Occurs during downturns of the business cycle, when the economy is in a
deflationary or recessionary gap → declining or low AD
● As AD falls, real GDP falls, and firms lay off workers, cyclical unemployment
increases
● In upturns of business cycle, AD increases, real GDP increases and cyclical
unemployment falls
AD/AS and unemployment
● At output Yp, real GDP is equal to potential or full employment GDP, where
unemployment is equal to natural rate of unemployment (NRU)
● If GDP is less than Yp, there is a deflationary/recessionary gap → unemployment
increases due to cyclical unemployment (greater than NRU)
● If GDP is greater than Yp, there is an inflationary gap → unemployment decreases
because structural, frictional or seasonal unemployment is reduced for short
while (less than NRU)
10.2: Low and stable rate of inflation
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Inflation, disinflation and deflation
● Inflation → sustained increase in the general price level (GPL)
o GPL is the average prices of goods and services in the economy
o Sustained means that price level must increase to a new level and not fall
back to previous lower level
● Deflation → sustained decrease in the price level
● Disinflation → Decrease in rate of inflation, inflation occurs at a lower rate
o If price level increases by 5% then 7% the next year, inflation occurs
o If price level increases by 10% and 7% in the next year, disinflation
occurs
Measuring inflation and deflation
The consumer price index
● CPI is the measure of the cost of living for the typical household, comparing the
value of a basket of goods and services in one year with the value of the same
basket in the base year
● Inflation and deflation are measured as a percentage change of the value of the
basket of goods from one year to another
Measuring inflation using CPI
● Price multiplied by quantity of each good, then sum it up to determine value of
basket of goods
● Choose a base year to determine the value of basket of goods
value of goods∈each year
● CPI in each year = value of goods∈base year ×100
● Rate of inflation calculated as percentage change of index (A)
final value of CPI−initial value of CPI
= × 100 %
initial value of CPI
Calculating real income
nomincome
● real income = ×100
CPI
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● If nominal income increases by same percentage as price level (measured by
CPI), then the real income remains unchanged
Problems with the CPI
● Different rates of inflation for different income earners → different
consumers have different consumption patterns depending on income level →
these may differ from what is included in the basket → different rates of inflation
compared to basket
o Due to variation in income, region, culture, tastes and preferences
● Substitution of goods due to price change → As the prices of goods vary over
time, consumers make substitutions, buying more units of the cheaper good and
less units of the expensive good → cannot be accounted for
● Introduction of new products → basket of goods does not account for new
products in the market but may include old products which have been phased
out
● International comparison → CPIs of different countries differ due to the types
of good and services included in the basket → hard to make comparisons
● Compatibility over time → as basket of goods and services get updated, it
means rate of inflation is difficult to be compared with over the years
Causes of inflation
Demand-pull inflation
● Caused by increases in AD → excess AD at full employment level of output
● Rightward shift of AD → causes higher price level but increase in real GDP
Cost-push inflation
● Caused by decreases in SRAS → increase in costs of production or supply side
shocks
● Leads to both decreases in real GDP and increases in price level → stagflation
● Only can use monetarist model, not Keynesian
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Costs of high rate of inflation
Relationship between inflation, purchasing power and income
● Purchasing power refers to quantity of goods and services which can be bought
with money
● Real income is similar purchasing power → it decreases as prices rise and
increases as prices fall
● %∆ in real income or PP = % ∆ in nominal income - % ∆ in rate of inflation
● Inflation leads to a fall in real income only when nominal income is constant or
increases slower compared to increase in rate of inflation
Costs of inflation
● Redistribution effects
o People who receive fixed incomes or wages → as general price levels
increase, they become worse off
o People with incomes which increase less rapidly than inflation rate →
when incomes do not keep up with rising price level, there is a fall in real
income
o Holders of cash → real value of cash falls with inflation
o Savers → savers must receive a rate of interest that is equal to rate of
inflation
o Lenders → If the rate of interest on the loan is less than rate of inflation
● Uncertainty → cannot predict future changes in purchasing power, makes
people make fewer investments which can lead to lower economic growth
● Effects on saving → inflation lowers the incentive to save, and people may spend
more now to avoid higher prices in the future
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● Export competitiveness → country with high inflation means its exports are
more expensive, while imports become cheaper → difficulties in balance of
payments
● Economic growth → low investment, low savings, low (X-M) → low AD
● Resource allocation → distorted signals and incentives → increased allocative
inefficiencies
● Hyperinflation → due to very significant increases in the supply of money →
money loses its value rapidly → consumers buy now to avoid higher prices →
worsen demand pull inflation
Low and stable rate of inflation
● Not too low because it is dangerously close to deflation
● Range of 2-3% per year is the best range
Causes of deflation
Rare occurrence of deflation
● Wage of workers do not ordinarily fall → difficult for firms to lower prices of
products as it would cut into their profits
● Large oligopolistic firms fear price wars → firms avoid cutting prices altogether
because it would make everybody worse off
Decreases in AD
● Persisting low aggregate demand → “bad deflation” → recession, falling incomes,
fall in real GDP and increase in cyclical unemployment
Increases in SRAS
● Rightward shift of SRAS → “good deflation” → economic expansion, rising
incomes, increasing unemployment, economic growth
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Costs of deflation
● Redistribution effects
o Opposite of those in inflation → in a falling price level, individuals on fixed
incomes, holders of cash, savers and lenders instead gain real value of
income
● Increase in real value of debt → real value in terms of purchasing power
increases
● Uncertainty → unable to forecast costs and revenues due to declining price
levels
● Deferred consumption and deflationary spiral → consumers postpone
spending → they expect falling prices to continually fall → discourages spending,
borrowing (because real value of debt increases) → fall in C and I → fall in AD →
deflationary spiral
● Bankruptcies and financial crisis → bankruptcies of firms and consumers who
are unable to pay back their debts → large risk of financial crises
● Policy ineffectiveness → people’s expectations of a falling price level become
established, they get used to spending less → difficult to change mindset →
interest rates cannot be decreased further (monetary policy is ineffective)
● A positive effect of deflation → lower price level means imported goods are
more expensive while exports become cheaper → increase (X-M) → increase AD
● Deflation is dangerous due to high cyclical unemployment, threats of
deflationary spiral and financial crisis, and lack of policies to deal with deflation,
hence governments prefer a low and stable rate of inflation
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10.3: Relationship between unemployment and inflation
Conflict between low unemployment and low inflation
● Using Keynesian AS, when there is a deflationary gap → fall in AD → rate of
inflation is low while there is high cyclical unemployment
● As AD increases and economy approaches potential output, price level rises
while unemployment falls → as AD increases more, price rises faster, and
unemployment falls below natural rate of unemployment
● As AD increases, resources used more fully → bottlenecks, higher wages and
higher resource prices → eventually causes a higher price level
● Difficult to achieve low inflation and unemployment at the same time
Trade-off between unemployment and inflation (HL only)
Short run Phillips curve
● The Phillips curve is concerned with the relationship between unemployment
and inflation → unemployment rate on horizontal axis, rate of inflation on
vertical axis
● Every economy must choose between low inflation and high unemployment or
higher inflation and low unemployment
● The shape of the curve is illustrated by the AD-AS model → as AD increases, price
level increases, unemployment falls → explains the inverse relationship of the
Phillips curve
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Breakdown in the relationship: stagflation
● A number of aggregate supply shocks leads to a period of stagflation → decreases
in SRAS result in higher price levels and higher unemployment → break down in
the relationship in Phillips curve → explained by outward shifts of the Phillips
curve to indicate decreases in SRAS
Long run Phillips curve and natural rate of unemployment
● The relationship in the Phillips curve does not hold in the long run → LRPC is
instead vertical at level of full employment
● Explained by the automatic return to LRAS in the AD-AS model → given a
decrease in AD → point moves along SRPC from point a to point b
● Decreasing AD → falling price levels → falling resource prices → increase in SRAS
back to point on LRAS → matched by a rightward shift of the SRPC so it coincides
with the LRPC again
Differences between SRPC and LRPC
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● SRPC suggests that policy makers can choose between low unemployment and
low inflation and enact policies which affect aggregate demand
● LRPC suggests that policy makers do not have a choice and increases in AD only
result in inflation → should enact policies which increase LRAS instead.
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