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2.3 The Macroeconomic Objec ves

Introduction to the macroeconomic objectives
Macroeconomics studies aggregates of economic performance and how countries as a whole
can achieve certain objectives. Policymakers, informed by economic data, models, and
analysis, strive to implement policies aimed at achieving certain objectives, including:
● Full employment: When an economy is producing at its long-run potential level of
output, it is achieving full employment. When producing at full employment, a
country enjoys low unemployment, meaning that nearly everyone who is willing
and able to work is contributing to the country’s economic output.
● Low inflation: Economic stability means a country enjoys both low unemployment,
but also low inflation. Price level instability, in the form of deflation or high inflation,
creates an environment of economic uncertainty and can threaten a country’s
economy in many ways, leading to fluctuations in the business cycle and large swings
in output and employment.
● Economic growth: Increasing both the country’s actual output and its potential
output over time assures that the average standard of living enjoyed by a country’s
residents will improve over time. Economic growth requires policies that promote
improvements in human and physical capital, infrastructure, and other factors that
contribute to rising living standards in a country.
● Improved equity in the distribution of income: In many countries, economic
inequality poses a threat to social harmony and economic progress. The free market
system, with all its efficiency and focus on productivity, tends to result in an
inequitable distribution of opportunity, income, and wealth. Macroeconomic policy,
therefore, must be designed to reduce the inequalities that arise in market economies.

A nation’s policymakers, both its government and its central bank, have several policy tools
at their disposal to promote the achievement of these objectives. The different policy
options will be explored in detail in a later chapter. In this chapter, we will go through each
of the four macroeconomic objectives in detail, and determine:
● The meaning of each objective,
● The measurement of each objective
● The graphical illustration of each objective

Objec ve #1 ‐ Low unemployment

● Define the term unemployment.
● Explain how the unemployment rate is calculated.
● Explain the difficulties in measuring unemployment, including the existence of
hidden unemployment, the existence of underemployment, and the fact that it is an
average and therefore ignores regional, ethnic, age and gender disparities.

HL only objectives:
● Calculate the unemployment rate from a set of data.
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Unemployment is defined simply as the state of being out of work, actively seeking work,
but unable to get work. Note the following:
● Simply not having a job does not make an individual unemployed
● To be considered unemployed, an individual has to be of legal working age (over the
age of 15 in most countries)
● Being underemployed is different than being unemployed. Underemployment
refers to individuals who are working part-time but wish to work full time, or to
people who are working in a job for which they are over-qualified.

Measuring unemployment
To determine the extent to which unemployment is a problem for an economy, economists
calculate the unemployment rate, which is the percentage of the total labor force that is
unemployed
# of people unemployed
The Unemployment Rate (UR)= # of people in the labor force ×100

The labor force is the population of individuals in a nation who are of legal working age and
are either employed or unemployed. Not included in the labor force are people who are:
● too young to work (0-14 years old)
● of working age but not working or looking for work
● retired
● of working age but in school full time
● institutionalized (in prison or jail)
● non-civilians (employees of the armed forces)

The labor force participation rate (LFPR)

The labor force participation rate is the percentage of the eligible population (15 or above,
civilian, non-institutionalized) that is either employed or unemployed.
# of employed and unemployed
Labor Force Participation Rate (LFPR) = Total eligible population 100

Calculating the UR and the LFPR (HL only)

Consider the table below, which shows labor statistics for Brazil in 2010 and 2011.

Eligible
Number of Number of
Population
people people
Year (millions of
Employed Unemployed
people 15
(million) (millions)
or above)

2010 200 100 20

2011 220 105 22

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From this data, we can calculate the following:

In 2010:
# of people unemployed
● The UR = # of people in labor force 100 = 20m
120m 100 = 16.67%
# of people in labor force
● The LFPR = # of people in eligible population 100 = 120m
200m 100 = 60%
In 2011
● The UR = 127m
22m
100 = 17.32%
● The LFPR = 127m
220m 100 = 57.72%

The LFPR fell over this period, indicating that of the eligible population, a smaller
percentage was working or trying to find work in 2011.

The UR increased over this period, indicating that it was harder to find a job in 2011 than in
2010. Even though more people are employed, the percentage of the total labor force that is
unemployed has increased.

Consequences of unemployment
● Discuss possible economic consequences of unemployment, including a loss of
GDP, loss of tax revenue, increased cost of unemployment benefits, loss of income
for individuals, and greater disparities in the distribution of income.
● Discuss possible personal and social consequences of unemployment, including
increased crime rates, increased stress levels, increased indebtedness, homelessness
and family breakdown.

Unemployment has several consequences for individuals, society, and the economy as a
whole.

The Consequences of Unemployment

● Decreased household income: reduces households’ ability to buy the
necessities and therefore reduces the standards of living of the unemployed
For the
● Increased levels of psychological and physical illness: Studies show that stress,
Individual depression, undernourishment, and other physical and mental effects arise
from chronic unemployment

● Increased poverty and crime: There is a correlation between the level of

unemployment in an economy and crime rates; the higher unemployment the
more people will turn to crime to meet their basic needs
For Society ● Transformation of traditional societies: Unemployment in rural areas of
developing countries has risen as the global economy has changed the
structures of these countries’ economies, forcing traditional societies to adapt
and in some cases dissolve as people seek work in modern industries.

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● Less total demand for goods and services: Households in which there are
unemployed people earn less income and thus consume less, leading to less
demand for goods and services in the economy.
● Under-utilization of resources: A nation with high levels of unemployment is
For the
not achieving its production possibilities, thus peoples’ standards of living are
Economy less than what is possible.
● Downward pressure on wages for the employed: A large pool of unemployed
workers increases the supply of available labor and thus reduces the wages
offered to all workers.

Types and causes of unemployment

● Describe, using examples, the meaning of frictional, structural, seasonal and cyclical
(demand-deficient) unemployment.
● Distinguish between the causes of frictional, structural, seasonal and cyclical
(demand-deficient) unemployment.
● Explain, using a diagram, that cyclical unemployment is caused by a fall in aggregate
demand.
● Explain, using a diagram, that structural unemployment is caused by changes in the
demand for particular labour skills, changes in the geographical location of
industries, and labour market rigidities.
● Evaluate government policies to deal with the different types of unemployment.

Unemployment may take several forms, and arise from different macroeconomic conditions.
The table below introduces the different types of unemployment and identifies their causes.

Type of Unemployment Definition and Causes

Frictional unemployment consists of those searching for jobs or waiting
to take jobs soon; it is regarded as somewhat desirable, because it
indicates that there is mobility in labor markets as people change or seek
Frictional jobs.
Unemployment
Seasonal unemployment is a type of frictional unemployment; it includes
people who work seasonal jobs and are out of work for short periods of
time between seasons.
Structural unemployment arises due to changes in the structure the
economy and a mismatch between the type of labor demanded and the
type supplied, e.g. when certain skills become obsolete or geographic
Structural distribution of jobs changes. Examples: Glass blowers were replaced by
Unemployment bottle-making machines. Coal miners were displaced when natural gas
began replacing coal for electricity generation. Airline mergers displaced
many airline workers in 1980s. Foreign competition has led to
downsizing in U.S. industry and loss of jobs.

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Cyclical unemployment arises during the recession phase of the business

cycle; sometimes called demand-deficient unemployment. Cyclical
Cyclical Unemployment
unemployment is caused by a fall in demand for the nation's output,
which causes a loss of jobs in the economy.

The natural rate of unemployment (NRU)

When an economy is producing at its full employment level it experiences only frictional and
structural unemployment. The unemployment that exists when an economy is producing at
full employment is called the natural rate of unemployment.

Natural rate of unemployment (NRU) =frictional unemployment + structural

unemployment

The deviation of the actual unemployment rate from the natural rate of unemployment is
known as cyclical unemployment.
● If a country is in a recession, there will be positive cyclical unemployment; people
have lost their jobs due to weak demand for the country’s output.
● If a country is overheating, the actual unemployment rate will be lower than the
natural rate; demand for the country’s output is high and workers who would
normally be structurally or frictionally unemployed are instead employed.

Causes of structural unemployment

Structural unemployment arises due to changing technology or other factors that result in
a mismatch between the skills of a nation’s workforce and the needs of employers.
● If the technology used in production changes and becomes more capital intensive,
the demand for workers who were previously needed to produce goods will decline
● If foreign countries can produce goods more cheaply, then domestic demand for
certain types of labor will fall.
● If a nation’s education and jobs training system does not prepare workers with the
skills demanded in the labor market, structural unemployment will rise over time.

Causes of frictional unemployment

If unemployed workers cannot quickly and easily be matched up with firms that demand
labor, then frictional unemployment will be higher and last longer than if it is easy for
employers and potential employees to find one another

Causes of cyclical unemployment

Cyclical unemployment is caused by a reduction in output to a level below the full
employment level, also known as a recession. Recessions could be caused by either a
decrease in aggregate demand or a decrease in short-run aggregate supply.
● If the total demand for a nation’s output falls, firms will, in the short-run, reduce the
number of workers they employ and reduce their output.
● If the costs of production faced by a nation’s producers suddenly rise, firms will
employ fewer workers to try and remain profitable. National output falls and

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unemployment rises.

Changes in the natural rate of unemployment

A country’s natural rate of unemployment (NRU) can change over time if there is a
change in the level of frictional or structural unemployment. For example:
● An improvement in the skills and knowledge of the country’s labor force (also
known as “human capital”) can reduce the level of structural unemployment and
lower a country’s NRU
● New technologies (such as job-search websites) that match job-seekers with potential
employers will reduce the level of frictional unemployment and reduce the NRU

Graphical analysis of structural unemployment

To illustrate structural unemployment, a microeconomic diagram known as a labor market
graph is needed. Structural unemployment arises when demand for particular types of labor
(workers with certain skill sets) falls. For example, assume new robotic manufacturing
technologies are making factory workers increasingly obsolete. Demand for factory workers
will fall, as in the graph below.

Observe from the graph above:

● Due to improved manufacturing technology, demand for factory workers has fallen
from D1 to D2.
● The wage rate (WR1) does not decrease due to “sticky wages” - labor unions,
contracts, unemployment benefits, minimum wage laws, and other labor market
rigidities prevent the equilibrium wage rate from falling to the new intersection of
supply and demand.
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● At WR1 more workers are seeking jobs in factories (Qs) than there are factory
owners are willing to hire (Qd)
● The “excess supply of labor” from Qd - Qs represents the structural unemployment
resulting from improvements in robotic manufacturing technology.

Policies to reduce structural unemployment

Notice that one solution to reducing structural unemployment is increasing labor market
flexibility. If the wage rate were able to adjust to the fall in demand for labor more easily,
factory owners would be willing to hire more factory workers, choosing not to replace them
with robots.

On the other hand, the lower wage rate would lead fewer people to seek jobs as factory
workers, reducing the quantity supplied in the labor market. A greater quantity demanded
and smaller quantity supplied would restore equilibrium and eliminate structural
unemployment.

In a later chapter we’ll explore “supply-side policies” that would increase labor market
flexibility and help reduce structural unemployment. Some other government policies to deal
with structural unemployment include:
● Investing in job and skills training programs to match the skills possessed by workers
with those demanded by employers.
● Investing in education so that people entering the labor force are equipped with the
skills demanded by the country’s employers.

Graphical analysis of cyclical unemployment

Cyclical unemployment arises due to a fall in aggregate demand and the accompanying
recession phase of the business cycle. Therefore, graphing cyclical unemployment requires us
to use an AD/AS diagram and show a fall in AD and a recessionary gap, as seen below.

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Observe from the graph:

● As AD falls from AD1 to AD2 equilibrium national output falls from Yfe to Y1.
● At a lower level of output, fewer workers are needed.
● Firms will reduce employment in order to cut costs and reduce output in the face of
lower demand for their products.
● Cyclical unemployment results from a fall in aggregate demand.

One major and important difference between cyclical and structural unemployment is that
cyclically unemployed workers DO possess skills that would be in demand if only the
economy were producing at its full employment level. In contrast, structurally unemployed
workers do not possess relevant skills for the country’s economy.

In other words, when cyclical unemployment exists, it is evidence that the economy as a
whole is “sick”, or in recession. When structural unemployment exists, it is evidence that
certain workers in the country are in need of retraining to equip them with skills more
relevant to the country’s economy.

Policies to reduce cyclical unemployment

From the graph we can observe a couple of options policymakers have for reducing cyclical
unemployment:
● Demand-side policies: Policies aimed at increasing AD will reduce the level of
cyclical unemployment in a country. These include expansionary fiscal policies
and expansionary monetary policies; both will be explored in more detail in a later
chapter.
● Supply-side policies: Policies aimed at increasing SRAS will reduce the level of
unemployment. These include interventionist supply-side policies and
market-based supply-side policies; both will be explored in more detail in a later
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chapter.

Policies to reduce frictional unemployment

Frictional unemployment is a completely natural phenomenon and will never be eliminated,
nor should it be. People must always enter the labor force for the first time and seek jobs;
such entrance into the labor force, either through graduation from university or high school,
immigration, or people voluntarily out of the labor force reentering it, is essential for an
economy.

However, means of reducing the period of time people are frictionally unemployed can
improve the economy’s efficiency by helping employers find the employees they need more
quickly. Measures for reducing frictional unemployment include:
● Job placement agencies
● Hiring/recruiting services
● Websites to help workers seeking jobs get their resumes out to potential employers

Mobile and web technologies have vastly improved the ability of potential workers to find
potential employers, reducing the amount of frictional unemployment, and it could therefore
be argued, reducing the natural rate of unemployment.

Objec ve #2 ‐ Low infla on: The meaning of infla on, disinfla on and defla on
● Distinguish between inflation, disinflation and deflation.
● Explain that inflation and deflation are typically measured by calculating a consumer
price index (CPI), which measures the change in prices of a basket of goods and
services consumed by the average household.

HL only objectives:
● Construct a weighted price index, using a set of data provided.
● Calculate the inflation rate from a set of data.

The meaning of inflation

Inflation is defined as an increase in the average price level of goods and services in a nation
over time.

The percentage change in the price level between two periods of time is known as the
inflation rate. The inflation rate can be positive or negative. Some key terms relating to the
measurement of the price level are:
● Inflation: When the price level increases between two periods of time (a positive
inflation rate).
● Disinflation: When the rate of inflation decreases between two periods of time (a
decrease in the inflation rate).
● Deflation: When the price level decreases between two periods of time (a negative
inflation rate).

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Measuring inflation
To determine whether a nation’s price level is increasing or decreasing over a particular time
period, economists use what is known as a price index.
● The consumer price index (CPI) measures the price of a set basket of consumer
goods (usually includes hundreds or even thousands of goods that the typical
household in a nation consume) between one time period and another.
● The inflation rate is the percentage change in the CPI between two years:

CP I in year 2 CP I in year 1
T he inflation rate = CP I in year 1 100

Calculating inflation using a CPI (HL only)

The CPI for a particular year is the price of a basket of goods in that year divided by the
price of the same basket in a base year.

To calculate inflation between two years, we first must determine the CPIs for the two years
in question. Assume the CPI is made up of just three goods, whose prices during two years
are indicated in the table below.

Good or service Price in 2018 Price in 2019

Pizza 10€ 10.50€
Haircuts 20€ 19€
Wine 8€ 10€
Total basket price 38€ 39.50€

Assume 2018 is the base year, and we want to calculate inflation between 2018 and 2019.
First we must calculate the price indices for the two years:

P rice of the basket of goods in 2018 38

CPI for 2018 = P rice of the basket in base year 100 = 38 100 = 100

P rice of the basket of goods in 2019 39.5

CPI for 2019 = P rice of the basket in base year = 38 100 = 103.9

The CPI for 2018 is 100. Since 2018 is our base year, we are comparing the price of the
goods in that year to itself, so of course the index is equal to 100.

The price of the same basket in 2019 is €39.50, which when divided by the base year price
and multiplied by 100 results in a CPI of 103.9

With the CPIs known, we can calculate the rate of inflation:

CP I in year 2 CP I in year 1 103.9 100
The inflation rate = CP I in year 1 100 = 100 100 = 3.9%

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The CPI increased by 3.9% between 2018 and 2019, indicating that inflation equaled 3.9%.

Using a weighted price index to calculate inflation (HL only)

Because not all the goods measured in a nation’s CPI are equally important to the typical
household, governments assign weights to particular categories of goods.
● For example, food and beverages make up approximately 15% of the typical
household budget in a given year. But housing (either rental payments or mortgage
payments) make up 40%.
● In this example, housing prices should be weighted more heavily than food and
beverages

Consider the table showing the prices of the three goods measured in a CPI in two years,
including the weight given to each good based on the percentage of the typical consumer’s
income spent on it.

Price in Price in
Good Weight
2018 2019

Banana $2 $1.50 25%

Haircut $11 $10 30%

Taxi ride $8 $10 45%

Total 100%

To establish a price index with 2018 as the base year, we must calculate the weighted price of
the basket of goods for 2018. To do this, we multiply the average price of each good by its
weight, expressed in hundredths.

2018:
● Banana = 2 × 0.25 = 0.5
● Haircut = 11 × 0.3 = 3.3
● Taxi ride = 8 × 0.45 = 3.6
● 0.5+3.3+3.6 = 7.7

Weighted price index for 2018 = 7.7

2019:
● Banana = 1.5 × 0.25 = 0.375
● Haircut = 10 × 0.3 = 3
● Taxi ride = 12 × 0.45 = 5.4
● 0.375+3+5.4 = 8.775

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Weighted price index for 2019 = 8.775

The prices of the goods in the CPI have now been adjusted for their relative importance to
the consumer. A change in the price taxi rides (weighted at 45%) will now have a larger
impact on the overall inflation rate than a change in the price of bananas (which are only
weighted at 25%).

With the weighted price indices determined, we can calculate inflation between 2018 and
2019:

Inflation rate= 8.775

7.7
7.7
100 = 14%

Degrees of inflation
A country’s CPI does not always increase at a steady rate. The CPI could fall over time (as
goods get cheaper), it could increase very slowly (low inflation), or very rapidly (high
inflation). The table below distinguishes between different degrees of inflation.

Degrees of Inflation, from low to high

Deflation refers to a decrease in the average price level of goods/services over time.
● If the CPI for one year is smaller than the CPI from a previous year, then the
inflation rate will be negative.
Deflation: ● Deflation is considered highly undesirable because it discourages investment
and consumption (households and firms prefer to postpone spending until
prices are lower in the future) and therefore can lead to recession and rising
unemployment.

Inflation rates of between 0-5% are considered low and stable.

● This is the desired range for most countries, over which consumers’
Low inflation: confidence over the stability of future prices is sound; businesses and
households can invest, spend and save without fear of future erosions in the
values of their savings and investments.

Inflation rates of greater than 5% are considered high in most countries

● At high inflation rates, firms and households will rush to spend their money
High now before its value is eroded by higher prices. The race to spend while
inflation: money is dear causes AD to grow rapidly, causing demand-pull inflation,
reducing real incomes and contributing to instability across the economy

Shortcomings of the infla on rate as a macroeconomic measure

● Explain that different income earners may experience a different rate of inflation
when their pattern of consumption is not accurately reflected by the CPI.
● Explain that inflation figures may not accurately reflect changes in consumption
patterns and the quality of the products purchased.
● Explain that economists measure a core/underlying rate of inflation to eliminate the
effect of sudden swings in the prices of food and oil, for example.
● Explain that a producer price index measuring changes in the prices of factors of

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production may be useful in predicting future inflation.

Effect on different income earners

The inflation rate, like other macroeconomic measurements, is an aggregate measure, in
this case of what the typical household consumes. However, not all households’
consumption patterns will be accurately reflected by the CPI.

For example, a lower income household may be more affected by inflation in their everyday
consumption decisions than a wealthier households. Poorer consumers tend to spend a
greater percentage of their income on goods and services, whereas richer consumers tend to
save more. Therefore, an increase in the CPI could have a disproportionate effect on lower
income consumers than on the rich, who are saving more of their income.

Additionally, the composition of the basket of goods consumed by different households will
be very different. Higher income households may be able to substitute imported goods for
domestically produced goods when domestic inflation accelerates, sheltering them from
rising prices at home.

The inability of the CPI to reflect the consumption patterns of ALL households is one
obvious shortcoming of its usefulness as a measurement of economic well-being.

Changing consumption patterns and product quality

The goods included in CPI may remain fixed over several years, even as the goods purchased
by actual consumers change over time. If the goods in a CPI are not updated frequently, the
usefulness of the inflation rate will diminish as consumers switch to newer, different
products over time.

Additionally, the CPI might overstate inflation as prices rise even as the quality of the goods
consumers are buying increases exponentially. For example, a $25,000 car (say, the Toyota
Camry) purchased in 2008 might have increased to $30,000 by 2018, a 20% increase in price
(an average of 2% per year over 10 years).

However, the quality of the car purchased in 2018 may have increased exponentially.
Improvements in safety, comfort, entertainment and navigation systems, self-driving or
“autopilot” capabilities, and other factors affecting the consumer’s experience of the 2018
Camry are not reflected in that average 2% increase in its price over 10 years.

When technology and product quality increase disproportionately compared to goods’

prices, the inflation rate will overstate the burden of higher prices on consumers.

Core inflation
A country's inflation rate could appear rather volatile when the prices of certain products
within the CPI fluctuate wildly in a certain year. Energy and food prices tend to be rather
volatile, due to the highly inelastic supply of such commodities in the short-run.

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For example, during the year when oil prices fell from their 2008 high of nearly $150 per
barrel to $40 per barrel, the CPI increased less than it would have had oil prices remained
high.

In order to provide a picture for how MOST goods and services are changing in price, not
including those commodities whose prices regularly fluctuate, affecting the CPI, economists
measure what is known as the core CPI, to determine core inflation. Core inflation
measures the price of a basket of goods consumed by the typical household, excluding
energy and food. It gives a clearer picture of the long-run trends in living costs, ignoring
short-run fluctuations in certain commodity prices.

The chart below compares the United States’ CPI for all items (in red) to the core CPI (in
blue) between 2007 and 2017. The area shaded in gray indicates the Great REcession of
2008-2009.

Observe from the chart:

● The “headline” inflation rate (in red) fluctuates more than the “core” inflation rate
(in blue)
● Both headline and core inflation rates fell during the Great Recessions, due to lower
aggregate demand in the economy as a whole.
● The headline inflation rate became negative (deflation) in 2009, due to the fact that
commodity prices (such as food and energy) fell more than most consumer prices
during the recession.

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Alternative measures of inflation - the Producer Price Index

The CPI measures price changes in goods consumed the the typical household; therefore, it
does not represent how prices that affect firms are changing over time.

The Producer Price Index (PPI) measures the price of a basket of goods purchased by the
typical producer in a country over time. The PPI includes more primary commodities,
including mining, manufacturing, agriculture, fishing, and forestry - as well as natural gas,
electricity, construction, and other goods purchased by a country’s business firms.

The chart below compares the United States’ CPI and PPI from 1985 through 2015.

Observe from the chart:

● The CPI and PPI generally rise together over time.
● During recessions (gray periods in the chart), the PPI tends to experience steep
declines, while the CPI typically experiences slower growth (disinflation) or a
relatively small drop (mild deflation).
● The PPI (in blue) fluctuates more than the CPI, since commodity prices are more
volatile than prices for finished goods (due to their relatively inelastic supply and
demand).

Consequences of infla on
● Discuss the possible consequences of a high inflation rate, including greater
uncertainty, redistributive effects, less saving, and the damage to export

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competitiveness.

High inflation, like high unemployment, has several negative effects on households, firms
and the overall economy.

The Consequences of High Inflation

A households’ real income is its nominal income adjusted for any inflation in the
Lower Real economy. The more prices rise, the less a certain amount of income can buy for
Incomes households. Higher inflation makes consumers feel poorer, since the real value of
their incomes falls when inflation rises.

The real interest rate is the nominal interest rate minus the inflation rate. For
Lower Real example, if you have a savings account offering a 5% interest rate, and inflation
Interest Rates for is 2%, the real return on your savings is only 3%. But if inflation increases to 4%,
Savers your real return is just 1%. Inflation reduces the incentive for households to
save, driving up current consumption, causing even more inflation.

Higher nominal When banks anticipate high inflation in the future, they will raise the interest
interest rates for rates they charge borrowers today. This increases the cost of borrowing money
borrowers to invest in new capital or to buy homes or expensive durable goods.

Inflation reduces the real interest rate for borrowers. The money paid back by
borrowers is worth less than the money borrowed when there is inflation, thus
Lower real interest
the real interest paid is lower. Example: If a borrower faces a 5% interest rate on
rates for borrowers a loan, and the inflation rate increases from 2% to 3%, the real interest owed
decreases from 3% to 2%.

Reduced debt Similar to above, inflation erodes the real value of an individual’s or a nation’s
burden for debtors debt. The value of the money owed by a debtor decreases as inflation increases.

A country experiencing high inflation will find demand for its goods fall among
Reduced international consumers, as they become more expensive compared to other
international countries’ goods. Also, higher prices and wages will reduce foreign investment
competitiveness in the country as firms do not wish to produce where costs are rising, rather
where costs will be low in the future.

Consequences of defla on
● Discuss the possible consequences of deflation, including high levels of cyclical
unemployment and bankruptcies.

Deflation, a decrease in the average price level, sounds like a good thing. But it is not, and in
some circumstances can be worse for an economy than mild inflation.

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The Consequences of Deflation

With the expectation of lower future prices for their output, and with low
Rising demand for goods and services, firms are likely to lay off workers, leading to
Unemployment: higher unemployment and downward pressure on workers’ wages across the
economy

With the expectation of future price decreases, households will increase savings
Delayed and decrease spending. The decrease in current consumption can lead to further
consumption: deflation and contribute to a deflationary spiral, in which lower prices lead to
lower AD which leads to even lower prices

If firms expect less demand for their output in the future, they'll invest less
Declining now, which could result in slower economic growth, as the nation’s capital
investment: stock depreciates over time and is not being replenished at a rate that will
promise sustained growth

Deflation causes the value of money to increase over time. Therefore, the real
debt burden of borrowers increases as the price level falls. Bankruptcies result
Cost to borrowers:
as borrower's incomes fall while the value of the money they must pay back
increases.

Types and causes of infla on

● Explain, using a diagram, that demand-pull inflation is caused by changes in the
determinants of AD, resulting in an increase in AD.
● Explain, using a diagram, that cost-push inflation is caused by an increase in the
costs of factors of production, resulting in a decrease in SRAS.
● Evaluate government policies to deal with the different types of inflation.

Inflation can be caused by one of two ways, either as a result of an increase in aggregate
demand or as a result of a decrease in aggregate supply.

Demand-pull inflation occurs when there is an increase in total demand for a nation’s
output, either from domestic households, foreign consumers, the government or firms (C,
Xn, G or I). When demand increases without a corresponding increase in aggregate supply,
the nation’s output cannot keep up with the demand, and prices are driven up as goods
become scarcer.

Demand-pull inflation can be illustrated in the AD/AS model:

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Cost-push inflation occurs as the result of a negative supply shock, arising from a sudden,
often unanticipated, increase in the costs of production for the nation’s producers.
Cost-push inflation could result from any of the following:
● Increase in the wage rate
● Increase in resource costs
● Increased energy or transportation costs
● Increased regulation by the government
● Increased business taxes
● Reduction in the exchange rate

Cost-push inflation can be illustrated in the AD/AS model:

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Government policies to deal with inflation

Depending on its cause, policymakers have different options for dealing with inflation.

Demand-pull inflation requires the use of demand-side policies, such as contractionary

fiscal policy or contractionary monetary policy.
● Reducing government spending or increasing taxes will reduce aggregate demand
and reduce the rate of inflation
● Increasing interest rates (an action taken by the central bank) reduces the level of
investment and consumption and reduces the inflation rate.

Demand-side policies will be explored further in a later chapter.

Cost-push inflation requires the use of supply-side policies, including interventionist and
market-based supply-side policies, including.
● Labor market reforms
● Trade liberalization
● Investment in human capital, infrastructure, and technology,
● Anti-monopoly regulations
● Reductions in minimum wage and unemployment compensation.

Supply-side policies will be explored further in a later chapter.

Possible rela onships between unemployment and infla on (HL only)

● Discuss, using a short-run Phillips curve diagram, the view that there is a possible
trade-off between the unemployment rate and the inflation rate in the short run.
● Explain, using a diagram, that the short-run Phillips curve may shift outwards,
resulting in stagflation (caused by a decrease in SRAS due to factors including supply
shocks).
● Discuss, using a diagram, the view that there is a long-run Phillips curve that is
vertical at the natural rate of unemployment and therefore there is no trade-off
between the unemployment rate and the inflation rate in the long run.
● Explain that the natural rate of unemployment is the rate of unemployment that
exists when the economy is producing at the full employment level of output.

The short-run Phillips curve (SRPC)

As we have seen in our AD-AS analysis, whenever a country experiences a shift in aggregate
demand, in the short run there is a change in both inflation and unemployment.
● When AD increases, unemployment falls and inflation increases.
● When AD decreases, unemployment increases and inflation falls.

The short-run tradeoff between inflation and unemployment is so fundamental to

macroeconomics that economists have developed a model just to illustrate this relationship.
The Phillips curve model shows the rate of inflation on the vertical axis and the
unemployment rate on the horizontal axes. The curve itself is downward sloping, showing
the inverse relationship between the two in the short run.
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Assume that in the country represented by the Phillips Curve below the natural rate of
unemployment is 5% and the target inflation rate is between 2% and 3%.

Points along a country’s SRPC correspond with different levels of aggregate demand the
country could experience at any given period of time:
● At point A aggregate demand is relatively high, resulting in a high inflation rate (5%)
and a very low unemployment rate (<1%). The economy is producing beyond full
employment with a positive output gap.
● At point B AD has fallen to a level around full employment. Inflation is within the
target range of 2%-3% and unemployment is 5%, close to the natural rate of
unemployment.
● At point C AD has fallen further and the economy has lower than desired inflation
of 1% and unemployment that is greater than the natural rate at 9%. The economy
has a recessionary gap.
● At point D AD has fallen far below full employment and the economy has inflation
of -1% (deflation) and unemployment of 13%. The economy is experiencing a deep
recession.

The long-run Phillips curve (LRPC)

The long-run relationship between inflation and unemployment can be illustrated by the
long-run Phillips curve (LRPC), which is vertical at the natural rate of unemployment.

Recall from our study of the AD-AS model that the long-run aggregate supply (LRAS) curve
is vertical at the full employment level of output, explained by the fact that wages and other
input costs are fully flexible in the long run. Since output always returns to the full
employment level in the long run, the unemployment rate will always return to the natural
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rate of unemployment (NRU).

The graph below shows both the SRPC and the LRPC, which is vertical at the country’s
NRU of 5%.

Long-run equilibrium corresponds to the intersection of the SRPC and the LRPC. In the
short run, when wages and other input prices are fixed, an economy can be producing
anywhere along its SRPC. However, in the long run, when all prices are flexible, a country
will return to its NRU.

Demand shocks in the Phillips curve model

Changes to aggregate demand cause a movement along a country’s SRPC. For example,
assume a country is currently producing at its full employment level and is in its long-run
equilibrium in both the AD-AS model and the Phillips Curve model.

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Positive demand shocks

A positive demand shock will cause an increase in output, employment, and the price level in
the AD-AS model, and a movement up and to the left along the SRPC in the Phillips Curve
model:

A move from point A to B in the AD-AS model causes a move from point A to point B in
the Phillips Curve model.

In the long run, an economy producing at point B (beyond full employment) will experience
rising wages and input costs, causing the SRAS to decrease and output to return to the full
employment level. As this happens, inflation will increase and unemployment will return to
the NRU in the Phillips Curve model.

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Rising wages and other input prices causes the SRAS to shift in, restoring full employment in
the AD-AS model at a higher price level. The inward shift of the SRAS causes an outward
shift of the SRPC, restoring the NRU in the Phillips curve model at a higher inflation rate.

Negative demand shocks

A negative demand shock will cause an decrease in output, employment, and the price level
in the AD-AS model, and a movement down and to the right along the SRPC in the Phillips
Curve model:

A move from point A to B in the AD-AS model causes a move from point A to point B in
the Phillips Curve model.

In the long run, an economy producing at point B (below full employment) will experience
falling wages and input costs, causing the SRAS to increase and output to return to the full
employment level. As this happens, inflation will decrease and unemployment will return to
the NRU in the Phillips Curve model.

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Falling wages and other input prices causes the SRAS to shift out, restoring full employment
in the AD-AS model at a lower price level. The outward shift of the SRAS causes an inward
shift of the SRPC, restoring the NRU in the Phillips curve model at a lower inflation rate.

Supply shocks in the Phillips curve model

Whenever a factor leads to a shifts in the short-run aggregate supply (SRAS) curve, the
short-run Phillips curve (SRPC) shifts in the opposite direction.

A negative supply shock causes both higher inflation and higher unemployment. For
example, assume there is an unexpected increase in energy prices. SRAS will shift in as the
cost of producing output increases. Firms reduce both employment and output, while raising
prices to consumers.

A negative supply shock causes higher inflation and higher unemployment. A country
experiences stagflation when SRAS shifts in and the SRPC shifts out. Stagflation is a
mash-up of the words “stagnant” and “inflation”. In other words, the country’s economy
stagnates while inflation increases.

A positive supply shock leads to more output and employment and lower prices. The SRPC
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shifts inward, allowing a country to enjoy both lower inflation and lower unemployment.

A positive supply shock causes output to increase and the price level to fall. More output
means lower unemployment and a lower price level means lower inflation.

Shifts of the long-run Phillips curve

Factors that cause the natural rate of unemployment (NRU) to change will cause a shift of
the LRPC. Recall that the NRU consists of two types of unemployment:
● Structural unemployment arises due to changing technology or other factors that
result in a mismatch between the skills of a nation’s workforce and the needs of
employers.
● Frictional unemployment arises from workers who are in between jobs and cannot
quickly and easily be matched up with firms that demand labor.

An increase in structural or frictional unemployment cause an outward shift of the LRPC

and a higher natural rate of unemployment.

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A decrease in structural or frictional unemployment causes an inward shift of the LRPC and
a lower natural rate of unemployment.

Objec ve #3 ‐ Economic growth

● Define economic growth as an increase in real GDP.
● Describe, using a production possibilities curve (PPC) diagram, economic growth as
an increase in actual output caused by factors including a reduction in unemployment
and increases in productive efficiency, leading to a movement of a point inside the
PPC to a point closer to the PPC.
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