Topic X Unemployment

7
1. 2. 3. 4. 5. 6. 7.

and Inflation

LEARNING OUTCOMES
By the end of this topic, you should be able to: Describe the concept of unemployment and how to measure the unemployment rate; Differentiate between three types of unemployment; Point out the reasons and effects of unemployment; Summarise the concept of inflation and Consumer Price Index (CPI); Depict how inflation rate is measured; Discuss the effects and causes of inflation; and Summarise the Phillips Curve, which is the trade-off between inflation and unemployment.

INTRODUCTION

Now we come to a new topic on unemployment and inflation. Did you know that when an economic activity level is evaluated, individuals not only look at the countrys production or output but other factors too? These other factors are national production, information on unemployment and inflation, which are also important to determine the economic activity. What do unemployment and inflation show? Unemployment is an important guide pertaining to the labour market. Whereas, inflation shows the countrys overall price level. Before the 1920s, issues related to unemployment and inflation were not hot topics of discussion. Only after the great recession of 1929 did these issues became increasingly important and the focus of economists. Based on that, let us learn more on unemployment and inflation in this new topic. Are you ready? Let us start the lessons!

TOPIC 7

UNEMPLOYMENT AND INFLATION

153

7.1

UNEMPLOYMENT

Do you work, or are you still in the process of looking for a job? Are you a housewife or a university student? We often hear the term unemployment being mentioned, but how much do we understand about its actual meaning? An unemployed person is one who has the necessary qualifications to work, is willing to work and agrees to work for the market wage but unfortunately does not get any job. In order for you to understand the concept of unemployment, several other factors that are related to unemployment will be discussed at length. Basically, the population of a country is divided into two, namely: (i) (ii) Population of working age group; and Others (includes those who are too young to work and those who are ill or cannot work). Population = Working age group + Others What does it mean by working age group? Working age group means number of persons who are 16 years old and above, who have never been sentenced to prison, have never been admitted into a hospital or other care centres. Let us look at Figure 7.1.

Figure 7.1: Population of working age group

154 X TOPIC 7 UNEMPLOYMENT AND INFLATION

As summarised in Figure 7.1, the working age group is divided into two categories, namely those who are not in the labour force and those who are in the labour force. Those who are not in the labour force include mostly full-time students, retirees and housewives. Working age group can be simplified as: Working age group = Those who are not in the labour force + those who are in the labour force Those who are in the labour force can also be divided into two categories, namely those who are employed and those who are not. So, what can we conclude about unemployment? Labour force = Employed + Unemployed

In the economics context, unemployed means those who are not working but are actively looking for jobs. Figure 7.2 shows the composition of unemployment in Malaysia for September 2012.

Figure 7.2: Unemployment in Malaysia for September 2012 Source: http://statistics.gov.my

Based on Figure 7.2, we can see that in September 2012, there was an increase of the unemployed population by 66,700 persons, bringing to a total of 413.900 persons, while the number of employed persons recorded a marginal declined by 18,100 persons to 12.55 million persons. This situation contributes to the

TOPIC 7

UNEMPLOYMENT AND INFLATION

155

unemployment rate by 3.2 percent in September 2012, an increase of 0.5 percentage point from 2.7 percent in the previous month.

7.2

MEASURING UNEMPLOYMENT RATE

Did you know that the rate of unemployment is an important guide towards a countrys economic situation? We can measure the rate of employment using the following formula, where the unemployment rate measures the percentage of the labour force who are not working.
Number of unemployed persons Labour force

Unemployment rate =

x 100.

Let us look at how to measure it by referring to this example (Figure 7.3).

Figure 7.3: Employment in country X for the year 2001

Based on the information from Figure 7.3, the unemployment rate in country X for the year 2001 is:

Unemployment rate =

0.35 million x 100 = 3.54%. 0.35 million + 9.54 million

156 X TOPIC 7 UNEMPLOYMENT AND INFLATION

EXERCISE 7.1
1. 2. What is meant by unemployment? A country reports its unemployment rate as 4%. What is meant by this value?

7.3

LABOUR FORCE PARTICIPATION RATE

What is the purpose of labour source participation rate? Labour force participation rate measures the percentage of the working age group population who are in the labour force group. How do we do that? We can do that by using a simple formula. This is how the labour force participation rate is measured:
Labour force x 100. Working age group population

Labour force participation rate =

An increase in labour force participation rate may be due to expansionary economic conditions. On the other hand, the rate may drop because of an increase in the number of retirees or those who are continuing education or because the number of older people in a given the population has increased.

7.4

DISCOURAGED WORKER

What does discouraged worker mean? A discouraged worker is someone who is unemployed, ready to work but has not made an effort at finding a job in the last four weeks. Usually, a discouraged worker will provide excuses that he has tried to look for a job but is disappointed or he feels that the current labour market is not good. Therefore, any efforts to look for a job will be unfruitful.

TOPIC 7

UNEMPLOYMENT AND INFLATION

157

Since a discouraged worker has not made an effort to look for a job in the last four weeks, census will classify him as a discouraged worker and not an unemployed person. Therefore, this group is not included in the labour force. There are some parties who think that discouraged workers should be classified as unemployed persons in order to give a more accurate picture of the labour force situation.

ACTIVITY 7.1
In your opinion, should discouraged workers be classified as unemployed persons? Why? Give your reasons.

7.5

PART-TIME WORKERS

Have you ever worked part-time? What is the difference between a full-time worker and a part-time worker? Let us look at their definitions which can tell the difference between these two. Part-time workers are those who work less than 35 hours a week. Full-time workers are those who work 35 hours or more in a week. Part-time workers can be divided into two categories, namely, those due to economic factors and those that are due to non-economic factors. Table 7.1 shows the difference between these two categories.
Table 7.1: Differences between Part-time Workers Due to Economic Factors and Part-time Workers Due to Non-economic Factors Part-time Workers Due to Economic Factors They are called non-voluntary part-time workers. They work between 1 and 34 hours. At the same time, they try to be full-time workers. They failed to get time to work. Part-time Workers Due to Non- Economic Factors They are not interested in getting a fulltime job. They are not ready to undertake an available job. Include those who: x Have medical problems; x Have family commitments; and x Have limited time due to studies.

158 X TOPIC 7 UNEMPLOYMENT AND INFLATION

To test your understanding, try this exercise.

EXERCISE 7.2
1. State the difference between a discouraged worker and an unemployed worker. What is the main difference between a full-time worker and a parttime worker?

2.

ACTIVITY 7.2
Assume you are a part-time worker. You are not tied down by any long-term contract and you get good payments from your efforts working for many different companies. One day, you are offered a fulltime job with one of the companies at which you are working with parttime. What are the factors that will assist you to decide? What would be your decision?

7.6

TYPES OF UNEMPLOYMENT

The unemployment issue is one of the most important economic issues. It can be analysed in detail when you understand the different types of unemployment. As shown in Figure 7.4, generally, there are three types of unemployment, namely frictional unemployment, structural unemployment and cyclical unemployment.

Figure 7.4: Types of unemployment

The following are explanations for each type of unemployment.

TOPIC 7

UNEMPLOYMENT AND INFLATION

159

7.6.1

Frictional Unemployment

Let us ponder on Figure 7.5. What can you say about it?

Figure 7.5: Frictional unemployment

Basically, this is what you can say about frictional unemployment: Frictional unemployment or normal unemployment exists only for a short period. It happens when individuals are moving between jobs, careers and locations. Sometimes, people are willing to be unemployed while waiting to get another job and not because they are unable to look for a job. Usually, frictional unemployment will continue to exist all the time, mostly when the economy is having continuous rapid growth. This unemployment will exist even when the economy is at full employment. However, as this unemployment is short-term, it is not considered a serious problem.

160 X TOPIC 7 UNEMPLOYMENT AND INFLATION

7.6.2

Structural Unemployment

How about structural unemployment? When does it happen? Structural unemployment happens because workers do not have the expertise and the ability to work in a new sector. It usually exists for a longer period of time and a government policy has to be implemented to overcome this problem. Economic growth of a country will usually be followed by structural changes and changes in economic activities. For example, in Malaysia, in the early 1980s, the industrial sector became more prominent compared to the agricultural sector. This caused some workers to be laid off because skills possessed by farmers could not be used in the industrial sector. There are various factors that cause structural economic changes in a country such as changes in consumer preference and technology advancement.

7.6.3

Cyclical Unemployment

Lastly, let us learn about cyclical unemployment. Do you know what is the cause of this problem? Cyclical unemployment is caused by economic conditions that go up and down. It occurs when the unemployment rate moves in the opposite direction as the GDP growth rate. Therefore, when GDP growth is small (or negative) unemployment is high. When there is a recession, demand for goods and services will decrease. This will force firms to reduce their production and thus, cut down on their labour. For instance, when recession hits the Asian region in 1998 because of the currency crisis, many workers had to be laid off. In order to overcome unemployment caused by private sector demands, governments had to increase expenditure through a fiscal policy. The increase in government expenditure will create new job opportunities and subsequently, reduce unemployment rate.

TOPIC 7

UNEMPLOYMENT AND INFLATION

161

SELF-CHECK 7.1
For each description in the table below, write down the corresponding type of unemployment.
No. 1. Description This type of unemployment is due to unstable economic conditions, going up and down. This type of unemployment is short-term and is not considered serious. This type of unemployment happens because workers do not have the expertise and the ability to work in a new sector. This type of unemployment usually exists for a longer period of time and the government has to find a way to solve this problem. This type of unemployment usually exists. Answer

2.

3.

4.

5.

7.7

FULL EMPLOYMENT AND NATURAL UNEMPLOYMENT RATE

Firstly, let us look at the definition of full employment. Full employment is an economic condition whereby every individual who wants a job at the current market salary/wage gets a job. One of the main economic goals of a country is to achieve full employment.

Full employment can also be defined based on natural unemployment rate. This rate can be defined as natural unemployment rate equals to structural unemployment plus frictional unemployment.

162 X TOPIC 7 UNEMPLOYMENT AND INFLATION

Structural unemployment + Frictional unemployment = Natural Unemployment Rate

Full employment is achieved when the real unemployment rate is the same as the natural unemployment rate. This means, when the real unemployment rate of a country at a specific time only consists of structural and frictional unemployment, then the country has achieved full employment. In other words, cyclical unemployment does not exist at full employment level. Each country has a different natural unemployment rate depending on various economic factors. For instance, the natural unemployment rate in Malaysia is between 3% and 4%. The rate in the United States of America is between 4% and 5%, whereas in Europe, the rate is between 7% and 8%.

EXERCISE 7.3
1. 2. 3. Describe THREE types of unemployment. What does natural unemployment rate mean? What is meant by full employment and how is it related to natural unemployment rate ?

7.8
x x x

REASONS FOR UNEMPLOYMENT

There are three main reasons for being unemployed, namely: Job losers; Job leavers; and New entrants and re-entrants.

Let us look at these three factors further in the next subtopics.

TOPIC 7

UNEMPLOYMENT AND INFLATION

163

7.8.1

Job Losers

Let us look at Figure 7.6. What can you say about it?

Figure 7.6: Job loser

Based on Figure 7.6 we can define job losers. A job loser is someone who has been involuntarily terminated or laid off from a job, whether temporarily or permanently. There are many reasons for this, for example, failure of the worker to fulfil his work requirements/conditions or the firms failure to fulfil its employees needs. Those who have lost their jobs have two choices either to look for a new job or leave the labour force. Those who leave the labour force are not considered unemployed.

ACTIVITY 7.3
Think of the psychological effects on a person who has lost his/her job. What are the pressures and problems he/she faces? Who can he/she discuss this with?

164 X TOPIC 7 UNEMPLOYMENT AND INFLATION

7.8.2

Job Leavers

There are some who voluntarily leave their jobs and not necessarily because they were laid off. If they were leaving one job because they were accepting another offer, then this would not contribute towards the increase in unemployment rate. The unemployment rate will only increase if these job leavers are still looking for a new job.

7.8.3

New Entrants and Re-entrants

What do new entrants stand for? New entrants are those who have just completed their studies and are ready to join the work force. They have never before been employed and are actively seeking employment for the first time. However, while looking for a suitable job, they have to be unemployed. How about re-entrants? Re-entrants are those who had previously been classified as employed, but have been out of the labour force for a period of time before actively seeking employment once again. Usually, they have to be unemployed while trying for a new job.

ACTIVITY 7.4
Are you aware that some graduates are very choosy about the kinds of jobs they will do, want to hold a high position, or insist on being paid a lot higher than the market rate despite not having any experience? What is your opinion about this scenario? State your opinion.

TOPIC 7

UNEMPLOYMENT AND INFLATION

165

7.9

EFFECTS OF UNEMPLOYMENT

Unemployment is a common phenomenon. However, a high unemployment rate will affect a countrys economic growth. Do you know how much unemployment can affect or influence our countrys economic growth? Many people think that frictional unemployment is just a short-term phenomenon and need not to be worried about. This unemployment also happens due to the economic growth of a country. However, unemployment due to reduced job opportunities caused by recession such as cyclical unemployment, will bring about negative effects on the countrys economic stability. The negative effects of unemployment can be divided into two, namely, effects on the economy and effects on the individual and population.

7.9.1

Negative Effects on the Economy

A high rate of unemployment will ruin a countrys economic growth. Table 7.2 shows the negative effects of unemployment on the economy.
Table 7.2: The Negative Effects of Unemployment on the Economy Negative Effects Unemployment does not encourage economic growth Drop in government revenue Wastage of production resources Description A high unemployment rate will ruin economic growth and performance. There will also be excess capacity from industrial production factors such as machines. This will indirectly cause a drop in investment level. When people are unemployed, the tax collection is also reduced. The government then has to reduce its expenditure to boost economic growth. A high rate of unemployment forces the economy to operate at a level below maximum. The wastage of resources brings about output production far lower than the potential output.

166 X TOPIC 7 UNEMPLOYMENT AND INFLATION

7.9.2

Negative Effects on the Individual and Population

Besides the negative effects on the economy, as stressed in an earlier part of this subtopic, unemployment also affects the social life of an individual, the community and the population as a whole. Table 7.3 shows the negative effects of unemployment towards individuals and the population.
Table 7.3: Negative Effects of Unemployment on Individual and Population Negative Effects Loss of job Description Temporary unemployment will not ruin the lives of the people as daily activities can be carried out using savings or loans. However, continuous unemployment will create unhealthy side effects such as being forced to take part in illegal activities to obtain money. Some skills can only be maintained if they are used or practiced often. Long-term unemployment might cause an individual to lose his/her skills. Long-term or continuous unemployment can create chaos and the government will be under pressure and receive criticism from many parties. This problem indirectly contributes towards social problems and causes an increase in crime rates. Increase in crime rates can cause foreign investors to shy away.

Loss of skills

Political instability

EXERCISE 7.4
1. 2. What are the reasons for unemployment? What are the negative effects of unemployment on the economy?

7.10

INFLATION

Generally, inflation means continued increase in general price levels. General price reflects the price level for all goods and services that exist in the economy at any given time. Do you know the method used in Malaysia to measure the general price level? This can be seen from the definition of inflation.

TOPIC 7

UNEMPLOYMENT AND INFLATION

167

Inflation can be defined as a continued increase in general price level of goods.

Inflation is one of the important topics of discussion in economics. A rise in price does not refer to any specific item or product. It refers to prices in general, which is measured based on the price index. There are a few price indexes that are commonly used to portray the general price level and one that is frequently used is the consumer price index (CPI).

7.11

CONSUMER PRICE INDEX (CPI)

Why do we use consumer price index (CPI)? CPI is usually used by the government and the private sector to measure the price level paid by consumers. In other words, CPI is a measure used to track changes in prices of goods and services purchased by households, that is, of the consumer basket. The composition of goods in the consumer basket is fixed based on consumer spending patterns.

Let us look at Figure 7.7 which shows an example of CPI.

168 X TOPIC 7 UNEMPLOYMENT AND INFLATION

Figure 7.7: Consumer price index Indices for total and selected main groups, Malaysia (January 2011 to March 2012) Source: http://statistics.gov.my

EXERCISE 7.5
1. Price hikes are always related to inflation. However, not all price hikes reflect inflation. Describe the situation where price hikes can be concluded as indicating inflation. What are the main components in the consumer basket for a Malaysian CPI?

2.

7.12

CALCULATION OF CPI

The process of calculating the actual CPI is a complicated one because the consumer basket has many goods. In order to give a clear and easy picture of how the CPI is formed, let us look at a model of two goods. Assume that the consumer basket has two goods, apples and rice. The year 2000 is picked as the base period/year for comparison purposes, whereas the current year is 2001. Basically, there are three main steps in the calculation of CPI, namely:

TOPIC 7

UNEMPLOYMENT AND INFLATION

169

(a) (b) (c)

Calculate the cost of CPI consumer basket at base year price. Calculate the cost of CPI consumer basket at current year price. Calculate the CPI for base year and current year.

7.12.1

Calculate the Cost of CPI Consumer Basket at Base Year Price

At the base year, a consumer buys 10 apples and consumes 5kg of rice. The apples cost RM0.50 per apple and the rice costs RM1 a kilogram. Table 7.4 shows consumer expenditure information for the base year.
Table 7.4: Cost of CPI Consumer Basket at Base Year Price Consumer Basket Item Apple Rice Quantity 10 5 Price RM0.50/fruit RM1.00/kg Cost of Basket RM5.00 RM5.00 RM10.00

Cost of CPI basket at base year price

Based on the information above, the consumer spent RM5 on apples and RM5 on rice. The total consumer expenditure for that particular year was RM10.

7.12.2

Calculate the Cost of CPI Consumer Basket at Current Year Price

The cost of the consumer basket for the current year is calculated after counting the cost of the consumer basket for the base year. During the current year, the quantity of goods purchased did not change. However, the price of apples increased to 60 sen a fruit and the price of rice increased to RM1.10 per kilogram. Table 7.5 provides information regarding the cost of apples and rice for the current year.
Table 7.5: Cost of CPI Consumer Basket at Current Year Price CPI Basket Item Apple Rice Quantity 10 5 Price RM0.60/fruit RM1.10/kg Cost of CPI Basket RM6.00 RM5.50 RM11.50

Cost of CPI basket at current year price

170 X TOPIC 7 UNEMPLOYMENT AND INFLATION

Overall, the consumer spent RM11.50 to purchase the same amount of apples and rice. RM6 was spent on apples and RM5.50 was spent on rice.

7.12.3

Calculate the CPI for Base Year and Current Year

After calculating the cost of the CPI basket at base year price and current year price, the next step would be to calculate the CPI for both years. The formula to calculate the CPI for base year and current year is: CPI =

Cost of CPI basket at current year price u 100 Cost of CPI basket at base year price

Therefore, CPI for the year 2000 is:

CPI for year 2000 =

10 u 100 100 10

However, CPI for the year 2001 is:

CPI for year 2001 =

11.50 u 100 115 10

Based on the CPI that has been calculated, it can be concluded that the average price of goods and services for the year 2001 is 15% higher than for the year 2000.

7.13

CALCULATING THE INFLATION RATE

The inflation rate is one of the important guides in an economy. It is used by various parties including the government and policy-makers to evaluate the price changes in a country. Basically, the inflation rate measures the percentage increase in the price of goods and services (CPI) over a given period of time. The following formula is used to calculate inflation rate:

TOPIC 7

UNEMPLOYMENT AND INFLATION

171

Inflation Rate =

New CPI - Old CPI Old CPI

x 100

For instance, in the year 2000, the CPI value is 100. The CPI value for 1999 is 94. Based on this information, the inflation rate for the year 2000 can be measured like this:

100  94 u 100 Inflation Rate for 2000 = 94 = 6.38%.

Conclusively, the average price of the consumer basket for the year 2000 is 6.38% higher than the year 1999. In order to obtain the same quantity of goods as in 1999, consumers have to increase their spending by 6.38%. Figure 7.8 shows an example of the inflation rate in country X from 1990 to 2000.

Figure 7.8: Inflation rate in country X from 1990 to 2000

Referring to Figure 7.8, the highest inflation rate in country X was in 1998, when it was about 5.3%. This was because of the currency crisis that hit the Asian region. Except for 1998, the inflation rate for the remaining years were below 5%. This is quite low compared to other countries. The low inflation rate is due to the effectiveness of the policies implemented by the government in order to curb inflation in our country.

172 X TOPIC 7 UNEMPLOYMENT AND INFLATION

EXERCISE 7.6
1. Explain the THREE steps needed to calculate CPI with suitable examples. State the formula used to calculate inflation rate.

2.

7.14

EFFECTS OF INFLATION

Besides unemployment, inflation is also another serious economic problem. Inflation not only affects economic activities, it also has an impact on an individual and on societys welfare. The following subtopics explain the effects of inflation which can be divided into four categories.

7.14.1

Effects of Inflation on Total Production

In the short-term, inflation will encourage an increase in national production if the factors of production are not fully utilised. Price hikes are a sign to producers that they can reap more profits if they increase production. However, if production is already utilising full resources, then inflation will only increase the price and not the production. Therefore, only medium-sized inflation which has not utilised full resources will bring about an increase in national production.

7.14.2

Effects of Inflation on Savings and Investment

Inflation causes purchasing power to shrink (drop in the value of money). This means that those who hold wealth in the form of cash will suffer losses. This situation encourages people to spend, and hence reduce savings. Besides that, inflation also encourages people to use their savings to purchase shares and assets like property. This is because during inflation, prices of assets are prone to increase. The increase in price level also encourages firms to start new investments because of the increased profits. This usually happens when the economy is expanding.

TOPIC 7

UNEMPLOYMENT AND INFLATION

173

7.14.3

Effects of Inflation on Income Distribution and Economic Wealth

Inflation affects different people in different ways. Those who work for a fixed salary will suffer losses. This is because price hikes will deteriorate the value of money. Individuals with fixed salaries will suffer from reduced purchasing power. The same effect is on retirees who are paid pensions. Those who are fond of saving money (either in a savings account or through purchase of government bonds), also suffer losses. The interest rates received on their savings could be lower than the inflation rate. Those who make money when inflation hits are businessmen. At that time, they will increase the price at a higher rate compared to the rate of increase in production costs. This situation allows businessmen to obtain higher profits. Besides this, inflation also brings profits for those who own shares and permanent assets like houses and buildings. Shareholders will get higher returns when the company makes profits. Those who own properties, such as land and houses, will get more profits because the properties will be priced higher during inflation. Inflation also causes uneven distribution of income between those who borrowed money and those who lent out money. Those who borrowed will reap some benefits because the actual value of the repayment will deteriorate. Although the amount repaid will be the same, the actual value of the sum (measured based on quantity of goods that can be purchased) has decreased. Therefore, those who lent out money will suffer some losses because the amount now has lower purchasing power.

7.14.4

Effects of Inflation on a Countrys Balance of Payments

Inflation causes local products to become more expensive in foreign markets and foreign products to become cheaper in local markets. This will cause an increase in imports and a decrease in exports. This will bring about a balance of trade deficit. This means cash outflow is more than cash inflow into the country. If the capital account balance does not change, it will cause the countrys balance of payments to suffer a deficit.

174 X TOPIC 7 UNEMPLOYMENT AND INFLATION

However, if other factors do not change, the rise in export price and the drop in import price of a country will create better trade conditions. This means that with the same export quantity, the country can obtain a higher import quantity. This situation happens only if demand to export the countrys goods remain fixed.

7.15

CPI AND LIVING COSTS

What does CPI mean? The CPI is frequently called a cost-of-living index, which measures the change or increase in money that is needed to maintain the existing lifestyle. However, the usage of CPI in measuring living costs does not reflect the consumers complete standard of living. This is because CPI has some problems and weaknesses. These six problems and weaknesses of CPI have been listed in Figure 7.9. As for the explanation for these problems and weaknesses, let us look at Table 7.6.

Figure 7.9: Problems related to CPI

TOPIC 7

UNEMPLOYMENT AND INFLATION

175

Table 7.6: Weaknesses of CPI

Weaknesses of CPI Choice of goods and services Description The goods chosen must reflect societys expenditure pattern. However, this expenditure pattern is not permanent and keeps changing in line with peoples preferences. CPI fails to take into consideration these changes. This problem arises due to the price difference in goods and services according to the time and place. For instance, a new product like a computer will cost more than a typewriter, and this makes it more difficult to make comparisons with the earlier year. It is only fair that prices of goods and services increase due to better quality. This does not mean that purchasing power has weakened because the price hike is in line with increase in quality. However, the CPI fails to take into account changes in quality of goods and services. Another question that we need to ask is whether the change in quality is much bigger than the change in living costs. The base year is chosen based on the price stability in that year. The choice of base year is needed for purposes of comparison. However, it is a little difficult to choose any particular year that has price stability because inflation and deflation happen all the time. People now have a choice as to where they would like to go to purchase goods and services. For example, people are now more interested in going to hypermarkets that give discounts compared with small shops nearby. This shows that CPI does not look at opportunity costs and only considers the absolute costs. Due to some problems in calculations mentioned earlier, the calculated CPI may have some inaccuracies. Therefore, information about the inflation rate of a country is not accurate because the figure may have been over-valued or undervalued.

Price difference of goods and services

Change in quality of goods and services

Choice of base year

Not taking into account opportunity costs

Over-valued or undervalued estimation

7.16

FACTORS THAT CAUSE INFLATION

ACTIVITY 7.5

You have studied the concept of inflation. Think for a moment, in what situations can inflation happen and as a consumer, how would you react to inflation? There are various factors that can cause inflation. Figure 7.10 lists down these factors.

176 X TOPIC 7 UNEMPLOYMENT AND INFLATION

Figure 7.10: Four factors that cause inflation

Let us look at these factors one by one in the next subtopics.

7.16.1

Demand-Pull/Excess Demand

Inflation that is caused by high or excess demand is called demand-pull inflation. Demand-pull inflation is defined as a situation where a lot of money is used to obtain a small quantity of goods.

This inflation happens when excess demand at full employment level causes an increase in the average price. Referring to Figure 7.11, the increase in demand from AD to AD at full employment output level (Y*) causes a price hike from P to P.

Figure 7.11: Demand-pull inflation

TOPIC 7

UNEMPLOYMENT AND INFLATION

177

7.16.2

Increase in Costs

What about increase in costs? What does it do? Increase in production costs will force producers to shift their burden to the consumers by increasing the sale prices. This inflation is called cost-push inflation. For example, when the workers union demands a salary hike, this increases the firms production costs. The increase in costs will decrease supply at every price level. Let us refer to Figure 7.12.

Figure 7.12: Cost push inflation

This causes the supply curve to move left from AS to AS and price increases from P to P. This situation will continue because an increase in the price of goods will cause a drop in an individuals real income.

7.16.3

Supply Shock

Did you know that supply shock can cause a drastic change in production costs of basic goods? For instance, long and terrible drought can be disastrous to the agricultural sector. It can cause an increase in food price. When petrol prices go up, most firms that use petrol for their production also suffer as their costs increase as well. This will eventually make the end product much more expensive and inflation happens as a result of this.

178 X TOPIC 7 UNEMPLOYMENT AND INFLATION

7.16.4

Adaptive Expectations

Inflation may happen if consumers expect it to happen. This psychological factor is an important factor in the field of social science. If people expect prices to go up, they will purchase goods before the price increases. Increase in demand causes prices to go up and inflation to occur. Inflation due to this psychological factor is called adaptive expectation inflation.

7.17

THE PHILLIPS CURVE

Lastly, before we end this topic, let us learn about the Phillips curve. What is the relationship between inflation and unemployment rate? The Phillips curve which is named after A.W. Phillips who was the first to examine inflation using data on the United Kingdom, shows the relationship between the inflation rate and the unemployment rate. It is a trade-off between inflation and unemployment where we have to accept a higher inflation rate to lower the unemployment rate and vice versa. The Phillips curve is shown in Figure 7.13.

Figure 7.13: The Phillips curve

In the 1950s and 1960s there was a smooth relationship between inflation and unemployment rate and most people relied on the Phillips curve as the main explanation of inflation. However, in the 1970s and 1980s, apparently there was no particularly relationship between inflation and unemployment where the curve did not show a negative relationship between those two variables. Based on this can we conclude that there was no trade-off between inflation and unemployment? Not necessarily, as we can see that other factors besides unemployment affect inflation. Changes in any of these factors will affect the relationship between inflation and unemployment.

TOPIC 7

UNEMPLOYMENT AND INFLATION

179

x x x x x x

The two main problems in macroeconomics are unemployment and inflation. The discussion begins with a description of the unemployment concept and the methods to measure it. There are three types of unemployment: structural, frictional and cyclical. The relationship between full employment and natural unemployment rate is also explained. There are three main reasons for being unemployed, namely, the situations facing job losers, job leavers and new entrants and re-entrants. Unemployment due to reduced job opportunities caused by recession such as cyclical unemployment, will bring about negative effects on the countrys economic stability. The negative effects of unemployment can be divided into two, namely, effects on the economy and effects on the individual and population. Inflation means a continued increase in general price levels of goods. The Consumer Price Index (CPI) is a measure used to track changes in prices of goods and services purchased by households, that is, of the consumer basket. There are three main steps in the calculation of CPI, namely calculate the cost of CPI consumer basket at base year price, calculate the cost of CPI consumer basket at current year price and calculate the CPI for base year and current year. There are four main effects of inflation, that is, effects on total production, effects on savings and investment, effects on income distribution and economic wealth and effects on a countrys balance of payments. The relationship between the consumer price index and cost of living is also described in addition to factors that cause inflation. This topic ends with a discussion on the trade-off between inflation and unemployment which can be explained using the Phillips curve.

x x x

x x

180 X TOPIC 7 UNEMPLOYMENT AND INFLATION

Consumer price index Cyclical unemployment Demand-pull inflation Discourage worker Frictional unemployment Full employment Full-time worker Inflation Job learners

Job losers New entrants Part-time worker Phillips curve Re-entrants Structural unemployment Unemploy Working age group

Department of Statistics, Malaysia. (2012). Principal statistics of labour force, Malaysia, September 2012. Retrieved November 30, 2012, from http://statistics.gov.my/portal/images/stories/files/LatestReleases/empl oyment/Labour_Force_Indicator_Malaysia_Sept_2012BI.pdf. Department of Statistics, Malaysia. (2012). Free download Consumer Price Index, Malaysia October 2012. Retrieved November 30, 2012, from http://www.statistics.gov.my/portal/download_Prices/files/CPI/2012/ OKT/BI/02Malaysia.pdf.