Inflation and unemployment Tradeoff

1
Inflation and unemployment Tradeoff Okuns Law
1unemployment ? 2 reduction in GDP   The
sacrifice ratio total output that has to be
given up to reduce the inflation rate by 1. The
value of the sacrifice ratio varies depending on
the state of the economy and the method chosen to
reduce inflation.
2
There are variations in unemployment rates across
different groups in the labor force. The overall
rate of unemployment is the weighted average of
the unemployment rates of these different
groups   There is high turnover in the labor
market with constant flows into and out of the
unemployment pool.   Most of this turnover is
cyclical and most workers remain unemployed for
fairly short periods of time.   A significant
portion of US unemployment consists of workers
who will be unemployed over a long period of
time.
3
The Natural Rate of Unemployment Largely
composed of Frictional Unemployment Is
determined by the duration and frequency of
unemployment
4

• Structural characteristics that determine the
  duration of unemployment are
• the organization of the labor force,
• the demographic make-up of the labor force
• the availability of unemployment benefits, and
  the desire of some of the unemployed to continue
  the search for better jobs.

5
The frequency of unemployment is the average
number of times, per period, that a worker
becomes unemployed. It depends on two
factors          the variability of the demand
for labor across employers, and          the
rate at which new workers enter the labor force.
  The factors mentioned above determine the
natural rate of unemployment. Since these factors
constantly change, the natural rate does as well.
Many economists believe that the natural
unemployment rate in the U.S. was around 5.2 in
the late 1990s, but nobody knows for sure.
6
The idea that long periods of high unemployment
may actually contribute to a higher natural
unemployment rate is known as unemployment
hysteresis.   Explanations for hysteresis        
           Workers who are unemployed may become
accustomed to not being in the work force (though
they may take on odd jobs while receiving
unemployment benefits) or may get discouraged.
2)                     Workers with a history of
long and/or frequent unemployment may convey the
signal that they do not have the motivation or
skills required to ensure stable employment.  
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The replacement ratio (after-tax income while
unemployed divided by after-tax income while
employed) has a significant impact on the desire
of an unemployed person to accept a new job.
Unemployment insurance also reduces firms'
incentives to create stable employment by
reducing the consequences of laying off workers.
More generous unemployment benefits, together
with the inflexibility of wages (due to more
powerful labor unions) and the high cost of
firing workers, are often cited as reasons for
unemployment rates that are higher in many
European countries than in the U.S. or Japan.
8
Costs of anticipated inflation Few if wages,
taxes, interest rate are indexed to
inflation Menu costs Shoe-leather costs Costs of
holding currency rises with inflation
(dollarization)
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Costs of unanticipated inflation Wealth
Redistribution Debtors and Creditors
Homeowners with fixed mortgage payments
Social security recipients Tax Bracket
Creep COLA (decline in unionization)
Non-desirability of Zero inflation (Tobin)
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Chapter 8 terms Inside and outside lags Decision
and Action lags Advantages of Monetary
policy Automatic Stabilizers Targets,
Instruments, Indicators Activist Policy vs. Fine
Tuning Rules vs. Discretion Central Bank
Independence