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Definition, Types, Causes, Effects and
The Business Cycle
• The term business cycle refers to
alternating increases and decreases in
the level of economic activity; sometimes
extending over several years
• Individual business cycles (one “up” and
one “down” period) vary substantially in
duration and intensity.
• All business cycles show four phases:
peak, recession, trough, and recovery
• At the end of
economic expansion,
business activity
reaches a peak. At
the peak GDP or
output reaches a
maximum and then
begins to fall. When
the economy bottoms
out, a trough occurs.
From this low point
economic recovery
sets in and
eventually most
sectors share in the
Business Cycle
Rec rac tion
on /
The Business cycle
The Peak
• THE PEAK: The peak is the point at
which business activity has reached a
temporary maximum
• At the peak, the economy is at full
employment and the level of real
output is at or very close to its capacity
• The price level is likely to rise during
this phase
• The peak is followed by a recession—a period
of decline in real output, income, employment,
and trade, lasting 6 months or longer
• This downturn is marked by the widespread
contraction of business in many sectors of the
• But because many prices are downwardly
inflexible, the price level is likely to fall only
if the recession is severe and prolonged—that
is, if a depression occurs
The Business Cycle
• The trough of the recession/depression
is the phase in which output and
employment “bottom out” at their lowest
• The trough phase of the cycle may be
short-lived or quite long
The Business Cycle
• In the expansion or recovery phase,
output and employment increase toward
full employment.
• As recovery intensifies, the price level
may begin to rise before there is full
employment and full-capacity
Business Cycle Theories
• Although economists generally agree
that business cycles exist, they have
many competing theories on their causes.
• We will briefly consider two types of
– Endogenous (internal)
– Exogenous (external)
Endogenous Theories
• These theories place the cause of business
cycles within rather than outside the
1. Innovation Theory: when a business attempts
to market a new product it will first encounter
resistance. But when others perceive the profits
being made by the innovator, they will imitate
his new product with their own versions and
production will soar. Eventually the market
will be saturated and economic downturn will
occur. The downturn continues until a new
innovation takes hold and the process begins
2.Psychological Theory: alternating optimism
and pessimism (self-fulfilling prophecy)
affects the level of economic activities. If
business owners are optimistic, they will
invest in plant, equipment and inventory.
This will provide more jobs and result in
more consumer spending, justifying still
more investment, more jobs and more
spending. But eventually business owners
will turn pessimistic, perhaps because they
figure this prosperity cannot continue. As
pessimism sets in, investment, jobs, and
consumer spending all decline and a
recession begins.
3.Inventory Cycle Theory: during economic
recovery, as sales begin to rise, business owners
are caught short of inventory, so they raise their
orders to factories, thus raising factory
employment. As factory workers are called
back to work, they begin to spend more money,
causing business owners to order still more from
factories. Eventually the owners are able to
restock their inventories, so they cut back on
factory orders. This causes layoffs, declining
retail sales, further cutback in factory orders,
and general economic decline. The decline
persists until inventory levels are depleted low
enough for factory orders to increase once again.
5. Monetary Theory: when inflation threatens,
the monetary authorities slow or stop the
growth of the money supply. This causes a
recession. When they are satisfied that
inflation is no longer a problem, the monetary
authorities allow the money supply to grow at
a faster rate, which brings about economic
6. Under Consumption Theory: the under
consumption or over production theory
stipulates that our economy periodically
produces more goods and services than people
want or can afford. A variant is the
overinvestment in which businesses
periodically overinvest in plant and equipment.
Exogenous Theories
1. The Sunspot Theory: William Stanley Jevon
believed that storms on the sun, which were
observed through telescope as sunspots,
caused periodic crop failures. Bad harvest
leads to recessions.
2.The War Theory: production surge caused
by preparation for war and war itself cause
prosperity and the letdown after war
causes a recession.
Definition of Inflation
• Inflation may be defined as a sustained rise
in the average or the general price level of
goods and services over a period of time.
• Inflation rate is the rate at which the price
level increases
True or False?
• Inflation means that the prices of all goods and
services in the economy prices are rising
• This statement is false. Inflation does not
mean that the price level of all goods and
services is rising. In inflation, we consider the
general price level. That is, we consider on
average the increase in the price level in an
economy. The price level of some commodities
may be rising. It may even happen that the price
level of some commodities may be constant or
falling slightly. We however, do not consider
individually what is happening to prices of goods
and services but collectively what is happening
to prices of goods and services.
True or False
• If inflation rate is 11%, it means that the
price level of all goods and services in the
economy rose by 11%
• This statement is False. Inflation only
tells us averagely what is happening to
prices. Some price may rise by 10%, others
by 20%, or still others by 50% and others by
1% or even 0%. The 11% gives on average
what is happening to increase in prices of
all goods and services in an economy.
True or False
• Between January and April, inflation rate
reduced from 11.5% to 10%. This means that
generally the prices of goods and services are
• This statement is false. Anytime we speak
of inflation, we never refer to decreases in prices.
Deflation rather refers to decreases in price in
average level of prices. However, when the rate
of inflation decreases, it only tells us the rate of
increase in price level is slowing. In the language
of Mathematics, we say the price level generally
is increasing at a decreasing rate.
Types of Inflation
• 1.Types by causes
Demand-pull and Cost-push
• 2.Types by rates of price increase
• 3.Types by expectations
Unanticipated inflation
Forms of Inflation
Suppressed Inflation
• This occurs when the government uses tough
controls on price and wage levels to prevent
the price from rising without eliminating the
underlying inflationary pressures.
• This practice often leads to quantity shortages,
queues, waiting lists, and black-markets. If the
system of control breaks down, as was the case
in former Soviet Union, massive pent–up
demand combined with significant collapse of
production pulls up price level to give rise to
Creeping Inflation
• A relatively low rate of inflation such as a rate of
less than 4%. The price level gradually creeps
• It is a type of inflation where the rate of inflation
accelerates to several hundred percent a day. A
classic example took place in Germany after World
War I. In Germany the prices rose 10% per hour. The
German government had to print larger and larger
denominations of its currency. A modern day
example will be that of Zimbabwe with inflation rate
of more than 2 million percent (as at October 2008).
Hyperinflation is associated with political crises
when weak a government loses control over the
economy and tends to printing money to pay its debts.
• This refers to the incidence of
accelerating and relatively high rates
of unemployment combined with high
Causes: Theories of inflation
• Economists distinguish between two types of
inflation: demand-pull inflation and cost-push
• 1. Demand-pull inflation. Traditionally, changes
in the price level are attributed to an excess of
total spending beyond the economy’s capacity to
• Because resources are fully employed, the
business sector cannot respond to this excess
demand by expanding output, so the excess
demand bids up the prices of the limited real
output , causing demand-pull inflation
• The essence of this type of inflation is “too much
spending chasing too few goods.”
1.Demand-Pull Inflation
• Under demand-pull inflation, aggregate
demand in the economy increases by more
than aggregate supply.
• In other words, the economy usually
demand more goods and services than
companies are able to produce.
• Increased AD can come from increase in
money supply, increase in population
growth, economic growth, government
expenditure and credit creation
Causes of inflation
2. Cost-push or supply-side
• Inflation may also arise on the supply or cost side of the
• The theory of cost-push inflation explains rising prices in
terms of factors which raise per unit production costs.
• Rising per unit costs squeeze profits and reduce the amount
of output firms are willing to supply at the existing price
• As a result, the economy’s supply of goods and services
declines. This decline in supply drives up the price level
• Under this scenario, costs are pushing the price level
upward, rather than demand pulling it upwards, as with
demand pull inflation
• Two potential sources of cost-push inflation are increases in
nominal wages and increases in the prices of nonwage
inputs such as raw materials and energy
• There are three variants of cost- push inflation, namely:
• The Wage–price Spiral: Because wages constitutes nearly
2/3 of the cost of doing business, when ever workers receive
significant wage increase, this increase is passed along to
consumers in the form of higher prices. Higher prices raise
everyone’s cost of living, engendering further wage increases.
• The second variant of cost-push is profit-push inflation .
Because just a few handful of huge firms dominate many
industries (e.g. Detergents, cars, and oil), these firms have the
power to administer prices in those industries rather than
accept the dictates of the market forces of demand and
supply. To the degree that they are able to protect their profit
margins by raising prices, these firms will respond to any rise
in cost by passing them on to customers.
• Finally, we have the supply-side cost shock , most prominently
the oil shocks of 1973-74 and 1979. When the OPEC nations
quadrupled the price of oil in 1973, they touched of not just a
major recession but also a severe inflation. When the price of
oil increases, the cost of business rises as well and is
translated into prices.
Measurement of Inflation
• Inflation is measured by price-index numbers
such as:
• Consumer Price Index; Producer Price Index;
and GDP deflator
• A price index measures the general level of
prices in any year relative to prices in a base
• The rate of inflation can be calculated for
any specific year (say, 2021) by subtracting
the previous year’s (2020) price index from
that year’s (2021) index, dividing by the
previous year’s index, and multiplying by 100
to express the result as a percentage
Rule of 70
The Consumer Price Index (CPI)
• The Consumer Price Index (CPI)
measures changes over time in the
general price level of goods and
services that households acquire for the
purpose of consumption, with reference
to the price level in the base year,
which has an index of 100.
Market Basket of Ghana
Inflation Basket (Food and non-food items)
• Education, Hotels, Cafes and Restaurants,
Health, Food and Non-alcoholic
Beverages, Housing, Water, Electricity,
Gas and Others Fuels , Communications,
Alcoholic Beverages, Tobacco and
Narcotics Furnishings, Household
Equipment and Routine Maintenance,
Miscellaneous Goods and Services
Recreation and Culture, Clothing and
Footwear, Transport
Food and non-alcoholic beverages
• Milk, cheese and eggs, (Sugar, jam, honey,
chocolate and confectionery), Fish and sea
food, Oils and fats, Cereals and cereal
products, Food products n.e.c, Vegetables,
Mineral water, soft drinks, fruit and
vegetable juices, Meat and meat products
Fruits Coffee, tea and cocoa
Ways of Computing Inflation
• There are two basic ways of computing inflation based
on the prices/cost of “market basket of goods and
services” purchased by a typical consumer or producer.
These are consumer price index and the producer price
index. The GDP deflator could also be used to compute
• Consumer Price Index
• The Consumer Price Index expresses the change in the
current prices of the market basket in terms of the
prices during the same period in the previous year. The
consumer price index is an estimation of price changes
in a basket of goods and services representative of
consumption expenditure in an economy.
Measurement of Inflation
• The CPI is usually computed monthly or
quarterly. It is based on the expenditure
pattern of almost all urban residents and
includes people of all ages. Various
categories and sub-categories have been
made for classifying consumption items
and on the basis of consumer categories
like urban or rural. Based on these
indices and sub indices obtained, the
final overall index of price is calculated .
Measurement of inflation
• In Ghana, 2012 is used as the base year as
the basis for comparison. Initially, the base
year was 2002. The Ghana statistical
service sets the base period CPI at 100. An
index of 110 means that there’s been a 10%
rise in the price of the market basket
compared to the reference period.
Similarly, an index of 90 indicates a 10%
decrease in the price of the market basket
compared to the reference period.
Measurement of Inflation
An illustrative example
Suppose that in a given economy, the
prices of various goods and services
between two periods are as follows:
If 2012 is the base year, compute the rate
of inflation in 2013.
An illustrative example
Price in 2012
Price in
Quantity purchased (both years)
Health Services
Utility (Water)
Fruit Juice
Formula for computing Inflation
Cost of market basket
Market value in 2013
Market value in 2012
Computing Inflation
Effects of inflation
A.Redistributive effect
• 1.Inflation penalizes people who receive fixed nominal
• Inflation redistributes real income away from fixedincome receivers and toward others in the economy
• Nominal income is the number of dollars received as
wages, rent, interest, or profits. Real income measures the
amount of goods and services nominal income can buy
• If your nominal income increases faster than the price
level, your real income will rise. If the price level
increases faster than your nominal income, your real
income will decline
• Percentage change in real income= percentage change in
nominal income- percentage change in price level
• Example: Landlords who receive lease payments of fixed
cedi amounts will be hurt by inflation as they receive
cedis in declining value over time
Redistributive effect of inflation
• 2.Inflation hurts savers. As price rise, the real value,
or purchasing power ; of a nest egg of savings
• Savings accounts, insurance policies, annuities, and
other fixed-value paper assets once adequate to meet
rainy-day contingencies or provide for a comfortable
retirement decline in real value during inflation
• Example: A household may save GH1000 in a
certificate of deposit (CD) in a commercial bank at 6%
annual in interest. But if inflation is 13%, the real value
of purchasing of that GH1,000 will be cut to about
(GH938) by the end of the year
• The saver will receive GH 1060 (=GH 1000+ GH60 of
interest), but deflating that (GH 1060 for 13% inflation
means that the real value is only about GH938
Redistributive effect of inflation
• 3. Inflation redistributes real income between debtors and
• Unanticipated inflation benefits debtors (borrowers) at the
expense of creditors (lenders). Unanticipated inflation is
inflation whose full extent was not expected
• As prices go up, the value of the cedi comes down. Thus the
borrower is loaned “dear cedis” but, because of inflation pays
back “cheap cedis”
• At the national level, inflation reduces the real burden of public
• In fact, some nations such as Brazil once used inflation so
extensively to reduce the real value of their debt that lenders
forced them to borrow money in U.S dollars or in some
relatively stable currency instead of their own currency
• In this way, they were prevented from using domestic inflation
as a means of subtly “defaulting ‘’ on their debt because
domestic inflation will only reduce the value of their currency
rather than reducing the value of the dollar-denominated debt
they must pay back
Redistributive effect of
anticipated inflation
• The redistributive effects of inflation are less
severe or are eliminated if people (1) anticipate
inflation and (2) can adjust their nominal incomes
to reflect expected price-level changes
• Labour contracts with cost-of-living adjustment
(COLA) agreements automatically raise worker’s
nominal incomes when inflation occurs
• Similarly, the redistribution of income from
lender to borrower might be altered if inflation is
• Lenders can avoid the erosion of the purchasing
power of their money by charging an inflation
Redistributive effect of
anticipated inflation
• The inflation premium is the expected rate of
• This could be done by increasing the interest
rate by the rate of anticipated inflation
• In this case, the real rate of interest—which is
the percentage increase in purchasing
power—which the lender receives from the
borrower is the difference between the
money/nominal rate of interest and the rate
of inflation
• Nominal interest rate=real interest rate +
inflation premium
B. Output effects of inflation
• 1.Stimulus of demand-pull inflation. Some
economists argue that full-employment can be
achieved only if some modest amount of inflation
is tolerated
• These economists argue that if spending is low,
the economy will have price stability, but real
output will be substantially below its potential
and the unemployment rate is high
• If total spending increases, society must accept a
higher price level—some amount if inflation—to
achieve greater real output and the
accompanying lower unemployment rates
Output effects of inflation
• Cost-push inflation and unemployment.
There is an equally plausible set of
circumstances in which inflation might
reduce both output and employment
• If the economy starts from a point where
the level of total spending helps achieves
full employment and price level stability,
and cost-push inflation occurs, then the
level of total spending cannot buy the
existing real output due to high prices.
• This will lead to a fall in real output and
Hyperinflation and Breakdown
• Some economists are fearful that the mild, “creeping”
inflation which might initially accompany an economic
recovery phase can snowball into severe hyperinflation
• Hyperinflation is an extremely rapid inflation whose
impact on real output and employment can be
• As prices persist in creeping upward, households and
businesses will expect them to rise further. So rather
than let their idle savings and current incomes depreciate,
people will “spend now” to beat unanticipated price rises.
• Businesses will do the same by buying capital goods
• Actions based on this “inflationary psychosis” will then
intensify the pressure on prices, and inflation will feed on
(Wage-price inflationary spiral)
• Furthermore, as price rises, labour will demand and
get higher nominal wages. Unions may seek increases
sufficient not only to cover last year’s price increases
but also compensate for inflation anticipated during
the future life of their new collective bargaining
• Firms will not resist such demands, but will jack up
prices of their goods to recoup the rising labour costs
• Increases in price of goods will make workers further
demand high wages, triggering another round of price
increases from firms , and then to workers, and so on.
• The net effect is a cumulative wage-price inflationary
• Nominal wage and price rises feed on each other and
transform creeping inflation into galloping inflation
Hyperinflation and economic
Aside from its disruptive redistribution effects,
hyperinflation can cause economic collapse
Severe inflation encourages speculative
Businesses may find it increasingly profitable
to hoard both materials and finished products,
anticipating further price increases
But restricting the availability of materials and
products intensifies the inflationary pressure
Also, rather than invest in capital equipment,
businesses and individuals savers may
purchase unproductive wealth—jewels, gold
and other precious metals, real estate, and so
forth—as a hedge against inflation
Hyperinflation and economic
• In the extreme, with high prices, normal
economic activities are disrupted: businesses
do not know what to charge for their products;
consumers do not know what to pay; resources
suppliers want to be paid with actual output
rather than money; creditors avoid debtors
the economy enters into a barter, production
and exchange drop dramatically
• Consequently, economic, social and a possible
political catastrophe emerges
Historical examples of
1.The case of Hungary
• “The inflation in Hungary exceeded all
known records of the past. In August 1946,
828 octillion (1 followed by 27 zeros)
depreciated pengos equaled the value of 1
prewar pengo. The price of the American
dollar reached a value of 3*10*22 (3
followed by 22 zeros) pengos. Fishermen
and farmers in 1947 Japan used scales to
weigh currency and change, rather than
bothering to count it. Prices rose by some 116
imes in Japan, 1938 to 1948” (Morgan, 1952)
Historical examples of
2. The case of Germany
• Faced with huge budget deficits, the Weimar
government simply ran the printing press to meet the
bills. During 1922, the German price level went up 5,
470 percent. In 1923,the situation worsened; the German
price rose 1,300,000,000,000 times. By October of 1923,
the postage of lightest letter sent from Germany to US
was 200,000 marks. Butter cost 1.5 million marks per
pound, meat 2million marks and an egg 600,000 marks
• Prices increased so rapidly that sometimes waiters
changed the menu several times during the course of a
lunch. Sometimes customers had to pay double prices
listed on the menu when they ordered” (Williams,1980)
Control of Inflation
• Demand-Pull
• Use of Monetary Policies – Monetary Policy involves the
use of money supply and interest rates to control the level
of economic activities in an economy. The government
through the central bank could use certain policies such
OMO, bank rates, etc to control inflation. In this case credit
squeeze policies are used to help reduce money supply in
the economy. With the reduction in money supply, demand
for goods and services may also reduce to bring down
increases in the general price level.
• Use of Fiscal Policies – Fiscal policy involves the use of
government spending and taxes to regulate economic
activities. The government can also use fiscal policies such
as taxation to reduce the disposal income of people.
Government should not spend on ambitious and
unproductive ventures, project or infrastructure through
borrowing from the financial institutions. Government
financing of project through printing of new notes increases
the money supply that tends to fuel the level of inflation. 54
• Supply-Push
• Reasonable wage increases – higher wage
demands increase cost of production which
leads to higher prices. Wage increases
should be accompanied by equal higher
productivity. Government should control the
activities of trade unions
• Increase production – increasing production
of goods to prevent shortages can and most
importantly control inflation. The problems
of the agricultural sector that tend to
increase cost of food should be solved.
• Grant subsidies to increase production
Definition of Unemployment
• The International Conference of Labour Statisticians
(ICLS) of the ILO considers a person of working age (e.
g. 15+years in Ghana) to be unemployed if during a
specified reference period (either a day or a week),
that person had been:
• ‘without work’, not even for one hour in paid
employment or self‐employment of the type covered
by the international definition of employment;
• ‘currently available for work’, whether for paid
employment or self‐employment; and
• ‘seeking work’, by taking active steps in a specified
recent period to seek paid employment or
Measurement of Unemployment
• Determining the unemployment rate means first
determining who is eligible and available to
• We can divide the total population into three
groups: those who are under 16 and/or
institutionalized; those who are “not in the labour
force”; and those who are employed
• Those who are under 16 and/or institutionalized,
for example, in mental hospitals or correctional
institutions. These people are not considered
potential members of the labour force
Measurement of Unemployment
• Those who are “not in the labour force”
are adults who are potential workers but
for some reason—they are homemakers,
in school, or retired—are not employed
and are not seeking work
• The labour force is all people who are
able and willing to work. Both those who
are employed and those who are
unemployed but actively seeking work
are counted as being in the labour force
Measuring unemployment: The U.
S Approach
• Unemployment rate in U.S comes from a survey of
60000 households who respond to survey questions.
Only adults (16+). Each household is put into each of
the following categories:
• Employed: These include those who responded to the
survey that they worked as paid employees, worked in
their own business or worked as unpaid workers in a
family business. Those who were temporary absent due
to vacation, illness or bad weather are also included.
• Unemployed: Those unemployed but were available
for work and had tried to find employment during the
previous four weeks, those waiting to be recalled to a
job from which they had been laid off
• Not in the labour force: full time students, homemakers
or retirees
Measuring Unemployment
Flows Into and Out of Unemployment
Discouraged worker and
• Some on who is available for work but
who fails to exert the required effort in
seeking work is known as discouraged
• If an individual who is gainfully employed
searches for additional job to boost his
earnings or diversify his work portfolio,
then we say that person is moonlighting.
Types of Unemployment
• The major types of unemployment are
voluntary and involuntary unemployment
• (1) Voluntary unemployment consists of:
• (a) Frictional Unemployment
• (b) Structural unemployment
• (2) Involuntary Unemployment consists of:
• (a) Cyclical unemployment
• (b) Seasonal Unemployment
Involuntary Unemployment
• Involuntary unemployment is said to
exist if individuals cannot obtain work
even if they are prepared to accept
lower real wages or poorer conditions
than similar qualified workers who are
currently in employment (Shackleton,
Causes of involuntary
• 1.Institutional factors
• Some government regulations such as
fixing minimum wages can distort the
efficiency of the market system in
providing jobs. When the market system is
allowed to work such that in the labour
market, wages are determined by the point
where demand for labour is equal to the
supply of labour, then the market will
ensure that everybody gets a job.
Causes of involuntary
• 1.Institutional factors
• But if government, perhaps, realizing that the
market wage is low decides to fix a wage
rate above the market level, then employers
will respond by cutting down their demand
for labour in order to be able to meet the
legally enforced wage rate imposed by the
government. But while demand for labour
will reduce, more people will join the labour
market because now they see it is worth
’working’ since they believe that they will be
paid well. The excess labour creates
Causes of Involuntary
• 2. Efficient wage Hypothesis
• According to this theory, unemployment results
when firm fix efficient wages. Firms set
efficient wages for several reasons:
• A. To ensure workers do not shirk
• B. To reduce high turnover which will
eventually increase cost of production
• C. To attract highly qualified workers
• D. To induce a gift mentality in workers
• As a result of the high wages, only ‘few hands’
are needed and job seekers are turned away
• According to another economic model known
as the insider-outsider model, unemployment
results from the action of institutional players
such as the trade union who takes decision to
fix wages taking into consideration only the
interest of those who are employed. They set
laws to ensure that even those outsiders who
want to work at lower wages cannot do so.
• Also to reduce high turnover, firms pay good
wages to the insiders (employees). As a result,
the interest of the outsiders (job seekers ) are
Causes of Involuntary unemployment
• Unemployment can also result from a situation
where there is a lower aggregate demand to meet
output. In other words, in the entire economy, demand
for goods and services are low. Demand for goods
and services come from consumers (household
expenditure), investment (purchases of businesses),
government and net export.
• When, for example, consumers are not buying what is
produced in the economy, inventory (stock of unsold
goods in the warehouse) builds up and firm cuts on
production and reduce the demand for labour. This is
also known as
cyclical unemployment . Here, there is
deficiency in the demand for goods and services.
• Cyclical Unemployment: Because of the
general decline in the demand for
products during a recession most firms
reduce their demand for all inputs
including labor.
• This type of unemployment is consistent
with the ups and downs of the business
cycle and reflects the decline in
aggregate output that occurs during the
recessionary phase of the business cycle.
It is thus defined as the extra
unemployment that occurs during periods
of recession.
Involuntary unemployment:
Seasonal Unemployment
• Another variant of involuntary
unemployment isseasonal
unemployment .
• In this type of unemployment, seasonal
variations in demand cause insufficient
demand and hence reducing the
demand for labour.
• Economists use the term frictional unemployment—consisting
of search unemployment and wait unemployment—for
workers who are either searching for jobs or waiting to take
jobs in the near future
• At any time some workers will be “between jobs”. With
freedom to choose occupations and jobs, some workers will
be voluntarily moving from one job to another
• Others will have been fired and will be seeking
reemployment. Others will be temporarily laid off from their
jobs because of seasonality, for example bad weather.
• There will be some particularly young workers searching
for their first time jobs
• As these unemployed people find jobs or are called back
from temporary layoffs, other job seekers and temporarily
laid-off workers will replace them in the “unemployment
Frictional Unemployment
• “Frictional “ correctly implies that the
labour market does not operate perfectly
or instantaneously—without friction—in
matching workers and jobs.
• Many workers who are voluntarily
between jobs, are moving from lowpaying , low productivity positions.
• This means greater income for workers
and a better allocation of labour
resources—and therefore a larger real
output—for the economy as a whole.
• Another form of voluntary unemployment is
structural unemployment . This happens when there
is a mismatch between the skills required at the
work place and that possesses by the worker.
• Changes over time in consumer demand and in
technology alter the “structure” of the total
demand for labour, both occupationally and
• Occupationally, some skills will be in less demand
or may even become obsolete; demand for other
skills, including skills not existing earlier, will
Structural Unemployment
• Structural Unemployment results because the
composition of the labour force does not
respond quickly or completely to the new
structure of job opportunities
• Some workers thus find that they have no
marketable talents; their skills and experiences
have become obsolete or unneeded
• They are structurally unemployed due to a
mismatch between their skills and the skills
required by employers who are hiring workers.
Causes of Voluntary
• Geographically, the demand for labour
also changes over time. Industries can
migrate from one region to another.
• These shift in job opportunities mean that
some workers become structurally
unemployed; there is a mismatch between
their location and the location of the job
The Natural Rate of
The economy’sUnemployment
natural rate of unemployment refers to
the amount of unemployment that the economy normally
experiences at full employment. It can also be defined
as the level of unemployment in an economy when the
labour market is in long-run equilibrium, that is, when the
total demand for labour is equal to the supply of labour
at the prevailing level of real wage rate.
• In this situation, people may be unemployed because:
a) they are between jobs and are taking time to search for
the most appropriate job with the highest wage (frictional
b) the industry in which they have traditionally worked has
experienced a structural decline or has been influenced
by technological advances (structural/technological
c) There has been a seasonal decline in the demand for their
labour services (seasonal unemployment).
Natural rate of unemployment/ “Full
• Full employment does not mean zero
unemployment. Economists regard frictional
and structural unemployment as essentially
unavoidable in a dynamic economy
• Thus “full employment” is something less than
100 percent employment of the labour force
• Specifically, the full employment rate is equal
to the total frictional and structural
• State differently, the full-employment
unemployment rate is achieved when cyclical
unemployment is zero
“Full Employment”
• The full-employment rate of
unemployment is also referred to as the
natural rate of unemployment
• The real level of domestic output
associated with the natural rate of
unemployment is called the economy’s
potential output
• The economy’s potential output is the real
output produced when the economy is
“fully employed.”
Effects of Unemployment
• Economic Cost: Okun’s law
• The basic economic cost of unemployment is forgone
output. When the economy fails to create enough jobs
for all who are able and willing to work, potential
production of goods and services is irretrievably lost
• Economists measure this sacrificed output as the GDP
gap—the amount by which actual GDP falls short of
potential GDP
• Potential GDP is determined by assuming that the
natural rate of unemployment exists
• Macroeconomists Arthur Okun quantified the
relationship between the unemployment rate and the
GDP gap. Okun’s law, based on recent estimates,
indicates that
for every 1 percentage point which the
actual unemployment rate exceeds the natural rate,
a GDP gap of about 2 percent occurs
Other economic costs
• It leads to loss of revenue for the
government as these people will not be
able to pay tax.
• Consequently, an economy with high
unemployment will be running budget
deficit and resort to borrowing leading
to high public debt.
Effects of Unemployment
• Noneconomic Cost
• Severe cyclical unemployment is more than an
economic malady; it is a social catastrophe
• Depression means idleness. And idleness means loss
of skills, loss of self-respect, a plummeting of
morale, family disintegration, and sociopolitical
• A job “… gives hope for material and social
advancement. It is a way of providing one’s children
a better start in life. It may mean the only honourable
way of escape from the poverty of one’s parents. It
helps to overcome racial and other social barriers. In
short… a job is the passport to freedom and to a
better life. To deprive people of jobs is to read them
out of our society
“ (Reuss, 1964, p.133)
Effects of unemployment
Noneconomic cost
• It leads to poor health and lower attainment of
education e.g child labour
• It has psychological effect on jobseekers and
further worsen health
• It can create disaffection among jobseekers
and some of them, especially the youth, can
resort to social vices such as robbery,
• It leads to social upheavals and political
• It breeds poverty and deprivations