Unemployment, Inflation, AD/AS and Policy

Unemployment, Inflation, AD/AS and Policy

Two of the most important macroeconomic objectives for governments and central banks are maintaining low unemployment and stable, low inflation. This lecture examines how unemployment and inflation are defined and measured, the aggregate demand/aggregate supply (AD/AS) model that ties these concepts together, and the monetary and fiscal policy tools governments use to manage the economy.

Unemployment

The unemployment rate measures the percentage of the labour force that is unemployed — actively seeking work and available to start. It is important to note what is and is not included:

• The labour force includes both employed and unemployed persons; it excludes those not seeking work (e.g. full-time students, retirees, carers who have given up looking)
• The unemployment rate does not capture discouraged workers (those who have given up looking), underemployed workers (part-time workers who want full-time work), or those in jobs below their skill level

Economists classify unemployment into several types:

• Frictional unemployment — short-term unemployment arising from people being between jobs for normal reasons; the time taken to match workers with available jobs. Always present in a dynamic economy. Examples: graduates searching for first jobs, workers voluntarily leaving to find better positions.
• Structural unemployment — long-term unemployment caused by shifts in the structure of the economy — changes in technology, consumer tastes, or trade patterns that make certain skills obsolete and reduce demand for certain types of workers. The skills workers have no longer match the skills employers need. Example: manufacturing workers displaced by automation or offshoring.
• Cyclical unemployment — unemployment caused by a downturn in the business cycle (a recession); the economy is not producing enough output to employ everyone who wants to work. Cyclical unemployment falls in expansions and rises in recessions.
• Seasonal unemployment — unemployment arising from seasonal fluctuations in employment (e.g. tourism workers in off-season, agricultural workers during non-harvest periods).

Full employment does not mean zero unemployment — it means the absence of cyclical unemployment. At full employment, only frictional and structural unemployment remain. The unemployment rate at full employment is sometimes called the natural rate of unemployment.

NAIRU

NAIRU (Non-Accelerating Inflation Rate of Unemployment) is the level of unemployment below which inflation would be expected to accelerate. When unemployment falls below NAIRU, labour markets tighten, workers gain bargaining power, wages rise, and firms pass on higher labour costs as higher prices — generating inflation. NAIRU is not a fixed number — it varies over time and by country depending on labour market institutions, skills, and technology.

Inflation

Inflation is a sustained rise in the general price level — a reduction in the purchasing power of money. It is measured by the percentage change in the CPI from one period to the next. Costs of inflation include:

• Redistribution of wealth — inflation benefits debtors (who repay loans in dollars worth less than when borrowed) and harms creditors and those with fixed nominal incomes
• Menu costs — the costs of changing prices (literally, reprinting menus; more broadly, updating price lists, contracts, and systems)
• Shoe-leather costs — the time and effort costs of managing cash balances more carefully to avoid holding depreciating money
• Uncertainty — high and variable inflation makes planning and investment more difficult

Deflation (falling prices) can be even more damaging than moderate inflation — it increases the real burden of debt, reduces spending (consumers delay purchases expecting lower prices), and can trigger a deflationary spiral.

The AD/AS Model

The Aggregate Demand and Aggregate Supply (AD/AS) model is the macroeconomic equivalent of the demand and supply model. It shows how the overall price level and real GDP are determined in the economy as a whole.

Aggregate Demand (AD) is the total quantity of goods and services demanded in the economy at each price level. The AD curve slopes downward because:

• Wealth effect — higher prices reduce the real value of wealth (especially financial assets), reducing consumption
• Interest rate effect — higher prices increase demand for money, raising interest rates, reducing investment and interest-sensitive consumption
• International trade effect — higher domestic prices make exports less competitive and imports more attractive, reducing net exports

The AD curve shifts when any of the components of GDP (C, I, G, or NX) changes for reasons other than a change in the price level.

Aggregate Supply (AS) represents the total quantity of goods and services that all firms are willing and able to supply at each price level. In the short run (SRAS), the AS curve slopes upward. In the long run (LRAS), AS is vertical at potential GDP — determined by resource endowments and technology, not by the price level.

Monetary Policy

Monetary policy is conducted by the Reserve Bank of Australia (RBA) through control of the cash rate — the interest rate at which banks lend to each other overnight. Changes in the cash rate flow through to all interest rates in the economy, affecting borrowing costs for households and businesses:

• Expansionary monetary policy — the RBA decreases the cash rate to stimulate aggregate demand (AD); lower interest rates reduce the cost of borrowing, encouraging investment and consumption; lower rates also tend to depreciate the exchange rate, boosting exports
• Contractionary monetary policy — the RBA increases the cash rate to reduce aggregate demand and control inflation; higher interest rates discourage borrowing and spending

Monetary policy operates with a lag of typically 12–18 months before its full effect on the economy is felt — making it challenging to calibrate precisely.

Fiscal Policy

Fiscal policy is conducted by government through changes in government expenditure and taxation:

• Expansionary fiscal policy — increase government spending and/or reduce taxes to increase aggregate demand; typically used to combat recession and unemployment
• Contractionary fiscal policy — reduce government spending and/or increase taxes to reduce aggregate demand; used to combat inflation when the economy is operating above potential (above full employment)

Automatic stabilisers are fiscal policy elements that automatically expand or contract along with the business cycle without requiring new legislative action. Examples: unemployment benefits (which rise in recessions, supporting consumer spending) and income taxes (which fall in recessions as incomes fall, acting as automatic tax cuts). Automatic stabilisers smooth the business cycle without the delays of discretionary policy.

The Multiplier Effect

The multiplier effect means that an initial increase in government spending (or any component of aggregate demand) leads to a larger total increase in GDP. The logic: government spends $1 billion on infrastructure; workers and firms receive $1 billion in income; they spend a fraction of this income (determined by the marginal propensity to consume, MPC) on other goods and services; those sellers then spend a fraction of their new income; and so on. The total increase in GDP is the initial spending times the multiplier: Multiplier = 1 / (1 - MPC). If MPC = 0.8, the multiplier is 5; a $1 billion government spend increases GDP by $5 billion in total (in theory). In practice, the multiplier is smaller due to taxes, imports, and monetary policy responses.