CHAPTER THREE

MACROECONOMIC PROBLEMS AND POLICY INSTRUMENTS

It is clear and understandable that nations seek economic growth, full employment, and price
stability as their major macroeconomic goals. However, the experience of many industrial
countries shows that these goals have not always been achieved. This is because of the central
problem of macroeconomics such as inflation, business fluctuations, inequalities of income and
wealth, instability of prices, budget and trade deficit, etc. In the following sections we discuss in
detail three of these problems, namely, business cycle, unemployment, and inflation, which are
problem of determination of income and employment.
3.1. What are Business Cycles?
Business cycle or trade cycle refers to the regularly occurring fluctuations in economic activity
in market economies. Business cycles refer to alternating period of expansion and contraction
in economic activity. In a business cycle, there are wave-like fluctuations in four interlinked
economic variables: employment, income, and output and price level. When the values of these
economic variables over time are plotted on a graph, we get a wave-like figure, which is given
the name business ‘cycle’. They are often called business fluctuations.

3.1. Graphical depiction of Business cycle

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Phases of Business Cycles
Economists have identified four distinct phases of business cycles. These are:
 Peak (or boom)
 Contraction (or recession)
 Trough (or depression)
 Recovery (expansion)

3.1.1 Cyclical nature of Business cycle

o What are these four phases?
i. Boom: This is a phase of economic activity characterized by rising demand, rising
prices, rising investment, rising employment, rising incomes, rising purchasing power
and so on. Business continues to remain profitable. More loans are taken from banks and
financial institutions. As a result of excess demand of loanable funds there occurs rise in
interest rates. The investors, therefore, voluntarily undertake risks and go in for
investment, which further fuels boom conditions through the working of the multiplier
effect. During the boom period, there is over-optimism in business psychology, and thus
the economy can get over-heated.
 Peak is a period at which business activity has reached a temporary maximum. It
is the period of high employment, high level of demand, and high degree of
utilization of resources. The price level is likely to rise during this period.

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ii. Contraction or Recession: The recession phase corresponds to the contraction or
slowing down of economic activity. During this phase unemployment rises while sales,
income and investment all fall. Producers become pessimistic about the future level of
demand for their products and hence investment becomes less attractive. Thus, there may
be cuts in investment, resulting in cuts in employment, a fall in incomes, and declines in
purchasing power and demand. Prices may then begin to fall.
iii. Depression: A depression is a period of low economic activity characterized by
massive unemployment, a low level of consumer demand and widespread idle capacity in
industry. Most prices will be falling. Business profits will be low or even negative.
Investment will fall due to lack of confidence of the businessmen. There will be low
demand for loan able funds. Banks will have surplus funds because nobody is willing to
take risk. This is a stage when the business confidence is at its lowest. Investment,
employment, output, income, and prices reach bottom.
iv. Recovery: As the economy moves out of depression, it enters the phase of recovery. In
a sustained recovery, the level of investment, employment, output, income and prices
move upwards.
Now businessmen replace old and worn-out machinery. Employment, income and
consumer spending start rising. The rise in production, sales and profits yield place to
business optimism. So the existing labor forces and unused capacity are pressed into
service. Prices either stay constant or start rising during the recovery period.
3.1.2. Characteristics of Business Cycles
The following are some of the characteristics of business cycles:

1. Business cycles are the wave-like fluctuations in economic activity as reflected in basic
economic variables like employment, income, output and price level,
2. These fluctuations are cyclical in nature,
3. The sequence of changes in a business cycle (i.e., boom, recession, depression and recovery)
recur frequently and in a fairly similar pattern,
4. Periodicity between the cycles need not be same or similar,
5. Business cycles are fluctuations found in overall economic activities, and are not limited to
any particular firm or industry,

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6. Normally, if the boom is high the succeeding depression will also be severe. However, this
relationship might not hold good in the reverse,
7. Business cycles usually last for a period of 2 to 10 years. But their duration differs.
Sometimes a major depression may last for more than a decade; at other times the down turn
may be brief. It may last for 2-3 years. The great depression of 1929 lasted for 3-4 years.
3.1.3. What are the possible causes of business cycles?
Economists have suggested many theories to explain fluctuations in business activity. We will
briefly review these theories.
i. Major Innovations
Joseph Schumpeter offered his own explanation of trade cycles on the basis of the timing of
major innovations in a capitalist system. He has suggested an explanation of the business cycle in
terms of innovations that take place in the economic system of a capitalist country at periodic
intervals. By innovation, he means the introduction of new product or a new process (a new
method of producing an old product). In broad sense such innovations may refer to changes the
existing methods of production, the introduction of a mechanical invention like the introduction
of tractors, the introduction of a new product like a computer, the introduction of a new
technique of production, the development of new markets for the existing products, the
development of new variety of raw materials and at low costs, the introduction of new methods
of management in business such as time management, which have great impact on investment
and consumption spending. These, in turn, affect output, employment, and the price level. These
major innovations occur irregularly and thus contribute to the variability of economic activity.
According to Schumpeter, business cycles are simply a part of the capitalist system and cannot
be eliminated.
ii. Political and Random Events
Other economists have explained business cycles in terms of political and random events. For
example, wars, natural disasters, conflicts, and civil strives can be economically disruptive.
iii. Monetary Phenomenon
Still other economists view the business cycle as a purely monetary phenomenon. When
government creates too much money, they say, an inflationary boom occurs. In contrast, too
little money precipitates a decline in output and employment This theory developed by R.G.
Hawtrey. He attributed prime responsibility for business fluctuations to monetary instability.

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Let us start with a situation o recession. Hawtrey Monetary phenomenon implies that banks are
now flushed with funds (i.e., have excess reserves). They extend loans at low rates of interest.
This would stimulate (encourage) investment. The increase in planned investment raises
production and income, raising sales. The process goes on continuously in the expansionary
phase of the cycle.
According the Hawtrey, the unstable behavior of the banking system is the root cause of all
crises. In the expansionary phase, banks collectively extend more credit than would be required
for a full employment equilibrium output level as they share the business community’s
optimistic expectations about future business conditions.
iv. Changes in total Spending
Despite the above three views, many economists see changes in the level of total
spending as the immediate cause of cyclical changes in the levels of real output and
employment. In a market economy, businesses produce goods or services only if they can
sell them profitably. If total spending sunk, many businesses find that it is no longer
profitable to produce. Therefore, output, employment, and incomes will fall. In contrast, a
higher level of spending means that more production is profitable, and output,
employment, and incomes will rise.
3.1.4. Control of Business Cycles
Business cycles or cyclical fluctuations in economic activity cause a great deal of harm to the
smooth and orderly progress of a modern mixed economy. So planners and policy-makers
always make effort to bring them under control. However, it has to be noted that business cycles
are a part of our lives and cannot therefore be completely eliminated. We can only hope to
reduce their severity by adopting suitable policies. These policies are known as stabilization
policies and are of two broad categories, viz., monetary policy and fiscal policy
1. Monetary policy: Business Cycles are not a purely monetary phenomenon. But they are
aggravated by monetary factors. So it is necessary to reduce money supply during the
expansionary phase of the business cycle when there is a problem of price inflation. On the
other hand, if the economy is in the depression phase, it is essential to reduce the stock of money
in circulation. Various instruments are used by the central bank to control stock of money in
circulation with a view to stabilizing the economy such as the bank (discount) rate, open market
operations, and reserve ratios, selective credit control etc

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2. Fiscal policy: a positive fiscal policy helps to compensate for the ups and downs in economic
activities. While the economy losses its dynamism and falls below the full employment growth
path, fiscal policy may be used to bring aggregate demand back to the full employment level.
Taxes have to be reduced; expenditures increased and total spending there by rising. When the
economy shows signs of dynamism and there is danger of inflation, an exactly opposite type of
fiscal action is called for to dampen the economy. Taxes have to be raised and expenditures
reduced. The net result is likely to be an elimination of excess aggregate demand that was
causing the trouble. It is, of course, not possible to eliminate recession or price inflation
altogether, but an appropriate compensatory fiscal policy can keep the economy close to its full
employment path.
3.2. Inflation
3.2.1. Meaning of Inflation
Inflation is a continual and ongoing rise in general or average price level on a specified period of
time. A birr today doesn’t buy as much as it did ten years ago. Thus, Inflation, in general terms,
is described as a situation characterized by a sustained increase in the general price level. It may
be noted thus:
 A small rise in prices or an irregular price rise cannot be called inflation. It is a persistent
and appreciable rise in prices which is called inflation.
 During inflation, all costs and prices do not rise together and in the same proportion. It is
an increase in the general level of prices measured by a price index, which is an average
of consumer or producer prices.
 Inflationary movements are not a rise in any single price or some group of prices.
Note: Periods of falling prices, called deflation, were almost as common as periods of rising
prices.
3.2.2. Causes of Inflation
Inflation cannot be attributed to a single factor. Rather, a mix of several factors is responsible for
it. Normally, these factors are divided into two broad types: Demand-Pull factors and Cost-Push
factors. Accordingly, we have the concepts of Demand-Pull inflation and Cost-Push inflation.
1. Demand-Pull Inflation
When the demand for goods and services exceeds the available supply at current prices, it is a
demand-pull inflation. The situation is described as “too much money chasing too few goods”.

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For some reason people come into possession of more money or purchasing power, but there is
no corresponding expansion of the supply of goods and services. The expenditure increases, and
prices keep on rising continuously.
 The various causes for demand-pull inflation include:
 An increase in government expenditure: This increases the demand for goods and
services, and hence, is responsible for price rise,
 An increase in money supply: Such a situation is followed by rises in prices. Money
represents purchasing power over goods and services,
 An increase in investment: When this is done by the private or public sector it leads to a
large demand for goods and services, which is followed by price rises.
 An increase in wages: particularly when this does not match a corresponding increase in
productivity, it increases the general price level,
 Black money: Such money, which is normally spent on non-essential goods and services,
plays an important role in pushing up the prices in a country.
 Deficit financing: This is an important factor for rises in money supply and therefore for
rises in price level,
 Credit Expansion: This is also a major cause of price rise. As a result of credit
expansion, people buy more goods, leading to increases in the demand for goods and this
leads to increase in the prices of goods.
2. Cost-Push Inflation
Inflation resulting from rising costs of production and slack resource utilization is called cost-
push inflation. This is sometimes also known as supply-shocked inflation. Setbacks in
agricultural and industrial production due to various reasons –shortage of raw materials, power
breakdowns, strikes and lockouts, bad weather conditions, increase in input prices, etc. – lead to
a decreased supply of goods in comparison to their demand, which further leads to price rise.
Also, hoarding, both by firms and households, contributes to restricting the supply of goods and
services in the economy, which leads to a rise in price level. Firms are interested in speculative
dealings to earn large profits, whereas households hoard goods when they expect that prices will
rise in the future.
Remarks: Demand-pull and cost-push inflation go together in an economy. In both situations,
two common features exist:

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  rise in the prices of factor inputs, and
 rise in the prices of final goods.
 Therefore, demand-pull and cost-push inflation intermingle, and it may not be possible to
separate them.
3.2.3. Measuring Inflation
Economists measure changes in the cost of living using the price indexes that we have discussed
in the previous topics. Thus, measuring inflation means a measurement of variations in general
price level. To do this, various types of price indexes, such as producer price index, consumer
price index, etc. are constructed. These price indexes are indicators of the overall or general price
level. The Consumer Price Index (CPI) is the most widely accepted index for measuring the rate
of inflation, since it measures the average price of goods and services bought by general
consumers. CPI measures the cost of a “market basket” of consumer goods and services in
current time relative to the cost of that bundle during a particular base year. The base year is a
reference year.

Cost of market basket of goods at current prices

CPI= *100%
Cost of the same basket of goods at base year prices
Rate of inflation measures the extent of the increase in the general price level over time. It is
usually measured as the percentage change in the general price level from one year to the next.
The inflation rate measures how fast prices are rising. The inflation rate is the positive
percentage change in the price level on an annual basis.
Example1. The consumer price index (CPI) in December 1999 was 168.9, and the CPI in
December 2000 was 174.6. The inflation rate for 2000 is the percentage change in prices from
the end of December 1999 through the end of December 2000.
CPI t  CPI t  1
Infilationrate()  *100%
CPI t  1

174.6  168.9
 *100%
168.9
3.37% 3.4%

This means the inflation rate in 2000 was approximately 3.4 percent.

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Self Check Exercise:. Assume a simple economy in which a typical consumer buys only two
goods-wheat and edible oil. The consumer buys 50 kg of wheat and 10 liters of oil per year and
assume that the prices of these basket of goods in three different years are the following
YEAR Price of a kilo of wheat Price of a liter of oil
2000 E.C. Birr 2 Birr 10
2001 E.C. 3 13
2002 E.C. 2 14
2003 E.C. 4 24

a. Calculate the consumers price index and the inflation rate for 2001, 2002, 2003 by assuming
the respective previous year of each year a base year?
3.2.4. The impact of inflation
3.2.4.1. The Effects of Inflation on the Society
Did you try it? It is good. If you ask the average person why inflation is a social problem, he will
probably answer that inflation makes him poorer. “Each year my boss gives me promotion (a
raise in salary), but prices go up and that takes some of my increased salary away from me.’’ The
implicit assumption in this statement is that if there were no inflation, he would get the same
raise and be able to buy more goods. This complaint about inflation is a common fallacy.
Why, then, is a persistent increase in the price level a social problem? It turns out that the costs
of inflation are subtle. Indeed, economists disagree about the size of the social costs. In the next
few paragraphs, we will see the costs of expected and unexpected inflation.
1. The Costs of Expected Inflation
Suppose that every month the price level rose by 1 percent. What would be the social costs of
such a steady and predictable 12-percent annual inflation?
A. One cost is the distortion of the inflation tax on the amount of money people hold. As we
have already discussed, a higher inflation rate leads to a higher nominal interest rate, which in
turn leads to lower real money balances. If people are to hold lower money balances on average,
they must make more frequent trips to the bank to withdraw money—for example, they might
withdraw birr 100 twice a week rather than birr 200 once a week. The inconvenience of reducing
money holding is metaphorically called the shoe-leather cost of inflation, because walking to the
bank more often causes one’s shoes to wear out more quickly.
B. A second cost of inflation arises because high inflation induces firms to change their
posted prices more often. Changing prices is sometimes costly: for example, it may require

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printing and distributing a new catalog. These costs are called menu costs, because the higher the
rate of inflation, the more often restaurants have to print new menus.
C. A third cost of inflation arises because firms facing menu costs change prices infrequently;
therefore, the higher the rate of inflation, the greater the variability in relative prices. For
example, suppose a firm issues a new catalog every January. If there is no inflation, then the
firm’s prices relative to the overall price level are constant over the year. Yet if inflation is 1
percent per month, then from the beginning to the end of the year the firm’s relative prices fall
by 12 percent. Sales from this catalog will tend to be low early in the year and high later in the
year. Hence, when inflation induces variability in relative prices, it leads to microeconomic
inefficiencies in the allocation of resources.
D. A fourth cost of inflation may result from tax laws. Many provisions of tax code do not
take into account the effects of inflation. Inflation can alter individuals’ tax liability, often in
ways that lawmakers did not intend. One example of the failure of the tax code to deal with
inflation is the tax treatment of capital gains. Suppose you buy some stock today and sell it after
a year from now at the same real price. It would seem reasonable for the government not to levy
a tax, because you have earned no real income from this investment. This implies , if there is no
inflation, a zero tax liability would be the outcome. But suppose the rate of inflation is 12 percent
and you initially paid birr 100 per share for the stock; for the real price to be the same a year
later, you must sell the stock for birr 112 per share. In this case a tax code that ignores the effects
of inflation, says that you have earned birr 12 per share in income, and the government taxes you
on this capital gain. This means that the tax code measures income as the nominal rather than the
real capital gain. In this example, inflation distorts how taxes are levied.
E. A fifth cost of inflation is the inconvenience of living in a world with a changing price level.
For example, a changing price level complicates personal financial planning. One important
decision that all households face is how much of their income to consume today and how much
to save for retirement. Deciding how much to save would be much simpler if people could count
on the stable price level in 30 years being similar to its level today.
2. The Costs of Unexpected Inflation
Unexpected inflation has an effect that is more harmful than any of the costs of anticipated
inflation: Let us it see using different cases.

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Firstly, consider long-term loans. Most loan agreements specify real interest rate, which is
based on the rate of inflation expected at the time of the agreement. If inflation turns out
differently from what was expected, the ex post real return that the debtor pays to the creditor
differs from what both parties anticipated.
 If inflation turns out to be higher than expected, the debtor wins and the creditor loses
because the debtor repays the loan with less valuable dollars.
 On the other hand, if inflation turns out to be lower than expected, the creditor wins and
the debtor loses because the repayment is worth more than what the two parties
anticipated.
Secondly, unanticipated inflation also hurts individuals on fixed pensions. Workers and firms
often agree on a fixed nominal pension when the worker retires (or even earlier). Because the
pension is deferred earnings, the worker is essentially providing the firm a loan: the worker
provides labor services to the firm while young but does not get fully paid until old age.
 Like any creditor, the worker is hurt when inflation is higher than anticipated.
 Like any debtor, the firm is hurt when inflation is lower than anticipated.
The more variable the rate of inflation, the greater the uncertainty that both debtors and creditors
face. Because most people are risk averse (dislike uncertainty) the unpredictability caused by
highly variable inflation hurts almost everyone.
3.2.4.2. The Impact of Inflation On Economic Growth
Inflation has different levels or degrees of severity, described as moderate, galloping, and hyper
inflation. A moderate inflation is generally believed to be a necessary condition of economic
growth. A state of zero inflation rate is not expected to yield the desired growth rate in the case
of a developing economy. Inflation leads to a shift in real incomes, provides encouragement to
investment, and can be used as a tool to raise the level of savings. However, inflation may also
retard economic development in a number of ways. It may lead to lopsided development; lead to
increased consumption and have a negative effect on savings; have an adverse effect on the
balance of payments; and introduce uncertainty and instability. It may be noted that unchecked
inflation may change into hyper-inflation, which is the most severe type of inflation.
We discuss briefly, in the following paragraphs, some of the specific effects of inflation
including redistribution effect, price effect, income effect, and effect on production (or output).

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For a better understanding of the impact of inflation on economic growth, we classify these
effects into two categories: favorable effects and adverse effects.
1. Favourable Effects or positive effects of Inflation
Mild inflation has some favorable effects on production, capital formation and economic
development. Some such favorable effects are the following:
 Effect on Production: When prices are rising, profit expectations become brighter
and thus investment climate becomes favorable. Therefore the entrepreneurs
undertake new investments, set up new production units, and expand the existing
plants. All these lead to greater production.
 Effect on Capital Formation: Rising prices bring in higher profits to the
capitalists. In turn, a greater part of these profits is reinvested with a view of
earning further profits. Thus, investment increases and rate of capital formation
becomes higher.
 Effect on Employment: Rising prices lead to increased investment by the
entrepreneurs in various sectors of the economy with a view to producing and
selling larger quantities of goods and services, and thus further adding to their
profits. Increased production requires more labour and other resources. Thus
employment of labour also increases.
 Effect on Economic Development: Rising prices that raise profit expectations,
build up favorable investment climate, and increase production and employment,
thus lead to an increase in the growth rate of national income and raise the pace of
economic development.
 Inflation may be Self-Liquidating: As stated above, a slow and mild rate of
inflation helps to increase investment, production and employment. It increases the
tempo of development. Thus, over a period of time more goods flow from the
farms and factories, and the overall supply in the economy increases. Since
inflation is caused by an excess of demand over supply, the supply will increase
after some time and become equal to demand. The prices would thus fall due to
increased supply, and inflation would end. Thus, inflation can be self-liquidating.

2. Adverse Effects or Negative effects of Inflation

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Many times, inflation is not self-liquidating; it becomes self-sustained. Then the price level
keeps on increasing continuously over a long period of time.Accordingly, inflation starts
showing its adverse effects, some of which are the following:
 Income Effect: Inflation adversely affects fixed-income groups like wage and salary
earners and those whose income consists of rent from property or interest on loans. The
wages and salaries are fixed payments which do not increase with prices. Thus, when
wages remain more or less fixed, rising prices continuously reduce purchasing power and
hence the wage and salary earners suffer a loss in real income. The same is the case with
other fixed incomes like rents, interest, etc., which are contractual payments and do not
increase with rising prices.
 Saving Effect: With a rise in prices, the purchasing power of money declines. Thus more
money has to be spent to buy the same amount of goods and services. This reduces the
level of savings out of a given level of income.
 Redistribution Effect: Under mild inflation or a continued slow rise in prices, profits
keep on increasing. As wages and salaries remain more or less fixed, income of the
industrial and business classes increases relative to the income of working classes. Thus,
there is a redistribution of income in favor of the rich capitalists and business people, and
therefore, the gap between the rich and the poor become wide and results in income
inequality
 Price-Wage Spiral: Due to rises in prices, labourers demand higher wages. If this
demand is fulfilled, the increase in wages leads to a further rise in prices. The rise in
prices, in turn, leads to further rises in wages. This creates a vicious circle of wage and
price rises.
 Effect on Economic Planning: Most of the under-developed countries, including
Ethiopia, have adopted planning as a means for furthering rapid economic development.
A plan is prepared, say for five years ,in which targets are fixed and resources are
mobilized and put in the planned channels of production to achieve these targets. If prices
start rising, then the actual cost of inputs to be used for achieving production targets
becomes higher, and hence more financial resources are needed. But under inflation,
savings get reduced and, at the same time, it becomes more difficult for governments to
impose new taxes to collect more revenue. Hence, plan targets are either curtailed or most

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 of them remain beyond reach(or postponed), thereby upsetting the whole planning
process.
 Effect on Balance of Payments: Balance of payments shows how much a country has to
receive from the rest of the world as payment for goods and services it has exported and
how much it has to pay for imports from other countries. When total payments are more
than the total receipts, it is called a balance of payments deficit. With inflation or rising
prices this deficit increases. This is because under prevailing high prices, foreigners will
not buy our high priced goods. So, our exports will fall. On the other hand, our people
will buy more of the relatively cheaper foreign goods, thereby increasing our imports.
Since imports are more than exports, it means that the country has to make more
payments than what it receives. Thus the deficit in balance of payments increases.
Remarks: Besides these, effects rising prices encourage speculation and hoarding, profiteering,
corruption, strikes, social unrest, and many more problems. It is therefore necessary that inflation
should be controlled and prices stabilized or allowed to rise only within narrow limits.
3.3. Unemployment
Unemployment is the macroeconomic problem that affects people most directly and severely.
For most people, the loss of a job means a reduced living standard and psychological distress. It
is no surprise that unemployment is a frequent topic of political debate and that politicians often
claim that their proposed policies would help to create jobs.
3.3.1. Measuring Unemployment Rate
One aspect of economic performance is how well an economy uses its resources. Because an
economy’s workers are its chief resource, keeping workers employed is a dominant concern of
economic policy makers.
To understand how unemployment can be measured, we have to understand the following
concepts
i. Employed: A person who have a job and actively participate at a paid job. It refers to any
arrangement by which a person earns income or a means of livelihood. Such an arrangement may
be
 In the form of self-employment, where a person uses his/her own resources (apart from
his/her labour) to make a living. Examples of self-employment are the activities of
shopkeepers, traders, businessmen, professionals, etc.

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  By offering their labour services to others and in return get wages. Such an arrangement,
in which a worker sells his/her labour and earns wages in return, is called wage-
employment. In this case, the supplier of labour (worker) is called employee and the
buyer of the labour is called an employer.
ii. Unemployed: refers to a situation where the persons who are able to work and willing to
work, at the current market wage rate, fail to secure work or activity which gives them income or
a means of livelihood. A person who is willing to have a job and actively seeking it but couldn’t
find the job. All persons who were not working and were waiting to be called back to a job from
which they had been temporarily laid off.
iii. The labour force is defined as the sum of the employed and unemployed. A labour force
consists of all those who are fit for work and are willing and available to work. In other words, if
we exclude children(below 15 age), old persons(above 60 age), individuals who are unable to
work, etc., from the population of a country, we get the number of those who are able to work.
We further deduct from this those who are not willing or are not available to work. This gives us
the labour force.
Labour force = No. of Employed persons + No. of Unemployed persons
iv. Unemployment rate: is the percentage of the labor force that is unemployed. It is equal to
the number of unemployed persons divided by the labor force. Then unemployment rate is the
statistic that measures the percentage of those people wanting to work but who do not have jobs.
Numberofunemployed
UnemploymentRate= ×100
Labourforce

v. Labour-force-participation rate: the ratio of this labour force to the adult population is
called the labour-force participation rate. This gives us the number of people who are able to
work, willing to work and available for work.
LabourForce
Labour−ForceParticiaptionRate= ×100
AdultPopulation

Illustration

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Spouses the Statistical Authority in Ethiopia have the following result from the census taken in
1994. The number of unemployed is 45 billion, employed 20 billion and adult population 50
billion.
Find
1. Unemployment Rate
2. Labour-Force Participation rate
Solution
To find the unemployment rate first we need to have the Labour Force;

Labour Force= Unemployed + Employed

= 45 billion + 20 Billion
= 65 billion
Then;
Numberofunemployed
UnemploymentRate= ×100
Labourforce

45 billion
UnemploymentRate= ×100=0. 6923 %
65 billion

Labour-force participation rate can be also calculated as follows:

LabourForce
Labour−ForceParticiaptionRate= ×100
AdultPopulation

65 billion
Labour−ForceParticiaptionRate= ×100=1 . 3 %
50 billion
3.3.2. Types of Unemployment
Normally, in economics, three different types of unemployment are identified— frictional,
structural, and cyclical.
1. Frictional Unemployment: is temporary unemployment which exists during a period of the
transfer of labour from one occupation to another.
Frictional unemployment may also arise where people are thrown out of work in one location
and are unwilling or unable to move to a similar work in another area. For example, big

16
industrial units and polluting industries are sometimes moved out of large towns and cities and
relocated in distant places. The labor thus thrown out of jobs may be either unwilling or unable
to move to these new locations of work, thus giving rise to frictional unemployment. Other
examples of frictional unemployment are students searching for jobs for short durations or
people reentering the labour force due to changed social or family situations.
2. Structural Unemployment
Structural unemployment refers to a situation in which workers become jobless due to change in
the pattern of demand, leading to changes in the structure of production in the economy.
For example,
 A change of energy use from coal to electric power is bound to curtail coal mining
activity and cause unemployment there.
 An increased use of synthetic rubber is bound to reduce demand for natural rubber and
lead to unemployment in rubber plantations.
 Since the person thus unemployed may not be in a position to learn the technologies used
in the newly expanding industries, they may be rendered permanently unemployed. Thus,
Structural unemployment signifies a mismatch between the supply of and the demand for
labor.
Note: Natural Unemployment: is the sum frictional unemployment and the structural
unemployment.
3. Cyclical Unemployment
As the name ‘cyclical unemployment’ suggests, this form of unemployment is associated with or
cyclical fluctuations in economic activity like ‘trade cycles’ or ‘business cycles’. This is caused
by slackness in business conditions. During depressions, investment activities get discouraged
and hence contractions in business activities render large numbers of workers unemployed. Thus,
unemployment which arises due to inadequate overall demand associated with the downswing,
recession or depression period of a trade cycle is called cyclical unemployment. Remarks: In the
study and analysis of unemployment, we come across many other terms and concepts. A brief
introduction to such terms is given below, for the sake of reference.
 Full Employment: refers to a situation where all those workers who are able and willing
to work get employment. At full employment levels, there is an optimum utilization of
resources.

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  Underemployment: refers to a situation in which people are engaged in jobs but these
jobs do not measure up to their capabilities, efficiency and qualifications.
 Involuntary Unemployment: refers to a situation in which the workers are willing to
work under any conditions and at any wage rate but they fail to get employment.
 Voluntary Unemployment: When the economy offers employment opportunities to the
workers, but they themselves are not willing to take up jobs because employment
conditions, such as wage rate, location, promotional avenues, physical environment,
attitude of the employer, etc., do not suit them
 Technological Unemployment: refers to unemployment condition created because of
the introduction of a new technology which requires changes in a labour force.
 Disguised Unemployment: When more workers are engaged in a type of work than
actually are required to do that work, it is called disguised unemployment.
 Seasonal Unemployment: Employment and unemployment levels vary with different
seasons in many sectors of the economy. There are busy seasons, when most of the
people are employed or even overworked, and there are slack seasons, when most of
them are without work. Apart from agriculture, such unemployment is found in seasonal
industries like ice factories, or seasonally affected trades like the tourist industry.
3.4. Relationship between Macro Economic Variables
3.4.1. The Business Cycle and the Output Gap
Inflation, growth, and unemployment are related through the business cycle. The business cycle
is the more or less regular pattern of expansion (recovery) and contraction (recession) in
economic activity around the path of trend growth. At a cyclical peak, economic activity is high
relative to trend; and at a cyclical trough, the low point in economic activity is reached. Inflation,
growth, and unemployment all have clear cyclical patterns. In short, Business cycle shows us the

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ups and downs of country’s GDP.

The trend path of GDP is the path GDP would take if factors of production were fully employed.
Over time, real GDP changes for the two reasons.
 First, more resources become available which allows the economy to produce more
goods and services, resulting in a rising trend level of output.
 Second, factors are not fully employed all the time. Thus, increasing capacity utilization
can increase output.
Output is not always at its trend level, that is, the level corresponding to full employment of the
factors of production. Rather output fluctuates around the trend level. During expansion (or
recovery) the employment of factors of production increased, and that is a source of increased
production. Conversely, during recession unemployment increases and less output are produced
than can in fact be produced with the existing resources and technology. Deviations of output
from trend are referred to as the output gap.
The output gap measures the gap between actual output and the output the economy could
produce at full employment given the existing resources. Full employment output is also called
potential output.
Output gap  potential output – actual output
2. Okun’s Law: which named after its discoverer, Arthur Okun states there is negative
relationship between real growth and changes in the unemployment rate. Because employed

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workers help to produce goods and services and unemployed workers do not, increases in the
unemployment rate should be associated with decreases in real GDP. Okun’s law says that the
unemployment rate declines when growth is above the trend rate.

u = -x (ya – yt)
Where u is change in unemployment, x the magnitude in which unemployment declines due to
a percentage point growth, ya actual growth rate of output, and yt is trend output growth rate.
Percentage change in real GDP

Growth and Unemployment Dynamics

12

0
-3 -2 -1 0 1 2 3

-3
Change in unemployment rate

Fig 3.4.Growth and Unemployment Dynamics

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3. Inflation –Unemployment Dynamics
The Phillips curve describes the empirical relationship between inflation and unemployment:
the higher the rate of unemployment, the lower the rate of inflation. The curve suggests that less
unemployment can always be attained by incurring more inflation and that the inflation rate can
always be reduced by incurring the costs of more unemployment. In other words the curve
suggests there is a trade-off between inflation and unemployment.
Fig 3.5 Phillips curve
Inflation
Rate

0
Unemployment rate

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