Chapter Five

Macroeconomic Problems
What Is Unemployment?
The term unemployment refers to a situation where a
person actively searches for employment but is unable to
find work.
Unemployment is considered to be a key measure of
the health of the economy.
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
 Concept and Measures of
Unemployment
Unemployment is one of the major issues of national
economies.
The wellbeing of the labour market or participants of the
labour market (i.e., workers or households) also affects
the wellbeing of the economy as a whole. This is because
the income of a society depends on employment, and
the ability of community to purchase in turn
determines national output. This is why every
country’s policy makers (governments) are concerned
with solving or reducing the problem of
unemployment as much as possible.
 Measures of Unemployment
Unemployment rate (R) defined as the percentage or the
proportion of the labour force that is unemployment or has
no job while they are ready to work at prevailing wage rate.
Labour force (L) is the sum of both employed (E) and
unemployed people of working age and ready to work (U).
This can be given by the following equation:
L=E+U
Then, unemployment rate (R) is calculated as follows;
 Number of Unemployed  U 
R =   X (100)   X (100)
Labour Force  L
 
 Measures of Unemployment
In-fact unemployment rate fluctuates around a line
known as ‘natural rate of unemployment’.
Natural rate of unemployment is a rate where there is no
unemployment because of economic recession (cyclic
unemployment) or when all the unemployment is
frictional and structural ones
Example: Suppose in a country where there are
130,000,000 total population 5,000,000 people were
unemployed and 85,000,000 held jobs; then calculate,
◦ The total labor force
◦ National employment rate
◦ National unemployment rate
Measures of Unemployment
a) National Labor force = Employed (E) + Unemployed (U)
= 85,000,000 + 5,000,000 = 90,000,000

 85,000,000 
b) Employment rate =   X 100 = 94.4%
 90,000,000 

 5,000,000 
c) Unemployment rate =   X 100 = 5.6%
 90,000,000 
 Reasons for and Types of
Unemployment
An unemployed person may fall into one of four categories.
1. Job loser: This is a person who was employed in the civilian
labor force and was either fired or laid off.
2. Job leaver: This is a person employed in the civilian labor force
who quits his or her job. If you quit your current job and are
looking for a better job, then you are a job leaver.
3. Reentrant: This is a person who was previously employed,
hasn’t worked for some time, and is currently reentering the
labor force.
4. New entrant: This is a person who has never held a full-time
job for two weeks or longer and is now in the labor force looking
for a job.
Reasons for and Types of
Unemployment
Frictional Unemployment
The unemployment owing to the natural “friction” of the
economy, which is caused by changing market conditions
and is represented by qualified individuals with
transferable skills who change jobs, is called frictional
unemployment.
In fact, workers have different preferences and abilities,
and jobs have different attributes. Furthermore, the flow
of information about job candidates and job vacancies is
imperfect, and the geographic mobility of workers is not
instantaneous. For all these reasons, searching for an
 Reasons for and Types of
Unemployment
Indeed, because different jobs require different skills and
pay different wages, unemployed workers may not accept
the first job offer they receive. Such unemployment caused
by the time it takes workers to search for a job is also
frictional unemployment.
Structural Unemployment
•This is unemployment due to structural changes in the
economy that eliminate some jobs and create other jobs for
which the unemployed are unqualified.
•Most economists argue that structural unemployment is
largely the consequence of automation (laborsaving
devices) and long-lasting shifts in demand.
Reasons for and Types of
Unemployment
•Structural Unemployment contd…
•Structural unemployment is similar to frictional
unemployment since both reflect the problem of
matching workers with job vacancy, but structural
unemployment covers the time needed to acquire new
skills not just short term search process.
•For example, suppose there is a pool of unemployed
automobile workers and a rising demand for computer
analysts. If the automobile workers do not currently
have the skills necessary to become computer
analysts, they are structurally unemployed.
Reasons for and Types of
Unemployment
Cyclical Unemployment
•Cyclical unemployment occurs due to general
downturn in the business activities including
production and demand for the products and
services.
•During recession business conditions, only few goods
are produced and for such low production, only few
employment opportunities would be available.
•Employers are therefore, obliges to lay-off workers and
cut back employment.
Reasons for and Types of
Unemployment
Generally, there is always some amount of unemployment and
economists very frequently use the term full employment. Full
employment occurs when the unemployment rate is equal to the
natural rate of unemployment. However, note that the concept
of full employment does not mean that all workers are employed.
As cyclical unemployment is the result of insufficient
aggregate demand (during recession) in the economy to
generate enough jobs for those seeking them, is also known as
demand deficient unemployment.
The policy instrument to solve this problem is fiscal policy (for
instance increasing government expenditure and
reducing tax rates) and/or monetary policy (such as
reducing interest rate and increasing money supply).
Reasons for and Types of
Unemployment
Seasonal Unemployment:
•Seasonal unemployment is the type of unemployment
that arises from a decline in the economic activity in
some seasons (particular time in a year) and in
some sectors. Therefore, seasonal unemployment
results from fluctuations in demand for labour in
these sectors and/or seasons.
•The special characteristic of this type of unemployment
is that fluctuation can take a regular course of action
and can be anticipated so that workers also make
their own plan to move to particular sector in
Reasons for and Types of
Unemployment

For instance, workers can seek job in agricultural

sector during the first season of cultivation and during
harvest time. In other seasons the demand for labour
in agriculture becomes low and as a result workers
would look for job in other sectors.
Reasons for and Types of
Unemployment
Natural Unemployment
•Adding the frictional unemployment rate and the
structural unemployment rate gives the natural
unemployment rate (or natural rate of unemployment).
•The natural rate of unemployment is the long-run
average or “steady state” rate of unemployment.
•It depends on the rates of job separation and job
finding.
Reasons for and Types of
Unemployment
In conclusion, with frictional and structural
unemployment there could be enough jobs, but it
is difficult to match job seekers with job
vacancies.
With cyclical unemployment, on the other hand,
there are no enough jobs for job seekers. If
the recession is handled and solved quickly, the
duration of cyclical unemployment can be in
between frictional and structural unemployment
Reasons for and Types of
Unemployment
Note that sometimes concepts such as underemployment,
disguised unemployment and open unemployment are
used to demonstrate different degrees of unemployment.
Underemployment refers to the people who work below their
capacity. For instance, a person may be employed for only 5
hours a day while he/she can and wants to work more than
that.
Disguised unemployment is the case where the worker is
employed but adding nothing to the output.
Open unemployment represents the formal definition we
have discussed above where the person has no job at all while
he/she is ready to work at the prevailing market wage rate.
Relationship between
Unemployment and Output
In most economic models, the level of output that is
produced is proportional to the level of the inputs—
typically, capital and labor. Thus, one might imagine
that increasing unemployment above its natural rate
might be associated with output falling below its
potential, and vice versa.
Group discussion
Relationship between Unemployment
and Output
Labour supply and Business Cycle
Labour Market Equilibrium
Labour is the manpower or effort used to produce a firm's goods and
services.
The labor market, also known as the job market, refers
to the supply of and demand for labor, in which
employees provide the supply and employers provide
the demand. It is a major component of any economy
and is intricately linked to markets for capital,
goods, and services.
The labour market is influenced by the supply and demand for workers
in an economy. When the supply equals the demand, the market
reaches equilibrium.
Labour Market Equilibrium
The labour market contains two main participants:
workers and firms. Typically, more workers will
join the labour market when the wage is higher,
while firms will want to hire more workers at a
lower wage rate.
The equilibrium in the labour market occurs when
the supply of labour (workers) equals the
firms’ demand for labour. In reality, this is unlikely to
happen since economic and political shocks will
continuously shift the supply and demand curves in the
labour market.
Measures/ Policies to reduce unemployment
Some countries are more successful than others in reducing the scale of
unemployment. In the long term, effective policies are required for both
the demand and the supply side of the economy so that enough new
jobs are created and that people possess the skills and incentives to take
those jobs.
In general the most effective policies are:
Stimulate an improvement in the human capital of the workforce – so
that more of the unemployed have the skills to take up the available
jobs. Policies normally concentrate on improving the occupational
mobility of labour. The pattern of employment in any modern economy
is always changing, so people need to have sufficient flexibility to adapt
to structural changes in industries over the years
Measures/ Policies to reduce
unemployment
Improve incentives for people to search and then accept paid
work – this may require reforms of the tax and benefits system. For
example, a reduction in the starting rate of income tax is an incentive
for people in lower paid jobs.
Employment subsidies: Government subsidies for those firms that
take on the long-term unemployed will create an incentive for
businesses to increase the size of their workforce.
Achieve a sustained period of economic growth – this requires that
aggregate demand is sufficiently high for businesses to be looking to
expand their workforce.
Inflation
Inflation is a continual and ongoing rise in general or
average price level on a specified period of time.
The term inflation is usually used to indicate a rise in
the general price level.
A birr today doesn’t buy as much as it did ten years
ago. The cost of almost everything may go up. This
increase in the overall level of prices is called
inflation, and it is one of the primary concerns of
economists and policymakers.
Inflation
Periods of falling prices, called deflation,
were almost as common as periods of rising
prices.
Types of Inflation
There are four types of inflation with four
different causes.
 Demand pull inflation
 Cost push inflation
 Pricing power inflation
Types of Inflation
1. Demand Pull Inflation
It is also known as excess demand inflation. It occurs
when the total demand for goods and services in
an economy exceeds the available supply, so the
prices for them rise in a market economy.
Historically, this has been the most common type and
at times the most serious.
Types of Inflation
2. Cost Push Inflation
Since cost push inflation occurs due to factors that arise
from the supply side, we call it supply side inflation.
It occurs when the costs of production rise, for
one reason or another, and force up the prices of
finished goods and services. When cost increases,
supply will decrease which lead a rise in price.
Often a rise in wages and salaries in excess of any
gains in labor productivity is what raises unit costs of
production and thus raises prices.
Types of Inflation
3. Pricing Power Inflation
Pricing power inflation is also known as administered
price inflation or oligopolistic inflation since it
occurs whenever businesses in general decide to
boost their prices to increase their profit margins.
This does not normally occur in recessions but when
the economy is booming and sales are strong.
Oligopolies have the power to set their own prices and
raise them when they decide the time is ripe.
Types of Inflation
In addition to the above types of inflation, there are also
monetary and fiscal inflation.
Monetary inflation was most famously seen in Weimar
Germany during the 1920s, when the German government
went crazy with the printing presses to the point where it took
billions of marks to equal one dollar. This wiped out the
savings of the middle class, most members of which were
compensated with (worthless) “million mark” notes.
Fiscal inflation is due to excess government spending,
for which the budget deficit is a reasonably good proxy.
Measures of Inflation
Measuring inflation is a difficult problem for government
statisticians. To do this, a number of goods that are
representative of the economy are put together
into what is referred to as a "market basket".
The cost of the basket is then compared over time. This
results in a price index, which is the cost of the market
basket (CMB) today as a percentage of the cost of that
identical basket in the starting year.
Therefore, inflation can be measured by the price
index. There are three types of price indexes: consumer price
index (CPI), GDP deflator and the producer price index (PPI).
Consumer price index (CPI)
The CPI is based on a representative group of goods and services purchased by a
typical household. This representative group of goods is called the market
basket
When a news report says that the “cost of living” increased by, say, 7 percent, it
is usually referring to the CPI.
The CPI does not include capital goods, exports or items of government
purchase. The price of imported goods purchased by a typical consumer,
however, is considered.
Consumer price index (CPI)

Inflation rate is the rate at which the average overall price level increases
from period to period. Based on the value of inflation rate;
Inflation can be classified as creeping, walking, running, and hyper-
inflation
 Creeping inflation happens when prices level increase by less than 3%
 walking inflation occurs when prices level increases by 3 to 10 %;
 Running inflation occurs when prices level increase 10 to 20%
 Hyperinflation when inflation rate goes above 20%.
 Consumer price index (CPI)
Year
2005 (base year) 2006
Market basket of goods
Quantity purchased Basket
and services Basket Market
Market Price Market Price Market
Cost
Cost
Shirt 3 (in No) 90 270 100 300
Meat 24 kg 2 48 1.5 36
Bus ticket 480 (in No) 0.15 72 0.3 144
Total cost 390 480

𝟏𝟐𝟑 . 𝟎𝟖 – 𝟏𝟎𝟎
𝑹𝒂𝒕𝒆 𝒐𝒇 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏= 𝐱 𝟏𝟎𝟎=𝟐𝟑 . 𝟎𝟖 %
𝟏𝟎𝟎
The GDP Deflator
The GDP deflator is the other important price index. The GDP
deflator is the ratio of nominal GDP in a given year to real GDP of
that year.
The deflator measures the change in prices that has occurred
between the base year and the current year. Since the GDP deflator
is based on a calculation involving all the goods produced in the
economy, it is a widely based price index that is frequently used to
measure inflation.
The GDP Deflator
Assume the ratio of nominal to real GNP in 2004 is 1.22 (=21
million/17.2 million). In other words, output is 22 % higher in 2004
when it is valued using the higher prices of 2004 than valued in the
lower prices of 2000. We ascribe the 22 % increase in the value of
the output to price increases, or inflation, over the 2000-2004
periods. Therefore, in the period between 2000 and 2004, inflation
rate was 22%.
Differences between CPI and
GDP deflator
The deflator measures the prices of a much wider group of goods
than the CPI does.
The CPI measures the cost of a given fixed basket of goods, which is
the same from year to year. The basket of goods included in the
GDP deflator, however, differs from year to year, depending on
what is produced in the economy in each year. When corn crops are
large, corn receives a relatively large weight in the computation of
the GDP deflator.
The CPI directly includes prices of imports, whereas the deflator
includes only prices of goods produced in the country, say Ethiopia.
Producer Price Index (PPI)
The producer price index (PPI) is the third price index that is widely
used. Like the CPI, this is a measure of the cost of a given basket of
goods.
The PPI measures the prices of products purchased by producers.
This price index measures the price level for products which are used
to produce other goods (not for personal consumption).
It shows the change in the cost of production of basket of goods. Its
interpretation is also similar to that of the CPI.
It differs from the CPI partly in its coverage, which includes, for
example, raw materials and semi finished goods.
Producer Price Index (PPI)
It differs, too, in that it is designed to measure prices at an early
stage of the distribution system. Whereas the CPI measures prices
where urban households actually do their spending—that is, at the
retail level—the PPI is constructed from prices at the level of the first
significant commercial transaction. This makes the PPI a relatively
flexible price index and one that generally signals changes in the
general price level, or the CPI, some time before they actually
materialize. For this reason the PPI and, more particularly, some of its
sub-indexes, such as the index of "sensitive materials,'' serve as one of
the business cycle indicators that are closely watched by policy
makers.
Effects or Consequences of
Inflation
Whatever its sources or its causes, inflation has some common
major effects on the society or the country. Some of these effects are
high living costs, higher wage rates, excess nominal money supply
over the real products, shortage of supply of goods and services
due to high cost of production, very low value of domestic currency
(or money), expensive imports, and so on.
Again when inflation occurs, the price of commodities and services
becomes higher. So each unit of consumer goods is bought at higher
price and living expenses become higher unless the income of
individuals increases as well.
Effects or Consequences of
Inflation
Compared to foreign currencies the value of domestic currency
becomes very low and becomes subject to be changed to smaller
amount of foreign currency. This implies that the purchasing capacity
of money or domestic currency deteriorates.
In developing countries petroleum products constitute the major
part of imports and hence imports are inelastic.
Imports remain the same despite it becomes costly for the domestic
country, the country becomes poorer.
Measures to be taken to reduce inflation
The main anti-inflation controls available to a government are:
Fiscal Policy: If the government believes that AD is too high, it may
reduce its own spending on public and merit goods or welfare
payments. Or it can choose to raise direct taxes, leading to a
reduction in disposable income. Normally when the government
wants to “tighten fiscal policy” to control inflation, it will seek to cut
spending or raise tax revenues so that government borrowing (the
budget deficit) is reduced. This helps to take money out of the
economy.
Measures to be taken to
reduce inflation
Monetary Policy: A tightening of monetary policy involves higher
interest rates to reduce consumer and investment spending.
Supply side economic policies: Supply side policies include those
that seek to increase productivity, competition and innovation – all
of which can maintain lower prices.
Relationship between
unemployment and inflation
Normally, there is negative relationship between inflation rate and
unemployment rate.
When unemployment rate is very low, then workers have the market
power to push up wages. Higher wage rate means that the cost of
production is high and so sellers charge higher prices implying higher
inflation rate. When unemployment rate is very high, then workers do
not have much bargaining power; rather, they would be ready to accept
lower wage to get job. Therefore the pressure on prices also remains low.
The relation ship between unemployment and inflation can be described
by Phillips curve .
Relationship between
unemployment and inflation
Phillips curve has been used for macroeconomic policy analyses which
suggest that policymakers could choose different combinations of
unemployment and inflation rates.
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 implies that there is a trade-off between
policies interned to reduce inflation and that intended to reduce
unemployment. As a result, we have low unemployment with high
inflation.
Relationship between
unemployment and inflation