THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

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Introduction to Economics ECO401

UNIT - 11

Lesson 11.1

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

To study any major issue or problem in macroeconomics, it is important to address at least three

questions about it:

i. Why is it important (i.e. what are its costs);

ii. What are its causes or the possible diagnoses of the problem; and

iii. What is the policy prescription associated with each different diagnosis.

We will look at four major problems here:

i. Unemployment,

ii. Inflation,

iii. Balance of payments problem and

iv. The lack of growth.

Because this is a course in introductory economics, some of these problems will have to be

introduced in the context of the economic history of HICs.

We'll begin with unemployment, which, as you know, peaked during the Great Depression

leading to the great rift between Keynes and the Classicists, and the subsequent birth of modern

macroeconomics. We shall then move to inflation which became a major problem in the 1970s in

the context of the two oils price shocks. We'll then turn to balance of payments disequilibria

which have especially afflicted the LICs since the early 1980s. Finally we'll look at the challenges

involved in achieving sustainable and sustained economic growth.

One thing you should remember at all times is that macroeconomic problems tend to be related

to each other, and it is difficult (and often misleading) to analyze them in isolation. It would be

important, therefore, to see how these four problems might be interrelated.

UNEMPLOYMENT

The History of Unemployment:

The history of unemployment, which is relevant to macroeconomics, started way back in the

Great Depression (1929-33), when unemployment rates reached levels of 25% in the US and

western Europe. During the second world war, the problem subsided due to higher

government defense spending and war-related recruitment. Post-war, unemployment rates

continued to fall as rebuilding efforts gathered pace all over the world, esp. in war-ravaged

Europe and East Asia. Many colonies gained independence during this time as well (late

1940s till early 1960s) and undertook massive infrastructure and industrial initiatives which

absorbed a large part of the workforce. The problem did not raise its head again until the

1970s, when two oil price shocks (1973, 1979), and the associated episodes of cost-push

inflation and balance of payments deficits in many countries led to a global recession that was

compounded in the early 1980s by rising interest rates (induced by tight US monetary policy).

The world recovered from recession in the mid-1980s, and following a brief recession (that

lasted till the early 1990s), saw the rise of the new economy (i.e., the age of information

technology) and a rapid growth in jobs related thereto. By the turn of the millennium, however,

the new economy bubble had burst, causing decline in growth rates in many HICs. This

decline was compounded by the events of September the 11th in the New York and the

subsequent "war on terror" started by the U.S. and its allies. It is worth noting that Japan, the

world's 2nd largest economy, has remained in recession virtually all through the 1990s.

Interestingly, there has been a general rise in the rate of unemployment in many LICs (except

East Asia) over the last 2-3 decades a rise that has not been strictly correlated with global

boom-recession cycles. The unemployment problem in these LICs was seen to assume a

more permanent nature due to their high population growth rates rates that far outstripped

the rate of new job-creation in these economies. Also there was a loss of jobs in many of these

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countries due to adoption of capital-intensive as opposed to labour-intensive technologies in

industrial production.

Definition of unemployment:

While unemployment can be defined in terms of absolute numbers, in most cases, it is the rate

of unemployment which is quoted and which enables cross-country comparisons. The

unemployment rate is defined as the ratio of the no. of unemployed people divided by the sum

of the employed and unemployed people. A rate of 3-4% is usually considered low, 10-15%

considered high, and over 20% considered extremely high. It is worth mentioning that

unemployment figures, because they are such a sensitive political issue, are often under-

stated by government and over-stated by opposition groups. In most LICs, "official"

unemployment rates are seriously misleading, and you can find the government quoting a

figure of 5% for unemployment, when the actual rate is around 20-25%, if not higher.

The Concept of Labor Force ( LF):

A fundamental concept in relation to the above definition of unemployment is that of the labour

force (LF). The labour force is essentially the denominator in the formula for unemployment

rate. The labour force includes all people eligible and able to work, so excludes children,

elderly people, parent(s) busy raising children, the handicapped and terminally ill etc.

Note, however that there is a difference between a person who is able to work and a person

who is also willing to accept a particular job. So, for instance, a chartered accountant who is

looking for a job may be offered the job of a bus driver, but he will not accept that job because

it is not worthy of his qualifications, and/or offers a wage below his reservation wage. Thus, in

order to be employed you need to fulfill two conditions: you have to be a member of the labour

force (LF) and you have to be willing to accept a particular job ("AJ"). This distinction will be

developed further shortly.

Definitional Problems with Unemployment Rate:

Keeping the AJ and LF distinction aside for a while, there can be some other definitional

problems with the unemployment rate that need to be addressed. In particular, we might wish

to see why the unemployment rate may be reported as:

a. Lower than it actually is (i.e. the severity of the problem of there being very few jobs

compared to workers is under-stated). There are two common reasons:

underemployment and disguised unemployment. Underemployment refers to the

situation when a person is reported as employed but is actually only doing a part-time

job. Disguised unemployment is a situation where a person gets a salary but does not

really have a job to do, as is often the case for excess workers in government

departments.

b. Higher than it actually is (i.e. the severity of the problem of there being very few jobs

compared to workers is over-stated). The possible reasons here could be:

i. The existence of child labour, i.e. children taking the jobs that would otherwise

have been available to adults.

ii. Incompatibility between skills and jobs, i.e. there might be a demand for

workers possessing a certain skill, but the people who are seeking jobs do not

have that skill and therefore remain unemployed.

iii. People doing more that one job. If a doctor works in a hospital in the morning

and runs his/her clinic at home in the evening, s/he is actually doing two jobs.

Were s/he to concentrate on his/her home practice only, the hospital job would

become available to some other doctor.

iv. Unemployment benefit given by the state to the unemployed. This is usually the

case for the welfare states (most HICs) where people can live off rather well on

unemployment benefit and therefore choose to not work. In LICs, where the

state does not quite pay unemployment benefits, the analogy would be

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beggary. Some people would rather beg on the streets than work honorably

and earn their living.

An important concept related to unemployment is that of its duration. The duration of any

particular unemployment spell depends on when the benefits of accepting a certain job exceed

the costs of continuing to searching for a better job (see also the section on search or frictional

unemployment below). In an aggregate sense, however, the duration of an unemployment

episode in a country depends on the rate at which people enter the pool of the unemployed

(i.e. become unemployed) and the rate at which they exit the pool of the unemployed (i.e. find

an acceptable job).

People entering the unemployed pool include those made redundant, sacked, resigning or

temporarily laid off. They could also include those formerly outside the labour force, for e.g.:

college leavers, women returning to the labour force after raising children.

People leaving the unemployed pool include those taking new jobs, returning to old jobs (if

they had been temporarily suspended or laid off) They could also include people who have

become disheartened and give up looking for a job, those who have reached retirement age,

or who temporarily withdraw from the labour force (e.g. to raise a family), those who emigrate

or die.

Costs of unemployment:

If unemployment is voluntary, i.e. people do not work because they feel they are better off

being unemployed, the costs are borne essentially by society, not the individual per se. The

costs are:

a. Output and hence national income is lower than potential.

b. Government loses tax revenues because of a.

c. Firms lose revenues as they could have employed more workers and produce and sell

more.

d. Other workers lose additional wages that they might have otherwise been able to earn

with higher national output.

e. There is a general tendency for crime and violence to rise in society as unemployment

levels increase.

If unemployment is involuntary, then all the above broader social costs are borne, but private

individual costs for the unemployed individual must also now be added. These would include

loss of personal income, mental stress due to loss in self-esteem, worsening of relationship

with family or friends.

Causes of unemployment:

There are essentially three schools of thought regarding the causes of unemployment: the

Classicist, Keynesian and Monetarist schools. However, before we delve into the specific

arguments presented thereby, we must develop an understanding of how labour market

equilibrium is generally struck in an economy.

Labor Market Equilibrium:

There is first the supply side of labour. As mentioned earlier, however, a distinction needs to

be made between LF and AJ. LF stands for the size of the labour force, and is drawn as an

upward sloping fairly inelastic line in wage no. of workers space. It is drawn as fairly inelastic

because the size of labour force would be expected to be fairly unresponsive to the wage rate.

A badly handicapped or terminally ill person will not suddenly decide to join the labour force

just because wages went up. Some people (like parents looking after kids) however might still

be inclined to become members of the labour force if wages go up; the reason why the LF

curve is not perfectly inelastic (i.e. vertical).

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The AJ curve represents those members of the labour force which are willing to accept

suitable jobs. The AJ curve is flatter than the LF curve because job seekers would be more

willing to accept jobs in response to a rise in wages compared to people who are not even

members of the labour force. The AJ curve is to the left of the LF curve because there will

always be some people in LF who cannot accept jobs (like the terminally ill). However, given a

flatter AJ and a steeper LF, it is clear why the horizontal gap between AJ and LF would narrow

at higher wage rates.

The demand for labour is generated by firms, government-owned or private, which need to

hire workers to produce goods and services. The lower the wage rate, the more will firms be

willing to hire workers. Therefore, the demand curve for labour, LD, is downward sloping in

wage no. of workers space.

The intersection of LD and AJ determines labour market equilibrium, i.e. the no. of potential

workers who will be employed (N1), and the wage rate that they will earn (w*). The intersection

of LD and LF delivers N*, the maximum possible no. of workers that can be employed at a

particular wage rate. The horizontal distance between N* and N1 is referred to as the natural

level of unemployment. When the horizontal axis measure the employment rate, the same

measures the natural rate of unemployment. To keep things simple, we will not differentiate

between the two terms and will use them interchangeably.

Classical Views about unemployment:

The Classicists viewed unemployment as an essentially voluntary phenomenon caused by

wages that were higher than the free market level. If wages were allowed to fall to the market-

clearing level, firms' demand for labour would increase, removing the initial unemployment.

Their main policy prescription was therefore to remove any factors (labour unions, minimum

wage legislation, unemployment benefit) that prevented wages from falling to market-clearing

levels. The theoretical problems with this view of unemployment aside, there were serious

difficulties that could be expected in implementing the above policy prescription. Unions were

politically strong bodies and could not simply be wished away; removing the minimum wage

threshold would hurt the poorest workers, whose wages would now fall below the threshold.

Similarly, removing unemployment benefit was likely to be seen as an attack on the safety net

for the poorest sections of society.

Keynesian Views about Unemployment:

Keynes located the origins of unemployment in deficient aggregate demand. According to him, if

aggregate demand could be boosted by pumping government expenditure, this would cause the

demand for labour to increase as part of a multiplier effect. The increased demand would absorb

the excess supply of labourers, thus alleviating the unemployment problem.

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