Imagine a fictitious country named Miniature that has a stable population of 120 people, of which 100 are in the labor force. Of these 100 people, 95 are employed and 5 are unemployed. That means Miniature’s unemployment rate is 5 percent (= 5/100). Suppose we could take a group photo of the unemployed workers each month so as to obtain a continuing record of their monthly numbers and reveal whom they are. By comparing the monthly photos over long periods, we could sort out the types of unemployment occurring in Miniature. Suppose that in a typical month there are 5 people in the photo. Also, suppose that 4 of these people are never the same individuals who were in the photo the previous month and the other person never shows up in the photo for more than two or three consecutive months. We can reasonably conclude that Miniature is experiencing frictional unemployment and structural unemployment. The frictionally unemployed workers are quickly finding jobs, and after retraining or relocation, the structurally unemployed workers are obtaining new jobs within a few months. Taking the places of these formerly unemployed persons are newly unemployed people who are looking for new jobs, waiting for future jobs, retraining, or relocating. Five percent of the labor force is unemployed each month, but nobody is unemployed for any substantial length of time. Miniature is not suffering an "unemployment problem." In contrast, suppose that over a six-month period we observe that the number of people in the unemployment photo increases from 5 to 10, with no change in the size of the labor force. Thereafter, the 10 percent unemployment rate continues for a full year. A comparison of the monthly photos reveals that it is mainly the same people who are employed month after month. We can reasonably conclude that Miniature is now experiencing cyclical unemployment. Total spending must have declined, reducing production and employment. The increase in the unemployment rate from 5 percent to 10 percent has accompanied this recession. Miniature now has a serious "unemployment problem." Cyclical unemployment is involuntary, relatively long lasting, and creates serious financial hardship for those people unemployed. It also results in an irretrievable loss of output to society.

8.2 Inflation button

Loosely defined, demand-pull inflation is "too much money chasing too few goods." Some interesting early episodes of demand-pull inflation occurred in Europe during the 9th to the 15th centuries under feudalism. In that economic system lords (or princes) ruled individual fiefdoms and their vassals (or peasants) worked the fields. The peasants initially paid parts of their harvest as taxes to the princes. Later, when the princes began issuing "coins of the realm," peasants began paying their taxes with gold coins. Some princes soon discovered a way to transfer purchasing power from their vassals to themselves without explicitly increasing taxes. As coins came into the treasury, princes clipped off parts of the gold coins, making them slightly smaller. From the clippings they minted new coins and used them to buy more goods for themselves. This practice of clipping coins was a subtle form of taxation. The quantity of goods being produced in the fiefdom remained the same, but the number of gold coins increased. With "too much money chasing too few goods," inflation occurred. Each gold coin earned by the peasants therefore had less purchasing power than previously because prices were higher. The increase of the money supply shifted purchasing power away from the peasants and toward the princes just as surely as if the princes had increased taxation of the peasants. In more recent eras some dictators have simply printed money to buy more goods for themselves, their relatives, and their key loyalists. These dictators, too, have levied hidden taxes on their populations by creating inflation. The moral of the story is quite simple: A society that values price-level stability should not entrust the control of its money supply to people who benefit from inflation.

Photograph courtesy of: (c)Photodisc # AA024177;

Costs of inflation button

The following metaphors may help you distinguish and remember the three categories of inflation costs. Menu costs Inflation requires firms to change the prices they charge from one period to another. This new pricing of products and the communication of the new prices to customers requires time and effort that could otherwise be used for more productive purposes. These inflation costs are sometimes called menu costs, because they are similar to the costs incurred by restaurants that need to print new menus when prices rise. Menu costs include all costs associated with the inflation-caused need to change prices. Yardstick costs Inflation interferes with money functioning as a measure of value and thus requires more time and effort to determine what something is worth (in real terms). Dollar price tags lose some of their meaning when inflation occurs, because the dollar’s value has declined relative to before. It is as if a yardstick that formerly measured 36 inches now measures 34, 33, or even fewer inches. All inflation-caused costs associated with determining real versus nominal values can be thought of as yardstick costs. Shoe-leather costs We have noted that people try to protect their financial assets against erosion from inflation by limiting the amounts of money they hold in their billfolds and in their non-interest-bearing checking accounts, putting those funds instead into interest-bearing saving accounts or stock and bond funds. But people actually need more money to buy the higher priced goods and services. So, they figuratively walk to and from financial institutions much more often in order to move money from these latter accounts to checking accounts or to get cash when it is needed. In the process they wear out their shoes—they incur so-called shoe-leather costs. These costs include all time and resource costs associated with the inflation-induced need to make more financial transactions.

Photograph courtesy of: (c)Nance Trueworthy;