Understanding Frictional And Structural Unemployment, Inflation, And Money Creation In Macroeconomic Theory

Frictional Unemployment and Structural Unemployment

1.a) The Australian Bureau of Statistics (ABS) classify unemployment levels based on criteria, which comprise three basic factors, including without work, presently available for work, and actively seeking for work. Foremost, without work criterion distinguishes those individuals who have a job and those people who do not. In ABS view, a person working for at least one hour within the reference week is considered employed (Gregory and Smith, 2016, p. 235). The Bureau believes that any time worked irrespective how small represents a form of employment. The second criterion, actively seeking work, explores individuals who actively search for employment for about four weeks but have not found a job. ABS classifies such individuals as unemployed. Active job seeking includes telephoning, applications for various jobs, registering with a hiring agency, and tendering for work among others. Lastly, currently available for work criterion reflects the unemployment data of the present available labor supply within a specified period. It helps to assess and evaluate measures and fluctuations in unemployment levels. Although ABS use the three principles to identify key indicators in the labor market, they are not satisfactory because of ever-changing economic structures. For instance, it is irrational to consider someone employed because he or she works one hour for the reference week. The criteria will be successful if it measures unemployment based on the minimum basic amount of salary required for survival.

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b) Frictional unemployment refers to the form of the unemployment that arises owing to the time spent searching for or transitioning from one occupation to another. Frictional unemployment is inevitable in an economy because individuals search for a job while others are switching companies every day (Abel, Bernanke, and Croushore, 2017, p. 47). Indeed, in an economic structure in which individuals can freely change their occupations and in which employers have the power to fire or dismiss inefficient employees, it is hard to eliminate frictional unemployment. Workers will often search for better job opportunities.  

c) Macroeconomic policymakers need to be concerned about structural unemployment because it is either long-lived or permanent and necessitate robust policies to correct it.  In light of Abel, Bernanke, and Croushore (2017), structural unemployment denotes a situation in which structural changes such as technological advancement adjust labor demand patterns (34). Policymakers should always ensure macroeconomic policies do not result in structural changes because certain skills in the labor market may become inappropriate or unnecessary. Structural unemployment differs from cyclical unemployment in that the former is long-lived and challenging to address, but the latter is usually short-lived and can be addressed within a short period. For instance, high-technology machinery replaces employees indefinitely but a cyclical disturbance such as changes in retirement age affect the labor market for a short period and its adverse effects can be easily addressed. 

Types and Causes of Inflation

2.a) Inflation refers to the increase in the prices of services and commodities. When the prices of goods and services increase, the consumer’s purchasing power decreases (Abel, Bernanke, and Croushore, 2017, p. 56). Economists claim that demand side, supply side, or both cause inflation. According to Chu and Lai (2013), inflation caused by demand-side factors is referred to as demand-pull inflation while that caused by supply-side factors is known as cost-push inflation (234). Firstly, demand-pull inflation transpires when Aggregate Demand (AD) increases at a rapid rate than Aggregate Supply (AS). In this way, the demand exceeds supply, and thus, the firms respond by increasing prices of the services and commodities. With the rapid growth in the economy, aggregate demand shifts from AD1 to AD2 while long-run aggregate supply remains constant thus increasing prices from p1 to p2. The level of output also increases from Y1 to Y2. This situation is illustrated using the graph below:


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                                                                                                                     Source: (https://www.investopedia.com)

On its part, cost-push inflation is also referred to as “wrong type” inflation. It is associated with deteriorating living standards. The short-run aggregate supply shift to the left from SRAS1 to SRAS2 thus increasing prices from P1 to P2 while reducing output from Y1 to Y2. Notably, cost-push inflation cause both falling output and inflation thus making it challenging to address it. This situation is illustrated in the figure below:


                                                                                                                      Source: (https://www.investopedia.com)

Monetarist and Keynesian Perspectives on Inflation

 2.b) Several factors cause the two types of inflation. Examples of two factors that cause demand-pull inflation include exchange rate depreciation and economic monetary stimulus. When exchange rate depreciates, exports become cheaper while imports become costly. With low level of imports from the consumers, while the exports increase, the aggregate demand rise. Additionally, with monetary stimulus in the economy mainly owing to decrease in interest rate, there is increased demand because consumers can borrow at a low rate (Wood, 2014, p. 131). On the other hand, two examples of factors causing cost-push inflation are higher wages and supply shock. Wages act as expenses to the firms. Therefore, strong labor unions may cause inflation by pushing for higher wages, which increase production costs, and thus, higher prices for commodities. Supply shock also leads to cost-push inflation when prices of significant commodities such oil rises. As a result, firms experience higher transport costs thus driving services and commodities’ prices up.

3.a) Monetarists argue that inflation represents a monetary phenomenon. However, they believe in the Phillips Curve, which states that there exists an inverse relationship between unemployment and inflation. On their part, Keynesians believe in demand-pull versus cost-push inflation, where economic growth rate determines the level and type of the inflation. They claim that in an economy where the demand surpasses production, the demand-pull inflation occurs. However, Keynesians do not believe in the notion that rise in money supply inevitably causes inflation unlike the monetarists (Wood, 2014, 128). These different perceptions between the two groups can be explained using both cost-push and demand-pull types of inflation.

Monetarists base their assumption “only money matters” on the argument that near or at full employment, excessive money supply causes a rise in aggregate demand thus leading to inflation. Indeed, a rise in nominal money supply makes the aggregate demand curve to shift rightward thus enabling individuals to possess excess cash balances. Consequently, people tend to increase their level of spending leading to an increase in prices of services and commodities. The price continues to increase until aggregate demand matches to aggregate supply. On the other hand, Keynesians postulate that inflation arises from the non-monetary sector. For instance, a tax cut may lead to a rise in aggregate demand because of augmented consumption expenditure leading to increased business investments or government expenditure. The tenet of Keynesian theory is that the government expenditure is inflationary. Therefore, the government can print additional money if a need arises.

Central Bank and Money Creation

b) The monetarists maintain that the Aggregate Demand (AD) is relatively elastic while the Aggregate Supply (AS) is inelastic in relation to the price level and expansion of money supply. In this regard, they plot AS curve as a vertical straight line indicating that adjustments in the quantity of money (M) do not affect on real output or employment level. Figure 1(a) illustrates this argument. When AD curve shift to AD1 owing to increase in M while AS remains fixed, the price increases from P1 to P2. The real income level remains the same at OQ. Monetarists claim that these variations in expenditure (MV) and money income in the economy principally results from money supply fluctuations. In their view, demand for money and velocity of circulation (V) remains constant owing to the slow variation of their determinants. In this perception, inflation is a monetary phenomenon, which suggests that with sufficient monetary flow, prices tend to increase. Money supply increase does not have a permanent impact on the functioning of an economy. Thus, policymakers should reduce the growth of money to a minimum in order to contain inflation.

On their part, proponents of Keynesian theory believe that AS is considerably more elastic and greater compared to the elasticity of AD to the price. The increase in government spending (G) or money supplies through either deficit or otherwise, it leads to a positive effect on output and employment level (Wood, 2014, p.141). Figure 1(b) demonstrates this argument. AS is represented as a vertical line from point F. AD intersects with AS to establish the price level P and real output. The shift in aggregate demand curve to AD1 based on the change in G and M, the price rises less proportionately, and thus, real income become OQFP1. In light of Keynesians, the overall increase in price from P to P1 represents reflation instead of inflation. In their view, inflation arises from post full employment scenario. Therefore, a further increase in money supply increases aggregate demand to AD2 thus pushing prices up from P1 to P2 since AS curve remains vertical.


                                                                                                        Source: (https://www.economicsdiscussion.net/keynesian)

Effects of Depositing a Pay Cheque from Another Bank

4.a) Yes, I agree that central bank is responsible for money creation through bank deposits. The central bank enjoys the autonomy and monopoly to regulate bank operations, including money creation. Indeed, the central bank oversees the modern banking system through fractional-reserve banking whereby money supply of the country is expanded beyond the amount deposited by the client (Lawrence, 2018, n.p). This process creates broad money in the banking system. The central bank (Reserve bank of Australia) directly determines the interest rate by regulating the base interest rate. In this way, it indirectly influences stock prices, exchange rate, and the economy’s wealth. In light of monetarists and some Austrians, the central bank has the mandate to control the money supply using its monetary operations, including policies on money creation. Therefore, it is monetary authority responsible for money creation

b) Depositing a pay cheque in my bank account from another bank does have an effect on the money supply because money was already deposited and used. The reserve maintained in the initial bank still remains, and the amount of money in the country does not change since they were already in the banking system.

c) The maximum amount the bank can lend will be calculated using the money creation formula, which requires retention of 10% reserve of the deposited amount. In this regard, WestPack bank can only lend out $900 to its customers when it receives $ 1000 because the central bank requires it to retain 10% in its reserve ratio. Consequently, bank’s clients can only use $900 to pay for services and goods. Then, $900 will be expected to be deposited back to the bank holding all other factors constant. This scenario represents the primary step in the process of WestPack bank money creation. So far, WestPack bank has generated $900 of money as well as the credit of a similar amount. Clients of the bank can use this amount to purchase assets thus contributing to economic growth. Assuming the entire amount was redeposited in the bank again, WestPack bank has an additional $810 to lend to its customers. The process continues until the initial amount of $1000 creates new deposits (money) and credit (loans) to a value of $9000. Indeed, WestPack’s balance sheet will have expanded from $1,000 to $10,000. The process of money creation is illustrated in the table below:


Customer Deposits

in $

10% reserved as cash at hand in $

Loans made in $

Step 1




Step 2




Step 3




Step 4




Step 5







Notably, WestPack bank can lend a maximum amount of $ 9,000

5.a) No. The sale of government securities to banks is meant to reduce money supply in the economy. This decrease of available money leads to available in the economy leads to the shrinking of investments and spending because the accessibility of loans becomes challenging owing to use of money to buy government securities.

b) No.  Borrowing from banks to boost government expenditure makes the available money for lending limited because banks will prefer to lend money to the government owing to security reasons. In light of Bernanke et al. (2018), government spending from borrowing does not automatically lead to an economic boom because the government has to recover the money borrowed through taxes to repay the debt thus offsetting the anticipated increase in money supply from government spending (96).

c) Yes. Central bank purchase of government securities from banks will lead to an increase in money supply. The banks will have more money to lend to its clients, and thus, they will borrow more funds. As a result, increased borrowing will lead to increased spending thus increasing money supply.

d) Possibly. Agreement by the central bank governor and treasurer to reduce target inflation rate would possibly increase the money supply. The low rate of inflation expectation makes individuals not to demand high salaries or wages, and thus, firms to increase their spending.  Indeed, if companies’ expect reduced inflation rate, they become more conscious about market prices. However, some individuals may prefer to wait until the policy is implemented to purchase goods and services at relatively low prices.