The Macroeconomy: Unemployment, Inflation, and Deflation Chapter 7 The Macroeconomy: Unemployment, Inflation, and Deflation

Introduction How does the U.S. government measure the overall level of prices? Why doesn’t the U.S. government use Wal-Mart prices in calculating inflation? This chapter will help you answer these questions. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Learning Objectives Explain how the U.S. government calculates the official unemployment rate Discuss the types of unemployment Describe how price indexes are calculated and define the key types of price indexes Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Learning Objectives (cont'd) Distinguish between nominal and real interest rates Evaluate who looses and who gains from inflation Understand key features of business fluctuations Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Chapter Outline Unemployment The Major Types of Unemployment Full Employment and the Natural Rate of Unemployment Inflation and Deflation Anticipated versus Unanticipated Inflation Changing Inflation and Unemployment: Business Fluctuations Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Did You Know That... Trying to understand and better forecast labor employment and the overall performance of the national economy is a central objective of macroeconomics? This branch of economics seeks to explain and predict movements in unemployment, the average level of prices, and the total production of goods and services? Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment Unemployment Total number of adults (aged 16 years or older) willing and able to work and who are actively looking for work and have not found a job Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Labor Force Individuals aged 16 years or older who either have jobs or who are looking and available for jobs; the number of employed plus the number of unemployed Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Question What are the costs of unemployment? Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Answers Lost output During early 2000s, unemployment rate rose by 2 percentage points Factory output was 80% of potential Lost output was $200 billion of goods and services that could have been produced Personal psychological impact Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 7-1 More Than a Century of Unemployment Source: U.S. Department of Labor, Bureau of Labor Statistics Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 7-2 Adult Population Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) The unemployment rate is the percentage of the measured labor force that is unemployed. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Labor force = The employed + The unemployed 152.7* = 145.4 + 7.3 Unemployed Labor force Unemployment rate = x 100 = x 100 = 4.8% 7.3 152.7 *U.S., millions of people; as of 2007 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Stock Flow The quantity of something, measured at a given point in time—for example, an inventory of goods Flow A quantity measured over time, such as the income you make per year, or the number of individuals fired every month Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Categories of individuals without work Job loser Reentrant Job leaver New entrant Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Job Loser An individual whose employment was involuntarily terminated or who was laid off 40–60% of the unemployed Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Reentrant An individual who has worked a full-time job before but left the labor force and has now reentered it looking for a job 20–30% of the unemployed Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Job Leaver An individual who voluntarily quit 10 to 15% of the unemployed Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) New Entrant An individual who has never worked a full- time job for two weeks or longer 10 to 15% of the unemployed Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Duration of unemployment More than a third of job seekers find work within one month. Approximately another third find employment within a second month. About a sixth are still unemployed after six months. Average duration is just over 15 weeks throughout the last 15 years. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 7-3 The Logic of the Unemployment Rate Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Question What is likely to happen to the duration of unemployment during a downturn in the economy? Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Discouraged Workers Question Individuals who have stopped looking for a job because they are convinced they will not find a suitable one Question How does the existence of discouraged workers bias the unemployment rate? Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unemployment (cont'd) Labor Force Participation Rate The proportion of noninstitutionalized working-age individuals who are employed or seeking employment Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Major Types of Unemployment Frictional Structural Cyclical Seasonal Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Major Types of Unemployment (cont'd) Frictional Unemployment Results from the fact that workers must search for appropriate job offers This takes time, so they remain temporarily unemployed Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Major Types of Unemployment (cont'd) Structural Unemployment Results from a poor match of workers’ abilities and skills with current requirements of employers Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Major Types of Unemployment (cont'd) Cyclical Unemployment Results from business recessions that occur when aggregate (total) demand is insufficient to create full employment Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Major Types of Unemployment (cont'd) Seasonal Unemployment Results from the seasonal pattern of work in specific industries Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Example: Challenges of Measuring the Unemployment Rate in China Measurement of China’s labor force and unemployment rate fails to encompass all of the roughly 115 million people who migrate from rural areas. In addition, China’s government has not yet developed a way to determine how many millions of people laid off from state- owned firms have obtained positions with private firms. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Full Employment and the Natural Rate of Unemployment Question Does full employment mean that everybody has a job? Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Full Employment and the Natural Rate of Unemployment (cont'd) An arbitrary level of unemployment that corresponds to “normal” friction in the labor market Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Full Employment and the Natural Rate of Unemployment (cont'd) The unemployment rate that is estimated to prevail in the long-run macroeconomic equilibrium Should not reflect cyclical unemployment When seasonally adjusted, the natural rate should include only frictional and structural unemployment. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation A sustained increase in the average of all prices of goods and services in an economy Deflation A sustained decrease in the average of all prices of goods and services in an economy Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation (cont'd) Purchasing Power The value of money for buying goods and services Varies with prices and income Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation (cont'd) Nominal value Price expressed in today’s dollars Real value Value expressed in purchasing power, adjusted for inflation Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation (cont'd) Measuring the rate of inflation Price Index The cost of today’s market basket of goods expressed as a percentage of the cost of the same market basket during a base year Price index =  100 Cost today of market basket Cost of market basket in base year Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation (cont'd) Market Basket Representative bundle of goods and services Base Year The point of reference for comparison of prices in other years Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Table 7-1 Calculating a Price Index for a Two-Good Market Basket Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation (cont'd) Real-world price indexes Consumer Price Index (CPI) Producer Price Index (PPI) GDP deflator Personal Consumption Expenditure (PCE) Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation (cont'd) Consumer Price Index (CPI) A statistical measure of a weighted average of prices of a specified set of goods and services purchased by wage earners in urban areas Market basket of goods and services of typical consumer Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation (cont'd) Producer Price Index (PPI) A statistical measure of a weighted average of prices of goods and services that firms produce and sell Used as a short-run leading indicator (before CPI) PPIs for Foodstuffs Intermediate goods Finished goods Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation (cont'd) GDP Deflator A price index measuring the changes in prices of all new goods and services produced in the economy Broadest measure of prices; reflects both price changes and the public’s market responses to those price changes Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inflation and Deflation (cont'd) Personal Consumption Expenditure (PCE) Index A statistical measure of average price using annually updated weights based on consumer spending Primary inflation index used by the Federal Reserve Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 7-4 Inflation and Deflation in U.S. History Source: U.S. Department of Labor, Bureau of Labor Statistics Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Anticipated versus Unanticipated Inflation To determine who is hurt by inflation we distinguish between the two types. The effects of inflation on individuals depend upon which type of inflation exists. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Anticipated versus Unanticipated Inflation (cont'd) The inflation rate that we believe will occur Unanticipated Inflation Inflation at a rate that comes as a surprise Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Anticipated versus Unanticipated Inflation (cont'd) Inflation and interest rates Nominal Rate of Interest The market rate of interest expressed in today’s dollars Real Rate of Interest The nominal rate of interest minus the anticipated rate of inflation Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Anticipated versus Unanticipated Inflation (cont'd) Real interest rate Nominal interest rate = 10% Expected inflation rate = 6% Real rate = 10% – 6% = 4% Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Anticipated versus Unanticipated Inflation (cont'd) Does inflation necessarily hurt everyone? Inflation affects people differently Unanticipated inflation Creditors lose Debtors gain Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Anticipated versus Unanticipated Inflation (cont'd) Protecting against inflation Cost-Of-Living Adjustments (COLAs) Clauses in contracts that allow for increases in specified nominal values to take account of changes in the cost of living Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Anticipated versus Unanticipated Inflation (cont'd) The resource cost of inflation Repricing or Menu Cost of Inflation The cost associated with recalculating prices and printing new price lists when there is inflation Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Inequality based on consumption of fuel, education, and health care Policy Example: How Pervasive Is “Inflation Inequality” in the United States? Inequality based on consumption of fuel, education, and health care Households facing higher inflation do so for a short period of time. To the extent inflation inequality exits, it is neither pervasive nor persistent. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Changing Inflation and Unemployment: Business Fluctuations The ups and downs in business activity throughout the economy Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Changing Inflation and Unemployment: Business Fluctuations (cont'd) Expansion A business fluctuation in which the pace of national economic activity is speeding up Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Changing Inflation and Unemployment: Business Fluctuations (cont'd) Contraction A business fluctuation during which the pace of national economic activity is slowing down Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Changing Inflation and Unemployment: Business Fluctuations (cont'd) Recession A period of time during which the rate of growth of business activity is consistently less than its long-term trend or is negative Depression An extremely severe recession Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 7-5 The Idealized Course of Business Fluctuations Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 7-6 National Business Activity, 1880 to the Present Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Changing Inflation and Unemployment: Business Fluctuations (cont'd) Leading Indicators Events that have been found to occur before changes in business activity Economic downturns often follow Reduction in the average workweek Rise in unemployment insurance claims Decrease in prices of raw materials Drop in the quantity of money circulating Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Issues and Applications: Wal-Mart, Product Quality, and the CPI Wal-Mart offers lower prices on most food items. The Bureau of Labor Statistics (BLS) uses prices charged at a nearby Kroger. As far as the BLS is concerned, lower Wal- Mart prices must reflect lower quality. BLS quality adjustments may result in an upward bias in the rate of CPI inflation. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Summary Discussion of Learning Objectives How the U.S. government calculates the official unemployment rate Percentage of the total number of adults willing and able to work who are actively looking for work but have not found a job The major types of unemployment Frictional Structural Cyclical Seasonal Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Summary Discussion of Learning Objectives (cont'd) Full employment Arbitrary level of unemployment Corresponds to “normal” friction in labor market Natural rate of unemployment Estimated to prevail in the long-run macroeconomic equilibrium All workers and employers adjust to any changes in economy Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Summary Discussion of Learning Objectives (cont'd) How price indexes are calculated and key price indexes Multiply 100 times the ratio of the cost of a market basket of goods in the current year to the cost of the same basket in a base year Key price indexes CPI PPI GDP deflator PCE Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Summary Discussion of Learning Objectives (cont'd) Nominal versus real interest rates Nominal rate is the market rate expressed in current dollars. Real rate is net of inflation. Hence the real interest rate equals the nominal interest rate minus the expected inflation rate. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Summary Discussion of Learning Objectives (cont'd) Losers and gainers from inflation Creditors lose as a result of unanticipated inflation. Borrowers gain. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Summary Discussion of Learning Objectives (cont'd) Key features of business fluctuations Increases and decreases in business activity Expansion from previous trough to new peak Contraction from previous peak to new trough Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Macroeconomy: Unemployment, Inflation, and Deflation End of Chapter 7 The Macroeconomy: Unemployment, Inflation, and Deflation