Chapter 7 The Macroeconomy: Unemployment and Inflation

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 7-2 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 © 2010 Pearson Addison-Wesley. All rights reserved. 7-3 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 © 2010 Pearson Addison-Wesley. All rights reserved. 7-4 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 © 2010 Pearson Addison-Wesley. All rights reserved. 7-5 Did You Know That... Estimates indicate that each year, discount pricing by retailers such as Wal-Mart, K-Mart, and Target, helps to keep the overall U.S. inflation rate about 0.4% lower? Additionally, every year discount pricing by food superstores holds the annual rate of increase in average U.S, food prices 0.75% below the rate it otherwise would reach? Trying to understand and better measure inflation and the overall performance of the national economy is a central objective of macroeconomics.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 7-6 Unemployment –Total number of adults (aged 16 years or older) willing and able to work and who are actively looking for work but have not found a job. –Unemployment creates a cost to the entire economy in terms of lost output – often ranging in the billions of dollars.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 7-7 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 The unemployment rate is the percentage of the measured labor force that is unemployed.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 7-8 Unemployment (cont'd) Question –What are the costs of unemployment?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 7-9 Unemployment (cont'd) Answers –Lost output During early 2000s, unemployment rate rose by 2 percentage points Firm output was 80% of potential Lost output was $200 billion of goods and services that could have been produced –Personal psychological impact

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Source: U.S. Department of Labor, Bureau of Labor Statistics Figure 7-1 More Than a Century of Unemployment

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Figure 7-2 Adult Population Source: U.S. Department of Labor, Bureau of Labor Statistics.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved * = Unemployment (cont'd) *U.S., millions of people; as of 2009 Labor force = The employed+ The unemployed Unemployment rate =  x 100 Unemployed Labor force =  x 100 = 6.7%

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Unemployment (cont'd) Stock –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 © 2010 Pearson Addison-Wesley. All rights reserved Unemployment (cont'd) Categories of individuals without work –Job loser –Reentrant –Job leaver –New entrant

Copyright © 2010 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 © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved Unemployment (cont'd) Job Leaver –An individual who voluntarily quit 10 to 15% of the unemployed

Copyright © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved Figure 7-3 The Logic of the Unemployment Rate

Copyright © 2010 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 © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved Unemployment (cont'd) Discouraged Workers –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 © 2010 Pearson Addison-Wesley. All rights reserved Unemployment (cont'd) Labor Force Participation Rate –The proportion of non-institutionalized working- age individuals who are employed or seeking employment

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Major Types of Unemployment The major types of unemployment –Frictional –Structural –Cyclical –Seasonal

Copyright © 2010 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 © 2010 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 –Considerable evidence shows that government labor market policies influence how many jobs businesses wish to create, thereby affecting structural unemployment.

Copyright © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved In 2007, home-building activity fell by more than 25%. Yet, cyclical unemployment increased by only 4%. What was different about this particular housing slump was that construction firms had hired large numbers of illegal- immigrant workers alongside U.S. residents. International Example: How Illegal Aliens Affect Measured Cyclical U.S. Unemployment

Copyright © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved Full Employment and the Natural Rate of Unemployment Questions –Does full employment mean that everybody has a job? –Is it always possible for everyone who is looking for a job to find one?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Full Employment and the Natural Rate of Unemployment (cont'd) Full Employment –An arbitrary level of unemployment that corresponds to “normal” friction in the labor market

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Full Employment and the Natural Rate of Unemployment (cont'd) Natural Rate of Unemployment –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 © 2010 Pearson Addison-Wesley. All rights reserved Inflation and Deflation Inflation –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 © 2010 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 © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved Inflation and Deflation (cont'd) Measuring the Rate of Inflation Market Basket –Representative bundle of goods and services Base Year –The point of reference for comparison of prices in other years

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Price index =  100 Cost today of market basket Cost of market basket in base year Inflation and Deflation (cont'd) –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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Example: Why are Women Confronting Higher Inflation Than Men The price index for the market basket of a typical U.S. female resident has increased at a rate at least 1% higher than her male counterpart. Compared to years past, more women are employed. They are also marrying and having children later in life. Higher-income single women tend to spend more of their income than men.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 7-1 Calculating a Price Index for a Two-Good Market Basket

Copyright © 2010 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 © 2010 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 © 2010 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 © 2010 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 © 2010 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 © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved Anticipated versus Unanticipated Inflation 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 © 2010 Pearson Addison-Wesley. All rights reserved Anticipated versus Unanticipated Inflation (cont'd) Anticipated Inflation –The inflation rate that we believe will occur Unanticipated Inflation –Inflation at a rate that comes as a surprise

Copyright © 2010 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 © 2010 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 © 2010 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 © 2010 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 © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved Changing Inflation and Unemployment: Business Fluctuations Business Fluctuations –The ups and downs in business activity throughout the economy

Copyright © 2010 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 © 2010 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 © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved Figure 7-5 The Idealized Course of Business Fluctuations

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Figure 7-6 National Business Activity, 1880 to the Present Sources: American Business Activity from 1790 to Today, 67th ed., AmeriTrust Co., January 1996, plus author’s estimates.

Copyright © 2010 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 © 2010 Pearson Addison-Wesley. All rights reserved The U.S. labor force participation rate is several percentage points higher today than it was a half- century ago. In recent years, however, labor force participation has fallen. What accounts for the decrease in U.S. labor force participation? Several factors have contributed to the decline in the labor force participation rate. Issues and Applications: Explaining the Downtrend in Labor Force Participation

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Issues and Applications: Explaining the Downtrend in Labor Force Participation (cont’d) One is that the number of new female entrants has been insufficient to replace women who have departed the labor force. Another factor is a dip in the labor force participation rate among teenagers. In addition, a number of people between the ages of 25 and 54 have dropped out of the labor force, many of whom have not graduated from high school or are high school graduates without college.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Issues and Applications: Explaining the Downtrend in Labor Force Participation (cont’d) Finally, altered legal rules have made it easier for all workers to receive disability benefits, and these changes help account for the decreases in labor force participation among men and women under the age of 55.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Figure 7-7 The U.S. Labor Force Participation Rate Since 1995 Source: U.S. Department of Labor, Bureau of Labor Statistics; author’s estimates

Copyright © 2010 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 © 2010 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 © 2010 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 © 2010 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 © 2010 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 © 2010 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