c h a p t e r twelve © 2007 Prentice Hall Business Publishing Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien Prepared by: Fernando & Yvonn Quijano Unemployment and Inflation

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 2 of 32 After studying this chapter, you should be able to: Define the unemployment rate and the labor force participation rate, and understand how they are computed. Identify the three types of unemployment. Explain what factors determine the unemployment rate. Define the price level and the inflation rate, and understand how they are computed. Use price indexes to adjust for the effects of inflation. Distinguish between the nominal interest rate and the real interest rate. Discuss the problems caused by inflation. Lucent Technologies Deals with Unemployment and Inflation LEARNING OBJECTIVES …, the contract between Lucent and its union workers increased wages by less than the increase in prices expected by the firm and the workers

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 3 of 32 Measuring the Unemployment Rate and the Labor Force Participation Rate LEARNING OBJECTIVE 1 The Household Survey Labor force The sum of employed and unemployed workers in the economy. Unemployment rate The percentage of the labor force that is unemployed. Discouraged workers People who are available for work, but who have not looked for a job during the previous four weeks because they believe no jobs are available for them.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 4 of 32 Measuring the Unemployment Rate and the Labor Force Participation Rate The Household Survey The Employment Status of the Civilian Working-Age Population, June 2005

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 5 of 32 The Household Survey  The unemployment rate measures the percentage of the labor force that is unemployed:  The labor force participation rate measures the percentage of the working-age population that is in the labor force: Measuring the Unemployment Rate and the Labor Force Participation Rate

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 6 of 32 What Happens If You Include the Military? LEARNING OBJECTIVE 1 People on active military service are not included in the employment, labor force, or working-age population totals compiled in the BLS household survey. Suppose people in the military were included in these statistics.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 7 of 32 Measuring the Unemployment Rate and the Labor Force Participation Rate Problems with Measuring the Unemployment Rate Trends in Labor Force Participation Trends in the Labor Force Participation Rates of Adult Men and Women Since 1948

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 8 of 32 Measuring the Unemployment Rate and the Labor Force Participation Rate The Establishment Survey: Another Measure of Employment HOUSEHOLD SURVEYESTABLISHMENT SURVEY MAYJUNECHANGE MAYJUNECHANGE Employed 141,475,000141,638, ,000133,391,000133,537, ,000 Unemployed 7,647,0007,486,000–161,000 Labor Force 149,122,000149,123,000+1,000 Unemployment Rate 5.1%5.0% Household and Establishment Survey Data for May and June – 2

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 9 of 32 Measuring the Unemployment Rate and the Labor Force Participation Rate Job Creation and Job Destruction Over Time Establishments Creating and Eliminating Jobs, September-December – 3 NUMBER OF ESTABLISHMENTS NUMBER OF JOBS ESTABLISHMENTS CREATING JOBS Existing establishments1,530,0006,365,000 New establishments379,0001,716,000 ESTABLISHMENTS ELIMINATING JOBS Continuing establishments1,467,0005,727,000 Closing establishments320,0001,485,000

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 10 of 32 Types of Unemployment LEARNING OBJECTIVE The Annual Unemployment Rate in the United States,

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 11 of 32 Types of Unemployment Frictional Unemployment and Job Search Frictional unemployment Short-term unemployment arising from the process of matching workers with jobs. Structural Unemployment Structural unemployment Unemployment arising from a persistent mismatch between the skills and characteristics of workers and the requirements of jobs.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 12 of 32 Types of Unemployment Cyclical Unemployment Cyclical unemployment Unemployment caused by a business cycle recession. Full Employment Natural rate of unemployment The normal rate of unemployment, consisting of structural unemployment plus frictional unemployment.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 13 of 32 Explaining Unemployment LEARNING OBJECTIVE 3 Government Policies and the Unemployment Rate UNEMPLOYMENT INSURANCE AND OTHER PAYMENTS TO THE UNEMPLOYED INTERNATIONAL COMPARISONS Average Unemployment Rates in the United States, Canada, Japan, and Europe,

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 14 of 32 Explaining Unemployment Government Policies and the Unemployment Rate MINIMUM WAGE LAWS Labor Unions Efficiency Wages Efficiency wage A higher-than-market wage paid by a firm to increase worker productivity.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 15 of 32 Why Did Henry Ford Pay His Workers Twice As Much As Other Car Manufacturers? Henry Ford claimed that paying a wage twice as high as his competitors was the finest cost-cutting move he ever made.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 16 of 32 Measuring Inflation LEARNING OBJECTIVE 4 Price level A measure of the average prices of goods and services in the economy. Inflation rate The percentage increase in the price level from one year to the next.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 17 of 32 Measuring Inflation The Consumer Price Index Consumer price index (CPI) An average of the prices of the goods and services purchased by the typical urban family of four The CPI Market Basket, December 2004

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 18 of 32 Measuring Inflation BASE YEAR (1999) PRODUCTQUANTITYPRICEEXPENDITURESPRICEEXPENDITURESPRICEEXPENDITURES Eye examinations1$50.00 $ $85.00 Pizzas Books Total FORMULAAPPLIED TO 2006APPLIED TO 2007 CPI = Don’t Miscalculate the Inflation Rate

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 19 of 32 Measuring Inflation Is the CPI Accurate?  Substitution bias.  Increase in quality bias.  New product bias.  Outlet bias.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 20 of 32 Measuring Inflation The Producer Price Index Producer price index (PPI) An average of the prices received by producers of goods and services at all stages of the production process.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 21 of 32 Using Price Indexes to Adjust for the Effects of Inflation LEARNING OBJECTIVE 5 Value in 2004 dollars = Value in 1980 dollars Falling Real Wages at Lucent

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 22 of 32 Calculating Real Average Hourly Earnings YEARNOMINAL AVERAGE HOURLY EARNINGS CPI ( = 100) 2002$ LEARNING OBJECTIVE 5 YEAR NOMINAL AVERAGE HOURLY EARNINGS CPI ( = 100) REAL AVERAGE HOURLY EARNINGS ( DOLLARS) 2002$ $

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 23 of 32 Real versus Nominal Interest Rates LEARNING OBJECTIVE 6 Nominal interest rate The stated interest rate on a loan. Real interest rate The nominal interest rate minus the inflation rate. Deflation A decline in the price level.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 24 of 32 Real versus Nominal Interest Rates Nominal and Real Interest Rates,

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 25 of 32 Does Inflation Impose Costs on the Economy? LEARNING OBJECTIVE 7 Inflation Affects the Distribution of Income The Problem with Anticipated Inflation Menu costs The costs to firms of changing prices. The Problem with Unanticipated Inflation

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 26 of 32 Why a Lower Inflation Rate Is Like a Tax Cut for Lucent’s Bondholders A lower inflation rate is like a tax cut for investors. PRINCIPAL REAL INTEREST RATE INFLATION RATE NOMINAL INTEREST RATE $1,0004%6%10% $1,0004%2%6% INFLATION RATE NOMINAL INTEREST PAYMENT TAX PAYMENT AFTER-TAX INTEREST PAYMENT ADJUSTMENT FOR INFLATION REAL AFTER-TAX INTEREST PAYMENT 6%$100– $25= $75– $60= $15 2%$60– $15= $45– $20= $25

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 12: Unemployment and Inflation 27 of 32 Consumer price index (CPI) Cyclical unemployment Deflation Discouraged workers Efficiency wage Frictional unemployment Inflation rate Labor force Labor force participation rate Menu costs Natural rate of unemployment Nominal interest rate Price level Producer price index (PPI) Real interest rate Structural unemployment Unemployment rate