Macroeconomics ECON 2301 May 2010 Marilyn Spencer, Ph.D. Professor of Economics Chapter 7

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

Learning Objectives 1. Explain how the U.S. government calculates the official unemployment rate 2. Discuss the types of unemployment 3. Describe how price indexes are calculated and define the key types of price indexes 4. Distinguish between nominal and real interest rates 5. Evaluate who looses and who gains from inflation 6. Understand key features of business fluctuations

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.

Did You Know That... 4 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? 4 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? 4 Trying to understand and better measure inflation and the overall performance of the national economy is a central objective of macroeconomics.

Unemployment 4 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 4 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

Unemployment (cont'd) 4 Question: What are the costs of unemployment? 4 Answers: ÜLost 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 ÜPersonal psychological impact

Source: U.S. Department of Labor, Bureau of Labor Statistics Figure 7-1 More Than a Century of Unemployment

Figure 7-2 Adult Population

Unemployment (cont'd) 4 The unemployment rate is the percentage of the measured labor force that is unemployed.

Unemployment (cont'd) *U.S., millions of people; as of 2007 Labor force = The employed+ The unemployed Unemployment rate =  x 100 Unemployed Labor force 155.7* = =  x 100 = 6.7%

Unemployment (cont'd) 4 Stock: The quantity of something, measured at a given point in time - for example, an inventory of goods 4 Flow: A quantity measured over time, such as the income you make per year, or the number of individuals fired every month

Unemployment (cont'd) 4 Categories of individuals without work ÜJob loser ÜRe-entrant ÜJob leaver ÜNew entrant

Unemployment (cont'd) 4 Job Loser: An individual whose employment was involuntarily terminated or who was laid off 40–60% of the unemployed 4 Re-entrant: 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

Unemployment (cont'd) 4 Job Leaver: An individual who voluntarily quit 10 to 15% of the unemployed 4 New Entrant: An individual who has never worked a full-time job for two weeks or longer 10 to 15% of the unemployed

Unemployment (cont'd) 4 Duration of unemployment - ordinarily ÜMore than a third of job seekers find work within one month. ÜApproximately another third find employment within a second month. ÜAbout a sixth are still unemployed after six months. ÜAverage duration is just over 15 weeks throughout the last 15 years.

Figure 7-3 The Logic of the Unemployment Rate

Unemployment (cont'd) 4 Question ÜWhat is likely to happen to the duration of unemployment during a downturn in the economy?

Unemployment (cont'd) 4 Discouraged Workers: Individuals who have stopped looking for a job because they are convinced they will not find a suitable one 4 Question ÜHow does the existence of discouraged workers bias the unemployment rate?

Unemployment (cont'd) 4 Labor Force Participation Rate: The proportion of non-institutionalized working- age individuals who are employed or seeking employment

The Major Types of Unemployment 4 The major types of unemployment: ÜFrictional ÜStructural ÜCyclical ÜSeasonal

The Major Types of Unemployment (cont'd) 4 Frictional Unemployment ÜResults from the fact that workers must search for appropriate job offers ÜThis takes time, so they remain temporarily unemployed

The Major Types of Unemployment (cont'd) 4 Structural Unemployment ÜResults from a poor match of workers’ abilities and skills with current requirements of employers

The Major Types of Unemployment (cont'd) 4 Seasonal Unemployment ÜResults from the seasonal pattern of work in specific industries

The Major Types of Unemployment (cont'd) 4 Cyclical Unemployment ÜResults from business recessions that occur when aggregate (total) demand is insufficient to create full employment

4 In 2007, home-building activity fell by more than 25%. Yet, cyclical unemployment increased by only 4%. 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

International Example: How Illegal Aliens Affect Measured Cyclical U.S. Unemployment (cont’d) 4 When the downturn in house construction occurred, most home builders discharged illegal workers and retained employees who were residents of the U.S. 4 Because official unemployment measures include only legal U.S. residents, the number of workers officially classified as cyclically unemployed rose only slightly cyclically. 4 Why might construction firms’ employment of illegal aliens also prevent measured cyclical unemployment from declining as much as it otherwise might the next time these is a boom in home-building activity?

Full Employment and the Natural Rate of Unemployment 4 Question: Does full employment mean that everybody has a job? 4 Full Employment: An arbitrary level of unemployment that corresponds to “normal” friction in the labor market

Full Employment and the Natural Rate of Unemployment (cont'd) 4 Natural Rate of Unemployment: The unemployment rate that is estimated to prevail in the long-run macroeconomic equilibrium ÜShould not reflect cyclical unemployment ÜWhen seasonally adjusted, the natural rate should include only frictional and structural unemployment.

Inflation and Deflation 4 Inflation: A sustained increase in the average of all prices of goods and services in an economy 4 Deflation: A sustained decrease in the average of all prices of goods and services in an economy

Inflation and Deflation (cont'd) 4 Purchasing Power: The value of money for buying goods and services ÜVaries with prices and income 4 Nominal value: Price expressed in today’s dollars 4 Real value: Value expressed in purchasing power, adjusted for inflation

Price index =  100 Cost today of market basket Cost of market basket in base year Inflation and Deflation (cont'd) 4 Measuring the rate of inflation or deflation ÜPrice 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

Inflation and Deflation (cont'd) 4 Market Basket: Representative bundle of goods and services 4 Base Year: The point of reference for comparison of prices in other years

Table 7-1 Calculating a Price Index for a Two-Good Market Basket

Inflation and Deflation (cont'd) 4 Real-world price indexes ÜConsumer Price Index (CPI) ÜProducer Price Index (PPI) ÜGDP deflator ÜPersonal Consumption Expenditure (PCE)

Inflation and Deflation (cont'd) 4 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 ÜMarket basket of goods and services of the “typical” consumer

Inflation and Deflation (cont'd) 4 Producer Price Index (PPI): A statistical measure of a weighted average of prices of goods and services that firms produce and sell ÜUsed as a short-run leading indicator (before CPI) ÜPPIs for Foodstuffs Intermediate goods Finished goods

Inflation and Deflation (cont'd) 4 GDP Deflator: A price index measuring the changes in prices of all new goods and services produced in the economy ÜBroadest measure of prices; reflects both price changes and the public’s market responses to those price changes

Inflation and Deflation (cont'd) 4 Personal Consumption Expenditure (PCE) Index: A statistical measure of average price using annually updated weights based on consumer spending ÜPrimary inflation index used by the Federal Reserve

Figure 7-4 Inflation and Deflation in U.S. History Source: U.S. Department of Labor, Bureau of Labor Statistics

Anticipated versus Unanticipated Inflation 4 To determine who is hurt by inflation we distinguish between the two types. 4 The effects of inflation on individuals depend upon which type of inflation exists.

Anticipated vs. Unanticipated Inflation (cont'd) 4 Anticipated Inflation: The inflation rate that we believe will occur 4 Unanticipated Inflation: Inflation at a rate that comes as a surprise

Anticipated vs. Unanticipated Inflation (cont'd) 4 Inflation and interest rates ÜNominal Rate of Interest: The market rate of interest expressed in today’s dollars ÜReal Rate of Interest: The nominal rate of interest minus the anticipated rate of inflation

Anticipated vs. Unanticipated Inflation (cont'd) 4 Real interest rate ÜNominal interest rate = 10% ÜExpected inflation rate = 6% ÜReal rate = 10% – 6% = 4%

Anticipated vs. Unanticipated Inflation (cont'd) 4 Does inflation necessarily hurt everyone? ÜInflation affects different people differently 4 Unanticipated inflation ÜCreditors lose ÜDebtors gain

Anticipated vs. Unanticipated Inflation (cont'd) 4 Protecting against inflation ÜCost-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

Anticipated vs. Unanticipated Inflation (cont'd) 4 The resource cost of inflation ÜRe-pricing or Menu Cost of Inflation: The cost associated with recalculating prices and printing new price lists when there is inflation

Changing Inflation and Unemployment: Business Fluctuations 4 Business Fluctuations: The ups and downs in business activity throughout the economy 4 Expansion: A business fluctuation in which the pace of national economic activity is speeding up 4 Contraction: A business fluctuation in which the pace of national economic activity is slowing down

Changing Inflation & Unemployment: Business Fluctuations (cont'd) 4 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 4 Depression: An extremely severe recession

Figure 7-5 The Idealized Course of Business Fluctuations

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 Miller’s estimates.

Changing Inflation and Unemployment: Business Fluctuations (cont'd) 4 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  Stock market downturn

Summary of Learning Objectives 4 How the U.S. government calculates the official unemployment rate ÜPercentage of the total number of adults willing and able to work who are actively looking for work but have not found a job 4 The major types of unemployment ÜFrictional ÜStructural ÜSeasonal ÜCyclical

Summary of Learning Objectives (cont'd) 4 Full employment ÜArbitrary level of unemployment Corresponds to “normal” friction in labor market 4 Natural rate of unemployment ÜEstimated to prevail in the long-run macroeconomic equilibrium All workers and employers adjust to any changes in economy

Summary of Learning Objectives (cont'd) 4 How price indexes are calculated and key price indexes ÜMultiply 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 ÜKey price indexes CPI PPI GDP deflator PCE

Summary of Learning Objectives (cont'd) 4 Nominal versus real interest rates ÜNominal rate is the market rate expressed in current dollars. ÜReal rate is net of inflation. ÜHence the real interest rate equals the nominal interest rate minus the expected inflation rate.

Summary of Learning Objectives (cont'd) 4 Losers and gainers from inflation ÜCreditors lose as a result of unanticipated inflation. ÜBorrowers gain as a result of unanticipated inflation.

Summary of Learning Objectives (cont'd) 4 Key features of business fluctuations ÜIncreases and decreases in business activity Expansion from previous trough to new peak Contraction from previous peak to new trough

Assignment to be completed before class, May 21: Pre-read Chapter 8, & also read: 14 th ed: end-of-chapter Problems 8-2, 8-5, 8-6, 8-8, 8-10, 8-11 & 8-16 on pp th ed: end-of-chapter Problems 8-2, 8-5, 8-6, 8-8, 8-11 & 8-16 on pp