Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 36 What we learned in our last class: What is GDP? Four important points in the definition. How to calculate GDP? Three approaches. GDP in the U.S.: Consumption, Net Export, Wages. Is GDP a good measurement of total production or the well- being? –Household production –The underground economy –Leisure, pollution, ecologic costs, social problem –The distribution of GDP Nominal GDP vs. Real GDP: price level, GDP deflator. Other measurement GNP, NI Discussion: World War II effect, Airline & trucking industry.

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 36 Unemployment and Inflation 8.1Define unemployment rate and labor force participation rate and understand how they are computed. 8.2Identify the three types of unemployment. 8.3Explain what factors determine the unemployment rate. 8.4Define price level and inflation rate and understand how they are computed. 8.5Use price indexes to adjust for the effects of inflation. 8.6Distinguish between the nominal interest rate and the real interest rate. 8.7Discuss the problems that inflation causes. Learning Objectives

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 36 Measuring the Unemployment Rate and the Labor Force Participation Rate Labor force The sum of employed and unemployed workers in the economy. Working-age population (adults): people aged 16 and over. Employed: Adults who worked during the week before the survey or were temporarily away from their jobs. Unemployed: Adults who did not work but were available for work during the week before the survey, and were actively looking for a job during previous four weeks. Learning Objective 8.1 The Household Survey Discouraged workers People who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 36 Learning Objective 8.1 FIGURE 8-1 The Employment Status of the Civilian Working-Age Population, April 2007 Measuring the Unemployment Rate and the Labor Force Participation Rate The Household Survey

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 36 Measuring the Unemployment Rate and the Labor Force Participation Rate Learning Objective 8.1 The unemployment rate measures the percentage of the labor force that is unemployed. The Household Survey The labor force participation rate measures the percentage of the working-age population in the labor force.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 36 Learning Objective 8.1 Measuring the Unemployment Rate and the Labor Force Participation Rate Problems with Measuring the Unemployment Rate Shortcomings: No discouraged workers are included. Part-time workers are counted as employed. Unverified responses: Claiming to be unemployed Illegal jobs

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 36 Learning Objective 8.1 FIGURE 8-2 Trends in the Labor Force Participation Rates of Adult Men and Women Since 1948 Measuring the Unemployment Rate and the Labor Force Participation Rate Trends in Labor Force Participation

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 36 Learning Objective 8.1 FIGURE 8-3 Unemployment Rates in the United States by Demographic Group, April 2007 Measuring the Unemployment Rate and the Labor Force Participation Rate Unemployment Rates for Demographic Groups

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 36 Learning Objective 8.1 Table 8-1 Duration of Unemployment LENGTH OF TIME UNEMPLOYEDPERCENTAGE OF TOTAL UNEMPLOYED Less than 5 weeks35.6% 5 to 14 weeks to 26 weeks weeks or more17.5 Measuring the Unemployment Rate and the Labor Force Participation Rate How Long Are People Usually Unemployed?

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 36 Learning Objective 8.1 Table 8-2 Household and Establishment Survey Data for March and April 2007 HOUSEHOLD SURVEYESTABLISHMENT SURVEY MARCHAPRILCHANGE MARCHAPRILCHANGE EMPLOYED 146,254,000145,786,000−468,000137,596,000137,684,000+88,000 UNEMPLOYED 6,724,0006,801,000+77,000 LABOR FORCE 152,979,000152,587,000−392,000 UNEMPLOYMENT RATE 4.4%4.5%+0.1% Measuring the Unemployment Rate and the Labor Force Participation Rate The Establishment Survey: Another Measure of Employment

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 36 Learning Objective 8.1 Table 8-3 Establishments Creating and Eliminating Jobs, April–June 2006 NUMBER OF ESTABLISHMENTS NUMBER OF JOBS ESTABLISHMENTS CREATING JOBS Existing establishments1,558,0006,286,000 New establishments360,0001,475,000 ESTABLISHMENTS ELIMINATING JOBS Existing establishments1,543,0005,937,000 Closing establishments341,0001,358,000 Measuring the Unemployment Rate and the Labor Force Participation Rate Job Creation and Job Destruction Over Time

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 36 Types of Unemployment Learning Objective 8.2 FIGURE 8-4 The Annual Unemployment Rate in the United States, 1950–2006

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 36 Unemployment rates in the U.S.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 36 Learning Objective 8.2 Frictional Unemployment and Job Search Frictional unemployment Short-term unemployment that arises from the process of matching workers with jobs. me if I quit or am fired; students who are looking for jobs after graduating; mothers who re-enter the labor force after taking time off to bear/raise children; Seasonal effect Eliminating all frictional unemployment? Types of Unemployment

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 36 Types of Unemployment Structural unemployment Unemployment arising from a persistent mismatch between the skills and characteristics of workers and the requirements of jobs. Tend to be longer-term unemployed Widespread adoption of new technologies creates demands for people with new skills, but can render other skills obsolete Bus drivers, as subway services expand Bicycle repair experts, as motorcycles. cars, buses and subways are used more COBALT and FORTRAN programmers, as C++ and Java become more widely used Fishermen as fish stocks become depleted

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 36 Types of Unemployment Cyclical unemployment Unemployment caused by a business cycle recession. – Some jobs disappear simply because the effects of slow GDP growth permeate through the economy – Policy makers spend a lot of time thinking about this type of unemployment in particular, how to maintain long term economic growth but minimize the magnitude of the business cycles

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 36 Learning Objective 8.2 Natural rate of unemployment The normal rate of unemployment, consisting of frictional unemployment plus structural unemployment. When the remaining unemployment is only structural and frictional unemployment, the economy is said to be in Full Employment. Full Employment Types of Unemployment

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 36 Learning Objective 8.2 How Should We Categorize the Unemployment at Alcatel-Lucent? Making the Connection The people who lost their jobs at Alcatel-Lucent fit into more than one category of unemployment.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 36 Learning Objective 8.3 Unemployment Insurance and Other Payments to the Unemployed Government Policies and the Unemployment Rate Explaining Unemployment Unemployment insurance payments from the government. (a half of the average wage, around six months) Maintain income and spending, which lessens the personal hardship of being unemployed and also helps reduce the severity of recessions. Reduce the opportunity costs of being unemployed!! Government policy can affect unemployment level.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 36 Learning Objective 8.3 FIGURE 8-5 Average Unemployment Rates in the United States, Canada, Japan, and Europe, 1997–2006 International Comparisons Government Policies and the Unemployment Rate Explaining Unemployment

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 36 What we learned in our last class? How to measure the unemployment: The household survey: Working-age population (adults), Labor force, Employed, Unemployed, Discouraged workers. How to calculate the unemployment rate and the participation rate. Shortcomings of the household survey: how do the shortcomings bias the measure of the unemployment ? The establishments survey: Why the establishment survey is needed. Net number Facts in the U.S.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 36 What we learned in our last class? How to measure the unemployment: Types of unemployment: Frictional, Structural, Cyclical Natural rate of employment, Full employment. Government policy affects the unemployment: unemployment insurance and the opportunity costs of being unemployed.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 36 Learning Objective 8.3 Minimum Wage Laws Government Policies and the Unemployment Rate Explaining Unemployment In 1938, the federal government enacted a national minimum wage law. If the minimum wage is set above the market wage determined by the demand and supply of labor, the quantity of labor supplied will be greater than the quantity of labor demanded. Economists agree that the current minimum wage is above the market wage for some workers, but they disagree on the amount of unemployment that has resulted.

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Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 36 Learning Objective 8.3 Efficiency Wages Efficiency wage A higher-than- market wage that a firm pays to increase worker productivity. Labor Unions Explaining Unemployment Labor unions are organizations of workers that bargain with employers for higher wages and better working conditions for their members.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 36 Learning Objective 8.3 Why Does Costco Pay Its Workers So Much More Than Wal-Mart Does? Making the Connection Costco’s relatively high wages and health benefits reduce employee turnover and raise morale and productivity.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 36 Measuring Inflation Prices in 1914: A Ford’s Model T: $600 A movie ticket: $0.08 A Box of Kellog’s Cone flakes: $0.08 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.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 36 Measuring Inflation Measuring the price level: GDP deflator: Including every final good and service. The broadest measurement! Consumer Price Index: An average of the prices of the goods and services purchased by the typical urban family of four. A market basket of 211 types of goods. Eight Categories. Cost-of-living index. Producer price index: An average of the prices received by producers of goods and services at all stages of the production process. A market basket of intermediate goods and services.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 36 Measuring Inflation Learning Objective 8.4 The Consumer Price Index FIGURE 8-6 The CPI Market Basket, December 2006

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 36

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 36 Measuring Inflation BASE YEAR (1999) PRODUCT QUANTIT YPRICEEXPENDITURESPRICE EXPENDITURES (ON BASE-YEAR QUANTITIES)PRICE EXPENDITURE S (ON BASE- YEAR QUANTITIES) Eye examinations 1$50.00 $ $85.00 Pizzas Books Total$750.00$900.00$ Learning Objective 8.4 Consumer price index (CPI) An average of the prices of the goods and services purchased by the typical urban family of four. Households are assumed to buy the same market basket of products each period. The Consumer Price Index

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 36 Measuring Inflation Learning Objective 8.4 The Consumer Price Index FORMULAAPPLIED TO 2008APPLIED TO 2009 CPI = Don’t Let This Happen to YOU! Don’t Miscalculate the Inflation Rate The CPI is intended to measure changes in the price level over time. (Inflation)

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Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 36

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 35 of 36 Measuring Inflation Learning Objective 8.4 Is the CPI Accurate? Substitution bias. Increase in quality bias. Outlet bias. New product bias. It is important that the CPI be as accurate as possible, but there are four biases that make changes in the CPI overstate the true inflation rate:

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 36 of 36 Using Price Indexes to Adjust for the Effects of Inflation Learning Objective 8.5 For some purposes, we are interested in tracking changes in an economic variable over time rather than in seeing what its value would be in today’s dollars. In that case, to correct for the effects of inflation, we can divide the nominal variable by a price index and multiply by 100 to obtain a real variable.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 37 of 36 Using Price Indexes to Adjust for the Effects of Inflation Value in current purchasing power: Suppose that your mom received a salary of $20,000 in How much was your mom’s salary if measured in purchasing power of 2006? We know CPI is 82 for 1980 and 202 for 2006.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 38 of 36 Solved Problem 8-5 Calculating Real Average Hourly Earnings Learning Objective 8.5 YEAR NOMINAL AVERAGE HOURLY EARNINGS CPI ( = 100) 2004$ YEAR NOMINAL AVERAGE HOURLY EARNINGS CPI ( = 100) REAL AVERAGE HOURLY EARNINGS ( DOLLARS) 2004$ $

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Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 40 of 36 Real versus Nominal Interest Rates Learning Objective 8.6 Nominal interest rate The stated interest rate on a loan. Real interest rate = Nominal interest rate − Inflation rate A better measurement of the true cost of borrowing and the true return from lending than nominal interest rate.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 41 of 36 Real versus Nominal Interest Rates Learning Objective 8.6 FIGURE 8-7 Nominal and Real Interest Rates, 1970–2006

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 42 of 36 Does Inflation Impose Costs on the Economy? Learning Objective 8.7 Inflation Affects the Distribution of Income The Problem with Anticipated Inflation Menu costs The costs to firms of changing prices. The Costs of holding paper money. The Costs for tax payers. The extent to which inflation redistributes income depends in part on whether the inflation is anticipated—in which case consumers, workers, and firms can see it coming and can prepare for it— or unanticipated—in which case they do not see it coming and do not prepare for it.

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 43 of 36 Cost of Inflation Taxpayers – People pay taxes on nominal returns, not real returns – Thus a 33% tax on an investment which yields a 12% return would require one to pay 4% of the return to the government; if the inflation rate is 9%, then the after tax real return on the investment is -1% – If real returns were taxed instead, then before tax real return of 3% would be taxed 33%: leaving the investor with an after tax real return of 2% – So people care about whether real, or nominal, returns are taxed, since this affects after tax real returns (which is what people really care about).

Chapter 8: Unemployment and Inflation © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 44 of 36 Does Inflation Impose Costs on the Economy? The Problem with Unanticipated Inflation An example: Mortgage.