1 Unemployment and Inflation Chapter 23 © 2006 Thomson/South-Western

2 Costs of Unemployment  Personal Cost  Loss of paycheck  Loss of self-esteem  Increase in stress related psychological problems  Increase in incidence of crime, suicide, and mental illness  Economic Cost  Loss in output

3 Measuring Unemployment  Civilian Noninstitutional Adult Population  All civilians 16 years of age and older  Excludes institutionalized in prisons or mental hospitals  Excludes those in military  Labor force  Those in the adult population who are either working or looking for work

4 Measuring Unemployment  Unemployed  Those with no job who are looking for work  Unemployment rate  Measures the percentage of those in the labor force who are unemployed  Equals the number unemployed divided by the number in the labor force  Does not include discouraged workers  Discouraged workers  Those who are no longer looking for work but are unemployed

5 Exhibit 1: The Adult Population Sums the Employed, the Unemployed, and Those Not in the Labor Force

6 Labor Force Participation Rate  The number in the labor force divided by the adult population  On average, two out of three adults are in the labor force  Increased from about 60% in 1970 to approximately 67% in 1990 and has remained relatively constant since  Convergence of the participation rates of men and women over last 40 years as more women enter the labor force

7 Trend of Unemployment Rate  Decline in the unemployment rate over last 20 years  Overall growth in the economy  Relatively fewer teenagers in the work force  Unemployment rate says nothing about who is unemployed or for how long – differs across  Race  Gender  Age  Geographical area  Occupational group

8 Exhibit 2: The U.S. Unemployment Rate Since 1900

9 Exhibit 3: Unemployment Rates for Various Groups

10 Exhibit 3: Unemployment Rates for Various Groups

11 Exhibit 4: Unemployment Rates Differ Across U.S. Metropolitan Areas

12 Sources of Unemployment  Frictional  Seasonal  Structural  Cyclical

13 Frictional Unemployment  Caused by time required to bring together labor suppliers and labor demanders  Employers need time to learn about the talent available  Job seekers need time to learn about employment opportunities  Generally short-term and voluntary

14 Seasonal Unemployment  Caused by seasonal changes in labor demand during the year  To eliminate the impact of such changes, monthly unemployment statistics are seasonally adjusted, which smoothes out these factors

15 Structural Unemployment  Exists because unemployed workers often  Do not have the skills demanded by employers, or  Do not live where their skills are in demand  Occurs because changes in tastes, technology, taxes, or competition reduce the demand for certain skills and increase the demand for other skills

16 Cyclical Unemployment  Fluctuates with the business cycle, increasing during contractions and decreasing during expansions  Means the economy is operating inside its PPF  Government policies to stimulate aggregate demand recessions is aimed at reducing this type of unemployment

17 Full Employment  Occurs only if there is no cyclical unemployment  Occurs when the only unemployment is frictional, structural, or seasonal  Does not mean zero unemployment  Frictional, seasonal, and structural unemployment can still occur  Occurs when from 4% to 6% of the labor force is unemployed

18 Unemployment Compensation  Cash transfers for those who lose their jobs and actively seek employment  Applies to unemployed workers who meet certain qualifications  Problems with unemployment compensation:  Workers who receive benefits tend to search less actively than those who don’t  May reduce the urgency of finding work

19 International Comparisons  Why are unemployment rates so high in Europe?  Ratio of unemployment benefits to average pay is higher  Unemployment benefits last longer, sometimes years, so workers have less incentive to find new jobs  Government regulations make employers in Europe reluctant to hire new workers because firing them is difficult

20 Exhibit 5: In the Last Two Decades, Unemployment Rates Fell in the United States, Rose in Japan, and Remained High in Europe

21 Problems with Unemployment Figures  Understate the actual amount of unemployment because they do not include discouraged workers and underemployed  Underemployment occurs when  people are counted as employed even if they can find only part-time jobs or  Are vastly overqualified for their job

22 Problems with Unemployment Figures  Tend to overstate unemployment because  Employment insurance and most welfare programs require recipients to seek employment  Some who would prefer to work part time can find only full-time work  Some are forced to work overtime and weekends, but would prefer to work fewer hours  People in the underground economy may not readily acknowledge such jobs because their intent is to evade taxes

23 Inflation  Inflation: a sustained increase in the average price level  Hyperinflation: extremely high inflation  Deflation: a sustained decline in the average price level  Disinflation: a reduction in the rate of inflation

24 Inflation  Inflation is typically measured annually  Annual inflation rate is the percentage increase in the average price level from one year to the next  Two sources of inflation  Demand-pull inflation  Cost-push inflation

25 Exhibit 6a: Inflation Caused by Shifts of AD and AS Curves Increase in the AD curve pulls up the price level. To generate continuous demand-pull inflation, the AD curve must keep shifting outward along a given AS curve Increase in costs of production push up the price level. To generate continuous cost-push inflation, the AS curve must keep shifting to the left along a given AD curve.

26 Exhibit 7a: Consumer Price Index Since 1913

27 Exhibit 7b: CPI Since 1913 – Annual Percentage Change

28 Anticipated versus Unanticipated Inflation  Unanticipated inflation creates more problems for the economy than does anticipated inflation  To the extent that inflation is higher or lower than anticipated, it arbitrarily creates winners and losers  If it is higher than expected, the winners are all those who had contracted to pay a price that anticipates lower inflation  The losers are all those who agreed to sell at that price  If inflation is lower is lower than expected, the situation is reversed

29 Transaction Costs of Inflation  When prices are stable, people correctly believe they can predict future prices and can plan accordingly  But, if inflation changes unexpectedly, planning gets harder which undermines the ability of money to serve as a link between the present and the future  When dealing with the rest of the world, they must also anticipate how the value of the dollar might change relative to foreign currencies

30 Obscures Relative Price Changes Relative prices describe the exchange rate between goods—how much one good costs compared to another  Inflation does not necessarily cause the change in relative prices, but it can obscure them  Occurs because of the greater uncertainty about the price of one good relative to another

31 Inflation Across Metropolitan Areas  Inflation rates differ across regions mostly because of differences in housing prices, which grow faster in some places than in others  Federal government tracks separate CPIs for each of 26 metropolitan areas.

32 Exhibit 8: Average Annual Inflation from 1994 to 2004 Differed Across U.S. Metropolitan Areas

33 Inflation Across Countries Exhibit 9: Inflation Rates in Major Economies Have Trended Lower Over the Past Two Decades

34 Inflation and Interest Rates  Interest is the dollar amount paid by borrowers to lenders because lenders must be rewarded for forgoing present consumption  The interest rate is the interest per year as a percentage of the amount loaned

35 Exhibit 10: The Market for Loanable Funds  Greater the interest rate, the greater the reward for loaning money: supply curve slopes downward  The higher the interest rate, the higher cost of borrowing – the quantity of loanable funds demanded decreases as the interest rate increases, other things constant: demand curve for loanable funds is downward sloping  Equilibrium interest rate is at the intersection of the supply of and demand for loanable funds

36 Interest Rates  Nominal interest rate  Measures interest in terms of the current dollars paid  The interest rate that appears on the borrowing agreement  The rate quoted in the news media  Real interest rate  Equals the nominal rate of interest minus the inflation rate  Expressed in dollars of constant purchasing power

37 Interest Rates  With no inflation, the nominal and real interest rates would be identical  With inflation, the nominal interest rate exceeds the real interest rate  If the inflation rate is high enough, the real interest rate can actually be negative  The nominal interest would not even offset the loss in spending power because of inflation – lenders would lose purchasing power  Why lenders and borrowers are concerned more about the real interest rate than the nominal interest rate

38 Interest Rates  The higher the expected rate of inflation, the higher the nominal rate of interest that lenders require and that borrowers are willing to pay  Expected real interest rate equals the nominal rate of interest minus the expected inflation rate

39 Why is Inflation Unpopular?  Problems with unanticipated inflation  Hits those whose incomes are fixed in nominal terms  Arbitrarily redistributes income and wealth from one group to another  Reduces the ability to make long-term plans  Forces buyers and sellers to pay more attention to prices - less time for production - overall productivity of economy falls

40 COLA  Cost of Living Adjustment: the increase in a transfer payment or wage that reflects the increase in the price level