Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

C H A P T E R 8 The Anatomy of Inflation and Unemployment Learning objectives äUnderstand that the costs of unemployment are large. äUnderstand that the costs of anticipated inflation are very small. äUnderstand that costs of unanticipated inflation are mainly distributional. äUnderstand that unemployment rates vary widely across demographic groups. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

Slide 2 The Anatomy of Unemployment oUnemployed person oUnemployed person: Someone who is out of work and: 1)Has actively looked for work in the last four weeks, or 2)Is waiting to be recalled to a job after having been laid off, or 3)Is waiting to report to a new job within four weeks. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 3 The Anatomy of Unemployment oThe Canadian unemployment rate exhibits the following characteristics: oLarge variations in unemployment rates across age groups and across populations. oThere are substantial flows of individuals in and out of unemployment each month, and most people who become unemployed in any given month remain unemployed for only a short time period. oPeople who become unemployed for a long period of time account for much of the unemployment rate. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 4 The Anatomy of Unemployment Table 8-1: Canadian Labour Force and Unemployment, December 2002 (Thousands of persons, years old) 1,195 Unemployed Unemployed 15,548 Employed Employed 16,744 Labour Force Labour Force 4,872 Not in Labour Force Not in Labour Force 21,616 Population Years

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 5 The Anatomy of Unemployment oUnemployment Pool oUnemployment Pool: The number of unemployed people at any point in time. oReasons for becoming unemployed: oA person may be a new entrant or re-entrant into the labour force. oA person may quit a job in order to look for alternative employment and may register as unemployed while searching. oA person may be laid-off. oA person may lose a job. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 6 The Anatomy of Unemployment oReasons for moving out of the unemployment pool: oA person may be hired into a new job. oSomeone laid off may be recalled by his or her employer. oAn unemployed person may stop looking for a job. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 7 The Anatomy of Unemployment 1) u = w 1 u 1 + w 2 u 2 + … + w n u n u: overall unemployment rate u i : unemployment rate of groups within the labour force. w i : (weight) fraction of the labour force that falls within a specific group. 7.1% = (0.842)6.3% + (0.158)11.8% Variations in Unemployment Across Groups Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 8 The Anatomy of Unemployment Figure 8-1: Unemployment Rates Across Various Demographic Groups, Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 9 The Anatomy of Unemployment Figure 8-2: Unemployment Rates Across Regions, Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 10 The Anatomy of Unemployment oFrictional Unemployment oFrictional Unemployment: The unemployment that exists when the economy is at full employment. oCyclical Unemployment oCyclical Unemployment: Unemployment in excess of frictional unemployment; occurs when output is below its full employment level. Cyclical and Frictional Unemployment Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 11 Full Employment oNatural Rate of Unemployment oNatural Rate of Unemployment: Rate of unemployment at which the flows into and out of the unemployment pool balance; also the point on the augmented Phillips curve at which expected inflation equals actual inflation. oThe Natural Rate can be thought of in terms of duration and frequency of unemployment. Determinants of the Natural Rate Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 12 Full Employment oThe duration of unemployment depends on cyclical factors and the following structural characteristics of the labour market: oThe organization of the labour market, including the presence or absence of employment agencies, youth employment agencies and the like. oThe demographic make-up of the labour force. oThe ability and desire of the unemployed to keep looking for a better job, which depends in part on the availability of unemployment benefits. Determinants of the Natural Rate Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 13 Full Employment oThe frequency of unemployment is the average number of times, per period, that workers become unemployed. There are two basic determinants of the frequency of unemployment: oThe variability of the demand for labour across different firms in the economy. oThe rate at which new workers enter the labour force. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 14 Full Employment 2) u* = w 1 u 1 * + w 2 u 2 * + … + w n u n * u*: Natural rate of unemployment. u i : Natural rate of unemployment for groupswithin the labour force. w i : (weight) fraction of the labour force that falls within a specific group. Estimates of the Natural Rate of Unemployment Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 15 The Anatomy of Unemployment Figure 8-3: The Actual Rate of Unemployment and the Estimated Natural Rate of Unemployment, Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 16 The Costs of Unemployment oCosts of Cyclical Unemployment oCosts of Cyclical Unemployment: Sacrifice Ratio oThe Sacrifice Ratio: The percentage of output lost for each 1 percentage-point reduction in the inflation rate. oMeasures by combining the short-run Phillips curve and the slope of the Okun’s law curve. oDistributional Impact of Unemployment oOther Costs and benefits oMore leisure oLost tax revenue Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 17 Action Policy in Action The Disinflation of the early 1980s.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 18 The “Sacrifice Ratio” - International BOXBOX Canada1.00Australia Ratio % Country Estimated Average Sacrifice Ratios 1.74Italy 2.92Germany0.75France 2.39 United States 0.79 United Kingdom 1.57Switzerland0.93Japan

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 19 Unemployment in International Perspective BOXBOX 8-3

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 20 The Costs of Inflation oPerfectly Anticipated Inflation oPerfectly Anticipated Inflation: When all agents correctly anticipate the future inflation rate. o“Shoe-leather” costs. oMenu costs. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 21 The Costs of Inflation oImperfectly Anticipated Inflation oImperfectly Anticipated Inflation: Inflation is unexpected. oWealth distribution: oWealth distribution: Those who hold financial assets have some of their purchasing power transferred to those who issue financial assets. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 22 Inflation and Indexing oIndexation oIndexation: Ties the terms of contracts to the behaviour of the price level. oInflation and Interest Rates oInflation and housing oIndexed debt oIndexation of wages (COLAs) Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 23 Inflation and Indexing oGovernments are reluctant to index because: oDifficulty for the economy to adjust for shocks. oComplicated in practice. oWill make the economy worse off by leading to still higher inflation. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 24 Is a Little Inflation Good for the Economy? BOXBOX 8-5 James Tobin argued that a small amount of inflation is good for the economy - and it reduces the natural rate of unemployment - because it provides a necessary mechanism for lowering real wages without cutting nominal wages.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 25 Chapter Summary Most unemployment is accounted for by people who will be unemployed for a long time. There are significant differences among unemployment rates across age groups and regions in Canada. The concept of the natural rate of unemployment is used to describe how much unemployment would exist even if the economy was at full employment. The major cost of unemployment are in terms of lost output. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 26 Chapter Summary (cont’d) The economy can adjust to perfectly anticipated inflation by moving to a system of increased taxes and to nominal interest rates that reflect the expected rate of inflation. In Canada, the government uses real return bonds. Imperfectly anticipated inflation has important redistributive effects among sectors. Small, positive inflation lubricates the economy by reducing real wage rigidity. Chapter 8: Anatomy of Inflation and Unemployment

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 27 The End Chapter 8: Anatomy of Inflation and Unemployment