11 CHAPTER Monitoring Jobs and Inflation

© Pearson Education 2012 After studying this chapter you will be able to:  Explain why unemployment is a problem and describe the trend and cycles in the labour market indicators  Explain why unemployment is an imperfect measure of underutilized labour and why it is present even at full employment  Explain why inflation is a problem, how we measure it and why the official measure might be biased

© Pearson Education 2012 Each month, we chart the course of employment and unemployment as measures of the health of the economy. How do we measure the unemployment rate? Is the unemployment rate a reliable vital sign for the economy? Having a job that pays a decent wage does not determine the standard of living; the cost of living also matters. We track the cost of what we buy by publishing the Consumer Prices Index and the Retail Prices Index. How are they calculated? Do they provide a good guide to the cost of living?

Employment and Unemployment What kind of job market will you enter when you graduate? Those leaving the university in 2010 had a tough time: In May 2009, the number of people in the UK who wanted a job but couldn’t find one past the 2.4 million mark. Usually, unemployment is less than half that number. The UK economy creates lots of jobs. Even in 2009, 26 million people in the UK had jobs. But in recent years, the population has grown faster than the number of jobs, so unemployment has become a major problem. © Pearson Education 2012

Employment and Unemployment Why Unemployment is a Problem Unemployment results in:  Lost incomes and production  Lost human capital The loss of income is devastating for those who bear it. Employment benefits create a safety net but don’t fully replace lost wages, and not everyone receives benefits. Prolonged unemployment permanently damages a person’s job prospects by destroying human capital. © Pearson Education 2012

Employment and Unemployment Labour Force Survey The Office for National Statistics conducts a monthly population survey to determine the status of the UK workforce. The population is divided into two groups: 1 The working-age population – the number of men aged 16 to 64 years and women aged 16 to 59 years who are not in prison, hospital or some other form of institutional care 2 People under 16 years or in institutional care

© Pearson Education 2012 Employment and Unemployment The working-age population is divided into two groups: 1People who are economically active – have a job or are willing and able to take a job 2People who are economically inactive – do not want a job The workforce is the sum of employed and unemployed workers.

© Pearson Education 2012 Employment and Unemployment To be counted as unemployed, a person must be in one of the following three categories: 1 Without work, but has made specific efforts to find a job within the previous four weeks 2 Waiting to be called back to a job from which he or she has been laid off 3 Waiting to start a new job within 30 days

© Pearson Education 2012 Employment and Unemployment Figure 11.1 shows the population workforce categories. In 2010: Population: 62.1 million. Working-age population: 40 million. Economically active: 93 million Employed: 28.3 million Unemployed: 2.4 million

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Employment and Unemployment Three Labour Market Indicators  The unemployment rate  The employment rate  The economic activity rate

© Pearson Education 2012 Employment and Unemployment The Unemployment Rate The unemployment rate is the percentage of the workforce that is unemployed. The unemployment rate is (Number of people unemployed ÷ Workforce)  100. In 2010, the number of people employed was 28.3 million and the number unemployed was 2.4 million. So the unemployment rate was (2.4 ÷ 30.7)  100, or 7.8 per cent. Figure 11.2 on the next slide shows that the unemployment rate reaches its peaks during recessions.

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Employment and Unemployment The Employment Rate The employment rate is the percentage of working-age people who have jobs. The employment rate equals (Number of people employed ÷ Working-age population)  100. In 2010, the number of people employed was 28.3 million and the working-age population was 40 million. The employment rate was 70.8 per cent.

© Pearson Education 2012 Employment and Unemployment The Economic Activity Rate The economic activity rate is the percentage of the working-age population who are members of the workforce. The economic activity rate is (Workforce ÷ Working-age population)  100. In 2010, the workforce was 30.7 million and the working- age population was 40 million. The economic activity rate was 76.8 per cent.

© Pearson Education 2012 Employment and Unemployment Figure 11.3 shows the employment rate falls during recessions and rises in expansions, … but the economic activity rate has no trend.

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Employment and Unemployment Other Definitions of Eonomic Inactivity and Unemployment The purpose of the unemployment rate is to measure the underutilization of labour resources. The ONS believes that the unemployment rate gives a correct measure. But the official measure is an imperfect measure because it excludes:  Discouraged workers  Others who want a job © Pearson Education 2012

Employment and Unemployment Discouraged Workers A discouraged worker is a person who is available and willing to work but who has stopped actively looking for a job because he or she believes that no jobs are available. Discouraged workers often temporarily leave the workforce during a recession and re-enter during an expansion. The distinction between an unemployed person and a discouraged worker turns on whether there has been job search activity. © Pearson Education 2012

Employment and Unemployment Others Who Want a Job These people are economically inactive, willing to work but have stopped actively looking for a job because they are not available to start a job in the next two weeks. Figure 11.4 shows that discouraged workers are a small percentage of the economically inactive. © Pearson Education 2012

Employment and Unemployment Most Costly Unemployment All unemployment is costly, but the most costly is long- term unemployment that results from job loss. People who are unemployed for a few weeks and then find another job bear some costs of unemployment. But their costs are low compared to the costs borne by people who remain unemployed for many weeks. © Pearson Education 2012

Unemployment and Full Employment Types of Unemployment Unemployment can be classified into three types:  Frictional unemployment  Structural unemployment  Cyclical unemployment

© Pearson Education 2012 Unemployment and Full Employment Frictional Unemployment Frictional unemployment is unemployment that arises from normal labour market turnover. The creation and destruction of jobs requires that unemployed workers search for new jobs. Increases in the number of people entering and re- entering the workforce and increases in unemployment benefits raise frictional unemployment.

© Pearson Education 2012 Unemployment and Full Employment Structural Unemployment Structural unemployment is unemployment created by changes in technology and foreign competition that change the skills needed to perform jobs or the locations of jobs. Structural unemployment lasts longer than frictional unemployment.

© Pearson Education 2012 Unemployment and Full Employment Cyclical Unemployment Cyclical unemployment is the higher than normal unemployment at a business cycle trough and lower than normal unemployment at a business cycle peak. A worker laid off because the economy is in a recession and is then rehired when the expansion begins experiences cyclical unemployment.

© Pearson Education 2012 Unemployment and Full Employment ‘Natural’ Unemployment Natural unemployment is the unemployment that arises from frictions and structural change when there is no cyclical unemployment. Natural unemployment is all frictional and structural unemployment. The natural unemployment rate is natural unemployment as a percentage of workforce.

© Pearson Education 2012 Unemployment and Full Employment Full employment occurs when there is no cyclical unemployment or, equivalently, when all unemployment is frictional and structural. The unemployment rate when the economy is at full employment is called the natural unemployment rate. The natural unemployment rate was high during the 1980s but has gradually decreased.

The natural unemployment rate changes over time and is influenced by many factors. Key factors are:  The age distribution of the population  The scale of structural change  The real wage rate  Unemployment benefits Unemployment and Full Employment © Pearson Education 2012

Unemployment and Full Employment Real GDP and Unemployment Over the Cycle Potential GDP is the quantity of real GDP produced at full employment. Potential GDP corresponds to the capacity of the economy to produce output on a sustained basis. Real GDP minus potential GDP is the output gap. Over the business cycle, the output gap fluctuates and the unemployment rate fluctuates around the natural unemployment rate. © Pearson Education 2012

Figure 11.5 shows the output gap and … the fluctuations of the unemployment rate around the natural unemployment rate. When the output gap is negative…. The unemployment rate exceeds the natural unemployment rate. Unemployment and Full Employment © Pearson Education 2012

The Price Level, Inflation and Deflation The price level is the average level of prices and the value of money. A persistently rising price level is called inflation. A persistently falling price level is called deflation. We are interested in the price level because we want to: 1Measure the inflation rate or the deflation rate. 2Distinguish between money values and real values of economic variables.

© Pearson Education 2012 The Price Level, Inflation and Deflation Why Inflation and Deflation Are Problems Low, steady, and anticipated inflation or deflation is not a problem. Unpredictable inflation or deflation is a problem because it:  Redistributes income  Redistributes wealth  Lowers real GDP and employment  Diverts resources from production

© Pearson Education 2012 The Price Level, Inflation and Deflation Unpredictable changes in the inflation rate redistribute income in arbitrary ways between employers and workers and between borrowers and lenders. A high inflation rate is a problem because it diverts resources from productive activities to inflation forecasting. From a social perspective, this waste of resources is a cost of inflation. At its worse, inflation becomes hyperinflation − an inflation rate 50 per cent a month or higher that grinds the economy to a halt and society to a collapse.

© Pearson Education 2012 The Price Level, Inflation and Deflation The Price Indexes Every month the Office for National Statistics calculates the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). Both the RPI and the CPI measure the average of the prices paid by consumers for a ‘fixed’ basket of consumer goods and services.

© Pearson Education 2012 The Price Level, Inflation and Deflation Reading the RPI and CPI The RPI is defined to equal 100 for the reference base period. Currently, the reference base period is January That is, for January 1987, the RPI equals 100. In January 2010, the RPI was This number tells us that the average of the prices paid by consumers for a fixed basket of goods was per cent higher in 2010 than it was in January 1987.

© Pearson Education 2012 The Price Level, Inflation and Deflation Constructing the RPI and CPI Constructing the RPI and the CPI involves three stages:  Selecting the basket  Conducting a monthly price survey  Calculating the price index

© Pearson Education 2012 The Price Level, Inflation and Deflation Selecting the Basket The RPI basket is selected to be representative of the items bought by an average household in the UK. The CPI basket is different from the RPI basket and covers all expenditure on consumer good and services made in the UK by private households, residents of institutions and tourists.

© Pearson Education 2012 The Price Level, Inflation and Deflation Figure 11.6(a) illustrates the RPI basket. Housing and household expenditure is the largest component. Travel and leisure and food and catering are the next largest components. The other components account for 20 per cent of the basket.

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The Price Level, Inflation and Deflation Figure 11.6(b) illustrates the CPI basket. Transport, recreation and culture, housing and household services are the largest components. Restaurants and hotels, and food and non- alcoholic beverages are the next largest components.

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The Price Level, Inflation and Deflation Conducting a Monthly Price Survey Every month, ONS employees check 110,000 prices of more than 550 types of goods and services. Calculating the Price Index 1Find the cost of the basket at base-period prices. 2Find the cost of the basket at current-period prices. 3Calculate the price index for the base period and for the current period.

© Pearson Education 2012 The Price Level, Inflation and Deflation Let’s work an example of the RPI calculation. In a simple economy, people consume only oranges and haircuts. The RPI basket is 10 oranges and 5 haircuts. The table also shows the prices in the base period. ItemQuantityPrice Oranges10£1£1 Haircuts5£8

© Pearson Education 2012 The Price Level, Inflation and Deflation The cost of the RPI basket in the base period was £50. ItemQuantityPrice Cost of RPI basket Oranges10£1£10 Haircuts5£8£40 Cost of RPI basket at base period prices£50

© Pearson Education 2012 The Price Level, Inflation and Deflation ItemQuantityPrice Cost of RPI basket Oranges10£2£20 Haircuts5£10£50 Cost of RPI basket at current-period prices £70 This table shows the prices in the current period. The cost of the RPI basket at current-period prices is £70.

© Pearson Education 2012 The Price Level, Inflation and Deflation The RPI is calculated using the formula: RPI = (Cost of basket at current-period prices ÷ Cost of basket at base-period prices)  100. Using the numbers for the simple example: In the base period: RPI = (£50 ÷ £50)  100 = 100. In the current period: RPI = (£70 ÷ £50)  100 = 140. The RPI is 40 per cent higher in the current period than it was in the base period.

© Pearson Education 2012 The Price Level, Inflation and Deflation Measuring the Inflation Rate The major purpose of the RPI is to measure inflation. The inflation rate is the percentage change in the price level from one year to the next. The inflation formula is: Inflation rate = [(RPI this year – RPI last year) ÷ RPI last year]  100.

The Price Level, Inflation and Deflation Distinguishing High Inflation from a High Price Level Figure 11.7 shows that the inflation rate is:  High when the price level is rising rapidly and  Low when the price level is rising slowly. © Pearson Education 2012

The Price Level, Inflation and Deflation Biased Price Indexes The main sources of bias in a price index are:  New goods bias  Quality change bias  Substitution bias

© Pearson Education 2012 The Price Level, Inflation and Deflation New Goods Bias New goods that were not available in the base period appear and, if they are more expensive than the goods they replace, they put an upward bias into the price index. Quality Change Bias Quality improvements occur every year. Part of the rise in the price is payment for improved quality and is not inflation. The price index counts all the price rise as inflation.

© Pearson Education 2012 The Price Level, Inflation and Deflation Substitution Bias The market basket of goods used in calculating the price index is fixed and does not take into account substitutions that consumers make away from goods whose relative prices rise. As the structure of retailing changes, people switch to buying from cheaper sources, but the price index, as measured, does not take account of this switch in where people shop.

© Pearson Education 2012 The Price Level, Inflation and Deflation Some Consequences of the Bias in the RPI and CPI The bias  Distorts private contracts  Increases government outlays  Might lead to inappropriate monetary policy decisions by the Bank of England

The Price Level, Inflation and Deflation Alternative Price Indexes One of the alternative measures of the price level is the GPD deflator. The GDP deflator is an index of the prices of all the items in GDP. The GDP deflator = (Nominal GDP ÷ Real GDP) × 100. The GDP deflator, a broader price index, is appropriate for macroeconomics because it is a comprehensive measure of the cost of the real GDP basket of goods and services. © Pearson Education 2012

The Price Level, Inflation and Deflation The Alternatives Compared Figure 11.8 compares the three measures of inflation. These measures give different average values and different fluctuations. RPI fluctuates more than CPI, … but GDP deflator is the least volatile. © Pearson Education 2012

The Price Level, Inflation and Deflation The Real Variables in Macroeconomics We can use the GPD deflator to deflate nominal variables to find their real values. For example, Real wage rate = (Nominal wage rate ÷ GDP deflator)  100 But not the real interest rate! It is different. © Pearson Education 2012