1. Prepared by: Jamal Husein C H A P T E R 11 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Unemployment and Inflation

2. 2 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin What Is Unemployment?  The unemployed are those individuals who do not currently have a job but who are actively looking for work.  The employed are individuals who currently have jobs.  Together, the employed and unemployed comprise the labor force.

3. 3 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Unemployment Measures  The unemployment rate is the percentage of people in the labor force who are unemployed. Labor Force = employed + unemployed Number of Unemployed Labor Force Unemployment Rate Unemployment Rate =

4. 4 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Unemployment Measures  The working age population includes individuals 16 years of age and older who can legally work in the U.S.  The labor force participation rate is the ratio of people in the labor force to the working-age population. Labor Force Population 16 and over Labor Force Participation Rate =

5. 5 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Unemployment Measures  For example, suppose an economy consists of: 200,000 individuals 16 years and older. 122,000 employed. 8,000 unemployed. Labor Force = (122,0000 + 8,000) = 130,000 130,000 200,000 Labor Force Participation Rate = = 65% 8,000 130,000 Unemployment Rate Unemployment Rate = = 6.15%

6. 6 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Unemployment Data, January 2003 U.S. civilian population over 16 years of age 219,897,000 Labor force 145,838,000 Not in the labor force 74,059,000 Employed 137,536,000 Unemployed 8,302,000 Labor force participation rate64.12% Unemployment rate5.7%

7. 7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Unemployment Rates (2003) CountryUnemployment Rate (%) United States5.7 Belgium10.8 Sweden5.1 France9.1 Italy8.9 Spain12.1 United Kingdom5.1 Netherlands4.3 Japan5.5 Australia6.1

8. 8 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Who Are the Unemployed?  The Bureau of Labor Statistics conducts a monthly survey of households to determine who is employed, unemployed, or not in the labor force.  It is difficult to determine if someone is truly looking for work, therefore, to distinguish between those people who are unemployed and those who are not in the labor force.

9. 9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Who Are the Unemployed?  People who were looking for work in the recent past but did not find work and stopped looking are considered discouraged workers.  Discouraged workers are not counted as unemployed, but considered to have dropped out of the labor force.

10. 10 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Who Are the Unemployed?  Workers who hold part-time jobs but would prefer to have full-time jobs, and workers holding jobs far below their capabilities are called the underemployed.  It is also difficult to distinguish between employed and underemployed workers.

11. 11 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Unemployment Rates Total5.7 Males 20 years and older5.4 Female, 20 years and older4.7 Both sexes, 16-19 years16.8 White5.1 African American10.3 White, 16-19 years15.2 African American, 16-19 years30.4 Married men3.5 Married women3.8 Women maintaining families8.0 Selected Unemployment Rates, January 2003 (in percent)

12. 12 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Types of Unemployment  Cyclical unemployment is the result of fluctuations in real GDP. Unemployment rises when real GDP falls, and falls when the economy improves.  Frictional unemployment occurs naturally in the economy. It refers to the time it takes to find an appropriate job.

13. 13 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Types of Unemployment  Structural unemployment refers to the mismatch between job openings and the skills of workers seeking jobs. It is difficult to draw the line between frictional and structural unemployment. Are workers from the “old economy” able to find jobs in the “new economy”?

14. 14 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Natural Rate of Unemployment  When the economy is at full employment, the unemployment rate is not zero, but equal to the natural rate of unemployment.  The natural rate of unemployment consists of frictional and structural unemployment. It is the unemployment that exists when actual GDP is equal to potential GDP—there is no cyclical unemployment.

15. 15 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Natural Rate of Unemployment  In the United States, economists estimate that the natural rate of unemployment is between 4.0% and 5.5%. In Europe it is between 7% and 10%.  The economy needs some frictional unemployment to operate efficiently.

16. 16 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Natural Rate of Unemployment  When the growth rate of real GDP slows down relative to its long-run trend, the actual unemployment rate exceeds the natural rate of unemployment—cyclical unemployment rises.  On the other hand, if economic growth is too rapid, the economy will “overheat” and cyclical unemployment will be negative.

17. 17 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Costs of Unemployment  Excess unemployment cause both society and individuals to suffer:  Excess unemployment means the economy is no longer producing at its potential, i.e., some of society’s resources are being wasted;  Lower employment translates into reduced income and immediate hardship for individuals, especially those with fixed obligations;  Unemployment cost can also linger into the future. Some skills are likely to be lost as a result of prolonged unemployment;  Unemployment can impose psychological costs, i.e., divorce, crime, suicide, … etc.

18. 18 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Unemployment and Inflation  When the economy is “overheated,” and unemployment rates are low, firms will find it difficult to recruit workers, and competition among firms will lead to increases in wages.  As wages increase, increases in prices soon follow. The sign of overheating will be a general rise in prices for the entire economy, or inflation.

19. 19 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Consumer Price Index  The Consumer Price Index (CPI) is an index that measures changes in a fixed “basket of goods” which contains items purchased by the typical consumer.  The CPI is a measure of the value of money over time.  Reality PRINCIPLE What matters to people is the real value or purchasing power of money or income, not its face value.

20. 20 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Consumer Price Index  The CPI index for a given year, say year K, is defined as: Cost of Basket in Year K Cost of Basket in base Year CPI in CPI in Year K = × 100

21. 21 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Consumer Price Index Prices increased an average of 25% over this five-year period. Example:  Cost of basket in 1992, the base year = $200  Cost of same basket in 1997 = $250

22. 22 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The CPI and the Standard of Living  Suppose you have $300 in 1992. How much would you need to be able to have the same standard of living in 1997?  Using the ratio of the CPI in 1997 to the CPI in 1992:  You need $375 in 1997 just to maintain what was your standard of living in1992.

23. 23 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Components of the CPI, 1992 Food & beverage (18.00%) Other services (7.00%) Household services (9.00%) Transportation (7.00%) Medical (5.00%) Apparel (6.00%) Non-durables (11.00%) Durables (11.00%) Rent (26.00%) Components of the CPI

24. 24 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The CPI Versus the GDP Deflator  Both the CPI and the GDP deflator (including the more recent chain price for GDP) are measures of the average prices for the economy.  The CPI includes goods produced in prior years, as well as imported goods, while the GDP deflator does not.

25. 25 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Problems in Measuring Changes in Prices  The CPI tends to overstate true changes in the cost of living because it does not allow for the share of the goods whose prices have risen to decline in the typical basket of goods used by the Commerce Department.  In reality, all indexes tend to overstate actual price changes, primarily because we have a difficult time measuring quality improvements in goods and services.

26. 26 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The CPI Tends to Overstate Price Changes  Economists believe that the inflation rate is overstated by between 0.5% and 1.5% each year.  This means that cost-of-living adjustments to wages and social security payments based on changes in the CPI tend to be larger than they should be.

27. 27 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin InflationInflation  The percentage rate of change of a price index is the inflation rate.  Example: Price index in a country in 1998 = 200 Price index in 1999 = 210 Conclusion: the country experienced a 5% inflation rate.

28. 28 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin InflationInflation  Inflation refers not to the level of prices, whether they are high or low, but to their percentage change from one year to another.  If prices are high but remain the same from one year to another, there would be no inflation during that time.  Historically, the price level did not have a trend prior to the 1940s. After 1940, the price level increased sharply.

29. 29 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin U.S. Inflation Rate, 1950-2000

30. 30 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin DeflationDeflation  Deflation is a period during which the average level of prices falls.  During the Great Depression, between 1929 and 1933, average prices fell 33%.  As the average level of prices falls, wages tend to fall. Therefore, deflation is a problem because people may not be able to pay their debts.

31. 31 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Costs of Inflation  Costs associated with anticipated inflation ;  Menu costs or costs associated with physically changing prices;  Shoe-leather costs that results from holding less cash or the additional wear and tear necessary to hold less cash (more frequent trips to Banks and ATMs);  Tax system and financial system do not always fully adjust to anticipated inflation.

32. 32 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Costs of Inflation  When there is an unanticipated inflation, there are winners & losers ;  It causes unfair redistributions or transfers of income between parties, i.e, when inflation is higher than everyone expected, buyer with fixed dollar contracts would gain and sellers making a contract in dollar terms would lose;  It also imposes real costs on the economy. When people take actions based on beating inflation, the economy becomes less efficient.