1. Unemployment and Inflation
SECOND CANADIAN EDITION
MACROECONOMICS Paul Krugman | Robin Wells
Iris Au | Jack Parkinson
Chapter 8
Unemployment
and Inflation
© 2014 Worth Publishers

2. WHAT YOU WILL LEARN IN THIS CHAPTER
How unemployment is measured
The economic significance of the unemployment rate
Types of unemployment: frictional, structural and cyclical.
Non-cyclical unemployment: the natural rate of unemployment
Inflation adjustment: calculating real values.
The economic costs of inflation
How inflation and deflation create winners and losers
WHAT YOU
WILL LEARN
IN THIS CHAPTER

3. Unemployment Rate
Employment is the number of people currently employed in the economy, either full time or part time.
December 2014: 17,953,600
Unemployment is the number of people who are actively looking for work but aren’t currently employed. December 2014: 1,271,800
The labour force is equal to the sum of employment and unemployment.
December 2014: ,225,400
(Data source: Labour Force Survey for December 2014)

4. Unemployment Rate
The labour force participation rate is the percentage of the population aged 15 and older that is in the labour force.
(December 2014: x (19,225,400 / 29,190,000) = 65.9%)
(December 2014: 100 x (1,271,800/19,225,400)= 6.6%)
The unemployment rate is the percentage of the total number of people in the labour force who are unemployed.

5. Labour Force Survey Monthly survey of 56,000 households.
Basic labour market statistics: employment, unemployment, labour force, unemployment rate.
Also has information on job characteristics:
occupation, industry, hours of work, wages, etc.
And information on personal characteristics: age, sex, education level, family status, geographic location, etc.
Most recent results, first Friday of the month (Statistics Canada The Daily, see the link on the course site)

6. Unemployment Rate
Most recent recessions: , early-1980s, early-1990s.

7. Why do we care about unemployment?
An indicator of individual well-being.
Effects of income (current and future), self-esteem, etc.
An indicator of national economic well-being:
A measure of underperformance: economy could produce more output and income if unemployment was lower.
An indicator of the state of the economy.
The unemployment rate moves with the business cycle.
High unemployment can indicate structural economic problems.

8. Unemployment Definition: Omissions
Official definition: the unemployed are not working and are looking for work.
Official definition omits:
Discouraged workers: not working, want to work and are capable of working but have given up looking for work because of a lack of jobs.
Marginally attached workers: not working, want to work, but are not looking for work because they are waiting for a job to start.
Underemployment: -people who work part time because they cannot find full-time jobs.
- people who do not fully use their skills in their current job.

9. Supplementary Unemployment Rates
Figure Caption: Figure 8(23)-2: Supplementary Unemployment Rates,
The unemployment figures usually quoted in the media only include people who have been seeking working during the past four weeks. Broader measures also count discouraged workers, marginally attached workers, and the underemployed. These broader measures show a higher (modified) unemployment rate, but they move closely in parallel with the standard rate.
Source: Statistics Canada. 9

10. Unemployment Profile: Canada, 2014

11. National Unemployment Rates: Fall 2014
Who is highest?
Greece 25.9% Egypt 13.1%
Spain 24.0% Italy 12.6%
South Africa 25.4% Poland 11.3%
Who has low unemployment?
Thailand 0.8% (!!) S. Korea 3.2%
Singapore 1.9% Japan 3.6%
Malaysia 2.7% China 4.1%
Some Others?
US 5.8%, Germany 6.7%, UK 6.0%, India 8.8%
(Source: The Economist Economic and Financial Indicators)

12. Unemployment and Recessions
Figure Caption: Figure 8(23)-4: Unemployment and Recessions, January 1976-January 2012
This figure shows a close-up of the unemployment rate for the past three and a half decades, with the shaded bars indicating recessions. Clearly, unemployment always rises during recessions and usually falls during expansions. But in the early 1990s, the unemployment rate continued to rise for some time after the recession was over.
Source: Statistics Canada. 12

13. Unemployment varies with the Business Cycle
Unemployment rises during recessions, falls gradually during a recovery.
Unemployment lowest when the economy is booming.
Cyclical fluctuations in the economy are an important cause of unemployment levels and changes.
Real GDP growth rates and unemployment rate changes are positively related (see next slide).

14. Growth and Changes in Unemployment
Figure Caption: Figure 8-5: Growth and Changes in Unemployment,
Each dot shows the growth rate of the economy and the change in the unemployment rate for a specific year between 1946 and For example, in 2000, the economy grew 5.2% and the unemployment rate fell 0.8%, from 7.6% to 6.8%. In general, unemployment rate fell when growth was above its average rate of 3.62% a year and rose when growth was below average. Unemployment always rose when real GDP fell.
Source: Statistics Canada.

15. ECONOMICS IN ACTION We Don’t Want Our Youth to be NEET
Those who are aged between 15 and 29, and are Neither Enrolled in school, nor Employed, nor in Training are referred as the “NEET” group.
The NEET rate measures the percentage of youth who are at risk of becoming discouraged and disengaged, perhaps leading to reduced educational attainment, lack of satisfactory employment opportunities, and other related social problems as a consequence.

16. ECONOMICS IN ACTION
Some have argued that the civil unrest and regime changes that occurred in 2010 to 2012 in Tunisia, Egypt, Libya, Yemen, and other countries were due to a high NEET rate.
Are high NEET rates always a problem? may be caused by young people who choose to travel, take parental leave, do volunteer work.
In 2009, the NEET rate in Canada was 13.3% (quite low).
Current high unemployment rate countries like Spain have high NEET rates. Does this signal future unrest?

17. ECONOMICS IN ACTION
We Don’t Want Our Youth to be NEET

18. Classifying Unemployment: Three Types
Frictional unemployment is unemployment due to the time workers spend in job search.
Structural unemployment is unemployment that results when workers are unable to fill available jobs due to mismatch in skills or locations, or unable to get a job at the prevailing wage.
Cyclical unemployment is unemployment that arises due to business cycle downturns (recessions).

19. Frictional Unemployment
There is substantial turnover in the Canadian labour market.
Large numbers of workers enter or leave the labour market each month or move between jobs.
Some employers are expanding, others are shrinking; some new businesses start-up others go out of business.
Matching workers looking for work with employers looking for workers takes time giving frictional unemployment
Level of frictional unemployment depends on the efficiency of the search and matching process.
Likely at least 2%-3% of frictional unemployment in Canada.
Has information technology reduced frictional unemployment?
Frictional unemployment is likely to be short duration.

20. Net Labour Market Flows in 2007
Three Labour force states: Employed (E), Unemployed (U), Not-in-labour-force (NLF)
Figure Caption: Figure 8(23)-6: Net Labour Market Flows in 2007
The labour market is always in flux, as some people move from one category to another. And while only a small fraction of the people may be moving at any one time, there are millions of people in each category, which implies hundreds of thousands of people are shifting from category to category each year. Even in 2007, a year of low unemployment, large numbers of workers moved into and out of employment and unemployment. In net, over the year employment grew by about 370,000 jobs, unemployment dropped by about 1,600 people, and the not-in-labour force category grew by about 2,900 people.
Source: Statistics Canada.
Net flows for E, U and NLF are small compared to number in E,U, NLF.
Gross flows (arrows) for U are large vs. number unemployed (40% leave U
for either E or NLF in a typical month). Other flows: 2%-4% of source state. 20

21. Distribution of the Unemployed by Duration, 2007
Figure Caption: Figure 8(23)-7: Distribution of the Unemployed by Duration of Unemployment, 2007
In years when the unemployment rate is low, most unemployed workers are unemployed for only a short period. In 2007, a year of low unemployment, 40% of the unemployed were unemployed for less than 5 weeks and 68% for less than 14 weeks. The short duration of unemployment for most workers suggests that most unemployment in 2007 was frictional.
Source: Statistics Canada.
The typical unemployed person had been unemployed 14 weeks or less in Typical for an economy not in a recession. 21

22. Structural Unemployment: Possible Causes
lack of suitable jobs for the available workers.
lack of suitable workers for the available jobs.
mismatch: workers and job opening differ in skills or location.
Why?
Changes in structure of the economy: simultaneous decline in some industries or regions and expansion in others.
Government policies that slow adjustment may create it as an unintended consequence e.g. unemployment insurance; policies to keep people in declining regions or declining industries.
Institutions or policies that keep wages higher than equilibrium levels may also promote it (see below).

23. Structural Unemployment
The Effect of a Minimum Wage on a labour Market
Wage
Rate
Structural
unemployment
𝑊 𝐹
Minimum
wage
𝑊 𝐸
Figure Caption: Figure 8(23)-8: The Effect of a Minimum Wage on a labour Market
When the government sets a minimum wage, 𝑊 𝐹 , that exceeds the market equilibrium wage rate, 𝑊 𝐸 , the number of workers who would like to work at that minimum wage, 𝑄 𝑆 , is greater than the number of workers demanded at that wage rate, 𝑄 𝐷 . This surplus of labour, 𝑄 𝑆 − 𝑄 𝐷 , is structural unemployment.
𝑄 𝐷
𝑄 𝐸
𝑄 𝑆
Quantity of labour 23

24. Structural Unemployment and Wages
Minimum wage—a government-mandated floor on the price of labour. Each province and territory sets its own minimum wage. In January 2015, the minimum wage in Canada is between$10.00 in New Brunswick and $11 in Ontario and Nunavut.
Unions—by bargaining for all of a firm’s workers collectively (collective bargaining), unions can often win higher wages from employers than the market would have otherwise provided when workers bargained individually.
(could act like a minimum wage)
Efficiency wages—wages that employers set above the equilibrium wage rate as an incentive for better performance.

25. The Natural Rate of Unemployment
The natural rate of unemployment is the normal unemployment rate around which the actual unemployment rate fluctuates.
Natural unemployment = Frictional unemployment +
Structural unemployment
Cyclical unemployment is a deviation in the actual rate of unemployment from the natural rate.
Actual unemployment = Natural unemployment +
Cyclical unemployment

26. GLOBAL COMPARISON: Natural Unemployment Around the OECD
Global Comparison: The Organization for Economic Cooperation and Development (OECD) is an association of relatively wealthy countries, mainly in Europe and North America but also including Japan, Korea, New Zealand, and Australia. Among other activities, the OECD collects data on unemployment rates in its member nations using the U.S. definition. The figure shows average unemployment, which is a rough estimate of the natural rate of unemployment, for select OECD members, over the period 1996–2006. The purple bar in the middle shows the average across all countries. The U.S. natural rate of unemployment appears to be somewhat below average; those of many European countries (including the major economies of Germany, Italy, and France) are above average. Many, but not all, economists think that persistently high European unemployment rates are the result of government policies, such as high minimum wages and generous unemployment benefits, which both discourage employers from offering jobs and discourage workers from accepting jobs, leading to high rates of structural unemployment.
Source: OECD. 26

27. Changes to the Natural Rate of Unemployment
Why does the natural rate of unemployment change?
Demographics: more frictional unemployment if the share of young workers is high (younger: higher turnover)
Policy changes
e.g. more generous unemployment insurance or higher minimum wages may raise the natural rate (Canada 1970s)
Structural changes interacting with policies and institutions.
Technological change or globalization destroy some jobs and create others. Adjustment to large changes can raise structural unemployment (more so if policies and institutions slow adjustment).

28. Canadian Labour Force Makeup
Figure Caption: Figure 8-9: The Changing Makeup of the Canadian Labour Force,
In the 1960s and 1970s, large numbers of women entered the paid labour force for the first time, and the percentage of women in the force rose rapidly. And the percentage continued to rise in later decades, although not as rapidly. In comparison, the percentage of workers under 25 also rose rapidly in the 1960s and 1970s, as baby boomers came of working age; but instead of continuing to rise, this percentage fell in later years, as the birth rate declined. The natural rate of unemployment may have risen because many of these workers were relatively inexperienced. So job creation could not keep up with the rapid pace of labour force entry. Today, the labour force are much more experienced, which is one possible reason why the natural rate has fallen since the 1970s.
Source: Statistics Canada.

29. Canadian Natural Rate of Unemployment (NAIRU)

30. Labour Markets and the Circular Flow Diagram
Labour markets are factor markets: households supply their time to businesses or governments (demand).
Labour demand:
Slopes down in wages: less demanded if labour is more costly (less profitable to hire, incentives to substitute other inputs for labour);
more demand if labour is more productive (shift labour demand right).
Labour supply: households can supply labour and earn wages or use it for non-work (leisure).
Choice depends on which is of most value to worker.
e.g. More supplied if wages are higher; less supplied if need the wage income less or if have high alternative uses for time.
Unemployment in supply-demand? (Supply=Demand – no unemployment!)
Wages too high? (see minimum wage diagram)
Disequilibrium? slow adjustment to equilibrium.
Example from previous edition.

31. ECONOMICS IN ACTION Structural Unemployment in Eastern Germany
An uprising in 1989 overthrew the communist dictatorship in East Germany.
After reunification, employment in East Germany plunged.
The economy of the former East Germany has remained persistently depressed, with an unemployment rate of more than 16% in 2008.
East Germany found itself suffering from severe structural unemployment.
When Germany was reunified, it became clear that workers in East Germany were much less productive than their cousins to the west.

32. ECONOMICS IN ACTION Structural Unemployment in Eastern Germany
The result has been a persistently large mismatch between the number of workers demanded and the number seeking jobs.
How does the labour market respond?
Migration: workers migrate from East to West.
Wages: wages may fall to make hiring lower-productivity East German workers more attractive.
Government: what to do? Encourage migration? Boost East German productivity (infrastructure, investment, retraining)? Encourage West German businesses to locate in East?

33. Nominal and Real Values
The purchasing power of money changes over time because the prices of the goods and services bought with these money changes.
e.g. if prices double over time a given money payment will only buy half as many goods or services.
To accurately compare money payments across time these payments must be adjusted for changes in prices.
- money payments that have been adjusted for changing prices are in “real” terms.
- money payments that have not been adjusted for changing prices are in “nominal” or current dollar terms.

34. Inflation Adjustment: Calculating Real Values
The real wage is the nominal wage rate divided by the price level.
Real income is nominal income divided by the price level.
Example:
Real wage = Nominal wage x (inflation adjustment factor)
Inflation adjustment factor = (Price level in Base yr.)/ (Price level in current yr.)
Year Minimum CPI Real Minimum Wage
Wage (Base yr.=2002) (2002 dollars)
$ $1 x (100/17.5) = $5.71
$ $11x(100/125.9)=$8.74
(recall: CPI=100 in its base year)
The real interest rate is the nominal interest rate minus the rate of inflation.

35. Inflation Rate
Inflation rate: percentage increase in the price level between two time periods.
Period: usually an annual inflation rate.
Inflation rate = 100 x (Price index in yr. 2)-(Price index in yr. 1)
(Price index in yr. 1)
e.g. CPI in June 2014: and June 2013: 123.0
Inflation rate June 2013-June 2014 = 100 x ( )/123.0
= 2.36%
Deflation? Negative inflation (price level falling)

36. Inflation and Deflation
Figure Caption: Figure 8-10: The Price Level versus the Inflation Rate,
Over the past half-century the consumer price index has increased almost continuously. But the inflation rate – the rate at which consumer prices are rising – has fluctuated, going both up and down.
Source: Statistics Canada.

37. Inflation in Canada since 1960
What do we see in the previous chart?
High inflation in the 1970s (later: oil shocks and macro policy)
Inflation fell sharply in the early-1980s and early-1990s recessions (also fell in the milder recession).
Low, quite stable inflation since the mid-1990s.
(later: Bank of Canada was inflation targetting)
No deflation in this period.
last serious deflation in Canada in 1930s.
Modern deflations: Japan since 1990; will the Euro-zone see deflation in 2015?

38. Economic Costs of Inflation
Inflation reduces the purchasing power of money.
In periods of high inflation people avoid holding money;
Time, effort and resources involved in doing so are called Shoe-leather costs.
Menu costs refer to the real costs of changing listed prices.
Uses resources that can’t be used for something else.
Inflation makes money a less reliable unit of measurement.
Value is uncertain.
A price rises: is it an increase in the real price or just inflation?
Buyers and seller may mistakes that make them worse off.

39. Inflation and Deflation Problems
Arbitrary redistribution is another consequence of inflation.
Contracts often specify future money payments.
Inflation reduces the value of a future payment.
Debt contracts (loans, bonds): lenders lose, borrowers gain.
Labour contracts: workers lose, employers gain.
People on fixed incomes (often pensioners) lose.
Deflation: opposite distribution effects to those of inflation.
Indexing is a way to correct the effect of inflation on the purchasing power of a unit of currency.
e.g. a labour contract could tie future wage increases to future inflation.

40. The Cost of Disinflation
- Disinflation is the process of bringing the inflation rate down.
Disinflation may require a costly recession as in the early 1980s
and early 1990s.
Figure Caption: Figure 8-11: The Cost of Disinflation
There were two major periods of disinflation in modern Canadian history, in the early 1980s and in the early 1990s. This figure shows the track of the unemployment rate and the “core” inflation rate, which excludes food and energy, during these two episodes. In each case bringing inflation down required a temporary but very large increase in unemployment rate, demonstrating the high cost of disinflation.
Source: Statistics Canada.

41. ECONOMICS IN ACTION Israel’s Experience with Inflation
In the mid-1980s, Israel experienced a “clean” inflation: there was no war, the government was stable, and there was order in the streets.
But policy errors led to very high inflation (more than 10% a month).
The shoe-leather costs of inflation were substantial.
Israelis spent a lot of time moving money in and out of bank accounts that provided high enough interest rates to offset inflation.

42. ECONOMICS IN ACTION Israel’s Experience with Inflation
Businesses made efforts to minimize menu costs.
For example, restaurant menus often didn’t list prices.
It was hard for Israelis to make decisions because prices changed so much and so often.
e.g. did a high price for a good mean it was more expensive in real terms or did it just reflect inflation?

43. Summary
Inflation and unemployment are the main concerns of macroeconomic policy.
Employment is the number of people employed; unemployment is the number of people unemployed and actively looking for work. Their sum is equal to the labour force, and the labour force participation rate is the percentage of the population age 15 and older that is in the labour force.

44. Summary
The unemployment rate can overstate because it counts as unemployed those who are continuing to search for a job despite having been offered one (that is, workers who are frictionally unemployed). It can understate because it ignores frustrated workers, such as discouraged workers, marginally attached workers, and the underemployed.

45. Summary
The unemployment rate is affected by the business cycle. The unemployment rate generally falls when the growth rate of real GDP is above average and generally increases when the growth rate of real GDP is below average.

46. Summary
Job creation and destruction, as well as voluntary job separations, lead to job search and frictional unemployment. In addition, a variety of factors (such as minimum wages, unions, efficiency wages, and government policies designed to help laid-off workers) result in a situation in which there is a surplus of labour at the market wage rate, creating structural unemployment. As a result, the natural rate of unemployment, the sum of frictional and structural employment, is well above zero, even when jobs are plentiful.

47. Summary
The actual unemployment rate is equal to the natural rate of unemployment plus cyclical unemployment.
The natural rate of unemployment changes over time.
Policy-makers worry about inflation, as well as unemployment.

48. Summary
Inflation does not, as many assume, make everyone poorer by raising the level of prices. That's because wages and incomes are adjusted to take into account a rising price level, leaving real wages and real income unaffected. However, a high inflation rate imposes overall costs on the economy: shoe-leather costs, menu costs, and unit-of-account costs.

49. Summary
Inflation can produce winners and losers within the economy, because long-term contracts are generally written in dollar terms. Loans typically specify a nominal interest rate, which differs from the real interest rate which is adjusted for inflation. A higher-than-expected inflation rate is good for borrowers and bad for lenders. A lower-than-expected inflation rate is good for lenders and bad for borrowers.
Disinflation is very costly, so policy-makers try to prevent inflation from becoming excessive in the first place.

50. Key Terms Employment Natural rate of unemployment Unemployment
Cyclical unemployment
labour force
Real wage
labour force participation rate
Real income
Unemployment rate
Shoe-leather costs
Discouraged workers
Menu costs
Marginally attached workers
Unit-of-account costs
Underemployment
Nominal interest rate
Job search
Real interest rate
Frictional unemployment
Disinflation
Structural unemployment
Efficiency wages