L8: UNEMPLOYMENT

& INFLATION
 Measuring Average Price Level

Learning Outcomes
1. Measuring the price level: the CPI & GDP deflator
2. Measuring inflation
3. How good is the CPI as a measure of inflation?
4. Costs of inflation
5. Inflation and interest rates
6. Deflation
 The CPI Market Basket

Insurance and
financial services
Education 5.08% Food and non-
3.18% alcoholic beverages
Recreation and 16.84%
culture
12.56%
Alcohol and tobacco
7.06%
Communication
3.05%
Clothing and footwear
3.98%
Transportation
11.55%

Health Housing
5.29% 22.30%
Furnishings,
household equipment
and services
9.10%
 The Consumer Price Index:
Measuring The Price Level
Consumer price index is one of many different measures of inflation

Consumer price index (CPI) provides an objective measure of:

• average price level
• inflation.

The CPI measures the cost in a certain period of a standard basket of

goods and services relative to the cost of the same basket in the
base year.
The basket of goods & services varies between countries
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 Example: CPI calculation
ITEM UNIT PRICE UNIT PRICE COST (2014) COST (2017)
(2014) (2017)

Rent, two- $500 $630 $500 $630

bedroom apt
60 $2.00 $2.50 $120 $150
Hamburgers
10 Movie $6.00 $7.00 $60 $70
tickets
Total $680 $850
Expenditure

Cost of base-year consumption basket of goods and services in current year

CPI =
Cost of base-year consumption basket of goods and services in base year

å qi2014 pi2017
CPI in year 2017 =
å qi2014 pi2014 1-5
 $630 + ($2.50 ´ 60) + ($7 ´10)
CPI in year 2017 =
$500 + ($2 ´ 60) + ($6 ´10)

$850
CPI in year 2017 = = 1.25
$680
 Inflation Rate Õ t
The CPI is used to calculate the rate of inflation. This is the percentage change in the CPI over the specified time period t.

CPI t - CPI t-1

Õt = x100
CPI t-1
For example, if CPI Dec2011 = 122 and CPI Dec2010 = 120, inflation rate as at December 2011 is:

CPI Dec2011 - CPI Dec2010

Õ Dec2011 = x100
CPI Dec2010

122 - 120
PDec2011 = x 100 = 1.7%
120
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 The GDP Deflator

The consumer price index (CPI) measures the average price of

consumption, or equivalently, the cost of living.

The GDP deflator measures the average price of output. It is an index

of the prices of all items included in GDP.

Nominal GDPt
GDP deflatort = x100
Rea GDPt

We calculate inflation rate using the rate of change of the GDP deflator.
§ CPI: Measurement
Problem

§ Cost of Inflation
 Does The CPI Measure ‘True’ Inflation?
v The CPI overstates the actual level of inflation in the economy
for two significant reasons:

1. Quality adjustment bias

• Inflation can be overstated because quality improvements
over time in goods and services are difficult to adjust for. e.g.
Computers, housing,

2. Substitution bias
• The basket of goods and services is fixed, but higher prices in
one good leads consumers to substitute cheaper goods. e.g.
If price of red meat increases, substitute into chicken.
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 Some Costs Of High Inflation
v Distortions of the tax system:
• Higher effective tax rates caused by ‘bracket creep’ in a
progressive, non-indexed tax system.
• Governments typically don’t adjust incomes for inflation in
determining tax contributions. Why?
v Interference with planning for households, business &
government:
• Long-run business and personal decisions become more difficult to make with
high & erratic inflation. This can be a very serious problem

v Menu costs:
• Uncertainty and cost is caused by frequent changes in price lists.

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 The costs of high inflation (cont.)
§ Falling output and consumption in the economy caused by high
inflation reduces the economic wellbeing of households and firms.

§ Reduced investment also leads to reduced growth rates of future

output.

§ This has a disproportionate effect on poorer members who are less

likely to have their incomes increased.

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§ Inflation And Interest
Rates

§ Deflation
 Inflation And Interest Rates
v The nominal interest rate is the rate of interest specified in the
loan contract, credit card or the cash rate. There is more than
one nominal interest rate in any economy.

v The real rate of interest is the nominal rate of interest minus the
rate of inflation.

• It measures the reward to lenders, in terms of purchasing power,

paid by borrowers for lenders giving up spending over the
contract period.

• It is the nominal interest rate minus the rate of inflation

(approximately).
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 Inflation And Interest Rates (Cont.)
§ Borrowing and lending contracts specify how much money will be paid back to
the lender at a given time.

§ The higher the rate of inflation over the contract period, the more the lender is
penalised through a fall in the purchasing power of the money lent.
• So a rise in the expected inflation rate (πe) raises the rate of interest which
lenders demand.

§ Likewise, borrowers gain from inflation and a fall in the purchasing power of
money, so they tend to offer higher interest rates with inflation.

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 Example: Effects Of Real Interest Rate

Real interest rate = Nominal interest rate – inflation rate.

NOTE: People don’t make loans at nominal interest rates of 0% and

below (giving money away).

Example: If have 3% inflation would need nominal interest rates to be

more than 3% before people (banks) would be willing to make loans.

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 Deflation
Deflation is a sustained fall in the average price level.
• Problem: It can lead to high real interest rates, and high
real interest rates discourage important expenditure types
such as a firm’s investment in plant and equipment.

This is due to the fact that the nominal interest rate must
be above 0% or loans would not be made.
• Why would you loan money out, just to get the same
amount of money back?

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 Summary
The CPI measures the cost in that period of a standard basket of goods and
services relative to the cost of the same basket in the base year.

Inflation is the rate of change in CPI between two periods.

High and persisted inflation can be extremely costly to the society.

Real interest rates reflect the true cost of borrowing.

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Unemployment

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 Measuring Unemployment
§ The Australian Bureau of Statistics (ABS) categorises people
who are 15 years old or over into three categories:
1. Employed: Those who worked one hour or more
in paid employment, or on leave.

2. Unemployed: Those who did not work in paid

employment, and actively sought work.

3. Out of the labour force: Those who did not work

in paid employment and are not actively seeking
employment.
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 Measuring Unemployment (Cont.)

v Labour force = employed + unemployed

Number of unemployed
Unemployment rate = x100
Labour force

Labour force
Participation rate =
Working-age (15–64) population
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 Unemployment: terminologies

v Measures of unemployment understate the

true level of unemployment. Why?

Discouraged worker: a person who has given

up looking for a job because of lack of success in
finding a job. Out of labour force.

Under-employment: disguised unemployment.

However, the persons concerned are not counted
as unemployed.
 Costs Of Unemployment
§ Economic costs arise from output lost due to labour
force underutilisation, plus reduced tax collections and
increased welfare spending.

§ Psychological costs are associated with loss of self-

esteem and depression.

§ Social costs stem from increases in crime, domestic

violence, etc. (particularly in the case of male
unemployment)

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 Types Of Unemployment
§ Types of unemployment:

• Frictional unemployment

• Structural unemployment

• Cyclical unemployment

v Natural rate of unemployment

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 Types Of Unemployment
§ Frictional unemployment is when people are between
jobs and currently searching for another job.

§ Structural unemployment can be the result of:

• a mismatch of skills demanded (including language and
reliability) and job seekers’ skills (if any)

• minimum wage laws and other government regulation of

employment conditions

• high unemployment benefits which raise the opportunity cost of

working

• workplace discrimination.

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 Types Of Unemployment

§ Cyclical unemployment is the extra unemployment

that occurs during periods of economic contraction
and especially recessions.

§ Natural rate of unemployment = frictional +

structural. It exists independently of whether the
economy is in an expansion or contraction.

• Thus the natural rate of unemployment is positive

even when cyclical unemployment is equal to zero.

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 Summary

§ Natural rate of unemployment occurs when all

unemployed workers in the economy are either in
frictional or structural unemployment.

§ Minimising cyclical unemployment is the main concern

for policymakers and macroeconomists.

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