Lecture 2

Unemployment and Inflation

 Lecture Outline

1 Measuring the Unemployment Rate, the Labor Force

Participation Rate, and the Employment–Population
Ratio
2 Types of Unemployment

3 Measuring Inflation

4 Using Price Indexes to Adjust for the Effects of Inflation

5 Real versus Nominal Interest Rates

6 Does Inflation Impose Costs on the Economy?

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 1 LEARNING OBJECTIVE

Define the unemployment rate, the labor force participation rate, and the
employment–population ratio and understand how they are computed.

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 Labor force

The sum of employed and unemployed workers in the economy .

Unemployment rate

The percentage of the labor force that is unemployed.

Discouraged workers

People who are available for work but have not looked for a job
during the previous four weeks because they believe no jobs are
available for them.

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 Example:
The Employment Status
of the Civilian Working-
Age Population,
September 2011 in US

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 We can use the information from the above figure to calculate three important
macroeconomic indicators:

• The unemployment rate. The percentage of the labor force that is

unemployed:

Number of unemployed
100 Unemployment rate
Labor force

Using the numbers from the above figure, we can calculate the unemployment
rate for September 2011:

14.0 million
100 9.1%
154.0 million

• Labor force participation rate. The percentage of the working-age

population in the labor force:

Labor force
100 Labor force participation rate
Working - age population
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 For September 2011, the labor force participation rate was

154.0 million
100 64.1%
240.1 million

• The employment–population ratio. The percentage of the working-age

population that is employed:

Employment
100 Employment  population ratio
Working - age population

For September 2011, the employment–population ratio was

140.0 million
100 58.3%
240.1 million

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 Types of Unemployment

2 LEARNING OBJECTIVE

Types of unemployment.

1. Frictional unemployment

2. Structural unemployment

3. Cyclical unemployment

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 Frictional Unemployment and Job Search

Most workers spend at least some time engaging in job search, just as most
firms spend time searching for a new person to fill a job opening.

Frictional unemployment Short-term unemployment that arises from the

process of matching workers with jobs.

Seasonal unemployment refers to unemployment due to factors such as

weather, variations in tourism, and other calendar-related events.

Because seasonal unemployment can make the unemployment rate seem

artificially high during some months and artificially low during other months,

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 Structural unemployment Unemployment that arises from a persistent
mismatch between the skills and attributes of workers and the requirements
of jobs.

Cyclical unemployment Unemployment caused by a business cycle recession.

(some month work only, exp: tourism sector during covid 19 period)

Full Employment

When the only remaining unemployment is structural and frictional

unemployment, the economy is said to be at full employment.

Natural rate of unemployment The normal rate of unemployment, consisting

of frictional unemployment plus structural unemployment.

The natural rate of unemployment is also sometimes called the full-employment

rate of unemployment.

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 Government Policies and the Unemployment Rate

Unemployment Insurance and Other Payments to the Unemployed

The opportunity cost of continuing to search for a job is the salary you are giving
up at the job you could have taken.

In the United States and most other industrial countries, the unemployed are
eligible for unemployment insurance payments from the government.

Many high-income countries also have generous social insurance programs that
allow unemployed adults to receive some government payments even after their
eligibility for unemployment insurance has ended.

Because the opportunity cost of job search is lower in Canada and the countries
of Western Europe, most economists believe that unemployed workers in those
countries search longer for jobs, leading to higher unemployment rates.

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 Minimum Wage Laws :

Minimum wage law requiring firms to pay the lowest legal wage to its workers
Example: In US by 2011, the lowest legal wage was $7.25 per hour.
If the minimum wage is set above the market wage determined by the demand
and supply of labor, the quantity of labor supplied will be greater than the
quantity of labor demanded.

Labor Unions
Labor unions are organizations of workers that bargain 讨价还价 with employers
for higher wages and better working conditions for their members. About 9
percent of workers outside the government sector are unionized.

Efficiency Wages
Efficiency wage A higher-than-market wage that a firm pays to increase
worker productivity.

Minimum wage laws, unions, and efficiency wages can cause economies to
experience some unemployment even when cyclical unemployment is zero.
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 Measuring Inflation

3 LEARNING OBJECTIVE

Define price level and inflation rate and understand how they are computed.

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 Price level A measure of the average prices of goods and services in the
economy.
Inflation rate The percentage increase in the price level from one year to
the next.

Since the GDP deflator includes the price of every final good and service, it is the
broadest measure of the price level we have and may not clearly indicate how
inflation affects the typical household.

In this chapter, we focus on measuring the inflation rate by changes in the

consumer price index because these changes come closest to measuring
changes in the cost of living as experienced by the typical household.

A third measure of inflation is the producer price index.

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 The Consumer Price Index
Consumer price index (CPI)
Measure of the overall cost of goods & services
Bought by a typical consumer

How the consumer price index is calculated

1. Fix the basket
2. Find the prices
3. Compute the basket’s cost

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 The Consumer Price Index
How the consumer price index is calculated
4. Chose a base year and compute the CPI
Price of basket of goods & services in current year Divided
by price of basket in base year Times 100

CPI = Price of Goods and Services in the current year

100
Price of the Goods and Services in the base year
5. Inflation rate
The CPI is intended to measure changes in the price level
over time. Thus, the inflation rate is the Percentage change in
the price index from the preceding period

CPI in year 2 - CPI in year 1

Inflation rate in year 2  100
CPI in year 1

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 Step 1: Survey consumers to determine a fixed basket of goods
Basket = 4 hot dogs, 2 hamburgers
Step 2: Find the price of each good in each year

Year Price of hot dogs Price of hamburgers

2008 $1 $2
2009 2 3
2010 3 4
Step 3: Compute the cost of the basket of goods in each year
2008 ($1 per hot dog × 4 hot dogs) + ($2 per hamburger × 2 hamburgers) = $8 per basket
2009 ($2 per hot dog × 4 hot dogs) + ($3 per hamburger × 2 hamburgers) = $14 per basket
2010 ($3 per hot dog × 4 hot dogs) + ($4 per hamburger × 2 hamburgers) = $20 per basket
Step 4: Choose one year as a base year (2008) and compute the CPI in each year
2008 ($8 / $8) × 100 = 100
2009 ($14 / $8) × 100 = 175
2010 ($20 / $8) × 100 = 250
Step 5: Use the consumer price index to compute the inflation rate from previous year
2009 (175 – 100) / 100 × 100 = 75%
2010 (250 – 175) / 175 × 100 = 43%

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 The Consumer Price Index

Producer price index (PPI)

An average of the prices received by producers of goods and
services at all stages of the production process.

Problems in measuring the cost of living

• There are four biases that cause changes in the CPI to overstate the true
inflation

• Substitution bias.
The CPI is calculated by assuming that consumers purchase the same
monthly amount of each product in the market basket. But actually, When
the price of one good changes, consumers often respond by substituting
another good in its place. This implies that the CPI overstates the increase
in the cost of living over time.

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 • New product bias.
For many years, the market basket is not revised often enough, which excluded
new products introduced between updates. In general When a new good is
introduced, consumers have a wider variety of goods and services to choose
from.

• Increase in quality bias.

If the quality of a good falls from one year to the next, the value of a dollar falls;
if quality rises, the value of the dollar rises.

Attempts are made to correct prices for changes in quality, but it is often difficult
to do so because quality is hard to measure.

• Outlet bias.
In many cases the authority continue to collect price statistics from traditional
full-price retail stores, the CPI did not reflect the prices some consumers
actually paid at discount stores and over the Internet.

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 Using Price Indexes to Adjust for the Effects of Inflation

4 LEARNING OBJECTIVE

Use price indexes to adjust for the effects of inflation.

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 By using the CPI, we can calculate what $20,000 in 1984 was equivalent to in
terms of 2010 purchasing power.

 CPI in 2010 
Value in 2010 dollars Value in 1984 dollars  
 CPI in 1984 

Nominal variables
Economic variables that are calculated in current-year prices are
referred to as nominal variables.
Real variable
To correct for the effects of inflation, we divide the nominal
variable by a price index and multiply by 100 to obtain a real
variable.

Example Calculating Real Average Hourly Earnings

Nominal Average Hourly CPI
Year Earnings (1982–1984 = 100)
2008 $21.62 216.2
2009 22.21 215.9
2010 22.59 218.6
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 To calculate real average hourly earnings for each year, divide nominal
average hourly earnings by the CPI and multiply by 100.

For example, real average hourly earnings for 2008 are equal to
 $21.62 
  100 $10.00
 216.2 
Similarly the real average hourly earnings for 2009 and 200 are equal to
10.29 and 10.33 respectively.

To calculate the percentage change in real average hourly earnings

between 2009 and 2010?

 $10.33  $10.29 
  100 0.4%
 $10.29 

We can conclude that real average hourly earnings increased

slightly between 2009 and 2010.

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 Real versus Nominal Interest Rates

5 LEARNING OBJECTIVE

Distinguish between the nominal interest rate and the real interest rate.

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 The interest rate is the cost of borrowing funds, expressed as a percentage of
the amount borrowed.

Nominal interest rate:

The stated interest rate on a loan. I.e. Interest rate as usually reported
Without a correction for the effects of inflation

Real interest rate:

Interest rate corrected for the effects of inflation. The nominal interest rate
minus the inflation rate.
Real interest rate = Nominal interest rate − Inflation rate

The real interest rate provides a better measure of the true cost of borrowing
and the true return from lending than does the nominal interest rate.

Deflation is a decline in the price level.

Deflation is undesirable because the falling prices mean that incomes are also
falling, which reduces spending, output, employment, and, in turn, the price
level (a downward spiral). Inflation in modest amounts (<3%) is tolerable,
although there is not universal agreement on this point.
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 Real and nominal interest rates
Example: Sally Saver deposits $1,000 into a bank account that pays an annual interest rate of
10%. A year later, she withdraws $1,100.

What matters to Sally is the purchasing power of her money.

a.If there is zero inflation, her purchasing power has risen by 10%.
b.If there is 6% inflation, her purchasing power has risen by about 4%.
c.If there is 10% inflation, her purchasing power has remained the same.
d.If there is 12% inflation, her purchasing power has declined by about 2%.

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 Does Inflation Impose Costs on the Economy?

6 LEARNING OBJECTIVE

Discuss the problems that inflation causes.

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 Inflation Affects the Distribution of Income

The extent to which inflation redistributes income depends in part on whether

the inflation is anticipated—in which case consumers, workers, and firms can
see it coming and can prepare for it— or unanticipated—in which case they do
not see it coming and do not prepare for it.

The Problem with Anticipated Inflation

Even when inflation is perfectly anticipated, some individuals will experience

a cost.

Menu costs The costs to firms of changing prices.

The Problem with Unanticipated Inflation

When the actual inflation rate turns out to be very different from the expected
inflation rate, some people gain, and other people lose.
This outcome seems unfair to most people because they are either winning or
losing only because something unanticipated has happened.
This apparently unfair redistribution is a key reason people dislike
unanticipated inflation.
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