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CHAPTER 7
UNEMPLOYMENT AND INFLATION
In this chapter, you will find:
Learning Outcomes
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Solutions to Problems Appendix
Experiential Assignments
INTRODUCTION
This chapter examines the macroeconomic problems of unemployment and inflation. The idea is to show
what can go wrong with the economy, thereby providing the rationale for studying macroeconomics. If the
economy always operated smoothly, there would be less need to understand how it works. Four types of
unemployment are discussed: frictional, structural, seasonal, and cyclical. The composition and duration of
unemployment, along with unemployment insurance, are also examined. Inflation, deflation, disinflation (a
reduction in inflation), and changes in relative prices are covered in the second half of the chapter. This
chapter emphasizes the cost of unemployment and inflation, in addition to the shortcomings associated
with the official measurements, particularly in making international comparisons.
LEARNING OUTCOMES
7-1 Describe what the unemployment rate measures, and summarize four sources of unemployment.
The unemployment rate is the number of people looking for work divided by the number in the labor
force. The unemployment rate masks differences among particular groups and across regions. The
rate is lowest among white adults and highest among black teenagers. There are four sources of unemployment. Frictional unemployment arises because employers and qualified job seekers need time
to find one another. Seasonal unemployment stems from the effects of weather and the seasons on
certain industries, such as construction and agriculture. Structural unemployment arises because
changes in tastes, technology, taxes, and competition reduce the demand for certain skills and increase the demand for other skills. And cyclical unemployment results from fluctuations in economic
activity caused by the business cycle. Policy makers and economists are less concerned with frictional and seasonal unemployment. Full employment occurs when cyclical unemployment is zero.
7-2 Outline the pros and cons of unemployment insurance.
Unemployment often creates both an economic and a psychological hardship. For some, this burden
is reduced by an employed spouse and by unemployment insurance. Unemployment insurance provides a safety net for some and that’s good, but it may also reduce incentives to find work, as is
the case in Europe, and that’s an unintended consequence. Research suggests that those collecting
unemployment insurance remain unemployed longer than those who don’t.
7-3 Define inflation and describe the two sources of inflation.
Inflation is a sustained rise in the average price level. An increase in aggregate demand can cause
demandpull inflation. A decrease in aggregate supply can cause cost-push inflation. Prior to World
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 7
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94
War II, both inflation and deflation were common, but since then the price level has increased virtually every year.
7-4 Explain how unanticipated inflation harms some individuals and harms the economy as a whole.
Anticipated inflation causes fewer distortions in the economy than unanticipated inflation. Unanticipated inflation arbitrarily creates winners and losers, and forces people to spend more time and energy coping with the effects of inflation. The negative effects of high and variable inflation on productivity can be observed most dramatically in countries that have experienced hyperinflation, such as
Zimbabwe.
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDES 2-6 FOR THE FOLLOWING SECTION
Unemployment
Measuring Unemployment
 Labor force: Those in the adult population who are either working or looking for work.
 Unemployment rate: The number unemployed divided by the number in the labor force.
 Discouraged workers: People who have dropped out of the labor force.
USE POWERPOINT SLIDES 7-9 FOR THE FOLLOWING SECTION
Labor force participation rate: The number in the labor force divided by the adult population.
 The participation rates of men and women have converged since WWII.
 Participation rate climbs with education.
Unemployment over Time
 The unemployment rate experienced a downward trend between 1980-2000 due to the overall
economic upturn, and because there were fewer teenagers in the workforce.
 With the recession of 2001, the rate increased until it peaked at 6.0 percent in 2003. The rate then
declined over the next four years, but increased again during the recession of 2008–2009.
USE POWERPOINT SLIDES 10-12 FOR THE FOLLOWING SECTION
Unemployment in Various Groups
Unemployment rates are:
 Higher among blacks than among whites.
 Higher among teenagers than among those 20 and older.
USE POWERPOINT SLIDES 12-14 FOR THE FOLLOWING SECTION
Unemployment Varies across Occupations and Regions: The national unemployment rate reveals
nothing about the variation of unemployment rates across the country.
USE POWERPOINT SLIDES 15-17 FOR THE FOLLOWING SECTION
Sources of Unemployment
 Frictional Unemployment: Reflects the time required to bring together employers and job seekers.
 Seasonal Unemployment: Caused by seasonal changes in labor demand during the year.
 Structural Unemployment: Arises because of a mismatch of skills or geographic location.
 Cyclical Unemployment: Fluctuates with the business cycle, increasing during recessions and
decreasing during expansions.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 7
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95
USE POWERPOINT SLIDE 18 FOR THE FOLLOWING SECTION
The Meaning of Full Employment: There is no cyclical unemployment, but unemployment is not zero.
There will still be some frictional, structural, and seasonal unemployment in an economy considered to be
at full employment.
USE POWERPOINT SLIDE 19 FOR THE FOLLOWING SECTION
Unemployment Compensation
 Provides a safety net for the unemployed and is on average 40% of person’s take home pay
 May reduce the urgency of finding work, thereby increasing the average duration of unemployment
and the unemployment rate,
 Allows for a higher-quality job search.
USE POWERPOINT SLIDES 20-21 FOR THE FOLLOWING SECTION
International Comparisons of Unemployment: Should be analyzed carefully because definitions of
unemployment vary across countries.
USE POWERPOINT SLIDES 22-23 FOR THE FOLLOWING SECTION
Problems with Official Unemployment Figures:
 Ignore discouraged workers and those who are underemployed, causing unemployment rates to be
underestimated.
 Unemployment benefits and most welfare programs require recipients to seek employment or at least
go through the motions even if they do not want a job. This overestimates unemployment.
 Additionally, those in the underground economy may not admit to having a job since they are
breaking the law, resulting again in an overestimate of unemployment.
USE POWERPOINT SLIDES 24-25 FOR THE FOLLOWING SECTION
Inflation: A sustained increase in the economy’s average price level.
 Hyperinflation: Extremely high inflation.
 Deflation: A sustained decrease in the average price level.
 Disinflation: A reduction in the rate of inflation.
USE POWERPOINT SLIDES 26-27 FOR THE FOLLOWING SECTION
Two Sources of Inflation
 Demand-pull: A rising aggregate demand pulls up the price level.
 Cost-push: Inflation caused by a decrease in aggregate supply. Therefore, increases in production
costs will push up the price level.
USE POWERPOINT SLIDES 28-329 FOR THE FOLLOWING SECTION
A Historical Look at Inflation and the Price Level
Prior to WW II, years of inflation and deflation balanced out over the long run. Since the end of WW II,
the CPI has increased by an average of 3.7% per year. Inflation erodes confidence in the value of the
dollar over the long term.
USE POWERPOINT SLIDE 30 FOR THE FOLLOWING SECTION
Anticipated Versus Unanticipated Inflation
 Anticipated Inflation: Is largely neutral in its effects on real GDP.
 Unanticipated Inflation: Arbitrarily creates economic winners (debtors and those on fixed incomes)
and losers (creditors).
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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USE POWERPOINT SLIDES 31-32 FOR THE FOLLOWING SECTION
The Transaction Costs of Variable Inflation: Increase as inflation becomes more unpredictable.
Inflation Obscures Relative Price Changes: During periods of volatile inflation, there is greater
uncertainty about the price of one good relative to another.
Inflation across Metropolitan Areas: Inflation rates differ across regions mostly because of differences
in housing prices.
USE POWERPOINT SLIDES 33-34 FOR THE FOLLOWING SECTION
International Comparisons of Inflation: Inflation is difficult to compare across countries. When
calculating a price index, less-developed countries sample fewer products and measure prices only in the
capital city.
USE POWERPOINT SLIDES 35-39 FOR THE FOLLOWING SECTION
Inflation and Interest Rates
 Interest: The dollar amount paid by borrowers to lenders.
 Supply of loanable funds: Slopes upward, represents the amount people are willing to lend.
 Demand for loanable funds: Slopes downward, represents the amount demanded to purchase goods
or finance deficits.
 Nominal interest rate: Interest in terms of current dollars paid. This is the rate that is seen on loan
agreements and is discussed in the media.
 Real interest rate: Is known only after the fact; that is, after inflation occurs.
– Equals the nominal interest rate minus the rate of inflation (CPI).
– The higher the expected inflation, the higher the nominal rate of interest.
USE POWERPOINT SLIDE 40 FOR THE FOLLOWING SECTION
Why Is Inflation Unpopular?
Unanticipated inflation:
 Arbitrarily redistributes income and wealth from one group to another;
 Reduces the ability to make long-term plans;
 Forces buyers and sellers to focus more on money and prices.
CHAPTER SUMMARY
The unemployment rate is the number of people in the labor force who are looking for work divided by the
number in the labor force. The unemployment rate masks differences among particular groups and across
regions. The rate is lowest among white adults and highest among black teenagers.
There are four sources of unemployment. Frictional unemployment arises because employers and qualified
job seekers need time to find one another. Seasonal unemployment stems from the effects of weather and
the seasons on certain industries, such as construction and agriculture. Structural unemployment arises
because changes in tastes, technology, taxes, and competition reduce the demand for certain skills and
increase the demand for other skills. And cyclical unemployment results from fluctuations in economic
activity cased by the business cycle. Policy makers and economists are less concerned with frictional and
seasonal unemployment. Full employment occurs when cyclical unemployment is zero.
Unemployment often creates both an economic and a psychological hardship. For some, this burden is
reduced by an employed spouse and by unemployment insurance. Unemployment insurance provides a
safety net for some and that’s good, but it may also reduce incentives to find work for some, as is the case
in Europe, and that’s an unintended consequence.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 7
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97
Inflation is a sustained rise in the average price level. An increase in aggregate demand can cause demandpull inflation. A decrease in aggregate supply can cause cost-push inflation. Prior to World War II, both
inflation and deflation were common, but since then the price level has increased virtually every year.
Anticipated inflation causes fewer distortions in the economy than unanticipated inflation. Unanticipated
inflation arbitrarily creates winners and losers and forces people to spend more time and energy coping
with the effects of inflation. The negative effects of high and variable inflation on productivity can be
observed in countries that have experienced hyperinflation, such as Zimbabwe.
Because not all prices change by the same amount during inflationary periods, people have trouble
keeping track of the changes in relative prices. Unexpected inflation makes long-term planning more
difficult and more risky.
The intersection of the demand and supply curves for loanable funds yields the market interest rate. The
real interest rate is the nominal interest rate minus the inflation rate. Borrowers and lenders base decisions
on the expected real interest rate.
TEACHING POINTS
1. This chapter discusses two important macroeconomic problems, unemployment and inflation. Although these subjects are often discussed in the news, they are widely misunderstood by the general
public.
2. Most students will believe that the only people hurt when the unemployment rate rises are those
who lose their jobs. Society as a whole, however, loses output because of underutilization of
resources. Crime rates rise during this time. Government budget deficits, which also rise during this
time, typically create political pressure for tax hikes to balance the budget (however misguided
this policy may be). Those with jobs lose bargaining power in seeking higher wages. The list can go
on. Unemployment imposes a variety of costs.
3. You might choose to list and give examples of each of the four types of unemployment. For example, frictional—an electrical engineer, seasonal—orange pickers in Florida during the offseason,
structural—a blacksmith, and cyclical—autoworkers during an economic contraction.
4. Some students will believe that those who are unemployed represent a group perpetually without
jobs. This is untrue. The group of individuals currently unemployed is constantly changing.
Although some population subgroups have been unemployed for significant periods of time, many of
the unemployed find work within a relatively short period of time or give up seeking work (and fall
into the discouraged worker pool).
5. The idea that “full employment” includes frictional, structural, and seasonal unemployment needs
to be emphasized. You should note that while all unemployment has costs, frictional unemployment
and seasonal unemployment are short-term phenomena and therefore are less personally devastating.
The idea that structural unemployment (which may not be temporary because solving it requires retraining or new skills development, which may be extremely difficult for some elements of the work
force) occurs at full employment should not be construed as implying that its costs are not a source of
concern. You might point out, however, that lowering structural unemployment requires significant
effort in developing new job skills or moving to a region with more job opportunities.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
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Chapter 7
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6. Inflation can be as confusing as unemployment for the student. Most students believe that inflation
is a unique and precisely measured concept. It is easy to dispel this myth. The measured inflation rate
depends on, among other things, which prices are used in the price index and what weights are assigned to each price change. Usually economists choose the price index that most closely fits the object of their study. For example, if they wish to track movements in consumer standards of living, the
CPI would be used.
7. You may wish to emphasize that although unemployment and inflation are the most commonly
discussed topics in macroeconomics, there are other topics that macroeconomists study as well, such
as economic growth, international finance, and welfare economics.
8. A discussion of frictional and structural unemployment is important, since it lays the foundation
for the discussion of potential output found in Chapter 9 on Aggregate Expenditure and Aggregate
Demand.
SOLUTIONS TO PROBLEMS APPENDIX
1.
(Measuring Unemployment) Determine the impact on each of the following if 2 million
formerly unemployed workers decide to return to school full time and stop looking for work:
a. The labor force participation rate
b. The size of the labor force
c. The unemployment rate
a. The labor force participation rate drops since these workers have left the labor force.
b. The size of the labor force drops by 2 million.
c. The unemployment rate drops since the percentage drop in the number of unemployed is
greater than the percentage drop in the labor force.
2.
(Measuring Unemployment) Suppose that the U.S. noninstitutional adult population is 230
million and the labor force participation rate is 67 percent.
a. What would be the size of the U.S. labor force?
b. If 85 million adults are not working, what is the unemployment rate?
a. Of 230 million, 67 percent, or 154.1 million.
b. Of the 230 million adults in the population, 154.1 million are in the labor force. The
population (230 million) minus the number in the labor force (154.1 million) gives the
number of people outside the labor force who are not working (75.9 million). Statistics
given say that 85 million adults are not working, thus 85 million minus 75.9 million gives
the number of people in the labor force who are not working (9.1 million) which is the
number that represents the unemployed. The unemployment rate is the percentage of the
labor force (not the population) that is unemployed. The unemployment rate is equal to
the number of people counted as unemployed (9.1 million) divided by the labor force
(154.1 million) expressed as a percentage (5.9 percent).
3.
(Types of Unemployment) Determine whether each of the following would be considered
frictional, structural, seasonal, or cyclical unemployment:
a. A UPS employee who was hired for the Christmas season is laid off after Christmas.
b. A worker who is laid off due to reduced aggregate demand in the economy.
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Chapter 7
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c. A worker in a DVD rental store becomes unemployed as video-on-demand cable service
becomes more popular.
d. A new college graduate is looking for employment.
a.
b.
c.
d.
4.
Seasonal
Cyclical
Structural
Frictional
(Unemployment Insurance) What are the pros and cons of unemployment insurance?
Unemployment often creates both an economic and a psychological hardship. For some, this
burden is reduced by an employed spouse and by unemployment insurance. Unemployment
insurance provides a safety net for some and that’s good, but it may also reduce incentives to
find work, as is the case in Europe, and that’s an unintended consequence. Research suggests that those collecting unemployment insurance remain unemployed longer than those
who don’t.
5.
(The Meaning of Full Employment) When the economy is at full employment, is the unemployment rate at zero percent? Why or why not? How would a more generous unemployment
insurance system affect the full employment figure?
When the economy is at full employment, the unemployment rate is not zero because there
will always be some natural or normal rate of unemployment consisting of the frictionally
and structurally unemployed. A more generous unemployment insurance system would likely
increase the natural rate of unemployment and therefore reduce the percent of the labor
force employed that defines full employment.
6.
(Two Sources of Inflation) Using aggregate supply and aggregate demand, demonstrate two
sources of inflation.
An increase in aggregate demand can cause demand-pull inflation. A decrease in aggregate
supply can cause cost-push inflation. See Exhibit 6 below.
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Chapter 7
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(Inflation) Here are some recent data on the U.S. consumer price index:
Year CPI
Year CPI
Year CPI
1992 140.3
1998 163.0
2004 188.9
1993 144.5
1999 166.6
2005 195.3
1994 148.2
2000 172.2
2006 201.6
1995 152.4
2001 177.1
2007 207.3
1996 156.9
2002 179.9
2008 215.3
1997 160.5
2003 184.0
2009 214.5
Compute the inflation rate for each year 1993-2009 and determine which years were years of
inflation. In which years did deflation occur? In which years did disinflation occur? Was
there hyperinflation in any year?
Deflation, an actual decrease in the price level, occurred during the recession year of 2009.
Inflation occurred in all the other years given. Disinflation, a decrease in the rate of inflation,
occurred in 1994, 1997, 1998, 2001, 2002, 2006, and 2007. Hyperinflation, a very high rate of
inflation, did not occur over this period.
The rate is calculated as: [(CPI in a given year minus CPI from the prior year)/CPI prior
year] multiplied by 100.
Year
1993
1994
1995
1996
1997
8.
Inflation
Rate (%)
Year
1998
2.99 Inflation
1999
2.56 Disinflation 2000
2.83 Inflation
2001
2.95 Inflation
2002
2.29 Disinflation 2003
Inflation
Rate (% )
Year
1.56 Disinflation 2004
2.21 Inflation
2005
3.36 Inflation
2006
2.85 Disinflation 2007
1.58 Disinflation 2008
2.28 Inflation
2009
Inflation
Rate (%)
2.66 Inflation
3.39 Inflation
3.23 Disinflation
2.83 Disinflation
3.86 Inflation
−0,37 Deflation
(Sources of Inflation) Using the concepts of aggregate supply and aggregate demand, explain
why inflation usually accelerates during wartime.
One of the most important reasons why prices rise so quickly during wartime is that
household incomes increase as more workers are employed in the armed forces. Fewer
consumer goods are available as production shifts towards military goods. Military spending
by the government also rises. Thus, the aggregate demand curve shifts to the right. In some
countries, war creates a reduction in aggregate supply if many of the plants and much of the
equipment are destroyed. This occurred in both Germany and Japan during World War II.
Increasing aggregate demand and falling aggregate supply both lead to higher prices.
9.
(Inflation and Interest Rates) Using a demand-supply diagram for loanable funds (like Exhibit
10), show what happens to the nominal interest rate and the equilibrium quantity of loans
when both borrowers and lenders increase their estimates of the expected inflation rate from 5
percent to 10 percent.
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Chapter 7
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101
Higher expected inflation reduces the real rate of interest for a given nominal rate.
Therefore, at each nominal rate, suppliers are less willing to lend and demanders are more
willing to borrow. As a result, supply falls, demand rises, and the equilibrium nominal rate
rises. Since both sides of the market experience the same change in expectations, the nominal
rate should adjust to exactly compensate for the higher expected inflation and the total
quantity of loans should not change.
10.
(Anticipated Versus Unanticipated Inflation) If actual inflation exceeds anticipated inflation,
who will lose purchasing power and who will gain? How does unanticipated inflation harm
the economy?
When actual inflation exceeds anticipated inflation, those on fixed incomes and those who
save or lend money will be hurt. Borrowers will benefit because they will be re-paying loans
will money that has a lower purchasing power. Unanticipated inflation arbitrarily creates
winners and losers, and forces people to spend more time and energy coping with the effects
of inflation. The negative effects of high and variable inflation on productivity can be observed most dramatically in countries that have experienced hyperinflation, such as Zimbabwe.
Experiential Assignments
1. The chapter explains the definitions the government employs in measuring unemployment. Have
students interview 10 members of their class to determine labor market status—employed, unemployed, or not in the labor force. The interviewers should include themselves, and then compute the
unemployment rate and the labor force participation rate for the group of 11 people.
2. In recent years, how has the U.S. inflation rate compared with rates in other industrial economies?
Why should we be careful in comparing inflation rates across countries? The Federal Reserve Bank
of St. Louis maintains a Web page devoted to international economic trends:
http://research.stlouisfed.org/publications/iet/. Ask students to choose two countries and compare the
countries’ recent inflation experiences. (If students have Adobe Acrobat Reader, they can look at bar
charts of the data.)
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Chapter 7
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102
3. Have students scan the Economy page in the first section of today’s Wall Street Journal. They are
almost sure to find a discussion of a policy proposal that will affect unemployment, inflation, or
both. Ask them to use the aggregate demand and supply model to describe the effect of the proposal—if enacted—on the U.S. unemployment and inflation rates.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.