Download Chapter 9: Unemployment and Inflation

Chapter 9: Unemployment and In‡ation
Yulei Luo
SEF of HKU
February 1, 2016
Learning Objectives
1. Measuring the Unemployment Rate, the Labor Force
Participation Rate, and the Employment–Population Ratio.
2. Types of Unemployment.
3. Explain what factors determine the unemployment rate.
4. Measuring In‡ation.
5. Using Price Indexes to Adjust for the E¤ects of In‡ation.
6. Distinguish between the nominal interest rate and the real
interest rate.
7. Does In‡ation Impose Costs on the Economy?
DOL’s Bureau of Labor Statistics (BLS), Household
Survey (60,000 households)
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Each month, the U.S. Bureau of the Census conducts the
Current Population Survey to collect data needed to compute
the unemployment rate.
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Household members of “working age” (16+ years old).
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Asked about employment during “reference week”.
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Also asked about recent job-search activities.
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Employed people: If they worked during the week before the
survey or if they were temporarily away from their job because
they were ill, on vacation, on strike, or for other reasons.
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Unemployed people: If they did not work in the previous week,
but were available for work and had actively looked for work
at some time during the previous four weeks.
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Labor force: The sum of employed and unemployed workers in
the economy.
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Unemployment rate: The percentage of the labor force that is
unemployed.
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Discouraged workers: People who are available for work, but
who have not looked for a job during the previous four weeks
because they believe no jobs are available for them.
August 913 Civilian Working-Age Population
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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Figure 9.1
The employment status of
the civilian working-age
population, August 2013
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Unemployment Rate
Based on the CPS estimates,
we calculate several important
macroeconomic indicators.
• The most-watched is the
unemployment rate:
Number of unemployed
×100 = Unemployment rate
Labor force
11.3 million
×100 = 7.3%
155.5 million
This most-common measure
of unemployment is known
formally as BLS series U-3.
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Figure 9.1
The employment status of
the civilian working-age
population, August 2013
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Labor Force Participation and Employment-Population
Also important are the 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
155.9 million
×100 = 63.2%
245.9 million
… and the employment-population
ratio (the percentage of the workingage population that is employed):
Employment
×100 = Employment - population ratio
Working - age population
144.2 million
×100 = 58.6%
Figure 9.1
The employment status of
245.9 million
the civilian working-age
population, August 2013
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The Household Survey
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BLS classi…es people who do not have a job and who are not
actively looking for a job as not in the labor force.
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On a Friday early in each month the US DOL reports its
estimate of the previous month’s unemployment rate. It will
a¤ect investors’views on the health of the economy.
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The unemployment rate measures the percentage of the labor
force that is unemployed:
Unemployment rate =
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Number of unemployed
Labor force
(1)
The labor force participation rate measures the percentage of
the working-age population that is in the labor force:
Labor force participation rate =
Labor force
Working-age population
(2)
An example: What happens if you include the military?
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People on active military service are not included in the
employment, labor force, or working-age population totals
compiled in the BLS survey.
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Suppose now people in the military were included in these
statistics, what happens to the unemployment rate and the
labor participation rate?
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We can use expressions (1) and (2) to answer these questions.
Problems with measuring the unemployment rate
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Although the BLS reports the unemployment rate measured
to the tenth of a percentage point, it is not a perfect measure
of the current state of joblessness in the economy.
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Understate the degree of jobless: di¢ cult to distinguish
between the unemployed and people who are not in labor
force. E.g., in recession an increase in discouraged workers is
not counted as unemployed as more people stop actively
looking for a job then. In addition, part-time workers who
look for full-time are counted as employed.
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Overstate: BLS doesn’t verify the responses of interviewees.
Some people who claim to be unemployed and actively looking
for work may not be actively looking. May claim not to be
working to evade taxes or keep criminal activity unnoticed.
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The UER provides some useful information about the
employment situation in the country, but it is far from an
exact measure of joblessness in the economy.
Alternative Measures of Unemployment: U-6
Some people suggest that we should include
discouraged workers and underemployed workers in
the unemployment statistics, to create a broader
measure of unemployment.
• The BLS measures this, calling it BLS series U-6.
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Figure 9.2
The official
unemployment rate
and a broad measure
of the unemployment
rate, 1996-2013
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Trends in Labor Force Participation
The labor force participation rate of adult men has
declined gradually since 1948…
… but it has increased significantly for adult
women, making the overall rate higher today than
it was then.
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Figure 9.3
Trends in the labor
force: participation
rates of adult men and
women since 1948
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Making
the
Is Falling Labor Force Participation Bad?
Connection
Politicians often like to point to
a “falling labor force
participation rate” as a strongly
negative sign for the economy.
• Is this necessarily true?
The two major reasons why
the LFPR for men has fallen
over the last several decades
are:
• Men have been going to school for longer and retiring earlier
than before (why?)
• Increases in Social Security Disability Insurance availability
have allowed people with disabilities to stop work
Whether these are good or bad is a value judgment.
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Unemployment Rates for Different Groups
Unemployment rates vary by ethnic group…
… and by education level.
• These two observations are statistically
related.
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Figure 9.4
Unemployment
rates in the
United States,
August 2013
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How Long Are People Typically Unemployed?
Long periods of unemployment are bad for workers, as their skills
decay and they risk becoming discouraged and depressed.
• During the Great Depression of the 1930s, some people were
unemployed for years at a time.
Since World War
II, average
lengths of
unemployment
have been
relatively low; but
that changed
dramatically with
the 2007-2009
recession.
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How Long Are People Typically Unemployed?
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During the Great Depression of the 1930s, some people were
unemployed for years at a time.
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In the modern U.S. economy, the typical unemployed person
stays unemployed for a relatively brief period of time.
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In April 2007— which was during a period of economic
expansion— 82% of the people who were unemployed had
been unemployed for less than six months.
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In September 2011, after the end of the 2007 2009
recession, but during a time when the economy was growing
slowly, only 55% of the unemployed had been jobless for less
than six months.
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The average period of unemployment was only 17 weeks in
April 2007 but was 41 weeks in September 2011.
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The severity of unemployment during and after the
2007 2009 recession was a sharp break from the normal
U.S. experience.
Making The Employment Situation Following the 2007-2009 Recession
the
Connection
The fall of the employment–population ratio may give an even
better indication of how weak the U.S. labor market was during
and after the 2007–2009 recession.
• Explaining these changes is a top priority for labor economists.
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The Establishment Survey: Another Measure of
Employment
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In addition to the household survey, the BLS uses the
establishment survey, sometimes called the payroll survey, to
measure total employment in the economy (300,000
establishments).
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The establishment survey provides information on the total
number of persons who are employed and on a company
payroll.
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The establishment survey has the following four drawbacks:
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It does not provide information on the number of self-employed
persons because they are not on a company payroll.
It may fail to count some persons employed at newly opened
…rms that are not included in the survey.
It provides no information on unemployment.
Its initial employment values can be signi…cantly revised as
data from additional establishments become available.
Comparing the Household and Establishment Surveys
The table below gives the data from the July and August 2013
household and establishment surveys:
Household Survey
July
Employed
Unemployed
Labor force
Unemployment rate
Establishment Survey
August
Change
144,285,000
144,170,000
–115,000
11,514,000
11,316,000
–198,000
155,798,000
155,486,000
–312,000
7.4%
7.3%
July
135,964,000
August
Change
136,133,000
169,000
–0.1%
Table 9.1
Household and establishment survey
data for July and August 2013
Even if all surveys are truthfully and accurately answered, we do
not expect the numbers to be identical between the two surveys:
• Different groups are measured
• All surveys have measurement errors
But we get a more complete picture by considering both surveys.
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Revisions to Employment Numbers
Over time, the BLS adjusts its estimates of
employment and unemployment for previous months.
Revisions sometimes take place years later.
The large negative revisions were because the BLS
underestimated the severity of the 2007-2009
recession.
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Figure 9.5
Revisions to
employment changes,
as reported in the
establishment survey
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Job Creation and Destruction
Number of Jobs
Establishments Creating Jobs
Existing establishments
5,752,000
New establishments
1,299,000
Establishments Eliminating Jobs
Existing establishments
5,180,000
Closing establishments
1,203,000
Jobs are continually being created and destroyed in
the U.S. economy. In 2012, about 27.8 million jobs
were created, while about 25.5 million jobs were
destroyed.
This is a natural and normal process for the
economy.
The table shows jobs created and destroyed over a
three-month period from September to December
2012.
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Table 9.2
Establishments
creating and
eliminating jobs,
SeptemberDecember 2012
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U.S. Annual Unemployment Rate over Time
Unemployment rates rise when the economy is
faltering, and fall when the economy is doing well.
But they never fall to zero.
• To understand why, we will examine the types of
unemployment.
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Figure 9.6
The annual
unemployment rate in
the United States,
1950-2012
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Frictional Unemployment and Job Search
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Most workers spend at least some time engaging in job
search, just as most …rms spend time searching for a new
person to …ll a job opening.
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Frictional unemployment: Short-term unemployment that
arises from the process of matching workers with jobs.
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Frictional unemployment occurs mostly because of job search:
entering or re-entering the labor force, or being between jobs.
It also occurs because of seasonal unemployment: some jobs
‡uctuate in availability due to seasonal demand, like
ski-instructor or farm-work.
Seasonal unemployment refers to unemployment due to
factors such as weather, variations in tourism, and other
calendar-related events.
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Because seasonal unemployment can make the unemployment
rate seem arti…cially high during some months and arti…cially
low during other months, the BLS reports two unemployment
rates each month— one that is seasonally adjusted and one
that is not.
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Some frictional unemployment actually increases economic
e¢ ciency by allowing for better job matches.
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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.
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Structural unemployment is associated with longer
unemployment spells. Workers who are structurally
unemployed may require retraining in order to obtain
“modern” jobs.
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Cyclical Unemployment: Unemployment caused by a business
cycle recession.
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In normal recoveries after a recession, unemployment due to
cyclical factors will fall.
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Full employment: When the only remaining unemployment is
structural and frictional unemployment.
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When the economy moves into recession, many …rms …nd their
sales falling and cut back on production. As production falls,
they start laying o¤ workers.
The ‡uctuations around this normal rate are mainly due to the
changes in the level of cyclical unemployment.
Natural rate of unemployment (NRU): The normal rate of
unemployment, consisting of structural unemployment plus
frictional unemployment.
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In the US, most economists estimate the rate to be around 5%.
The NRU is also sometimes called the full-employment rate of
unemployment.
Making How Should We Categorize Unemployment at Caterpillar?
the
Connection
In 2013, Caterpillar
announced layoffs at its
South Milwaukee plant.
• Did this increase frictional,
structural, or cyclical
unemployment?
This is generally a hard
question to answer; we need
to look closely at this specific
plant:
• The South Milwaukee plant manufactured mining equipment.
• Prices for mining products were in decline, decreasing demand
for Caterpillar’s mining machinery. But sales of other equipment
remained strong.
• The laid-off workers were likely specialists at making mining
equipment; so they are probably structurally unemployed.
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Government Policies and the Unemployment Rate
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Governments often attempt to directly in‡uence
unemployment.
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Example: The government’s Trade Adjustment Assistance
program o¤ers training to workers whose …rms laid them o¤ as
a result of competition from foreign …rms. This would reduce
structural unemployment.
Other policies try to reduce frictional unemployment: by
subsidizing new hires.
However some other government policies probably increase
unemployment: Unemployment insurance and Minimum wage
laws.
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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.
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(Conti.) In the U.S. and most other industrial countries, the
unemployed are eligible for unemployment insurance (UI)
payments from the government, which help the unemployed
maintain their income and spending, lessening the personal
hardship of being unemployed and also helping to reduce the
severity of recessions.
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In the US, UI and other payments to the unemployed are equal
to about half of the average wage.
UI helps the unemployed maintain their income and spending,
which lessens the personal hardship of being unemployed and
also helps reduce the severity of recessions.
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Advantages: UI helps the unemployed maintain their income
and spending, which lessens the personal impact of
unemployment and also helps reduce the severity of recessions.
Disadvantages: The unemployed can spend more time
searching for better jobs because they receive these UI
payments and then increase the unemployment rate in the
economy.
Minimum Wage Laws
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In 1938, the U.S. federal government enacted a national
minimum wage law.
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The current level of MW in the U.S. is $7.25 per hour (At
…rst, it is $0.25 per hour. After in‡ation-adjusted, it becomes
$4.15 per hour). In November 2010, legislators of the Hong
Kong Government agreed to set a minimum wage level of
HK$28 ($4.70).
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If the MW is set above the market wage determined by the
demand and supply of labor, labor supply is greater than labor
demand. Some unemployed workers would have been
employed if there were no minimum wage. Consequently, the
unemployment rate will be higher than it would be without a
minimum wage.
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Economists agree that the current minimum wage is above
the market wage for some workers, but they disagree on the
amount of unemployment that has resulted.
Labor Unions
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Organizations of workers that bargain with employers for
higher wages and better working conditions for their members.
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In unionized industries (automobiles, steel, and telecom.), the
wage is usually above what otherwise would be the market
wage. This above-market wage leads to fewer workers hired in
those industries.
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But the e¤ect of the overall unemployment rate is minor
because only 9% of workers are unionized.
E¢ ciency Wages
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A higher-than-market wage paid by a …rm to increase worker
productivity.
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The reason is that in many business situations, it is di¢ cult to
monitor workers. (workers can hidden their activities.) Hence,
many …rms must rely on workers being motivated enough to
work hard.
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By paying a wage above the market wage, the …rm raises the
costs to workers of losing their jobs.
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Minimum wage laws, unions, and e¢ ciency wages can cause
economies to experience some unemployment even when
cyclical unemployment is zero.
Measuring In‡ation
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The prices of most goods and services rise over time. As a
result, the cost of living rises. E.g., in 1914, Ford’s $5-a-day
wage is extremely high, today it is only the level of minimum
wage.
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Price level: A measure of the average prices of goods and
services in the economy.
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In‡ation rate: The percentage increase in the price level from
one year to the next.
π t +1 =
pt +1 pt
,
pt
where pt is the price level at time t and π t is the in‡ation
rate at time t.
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(Cont.) Measuring the price level: The GDP de‡ator is a
broadest measure because it includes the price of every …nal
good and service.
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But it is too broad for some purposes. E.g., if we need to
know the impact of in‡ation on the typical household, it is
misleading.
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The consumer price index (CPI) is a better measure for the
cost of living of the typical urban family with four.
The Consumer Price Index (CPI)
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One year is chosen as the base year, and the value of the CPI
is set to 100 for that year.
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In any other year, the CPI is equal to the ratio of the dollar
amount necessary to buy the market basket of goods in that
year divided by the dollar amount necessary to buy the same
market basket in the based year, multiplied by 100.
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CPI is also called the cost-of-living index.
Consumer Price Index
The consumer price index is
a measure of the average
change over time in the prices
a typical urban family of four
pays for the goods and
services they purchase.
The chart shows the
composition of the basket of
goods used to create the CPI.
This basket of goods derives
from a survey of 14,000
households by the BLS.
Figure 9.7
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The CPI market basket,
December 2012
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A Simple CPI Calculation
Base Year (1999)
Product
Quantity
2014
Price
Expenditures
(on base-year
quantities)
$100.00
$85.00
$85.00
15.00
300.00
14.00
280.00
25.00
500.00
27.50
550.00
Price
Expenditures
Price
1
$50.00
$50.00
$100.00
Pizzas
20
10.00
200.00
Books
20
25.00
500.00
Eye
examinations
TOTAL
$750.00
2015
Expenditures
(on base-year
quantities)
$900.00
$915.00
The table above gives the information we need to create the CPI
in 2014 and 2015, using the basket of goods from 1999.
Formula
Expenditures in the current year
×100
CPI =
Expenditures in the base year
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Applied to 2014
 $900 
 ×100 = 120

 $750 
Applied to 2015
 $915 
 × 100 = 122

 $750 
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A Simple CPI Calculation—continued
Formula
Applied to 2014
Expenditures in the current year
×100
CPI =
Expenditures in the base year
 $900 
 ×100 = 120

 $750 
Applied to 2015
 $915 
 × 100 = 122

 $750 
Based on these data, the inflation rate from 2014 to 2015 is the
percentage change in the CPI:
 122 − 120 
 × 100 = 1.7%

120


Since the CPI measures consumer prices, it is often referred to as
the cost-of-living index. CPI-inflation is sometimes used to
generate “fair” increases in wages for workers, and government
benefits.
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Using Price Indexes to Adjust Prices
Suppose your mother received a salary of $25,000 in 1987. This
would have bought much more than a salary of $25,000 in 2012.
We can use the CPI to estimate the purchasing power of that
$25,000 in 2012 dollars:
 CPI in 2012 
Value in 2012 dollars = Value in 1987 dollars × 

 CPI in 1987 
 230 
= $25,000 × 
 ≈ $50,000
 114 
So $25,000 in 1987 would have bought about as much as
$50,000 in 2012.
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Nominal and Real Values
The current standard base “year” for the CPI is an average of 19821984 prices.
Values like wages in current-year dollars are called nominal variables.
When we adjust them for inflation, by dividing by the current year’s
price index and multiplying by 100, we convert them to real variables.
Example: Caterpillar employees signed a contract freezing wages
until 2018. How much less will their wages be worth then?
Year
Nominal Average
Hourly Earnings
CPI
(1982–1984 = 100)
Real Average Hourly Earnings
(1982–1984 dollars)
2013
$27.00
233
$11.59
2018
27.00
260 (est)
10.38
If the CPI rises to 260, then Caterpillar employees will receive a
real wage decrease of:
 $10.38 − $11.59 
 ×100 = −10.4%

$
11
.
59


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Is the CPI Accurate?
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CPI is the most widely used measure of in‡ation, so it is
important that it be as accurate as possible. 4 factors make it
overstate the true in‡ation rate (CPI overstates true in‡ation
by 0.5 to 1 percentage point):
1. Substitution bias: In constructing the CPI, the BLS assumes
that consumers purchase the same monthly amount of each
product in the market basket, but consumers actually buy
fewer of those products that increase most in price.
2. Increase in quality bias: Increases in the prices of the products
partly re‡ect their improved quality and partly are pure
in‡ation. It is di¢ cult to separate the two factors.
3. New product bias: For many years, the BLS updated the
market basket of goods used in computing the CPI only every
10 years, which excluded new products introduced between
updates.
4. Outlet bias: Because the BLS continued to collect price
statistics from traditional full-price retail stores, the CPI did
not re‡ect the prices some consumers actually paid at discount
stores and over the Internet.
The Producer Price Index (PPI)
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PPI: An average of the prices received by producers of G&S at
all stages of the production process.
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It is conceptually similar to the CPI, in that it uses a basket of
goods, but the goods are those used by producers.
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The PPI includes the prices of intermediate goods such as
cotton, steel, and raw materials.
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If the prices of these goods rise, the cost to …rms of producing
…nal products will rise, which may lead …rms to increase the
prices of products purchased by consumers.
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Changes in PPI can be used to predict future movements in
the CPI.
Real versus Nominal Interest Rates
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Nominal interest rate: The stated interest rate on a loan.
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Real interest rate: The nominal interest rate minus the
in‡ation rate. It provides a better measure of the true cost of
borrowing and the true return to lending than does the
nominal interest rate.
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For low rates of in‡ation, a convenient approximation for the
real interest rate is: Real interest rate = Nominal interest rate
- In‡ation rate
De‡ation: A decline in the price level, i.e., negative in‡ation.
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(Cont.) Holding the nominal interest rate constant, the higher
the in‡ation rate, the lower the real interest rate.
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E.g., if both of you and the person to whom you lend $1000
expected the in‡ation rate to be 2%, you both expected the
real interest rate to be 4% if the nominal interest rate is 6%.
If the actual in‡ation rate turns out to be 4%, the real rate
will be 2%: That’s good news for your borrower but bad news
for you.
U.S. Nominal and Real Interest Rates
The chart
shows the
interest rate on
three-month
treasury-bills, a
good measure
of the nominal
interest rate.
The real
interest rate
adjusts them
for changes in
the CPI.
Figure 9.8
Nominal and real interest
rates, 1970-2013
Notice that in 2009, the real interest rate was above the nominal
interest rate. This was because the change in the CPI was negative
then, indicating a rare deflation, or decrease in the price level.
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Does In‡ation Impose Costs on the Economy?
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In‡ation A¤ects the Distribution of Income: In‡ation does not
reduce the a¤ordability of goods and services to the average
consumer because an expected in‡ation rate of 10% will raise
the average price of goods and services by 10%, but it will
also raise average incomes by 10%.
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However, it still imposes costs on the economy.
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It is unlikely that everyone’s wages would increase at the same
rate. Many people have long-term contracts specifying their
wage in nominal terms, for example.
Also, nominal assets like cash decrease in value when there is
signi…cant in‡ation. If you hold much of your wealth in cash,
then in‡ation causes a signi…cant decrease in real wealth for
you.
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(Conti.) The extent to which in‡ation redistributes income
depends in part on whether the in‡ation is anticipated— in
which case consumers, workers, and …rms 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 In‡ation: Paper money loses
some of its value so that anyone holding paper money will …nd
that its purchasing power decreasing by the in‡ation rate. In
addition, …rms need to reprint their price catalog listing more
frequently.
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Menu costs The costs to …rms of changing prices.
The problem with unanticipated In‡ation: When the actual
in‡ation rate turns out to be very di¤erent from the expected
in‡ation 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 why people dislike unanticipated in‡ation.
What’s so Bad about De‡ation?
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What if an economy begins to experience falling prices –
de‡ation?
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Should falling prices encourage consumers to increase their
spending as G&S become less expensive? According to two
important de‡ationary episodes: the U.S. during the 1930s
and Japan during the 1990s, the answer is No. The main
reason is that many consumers in the face of de‡ation were
waiting for prices to go even lower.
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Waiting for falling prices was also a problem for the U.S.
housing market in the late 2000s. When housing prices began
to decline, many potential buyers postpones purchases in the
expectation that prices would continue to fall.
Making
the
Connection
What’s So Bad about Falling Prices?
Deflation is much more dangerous for an economy than inflation.
Why? Suppose you are considering buying a car. You know the car
will be cheaper next year, so you delay purchasing. But if everyone
does the same, then many purchases are postponed, firms stop
producing, people become unemployed, etc.
This can create a dangerous
downward-spiral, delaying
economic recovery. Economists
believe this occurred after the
Great Depression of the 1930s,
and also in Japan in the 1990s.
There were concerns that
significant periods of deflation
might have followed the
recession of 2007-2009. but
fortunately that did not occur.
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Common Misconceptions to Avoid
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Many economic indicators like the unemployment rate are
only created from sample data, so they are not exact
measures of economic well-being.
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The BLS does not estimate separately the causes of
unemployment; but these are still useful to understand.
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The price level compares prices in a given year to those in a
base year; in‡ation represents changes in price levels.