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Lecture 4
Chapter 8: Economic
Fluctuations,
Unemployment, Inflation
Monthly Household Budget of
the Typical Family in 2000 (Base
Year)
Constructing a Hypothetical CPI
Item
Cost (in 2000)
Rent, two-bedroom apartment
$500
Hamburgers (60 at $2.00 each)
120
Movie tickets (10 at $6.00 each)
60
Total expenditure
$680
Cost of Reproducing the 2000
(Base-Year) Basket of Goods and
Services in Year 2005
Constructing a Hypothetical CPI
Item
Cost (in 2005)
Cost (in 2000)
Rent, two-bedroom apartment
$630
$500
Hamburgers (60 at $2.50 each)
150
120
Movie tickets (10 at $7.00 each)
70
60
$850
$680
Total expenditure
850 - 680 170
Cost of Living 

 25% increase
680
680
The Consumer Price Index:
Measuring the Price Level

Constructing the CPI
 Bureau



CPI 
of Labor Statistics (BLS)
Pick a base year
Conduct the consumer expenditure survey to determine the
base-year basket of goods and services
Measure the current prices of the base-year basket
Cost of base - year basket of goods and services in current year
Cost of base - year basket of goods and services in base year
Cost of Reproducing the 2000
(Base-Year) Basket of Goods and
Services in Year 2005
Constructing a Hypothetical CPI
Item
Cost (in 2005)
Cost (in 2000)
Rent, two-bedroom apartment
$630
$500
Hamburgers (60 at $2.50 each)
150
120
Movie tickets (10 at $7.00 each)
70
60
$850
$680
Total expenditure
•The CPI in year 2000 = $850/$680 = 1.25
•Base year = 1.00
•The cost of living increased by 25% from 2000 to 2005
Calculating Inflation
Rates: 2000 - 2004
Year
CPI
2000
1.722
2001
1.771
2002
1.799
2003
1.840
2004
1.889
1.771 - 1.772
Inflation rate : 2000 - 2001 
 0.049/1.72 2  0.028  2.8%
1.772
Calculating Inflation
Rates: 1929 - 1933
Year
CPI
1929
0.171
1930
0.167
1931
0.152
1932
0.137
1933
0.130
0.167 - 0.171
Inflation rate : 1929 - '30 
 - 0.023 x 100  - 2.3%
0.171
0.152 - 0.167
Inflation rate : 1930 - '31 
 - 0.090 x 100  - 9.0%
0.167
Nominal GDP versus Real
GDP

Economic Naturalist
 Can
nominal and real GDP ever move in
different directions?
Adjusting for Inflation

Example
 Home
run hitters drive Cadillacs
1930 Babe Ruth’s salary was $80,000
 2001 Barry Bond’s salary was $10.3 million
 CPI (1982 - 84 = 100)

1930 = 0.167
 2001 = 1.78
 Babe Ruth’s real salary = $80,000/0.167 = $479,000
 Barry Bond’s real salary = $10.3/1.78 = $5.79 million

Adjusting for Inflation

Real Wage
 The
wage paid to workers measured in terms
of purchasing power
 The real wage for any given period is
calculated by dividing the nominal (dollar)
wage by the CPI for that period
Adjusting for Inflation

Example
 An

indexed labor contract
Contract specifics

1st year wage = $12/hr

Real wage will rise 2 percent in the 2nd and 3rd year

CPI: Year 1 = 1.00; Year 2 = 1.05; Year 3 = 1.10

Year 2 wage = W2/1.05 = $12 x 1.02 = $12.24


W2 = $12.24 X 1.05 = $12.85
Year 3 wage = W3/1.10 = 12.24 x 1.02 = $12.48

W3 = $12.48 X 1.10 = $13.73
Gross Domestic Product:
Measuring the Nation’s
Output

Market Value
 Market
value is used to aggregate the
quantities of different goods and services into
one measurement
Gross Domestic Product:
Measuring the Nation’s
Output

Market Value
 Calculating

GDP for Orchardia
Total production = 4 apples, 6 bananas, and 3
pairs of shoes
Price of apples = $0.25
 Price of bananas = $0.50
 Price of shoes = $20

Gross Domestic Product:
Measuring the Nation’s
Output

Market Value
 Calculating

GDP for Orchardia
GDP

(4 x $0.25) + (6 x $0.50) + (3 x $20) = $64
Gross Domestic Product:
Measuring the Nation’s
Output

Market Value
 Observation

More expensive items receive a higher weight than
cheaper items.
 Orchardia’s
production changes to 3 apples, 3
bananas , and 4 shoes

GDP

(3 x $0.25) + (3 x $0.50) + (4 x $20) = $82.25
Swings in the
Economic Pendulum
Instability in the Growth of Real GDP

Although real GDP in the United States
has grown at an average rate of approximately
3%, the growth has been characterized by
economic ups-and-downs. Note, periods of
recession are indicated with shading.
Annual growth
rate of real GDP
Long-run growth rate
(approx. 3%)
8
6
4
2
0
-2
1960
1965
1970
1975
Source: Economic Report of the President, various issues.
1980
1985
1990
1995
2000 2004
The Hypothetical Business Cycle
Real GDP
Business
peak
Trend line
Business
peak
Recessionary
trough
Recessionary
trough

Time
The four phases of the business cycle are expansion,
peak, contraction, and recessionary trough.
 In contrast with the hypothetical cycle represented
here, as the previous exhibit illustrated, real world
business cycles are characterized by expansions and
contractions of varying duration and magnitude.
Economic Fluctuations
and the Labor Market
The Unemployment Rate

Measuring Unemployment
 The
Bureau of Labor Statistics (BLS) surveys
about 60,000 randomly selected households
each month
The Unemployment Rate

Measuring Unemployment
 Those
16 years and over are placed in one of
three categories:
Employed
 Unemployed
 Out of the labor force

 The
BLS estimates how many people in the
U.S. fit into each category.
Labor Market Classifications

Employed
– a person (16 years old or over) who is




working for pay at least one hour per week,
self employed, or,
working 15 hours or more each week without pay in a
family-operated enterprise.
Unemployed
– a person not currently employed who is either


actively seeking a job, or,
waiting to begin or return to a job.

Civilian Labor force

Not in the labor force
– persons (16 years and older) who are neither
– civilians (16 years and older) who are either
employed or unemployed.
employed nor unemployed (like retirees,
students, homemakers, or disabled persons).
Labor Market Indicators

The non-institutional civilian adult population is
grouped into two broad categories:


Persons not in the labor force, and,
persons in the labor force. (This group
includes both the employed and unemployed).
# in the Labor Force
Labor Force
Participation Rate
=
Recall the Labor Force =

Civilian population (16+)
Employed + Unemployed
To be classified as unemployed, one must either
be on layoff or actively seeking work.
Rate of
Unemployment
Recall the Labor Force =
# Unemployed
=
# in the Labor Force
Employed + Unemployed
Unemployment and
Measurement Problems


The definition of unemployed involves some
subjectivity.
Some argue the employment/population ratio
is a better indicator of job availability than the
unemployment rate.
Employment /
Population Ratio
=
# employed
Civilian population (16+)
U.S. Population, Employment,
and Unemployment: 2004
Civilian population
16 and over
223.4 million
147.4 million
76.0 million
Civilian
labor force
Not in the
labor force
• Household workers
• Students
• Retirees
• Disabled
Employed
Labor Force
Participation Rate
Employment /
Population Ratio
Rate of
Unemployment
=
Civilian labor force
Civilian population (16+)
=
Number employed
=
Civilian population (16+)
Civilian labor force
147.4
223.4
=
223.4
66.0%
=
62.3%
8.1
=
147.4
• New entrants
• Reentrants
• Lost last job
• Quit last job
• Laid off
=
139.3
Number unemployed
=
Unemployed
• Employees
• Self-employed
workers
139.3 million
=
8.1 million
5.5%
U.S. Employment Data,
April 2005 (in millions)
Employed
141.1
Plus:
Unemployed
Equals: Labor force
7.66
148.76
Plus:
Not in labor force
76.68
Equals:
Working-age (over 16) population
225.44
Unemployment rate = unemployed/labor force = 7.66/148.76 = 5.2%
Participation rate = labor force/working-age population = 148.76/225.44 = 66.0%
Labor Force Participation Rate
of Men and Women: 1948-2003
Labor Force Participation Rate of Men and Women
87 %
83%
78 %
76 %
74 %
58 %
60 %
1990
1960
1975
–––––– Women ––––––
2003
46 %
33 %
1948
1990
1960
1975
––––––– Men –––––––
2003
1948
38 %
Source: www.bls.gov.

The labor force participation rate of women has been
steadily increasing for several decades.

During the same period the rate of men has been falling.
Composition of the
Unemployed by Reason
Job
leavers
9.3 %
New
entrants
7.3%
• There are various reasons why
persons were unemployed in 2003.
• A little more than two-fifths (42.4%)
of the unemployed were dismissed
from their previous jobs.
• 35.5% of the unemployed were
either new entrants or reentrants
into the labor force.
Source: www.bls.gov.
Reentrants
28.2%
Dismissed from
previous jobs
42.4%
On
layoff
12.8%
The Unemployment Rate
By Age and Gender: 2003
Unemployment Rate, 2003
19.3 %
15.6 %
10.6 %
9.3 %
6.3 %
5.0 %
16-19 20-24
25+
–– Men aged ––
All
men
6.0 %
All
workers
5.7 %
All
women
4.6 %
16-19 20-24
25+
–– Women aged ––
Source: www.bls.gov.


The unemployment rate for men in 2003 was 6.3%, for
women 5.7%, and for all workers 6.0%.
Notice how the unemployment rate for persons under age 25
(of each gender) is much higher than for those older.
The Unemployment Rate

The Cost of Unemployment
 Economic
 Psychological
 Social
The Unemployment Rate

The Duration of Unemployment
 The
impact of unemployment is influenced by
how long individuals have been unemployed.
The unemployment spell
 The duration of unemployment
 Long-term unemployed
 Chronically unemployed

The Unemployment Rate

Unemployment Spell
 A period
during which an individual is
continuously unemployed

Duration
 The
length of an unemployment spell
The Unemployment Rate

The Duration of Unemployment
 Discouraged
workers
 Involuntary part-time workers
 In April 2005:
Official unemployment rate = 5.2%
 Including discouraged workers and involuntary
part-time worker = 9.0%

The Unemployment Rate

Discouraged Workers
 People
who say they would like to have a job
but have not made an effort to find one in the
last four weeks
Three Types
of Unemployment
Three Types of Unemployment

Frictional Unemployment:
 Caused by imperfect information.
 Occurs because:
 employers are not aware of all available workers
and their qualifications, and,
 available workers are not fully aware of all the jobs
being offered by employers.

Structural Unemployment:
 Reflects
an imperfect match of employee
skills to skill requirements of the available
jobs.
 Also reflects structural and demographic
characteristics of the labor market.

Cyclical Unemployment:
 Reflects business cycle conditions
 When there is a general downturn in
business
activity, cyclical unemployment increases.
Employment
Fluctuations:
Historical Record
Unemployment and Output Are
Linked Over the Business Cycle
Share of labor
force unemployed
Actual rate of
unemployment
10
8
6
4
Natural rate of
unemployment
2
1960
1965
1970
1975
1980
1985
1990
1995
2000
2003
Source: http://www.bls.gov and Robert J. Gordon, Macroeconomics (Boston: Addison-Wesley, 2003).



Here we illustrate the unemployment rate from 1960-2003.
As expected, unemployment rose rapidly during each of the seven
recessions (the shaded years indicate periods of recession).
In contrast, soon after each recession ended, the unemployment
rate began to decline as the economy moved into an expansionary
phase of the business cycle. Note that the actual rate of
unemployment was greater than the natural rate during and
immediately following each recession.
The Concept of Full Employment

Full Employment:
The level of employment that results when the rate of
unemployment is normal, considering
both frictional and structural factors.


Full employment is closely related to the concept
of the natural rate of unemployment.
Natural Rate of Unemployment:
The level of unemployment that reflects “job
shopping” in an economy of imperfect information
and dynamic change.
The Concept of Full Employment

The natural rate of unemployment is:





neither a temporary high nor temporary low.
a rate that is both achievable and sustainable.
the level of unemployment accompanying an
economy’s “maximum sustainable rate of output.”
Both demographic factors (e.g. young workers
as a share of the labor force) and public policy
(e.g. the level of unemployment benefits)
influence the natural rate of unemployment.
The actual rate of unemployment generally rises
above the natural rate during a recession and
falls below the natural rate during a boom.
Unemployment Across Economies
Average Unemployment Rate
(1994-2003)
Spain
14.6 %
France
10.6 %
Italy
10.5 %
U.K.
8.6 %
Germany
U.S.
Japan
6.5 %
5.1 %
4.2 %
Source: Economic Outlook, OECD (June 2004).

In recent years, the unemployment rate in the U.S. and Japan has
been persistently lower than the comparable rate of major European
economies. Most economists believe the higher unemployment
benefits, less flexible collective bargaining, and more regulated labor
markets of Europe explain this phenomenon.
Actual and Potential
GDP
Actual and Potential GDP

Potential output :
Maximum sustainable output level
consistent with the economy’s resource
base, given its institutional
arrangements.

Actual and potential output will be
equal when the economy is at full
employment.
Actual & Potential GDP, 1960-2003
2001
recession
Real GDP
(billions of 2000 $)
10,000
1990-91
recession
8,000
Potential
GDP
Actual
GDP
6,000
1960
recession
1982
recession
4,000
1980
recession
1970
recession
2,000
1960
1965
1970
1974-75
recession
1975
1980
1985
1990
1995
2000
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Here we illustrate both actual and potential GDP.

Note the gap (shaded area) between actual and potential GDP
during periods of recession.
2003
Questions for Thought:
1. During a recession, which of the following will be
true?
a. The actual rate of unemployment will be
lower than the natural rate.
b. Actual GDP will be lower than potential GDP.
c. Actual employment will exceed what is
considered full employment.
2. How will increased usage of the Internet by
employers and employees influence the job
search process? Will it tend to increase or
decrease the natural rate of unemployment?
Questions for Thought:
3. True or false. When full employment is present the
rate of unemployment will be zero.
4. What is the relationship between the natural rate
of unemployment and full employment? Why
might the natural rate change?
5. Frictional unemployment is a result of:
(a) not enough jobs for everyone to be employed
(b) unemployed workers’ skills not matching
those needed for available jobs
(c) a decline in the demand for labor, such as
during a recession
(d) imperfect information & temporary periods
of unemployment while workers change jobs
Effects of Inflation:
An Overview
What is Inflation?

The Rate of Inflation is calculated as:
Inflation
rate

This year’s
price index
=
-
Last year’s
price index
Last year’s
price index
x 100
Inflation is an increase in the general level
of prices.

High rates of inflation are almost always associated
with substantial year-to-year swings in the inflation
rate, making them difficult to forecast accurately.
The Inflation Rate, 1953-2003
1973-1981 average
inflation rate = 9.2 %
Inflation rate
15
1983-2003 average
inflation rate = 3.1 %
10
1953-1965 average
inflation rate = 1.3 %
5
0
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2003
Sources: Derived from computerized data supplied by FAME ECONOMICS. Also see Economic Report of the President (annual).


Above is the annual rate of inflation for 1953-2003.
Between 1953 and 1965, the general price level increased at an
average annual rate of only 1.3%.

In contrast, the inflation rate averaged 9.2% from 1973 to 1981,
reaching double-digits during several years.

Since 1982, the average rate of inflation has been lower (3.1%
from 1983-2003) and more stable.
Unanticipated and
Anticipated Inflation

There are two different kinds of
inflation:
 Unanticipated
inflation:
An increase in the price level that
comes as
a surprise, at least for most individuals.
 Anticipated inflation:
A widely expected change in the price
level.
Effects of Inflation

High and variable rates of inflation are harmful
for a number of reasons:



Because unanticipated inflation alters the outcomes of
long-term projects like the purchase of a machine or
operation of a business, it will both increase the risks
and retard the level of such productive activities.
Inflation distorts the information delivered
by prices.
People will respond to high and variable rates of
inflation by spending less time producing and more
time trying to protect their wealth and income from the
uncertainty created by inflation.
What Causes Inflation?

Nearly all economists believe that
rapid expansion in the money
supply is the primary cause of
inflation.
Questions for Thought:
1. Suppose that the CPI was 150 at the end of last
year and 157.5 at the end of this year. What was
the inflation rate during the year?
2. If decision makers anticipate an inflation rate of
3% at the start of a year and prices during the
year rise by 7%, this is an example of
a. anticipated inflation.
b. an inflation rate higher than anticipated.
c. an inflation rate lower than anticipated.
3. True or false: when the inflation rate is high and
variable, decision makers will generally
be able to anticipate year-to-year changes in
inflation quite accurately.
Questions for Thought:
4. How would an unanticipated 5 percent jump in
inflation impact the wealth of:
a. Joe, who has a 30-year home mortgage at a fixed
interest rate.
b. The McCoy's, who hold most of their wealth in
long-term fixed yield bonds.
c. Hanna, a retiree drawing a pension of a fixed dollar
amount.
d. Jose, a heavily indebted small-business owner.
e. Mike, the owner of an apartment complex with
substantial debt at a fixed interest rate.
f. Tina, a worker whose wages are determined by a
3-year union contract ratified three months ago.