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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.