Download Chapter 7

Macroeconomics
ECON 2301
May 2010
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 7
Chapter 7: The Macroeconomy:
Unemployment, Inflation, and Deflation
Learning Objectives
1. Explain how the U.S. government calculates the
official unemployment rate
2. Discuss the types of unemployment
3. Describe how price indexes are calculated and define the
key types of price indexes
4. Distinguish between nominal and real interest rates
5. Evaluate who looses and who gains from inflation
6. Understand key features of business fluctuations
Introduction
How does the U.S. government measure
the overall level of prices?
Why doesn’t the U.S. government use
Wal-Mart prices in calculating inflation?
This chapter will help you answer
these questions.
Did You Know That...
 Estimates indicate that each year, discount pricing by
retailers such as Wal-Mart, K-Mart, and Target, helps to
keep the overall U.S. inflation rate about 0.4% lower?
 Additionally, every year discount pricing by food
superstores holds the annual rate of increase in average
U.S, food prices 0.75% below the rate it otherwise would
reach?
 Trying to understand and better measure inflation and the
overall performance of the national economy is a central
objective of macroeconomics.
Unemployment
 Unemployment: Total number of adults (aged
16 years or older) willing and able to work and
who are actively looking for work and have not
found a job
 Labor Force: Individuals aged 16 years or
older who either have jobs or who are looking and
available for jobs; the number of employed plus
the number of unemployed
Unemployment (cont'd)
 Question: What are the costs of unemployment?
 Answers:
Lost output
• During early 2000s, unemployment rate rose by 2
percentage points
• Factory output was 80% of potential
• Lost output was $200 billion of goods and services
that could have been produced
Personal psychological impact
Figure 7-1 More Than a Century
of Unemployment
Source: U.S. Department of Labor, Bureau of Labor Statistics
Figure 7-2 Adult Population
Unemployment (cont'd)
 The unemployment rate is the percentage
of the measured labor force that is
unemployed.
Unemployment (cont'd)
Labor force = The employed + The unemployed
155.7*
=
145.3
+
10.4
Unemployed
Unemployment rate =
Labor force
x 100
10.4
x 100 = 6.7%
=
155.7
*U.S., millions of people; as of 2007
Unemployment (cont'd)
 Stock: The quantity of something, measured at a
given point in time - for example, an inventory of
goods
 Flow: A quantity measured over time, such as the
income you make per year, or the number of
individuals fired every month
Unemployment (cont'd)
 Categories of individuals without work
Job loser
Re-entrant
Job leaver
New entrant
Unemployment (cont'd)
 Job Loser: An individual whose employment
was involuntarily terminated or who was laid off
• 40–60% of the unemployed
 Re-entrant: An individual who has worked a full-time
job before but left the labor force and has now reentered it
looking for a job
• 20–30% of the unemployed
Unemployment (cont'd)
 Job Leaver: An individual who voluntarily quit
• 10 to 15% of the unemployed
 New Entrant: An individual who has never
worked a full-time job for two weeks or longer
• 10 to 15% of the unemployed
Unemployment (cont'd)
 Duration of unemployment - ordinarily
More than a third of job seekers find work
within one month.
Approximately another third find employment
within a second month.
About a sixth are still unemployed after
six months.
Average duration is just over 15 weeks
throughout the last 15 years.
Figure 7-3 The Logic of the
Unemployment Rate
Unemployment (cont'd)
 Question
What is likely to happen to the duration of
unemployment during a downturn in the
economy?
Unemployment (cont'd)
 Discouraged Workers: Individuals who have
stopped looking for a job because they are
convinced they will not find a suitable one
 Question
How does the existence of discouraged workers
bias the unemployment rate?
Unemployment (cont'd)
 Labor Force Participation Rate:
The proportion of non-institutionalized workingage individuals who are employed or seeking
employment
The Major Types of
Unemployment
 The major types of unemployment:
Frictional
Structural
Cyclical
Seasonal
The Major Types
of Unemployment (cont'd)
 Frictional Unemployment
Results from the fact that workers must search
for appropriate job offers
This takes time, so they remain temporarily
unemployed
The Major Types
of Unemployment (cont'd)
 Structural Unemployment
Results from a poor match of workers’ abilities
and skills with current requirements of
employers
The Major Types
of Unemployment (cont'd)
 Seasonal Unemployment
Results from the seasonal pattern of work in
specific industries
The Major Types
of Unemployment (cont'd)
 Cyclical Unemployment
Results from business recessions that occur
when aggregate (total) demand is insufficient to
create full employment
International Example: How Illegal Aliens Affect
Measured Cyclical U.S. Unemployment
 In 2007, home-building activity fell by more than
25%. Yet, cyclical unemployment increased by
only 4%.
 What was different about this particular housing
slump was that construction firms had hired large
numbers of illegal-immigrant workers alongside
U.S. residents.
International Example: How Illegal Aliens Affect
Measured Cyclical U.S. Unemployment (cont’d)
 When the downturn in house construction occurred, most
home builders discharged illegal workers and retained
employees who were residents of the U.S.
 Because official unemployment measures include only
legal U.S. residents, the number of workers officially
classified as cyclically unemployed rose only slightly
cyclically.
 Why might construction firms’ employment of illegal
aliens also prevent measured cyclical unemployment from
declining as much as it otherwise might the next time these
is a boom in home-building activity?
Full Employment and the Natural
Rate of Unemployment
 Question: Does full employment mean that
everybody has a job?
 Full Employment: An arbitrary level of
unemployment that corresponds to “normal”
friction in the labor market
Full Employment and the
Natural Rate of Unemployment (cont'd)
 Natural Rate of Unemployment: The
unemployment rate that is estimated to prevail in
the long-run macroeconomic equilibrium
Should not reflect cyclical unemployment
When seasonally adjusted, the natural rate
should include only frictional and structural
unemployment.
Inflation and Deflation
 Inflation: A sustained increase in the average
of all prices of goods and services in an
economy
 Deflation: A sustained decrease in the
average of all prices of goods and services in
an economy
Inflation and Deflation (cont'd)
 Purchasing Power: The value of money for
buying goods and services
Varies with prices and income
 Nominal value: Price expressed in today’s
dollars
 Real value: Value expressed in purchasing
power, adjusted for inflation
Inflation and Deflation (cont'd)
 Measuring the rate of inflation or deflation
Price Index: The cost of today’s market
basket of goods expressed as a percentage of
the cost of the same market basket during a
base year
Cost today of market basket
Price index =
 100
Cost of market basket in base year
Inflation and Deflation (cont'd)
 Market Basket: Representative bundle of
goods and services
 Base Year: The point of reference for
comparison of prices in other years
Table 7-1 Calculating a Price Index for
a Two-Good Market Basket
Inflation and Deflation (cont'd)
 Real-world price indexes
Consumer Price Index (CPI)
Producer Price Index (PPI)
GDP deflator
Personal Consumption Expenditure (PCE)
Inflation and Deflation (cont'd)
 Consumer Price Index (CPI): A statistical
measure of a weighted average of prices of a
specified set of goods and services purchased by
wage earners in urban areas
Market basket of goods and services of the
“typical” consumer
Inflation and Deflation (cont'd)
 Producer Price Index (PPI): A statistical
measure of a weighted average of prices of goods and
services that firms produce and sell
Used as a short-run leading indicator (before CPI)
PPIs for
• Foodstuffs
• Intermediate goods
• Finished goods
Inflation and Deflation (cont'd)
 GDP Deflator: A price index measuring the
changes in prices of all new goods and services
produced in the economy
Broadest measure of prices; reflects both
price changes and the public’s market
responses to those price changes
Inflation and Deflation (cont'd)
 Personal Consumption Expenditure
(PCE) Index: A statistical measure of average
price using annually updated weights based on
consumer spending
Primary inflation index used by the
Federal Reserve
Figure 7-4 Inflation and Deflation
in U.S. History
Source: U.S. Department of Labor, Bureau of Labor Statistics
Anticipated versus
Unanticipated Inflation
 To determine who is hurt by inflation we
distinguish between the two types.
 The effects of inflation on individuals
depend upon which type of inflation exists.
Anticipated vs. Unanticipated Inflation (cont'd)
 Anticipated Inflation: The inflation rate that
we believe will occur
 Unanticipated Inflation: Inflation at a rate
that comes as a surprise
Anticipated vs. Unanticipated Inflation (cont'd)
 Inflation and interest rates
Nominal Rate of Interest: The market rate of
interest expressed in today’s dollars
Real Rate of Interest: The nominal rate of
interest minus the anticipated rate of inflation
Anticipated vs. Unanticipated Inflation (cont'd)
 Real interest rate
Nominal interest rate = 10%
Expected inflation rate = 6%
Real rate = 10% – 6% = 4%
Anticipated vs. Unanticipated Inflation (cont'd)
 Does inflation necessarily hurt everyone?
Inflation affects different people differently
 Unanticipated inflation
Creditors lose
Debtors gain
Anticipated vs. Unanticipated Inflation (cont'd)
 Protecting against inflation
Cost-Of-Living Adjustments (COLAs):
Clauses in contracts that allow for increases
in specified nominal values to take
account of changes in the cost of living
Anticipated vs. Unanticipated Inflation (cont'd)
 The resource cost of inflation
Re-pricing or Menu Cost of Inflation: The
cost associated with recalculating prices and
printing new price lists when there is inflation
Changing Inflation and Unemployment:
Business Fluctuations
 Business Fluctuations: The ups and downs in
business activity throughout the economy
 Expansion: A business fluctuation in which the
pace of national economic activity is speeding up
 Contraction: A business fluctuation in which
the pace of national economic activity is slowing
down
Changing Inflation & Unemployment:
Business Fluctuations (cont'd)
 Recession: A period of time during which the
rate of growth of business activity is
consistently less than its long-term trend or is
negative
 Depression: An extremely severe recession
Figure 7-5 The Idealized Course of
Business Fluctuations
Figure 7-6 National Business Activity,
1880 to the Present
Sources: American Business Activity from 1790 to Today, 67th ed., AmeriTrust Co.,
January 1996, plus Miller’s estimates.
Changing Inflation and Unemployment:
Business Fluctuations (cont'd)
 Leading Indicators: Events that have been
found to occur before changes in business activity
Economic downturns often follow:
Reduction in the average workweek
Rise in unemployment insurance claims
Decrease in prices of raw materials
Drop in the quantity of money
circulating
Stock market downturn
Summary of Learning Objectives
 How the U.S. government calculates the official
unemployment rate
Percentage of the total number of adults willing and
able to work who are actively looking for work but
have not found a job
 The major types of unemployment
Frictional
Structural
Seasonal
Cyclical
Summary of Learning Objectives (cont'd)
 Full employment
Arbitrary level of unemployment
• Corresponds to “normal” friction in labor market
 Natural rate of unemployment
Estimated to prevail in the long-run
macroeconomic equilibrium
• All workers and employers adjust to any changes in
economy
Summary of Learning Objectives (cont'd)
 How price indexes are calculated and key price
indexes
Multiply 100 times the ratio of the cost of a market
basket of goods in the current year to the cost of the
same basket in a base year
Key price indexes
• CPI
• PPI
• GDP deflator
• PCE
Summary of Learning Objectives (cont'd)
 Nominal versus real interest rates
Nominal rate is the market rate expressed in
current dollars.
Real rate is net of inflation.
Hence the real interest rate equals the nominal
interest rate minus the expected inflation rate.
Summary of Learning Objectives (cont'd)
 Losers and gainers from inflation
Creditors lose as a result of unanticipated
inflation.
Borrowers gain as a result of unanticipated
inflation.
Summary of Learning Objectives (cont'd)
 Key features of business fluctuations
Increases and decreases in business activity
• Expansion from previous trough to
new peak
• Contraction from previous peak to
new trough
Assignment to be completed
before class, May 21:
Pre-read Chapter 8, & also read:
14th ed: end-of-chapter Problems 8-2, 8-5, 8-6,
8-8, 8-10, 8-11 & 8-16 on pp. 209-211
15th ed: end-of-chapter Problems 8-2, 8-5, 8-6,
8-8, 8-11 & 8-16 on pp. 209-212