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Macroeconomic Instability:
Unemployment and Inflation
Chapter 8
Real GDP
• How do we compare GDP from one year to
the next?
• Finding a way to make the dollar worth the
same from year to year
• Create a price index
Price Index
• A measure of the price of a specified
collection of goods and services, called a
“market basket,” in a given year as
compared to the price of an identical
collection of goods and services in a
reference year
Real GDP
• GDP Price index
• = Nominal GDP/Price index (decimal/hundredths
form)
(Consumer) Price Index
• Price of Market Basket in Given Year X
Price of Market Basket in Base Period 100
Economic Growth
• Approximate number of years required to
double real GDP:
• = 70/annual % rate of growth
• 3%
Business Cycle
•
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•
Peak
Recession
Trough
Recovery
Causes of the Business Cycle
• Major innovations (railroad, automobile,
etc…) cause fluctuations
• Political events (e.g., war)
• Monetary: increases/decreases in money
supply
• Psychology—optimism and pessimism
• Fiscal: changes in government spending and
taxes
Noncyclical Fluctuations
• Changes in business activity not resulting
from business cycle:
– Pre-Christmas and Pre-Easter
• Secular Trend: expansion and contraction of
business cycle over a long period of years.
Durables/Nondurables
• Nondurables are “insulated” from most severe
effects of recession
• Durables (e.g., housing, commercial building,
heavy capital goods, refrigerators, gas ranges,
cars) are most affected due to:
• Postponability
• Monopoly power: reluctant to lower prices and set
off price war
• Durables benefit most from expansion
Types of Unemployment
Frictional Unemployment
• Search unemployment
• Wait unemployment: temporarily laid off
Structural Unemployment
• Changes in consumer demand
• Mismatch between their skills and skills
required
• Geographical mismatch between their
location and location of job openings
• Discrimination
Seasonal Unemployment
• Jobless during seasons/times of the year
Cyclical Unemployment
• Caused by lower total spending
Full Employment Unemployment
rate
•
•
•
•
•
•
•
•
•
Natural rate of unemployment
Cyclical unemployment = 0
4-6%
Not automatic: It has declined because:
Percentage can possibly change over time: 1960s—4%; 1980s—6%
Number of younger workers has declined
Temporary help agencies
Welfare laws require people to work
Prison population has increased removing the least employable people
Unemployment Rate
• (Unemployed/labor force) X 100
• Does not measure properly :
• Underemployment:
Part-time employment
Over-qualified
• Discouraged Workers: the jobless who have
stopped looking for work
Economic Cost of
Unemployment
Okun’s Law
• For every 1 percentage point which the
actual unemployment rate exceeds the
natural rate, a GDP gap of about 2 percent
occurs
• GDP Gap: amount by which actual GDP
falls short of potential GDP
Unequal Burdens of
Unemployment
• Occupation: white collar workers less affected
than blue collar workers
• Age: teenagers more unemployed than adults
• Race: minorities more unemployed than whites
• Gender: very similar
• Education: less educated more unemployed
• Duration: long-period unemployment (at least 15
weeks) is less than overall unemployment rate, but
it rises during recessions
Noneconomic Costs
• Psychological depression
• Family problems
• Sociopolitical unrest
INFLATION
Inflation
• A general rise in the price level
CPI
• Consumer Price Index
• Measures the value of the market basket of
goods in a given year compared to its value
in the base year (1982-1984)
• 154 in 1992: prices are 54% higher in 1992
compared to the base year
• 40 in 1950: prices are 60% lower in 1950
compared to the base year.
Rate of Inflation
• CPIpresent – CPIpast X 100
CPIpast
Rule of 70
• Number of years it takes for inflation to
double the price level
• = 70/annual percentage rate of inflation
Causes of Inflation
Demand Pull Inflation
• Total spending is greater than economy’s
capacity to produce
• Too much spending chasing too few goods
Demand Pull Inflation: Range 1
• Output and total spending is relatively low
• Unemployment high
• As total spending increases, real domestic
output will increase with no change in the
price level
Unemployed workers do not ask for salary
increases when called back to work
Demand Pull Inflation: Range 2
• Prices will rise before full employment is
reached since:
Some industries may reach full capacity
before others
• As full employment is reached, firms may
hire less qualified workers
• If unemployment falls below natural rate,
inflation increases at a more rapid rate
Demand Pull Inflation: Range 3
• firms respond to increases in demand by
raising prices
Cost-Push (Supply-Side)
Inflation
• Output and employment declining and prices
increasing
• Per-unit costs increasing
• Caused by:
• OPECstagflation
 Wage-price spiral
• Rising production costs
• Wage-push variant: unions set higher wages and
set a standard for non-union workers in other
firms
Redistribution Effects of
Unanticipated Inflation
• Fixed incomers are hurt
Social Security is not fixed income due to
COLAs
• Savers are hurt
• Creditors are hurt
• Debtors benefit because the money they pay
back is worth less than the money they
borrowed
Inflation Premium
• Increasing interest rate by the amount of the
anticipated inflation
• Nominal interest rate = real interest rate +
inflation premium
Hyperinflation
• Extremely rapid inflation
• 828 octillion pengos (1934) = 1 pengo pre-war in
Hungary
• Prices rose 116 times in Japan from 1938 to 1948
• Prices rose 1,300,000,000,000 time in Germany in
1923 (butter = 1.5 million marks, postage =
200,000 marks, bread = 200,000 marks, 1 egg =
600,000 marks
Redistribution Effects of
Unanticipated Inflation
• Consumers: real income decreases
• Poor are more affected by inflation because
they spend a greater percentage of their
income than wealthier people (regressive)
Deflation
• A general decline in prices
• Deflationary expectations can set in:
consumers will hold off on certain purchases
(especially durables)—AD decreasing
• Firms will lower prices, which will reinforce
deflationary expectations
• Result in a GDP declining and possibly a
recession or even a depression
Problems
• Text (3, 5, 7, 10) – pg 151