Download Who are the Unemployed?

Survey of ECON
Chapter 11
© AP PHOTO
Robert L. Sexton
Introduction to
Macroeconomics:
Unemployment, Inflation,
and Economic
Fluctuations
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Chapter 11 Sections
– Macroeconomic Goals
– Employment and Unemployment
– Types of Unemployment
– Reasons for Unemployment
– Inflation
– Economic Fluctuations
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Macroeconomic Goals
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Section 1
SECTION 1 QUESTIONS
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Macroeconomic Goals
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Three Major Macroeconomic
Goals
REAL GROSS DOMESTIC PRODUCT (RGDP)
the total value of all final goods and services
produced in a given period, such as a year or a
quarter, adjusted for inflation
• The term real gross domestic product (RGDP)
is used to measure output or production.
• The term real is used to indicate that the output
is adjusted for the general increase in prices
over time.
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Acknowledging Our Goals: The
Employment Act of 1946
• The Employment Act of 1946 and the
Full Employment and Balanced Growth
Act of 1978 (the Humphrey– Hawkins
Act) committed the U.S. government to
pursuing unemployment policies that
were also consistent with price stability.
• It first acknowledged formally primary
macroeconomic goals.
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Section 1
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Employment and
Unemployment
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Section 2
SECTION 2 QUESTIONS
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The Consequences of High
Unemployment
• The news of lower unemployment usually
sends stock prices higher; and the news
of higher unemployment usually sends
stock prices lower.
• Politicians are also concerned about the
unemployment figures because elections
often hinge precariously on whether
unemployment has been rising or falling.
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The Consequences of High
Unemployment
• A loss of a job can mean financial insecurity
and a great deal of anxiety.
• High rates of unemployment in a society
can increase tensions and despair.
– Society loses potential output of goods when
some of its productive resources—human or
nonhuman—remain idle, and potential
consumption is reduced.
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The Consequences of High
Unemployment
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© Masterfile
• Thus a loss in efficiency occurs when people
willing to work and equipment able to produce
remain idle.
• Other things being equal, relatively high rates of
unemployment are viewed almost universally as
undesirable.
What is the Unemployment
Rate?
• When discussing unemployment,
economists and politicians refer to the
unemployment rate.
• To calculate the unemployment rate, you
must first understand another important
concept—the labor force.
• It includes the number of people over the
age of 16 who are available for
employment.
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What is the Unemployment
Rate?
• The civilian labor force figure excludes
people in the armed services and those in
prisons or mental hospitals.
• Other people regarded as outside the
labor force include homemakers, retirees,
and full-time students.
• This is because they are not considered
currently available for employment.
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SOURCE: Bureau of Labor Statistics, Current Population Survey, Employment Situation Summary Table A. Washington D.C., March
5, 2010. Available at http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010).
Exhibit 11.1: The U.S. Labor Force, 2010
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What is the Unemployment Rate?
• To calculate the unemployment rate, we
simply divide the number of unemployed
by the number in the civilian labor force:
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What is the Unemployment
Rate?
• In August 2009, the number of civilians
unemployed in the United States was
14.46 million, and the civilian labor force
totaled 154.5 million.
• Thus the unemployment rate in August
2009 was 9.4 percent.
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The Worst Case of U.S.
Unemployment
• By far, the worst employment downturn in
U.S. history occurred during the Great
Depression, which began in late 1929
and continued until 1941.
– Unemployment rose from only 3.2 percent of
the labor force in 1929 to more than 20
percent in the early 1930s, and double-digit
unemployment persisted through 1941.
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The Worst Case of U.S.
Unemployment
• Some economists would argue that
modern macroeconomics, with its
emphasis on the determinants of
unemployment and its elimination, truly
began in the 1930s.
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Variations in the
Unemployment Rate
• Unemployment since 1960 ranged from a
low of 3.5 percent in 1969 to a high of
10.8 percent in 1982.
• The financial crisis of 2008 led to
unemployment rates of 9.4 percent by
mid-2009.
• Before 1960, variations in unemployment
were more pronounced.
21
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SOURCE: Bureau of Labor Statistics, CPS Tables, Annual Averages—Household Data, Employment status of the civilian
noninstitutional population, 1940s to date. Washington, D.C. Available at http://www.bls.gov/cps/tables.htm#empstat
(accessed March 25, 2010).
Exhibit 11.2: U.S. Unemployment Rates,
1960–2009
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Are Unemployment Statistics Accurate
Reflections of the Labor Market?
DISCOURAGED WORKER
an individual who has left the labor force
because he or she could not find a job
• Individuals who have not actively sought
work for four weeks are not counted as
unemployed; instead, they fall out of the
labor force.
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Are Unemployment Statistics Accurate
Reflections of the Labor Market?
• People looking for full-time work who
grudgingly settle for part-time jobs are
counted as “fully” employed, even though
they are only “partly” employed.
• At least partially balancing these two
biases in government employment
statistics, however, is the number of
people who are over-employed—that is,
working overtime or at more than one job.
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Are Unemployment Statistics Accurate
Reflections of the Labor Market?
• A number of jobs in the underground
economy (e.g., drug dealing, prostitution,
gambling, and so on) are not reported.
• In addition, many people may claim they
are seeking work when, in fact, they may
just be going through the motions so they
can continue to collect unemployment
compensation or receive other
government benefits.
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Who are the Unemployed?
• Unemployment usually varies greatly
across different segments of the
population and over time.
• According to the Bureau of Labor
Statistics, the unemployment rate across
the sexes and races among college
graduates is significantly lower than for
those who do not complete high school.
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Education as a Factor in
Unemployment
• College graduates have lower
unemployment rates than people who
have some college education but did not
complete their bachelor’s degrees (3.6
percent).
• The incidence of unemployment varies
widely among the population.
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Age, Sex, and Race as
Factors in Unemployment
• Unemployment tends to be greater
among the very young, among blacks
and other minorities, and among workers
with few skills.
• The unemployment rate for adult females
tends to be higher than that for adult
males.
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Age, Sex, and Race as
Factors in Unemployment
• Considering the great variations in unemployment
for different groups in the population, we calculate
separate unemployment rates for groups
classified by sex, age, race, family status, and
type of occupation.
• Some would regard teenage unemployment a
lesser evil than unemployment among adults,
because most teenagers have parents or
guardians on whom they can rely for subsistence.
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SOURCE: Bureau of Labor Statistics, Current Population Survey, Employment Situation Summary Table A. Washington, D.C.,
March 5, 2010. Available at http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010).
Exhibit 11.3: Unemployment in the
United States by Age, Sex, and Race
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Categories of Unemployed
Workers
• According to the Bureau of Labor
Statistics, the four main categories of
unemployed workers are
JOB LOSER
an individual who has been temporarily laid
off or fired
JOB LEAVER
a person who quits his or her job
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Categories of Unemployed
Workers
REENTRANT
an individual who worked before and is now
reentering the labor force
NEW ENTRANT
an individual who has not held a job before
but is now seeking employment
• It is a common misconception that most
workers are unemployed because they
have lost their jobs.
32
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SOURCE: Bureau of Labor Statistics, Current Population Survey, Employment
Situation Summary Table A. Washington, D.C., March 5, 2010. Available at
http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010).
Exhibit 11.4: Reasons for Unemployment
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How Much Unemployment?
• Even though unemployment is painful to
those who have no source of income,
reducing unemployment is not costless.
• In the short run, a reduction in
unemployment may come at the expense
of a higher rate of inflation, especially if
the economy is close to full capacity,
where resources are almost fully
employed.
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How Much Unemployment?
• Trying to match employees with jobs can
quickly lead to significant inefficiencies
because of mismatches between a worker’s
skill level and the level of skill required for a
job.
• That is, the skills of the employee may be
higher than those necessary for the job,
resulting in what economists call
underemployment.
• Another source of inefficiencies is placing
employees in jobs beyond their abilities.
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How Long are People
Usually Unemployed?
• The duration of unemployment is equally
as important as the amount of
unemployment.
• It is useful to look at the average duration
of unemployment to discover what
percentage of the labor force is
unemployed longer than a certain period,
say 15 weeks.
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How Long are People
Usually Unemployed?
• The duration of unemployment tends to be
greater when the amount of unemployment
is high and smaller when the amount of
unemployment is low.
• The loss of output resulting from
unemployment for any duration is
permanent; it is not made up when
unemployment starts falling again.
37
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SOURCE: Bureau of Labor Statistics, Current Population Survey, Employment Situation Summary Table A. Washington,
D.C., March 5, 2010. Available at http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010).
Exhibit 11.5: Duration of Unemployment
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Labor Force
Participation Rate
• The percentage of the population that is in the
labor force is what economists call the labor
force participation rate.
• Over the last several decades, the number of
women working shifted dramatically, reflecting
the changing role of women in the workforce.
• Today the labor force participation rate for men
has fallen to roughly 71 percent, as many men
stay in school longer and opt to retire earlier.
39
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SOURCE: Bureau of Labor Statistics, Current Population Survey, Table A-1. Employment status of the civilian population by sex and age.
Washington, D.C., March 5, 2010. Available at http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010).
Exhibit 11.6: Labor Force Participation
Rates for Men and Women
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Section 2
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Types of
Unemployment
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Section 3
SECTION 3 QUESTIONS
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Frictional Unemployment
• Frictional unemployment is the
temporary unemployment that results from
the search time that occurs when people
are searching for suitable jobs and firms
are looking for suitable workers.
• People seeking work do not usually take
the first job offered to them.
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Frictional Unemployment
• Likewise, firms do not usually take the first
person they interview.
• People and firms engage in a search to
match up skills and interests.
• While the unemployed are looking, they are
frictionally unemployed.
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Frictional Unemployment
• Whether the unemployment is due to
having been fired or from having voluntarily
quit, frictional unemployment is short term
and results from normal turnover in the
labor market, as when people change from
one job to another.
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Frictional Unemployment
• Some unemployment occurs because
certain types of jobs are seasonal in nature,
called seasonal unemployment.
• Occupations that experience either sharp
seasonal shifts in demand or are subject to
changing weather conditions may lead to
seasonal unemployment—such as in
agriculture where employment increases
during harvest season.
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Frictional Unemployment
• Since this type of unemployment can make
the unemployment rate higher in the offseason and lower during the in-season, the
Bureau of Labor Statistics (BLS) publishes
a seasonally adjusted unemployment rate
as well.
• These figures are more accurate because
they take into account the effects of
seasonal unemployment.
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Should We Worry about
Frictional Unemployment?
• Geographic and occupational mobility are
considered good for the economy
because they generally lead human
resources to go from activities of relatively
low productivity or value to areas of higher
productivity, increasing output in society
as well as the wage income of the mover.
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Should We Worry about
Frictional Unemployment?
• Frictional unemployment involving searches
by firms and workers to find more suitable
match-ups is obviously beneficial to the
economy.
• Although the amount of frictional
unemployment varies somewhat over time,
it is unusual for it to be much less than 2
percent of the labor force.
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Should We Worry about
Frictional Unemployment?
• Actually, frictional unemployment tends to
be somewhat greater in periods of low
unemployment, when job opportunities are
plentiful.
• This high level of job opportunity stimulates
mobility, which, in turn, creates some
frictional unemployment.
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Structural
Unemployment
• Like frictional unemployment, structural
unemployment is related to occupational
movement or mobility—in this case, to a
lack of mobility.
• It occurs when workers lack the necessary
skills for jobs that are available or have
particular skills that are no longer in
demand.
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Structural Unemployment
• The quantity of unemployed workers
conceivably could equal the number of job
vacancies, with the unemployment
persisting because the unemployed lack the
appropriate skills.
• Given the existence of structural
unemployment, it is wise to look at both
unemployment and job vacancy statistics in
assessing labor market conditions.
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Structural Unemployment
• Structural unemployment, like frictional
unemployment, reflects the dynamic
dimension of a changing economy.
• Over time, new jobs open up that require
new skills, while old jobs that required
different skills disappear.
• Government-subsidized retraining programs
are a popular means of reducing structural
unemployment for this reason.
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Structural Unemployment
• Another reason for structural unemployment
is that low-skilled workers are frequently
unable to find desirable long-term
employment.
• Since they acquired no new skill from the
old job, they may not find a long-term
secure job.
• That is, structural workers cannot be said to
be “in-between jobs” like those who are
frictionally unemployed.
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Structural Unemployment
• Structural unemployment is more long term
and serious than frictional unemployment
because these workers do not have
marketable skills.
• The dimensions involved are debatable, due
to the difficulty in precisely defining the term
in an operational sense.
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Some Unemployment Is
Unavoidable
• Frictional and structural unemployment
are simply unavoidable in a vibrant
economy.
• To a certain extent, both can be viewed as
phenomena resulting from imperfections
in the labor market.
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Some Unemployment Is
Unavoidable
• It takes time for suppliers of labor to find the
demanders of labor services, and it takes
time and money for labor resources to
acquire the necessary skills.
• Bringing together demanders and suppliers
of labor services does not occur
instantaneously, because information and
job searches are expensive.
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Cyclical Unemployment
• In years of relatively high unemployment,
some joblessness may result from shortterm cyclical fluctuations in the economy,
called cyclical unemployment.
• An unemployment rate that is greater than
normal, such as during recession, is due
to cyclical unemployment.
• Most attempts to solve the cyclical
unemployment problem emphasized
increasing aggregate demand to counter
recession.
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The Cost of Cyclical
Unemployment
• When the unemployment rate is high,
numerous economic and social hardships
result.
• Economic costs are the forgone output
when the economy is not producing at its
potential level.
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The Cost of Cyclical
Unemployment
• According to Okun’s Law (really, a rule of
thumb), a 1 percent increase in cyclical
unemployment reduces output by 2
percentage points.
• The costs are particularly high for those
groups with the least skills—the poorly
educated and teenagers with little work
experience.
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The Natural Rate of
Unemployment
• Over the period in which annual
unemployment data are available, the
median, or “typical,” annual
unemployment rate has been at or slightly
above 5 percent.
• Some economists call this typical
unemployment rate the natural rate of
unemployment.
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The Natural Rate of
Unemployment
• Abnormally high unemployment exists when
unemployment rises well over 5 percent,
and abnormally low unemployment exists
when it falls below 5 percent.
• The natural rate of unemployment of
approximately 5 percent roughly equals the
sum of frictional and structural
unemployment when they are at their
maximums.
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The Natural Rate of
Unemployment
• Thus, unemployment rates below the natural
rate reflect the existence of below-average
levels of frictional and structural
unemployment.
• Unemployment rates above the natural level
show the existence of cyclical unemployment.
• In short, the natural rate of unemployment is
the unemployment rate when the economy is
experiencing neither a recession nor a boom.
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The Natural Rate of
Unemployment
• The natural rate of unemployment is also
called the full employment rate of
unemployment.
• It can change over time as technological,
demographic, institutional, and other
conditions vary.
• Baby boomers, Internet and improvements
in job placement, and new work
requirements of welfare laws.
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Full Employment and
Potential Output
• When all the resources of an economy—
labor, land, and capital—are fully employed,
the economy is said to be producing its
potential output.
• This means that the economy is providing
employment for all who are willing and able
to work with no cyclical unemployment.
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Full Employment and
Potential Output
• It also means that capital and land are fully
employed.
– At the natural rate of unemployment, all
resources are fully employed, the economy is
producing its potential output, and no cyclical
unemployment is present.
• This, however, does not mean that the
economy will be producing at its potential
output of resources.
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Full Employment and
Potential Output
• For example, when the economy is
experiencing cyclical unemployment, the
unemployment rate is greater than the
natural rate.
• It is also possible for the economy to
temporarily exceed the natural rate as
workers put in overtime or moonlight by
taking on extra employment.
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Section 3
69
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Reasons for
Unemployment
70
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Section 4
SECTION 4 QUESTIONS
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Why Does Unemployment
Exist?
• In many markets, prices adjust to the
market equilibrium price and quantity,
and no prolonged periods of shortage or
surplus occur.
• However, in labor markets, obstacles
prevent wages from adjusting and
balancing the quantity of labor supplied
and the quantity of labor demanded.
72
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Why Does Unemployment
Exist?
• The market equilibrium wage equates the
quantity of labor demanded with the
quantity of labor supplied.
• When the quantity of labor supplied is
greater than the quantity of labor
demanded, an excess quantity of labor
supplied—unemployment—exists.
73
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Why Does Unemployment
Exist?
• More people want to work at the going
(nonequilibrium) wage than employers
want to hire, and those who are not able
to find work are “unemployed.”
• Three reasons are cited for the failure of
wages to balance the labor demand and
labor supply equilibrium—minimum
wages, unions, and the efficiency wage
theory.
74
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Exhibit 11.7: Wages above Equilibrium
Lead to Greater Unemployment
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Minimum Wages and
Unemployment
• The labor market for workers with little
experience and job skills is called the
unskilled labor market.
• Suppose the government decided to
establish a minimum wage rate (an
hourly wage floor) for unskilled workers
above the equilibrium wage.
76
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Minimum Wages and
Unemployment
• At the minimum wage, the quantity of
labor supplied grows because more
people are willing to work at a higher
wage.
• However, the quantity of labor demanded
falls because some employers would find
it unprofitable to hire low-skilled workers
at the higher wage.
77
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Minimum Wages and
Unemployment
• The gap that exists between the quantity
of labor demanded and the quantity
supplied represents a surplus of
unskilled workers—unemployment.
• Because minimum wage earners, a
majority of whom are 25 years or
younger, are a small portion of the labor
force, most economists believe the effect
of minimum wage on unemployment is
small.
78
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The Impact of Unions on
the Unemployment Rate
• If, through the process of collective
bargaining, union officials are able to
raise wages, then unemployment will rise
in the union sector.
• If the union wage increases above the
equilibrium level, the quantity of union
labor demanded will decrease, and the
quantity of union labor supplied will
increase, resulting in the unemployment
of union workers.
79
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The Impact of Unions on
the Unemployment Rate
• The union workers who still have their
jobs will be better off, but some who are
equally skilled will be unemployed and
will either seek nonunion work or wait to
be recalled in the union sector.
• Many believe that is why wages are
approximately 15 percent higher in union
jobs, even when nonunion workers have
comparable skills.
80
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The Impact of Unions on
the Unemployment Rate
• On the other hand, even though wages in
the union sector are typically higher than the
market wage, the presence of unions does
not necessarily lead to greater
unemployment because workers can find
jobs in the nonunion sector.
• Less than 10 percent of private sector jobs
are unionized.
81
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Efficiency Wage
• It is generally assumed that as
productivity rises, wages rise, and
workers can raise their productivity
through investments in human capital
such as education and on-the-job
training.
• Some economists, however, follow the
efficiency wage model, which is based
on the belief that higher wages lead to
greater productivity.
82
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Efficiency Wage
• Under this model, employers pay their
employees more than the equilibrium
wage to be more efficient.
• Proponents of this theory suggest that it
may lead to attracting the most productive
workers, fewer job turnovers, and higher
morale, which in turn can lead to lower
hiring and training costs.
83
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Efficiency Wage
• Since the efficiency wage rate is greater
than the equilibrium wage rate, the
quantity of labor supplied is greater than
the quantity of labor demanded, resulting
in greater amounts of unemployment.
84
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Efficiency Wage
• Some have argued that the positive
effects of the efficiency wage are unique
to assembly line production and its high
degree of worker interdependence.
• However, it is costly for firms to pay an
efficiency wage.
• Consequently, firms must monitor their
workers’ efforts.
85
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Efficiency Wage
• If enough firms resort to paying the
efficiency wage rate, then the average
real wage rate will be greater than the
equilibrium wage.
• Thus, this equilibrium will lead to
unemployment.
86
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Job Search
• Because of frictional unemployment,
some unemployment would exist even if
labor supply and labor demand were
balanced.
• It takes time and money to locate the
best available opportunities.
• Simultaneously, differences exist in job
seekers’ tastes and preferences about
types of jobs and job locations.
87
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Job Search
• Sometimes, getting information about
particular jobs suitable for the right job
candidate is difficult.
• These search activities prolong the
duration of unemployment.
• However, the search goes on because
the job seeker hopes to find a better offer.
88
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Job Search
• The labor demand and supply curves are
constantly shifting.
– That is, labor markets are constantly in flux
as people lose jobs, leave jobs, and reenter
jobs.
• In a growing and dynamic economy, jobs
are constantly being destroyed and
created, leading to temporary
unemployment as workers search for the
best jobs for their skills.
89
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Unemployment Insurance
• Unemployment insurance does not cover
those who were fired or quit their jobs.
• To qualify, recipients must have worked a
certain length of time and lost their jobs
because the employer no longer needed
their skills.
• The typical compensation is half salary
for 26 weeks.
90
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Unemployment Insurance
• Although the program is intended to ease
the pain of unemployment, it also leads to
prolonged periods of unemployment, as
job seekers stay unemployed for longer
periods searching for new jobs.
• It has been estimated that the existence
of unemployment compensation
programs may raise overall
unemployment rates by as much as 1
percent.
91
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Unemployment Insurance
• Without unemployment insurance, a job
seeker would be more likely to take the
first job offered, even if the job did not
match the job seeker’s preferences or
skill levels.
• A longer job search might mean a better
match, but it comes at the expense of lost
production and greater amounts of tax
dollars.
92
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Does New Technology Lead to
Greater Unemployment?
• Generally, new inventions are cost
saving, and these cost savings usually
generate higher incomes for producers
and lower prices and better products for
consumers—benefits that ultimately
result in the growth of other industries.
• If the new equipment is a substitute for
labor, it might displace workers.
93
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Does New Technology Lead to
Greater Unemployment?
• However, new capital equipment requires
new workers to manufacture and repair the
new equipment.
– The most famous example being the computer.
• The problem is that it is easy to see only
the initial effect of technological advances
(displaced workers) but difficult to
recognize the implications of that invention
throughout the whole economy over time.
94
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Does New Technology Lead to
Greater Unemployment?
• Some economists believe that some of
the real wage differentials between skilled
and unskilled workers in the last couple of
decades are due to technical changes
that are biased toward skilled workers.
• New machines, with highly sophisticated
computerization, require highly skilled
workers.
95
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Does New Technology Lead to
Greater Unemployment?
• Consequently, the new machines make
these workers more productive and they
therefore receive higher real wages.
– With an increase in demand for skilled labor,
their real wages and employment are higher.
– Simultaneously, the demand is lower for
workers without technical training in specialized
machinery, and the demand falls.
96
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Does New Technology Lead to
Greater Unemployment?
• As a result of the decrease in demand for
unskilled workers, real wages and
employment fall.
• Thus, skill-biased technical change tends
to create even greater disparities
between the wages of skilled and
unskilled workers.
97
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Exhibit 11.8: Skill-Biased Technical
Change and Wage Inequality
98
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Section 4
99
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Inflation
100
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Section 5
SECTION 5 QUESTIONS
101
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Inflation
PRICE LEVEL
the average level of prices in the economy
• Most prices in the U.S. economy tend to
rise over time.
INFLATION
a rise in the overall price level, which
decreases the purchasing power of money
102
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Stable Price Level as a
Desirable Goal
• Even when the level of prices is stable,
some prices will be rising while others
are falling.
• When inflation is present, the goods and
services with rising prices will outweigh
the goods and services with lower prices.
103
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Stable Price Level as a
Desirable Goal
• Without stability in the price level,
consumers and producers will experience
more difficulty in coordinating their plans
and decisions.
• When the overall price level is falling, it is
called deflation.
• The average price level in the U.S.
economy fell throughout the late
nineteenth century.
104
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Stable Price Level as a
Desirable Goal
• In general, the only thing that can cause a
sustained increase in the rate of inflation
is a high rate of growth in money.
105
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Measuring Inflation
• Inflation distorts the information that flows
from price signals.
• To measure the changing purchasing
power of the dollar, we must construct a
price index.
• A price index attempts to provide a
measure of the prices paid for a certain
bundle of goods and services over time.
106
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The Consumer Price Index
and the GDP Deflator
CONSUMER PRICE INDEX (CPI)
a measure of the cost of a market basket
that represents the consumption of a typical
household
• The typical CPI shopping basket is
shown in Exhibit 11.9.
GDP DEFLATOR
a price index that helps measure the
average price level of all final consumer
goods and services produced
107
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SOURCE: Bureau of Labor Statistics,
Consumer Price Index - February 2010,
Table 1. Consumer Price Index for All
Urban Consumers. Washington, D.C.,
March 18, 2010. Available at
http://www.bls.gov/news.release/cpi.t01.
htm (accessed March 25, 2010).
Exhibit 11.9: The Typical CPI Shopping
Basket of Goods and Services
108
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How is a Price Index
Created?
• Literally thousands of goods and services are in our
economy; attempting to include all of them in an index
would be cumbersome and make the index expensive
to compute, and it would take a long time to gather the
necessary data.
• Hence, a “bundle” or “basket” of representative goods
and services is selected by the index calculators (the
Bureau of Labor Statistics of the U.S. Department of
Labor for consumer and wholesale price indices; the
Office of Business Economics of the Department of
Commerce for the GDP deflator).
109
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Calculating a Simple Price Index
• Suppose a consumer typically buys 24
loaves of bread and 12 gallons of milk in
a year.
110
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Calculating a Simple Price Index
• Using the numbers from the table and the
following formula, we can calculate a price
index to measure the inflation rate.
111
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Calculating a Simple Price Index
• The year 2010 is designated as the base
year, so its value is set equal to 100.
• That is, the price index for 2012 compared
with 2010 is 125.
• Therefore, using the price index formula, we
can say that prices are 25 percent higher in
2012 than they were in 2010, the base year.
112
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SOURCES:Bureau of Labor Statistics, Consumer Price Index, Table Containing History of CPI-U U.S. All Items Indexes and Annual Percent
Changes From 1913 to Present. Washington, D.C., March 18, 2010. Available at ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt (accessed
March 25, 2010). Bureau of Economic Analysis, National Economic Accounts, Current-dollar and “real” GDP. Washington, D.C., February 26,
2010. Available at http://bea.gov/national/index.htm#gdp (accessed March 25, 2010).
Exhibit 11.10: The CPI and the
GDP Deflator
113
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The Price Level over the
Years
• What is the historical record of changes in
the overall U.S. price level?
• The problem with comparing prices today
with prices in the past is that it focuses on
the number of dollars it takes to buy
something, rather than the purchasing
power of the dollar.
114
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SOURCE: Bureau of Labor Statistics, Consumer Price Index, Table Containing History of CPI-U U.S. All Items Indexes and Annual Percent
Changes From 1913 to Present. Washington, D.C., March 18, 2010. Available at ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt (accessed
March 25, 2010).
Exhibit 11.11: The Inflation in the
United States, 1913–2009
115
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Who Loses with Inflation?
• Inflation brings about changes in peoples’
purchasing power, and these changes
may be either desirable or undesirable.
• Your real income—your income adjusted
to reflect changes in purchasing power—
falls.
116
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Who Loses with Inflation?
• Inflation lowers income in real terms for
people on fixed-dollar incomes.
• Likewise, inflation can hurt creditors.
– If the lender does not correctly anticipate the
higher rate of inflation, the borrower is paying
back with dollars that have much less
purchasing power than those dollars they
borrowed in periods of lower inflation.
117
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Who Loses with Inflation?
• People whose incomes are tied to long-term
contracts also sometimes lose out, at least
temporarily, due to high inflation.
• If inflation begins shortly after a labor union
signs a three-year wage agreement, it may
completely eat up the wage gains provided
by the contract.
• Businesses that agree to sell quantities of
one thing, for a fixed price for a given
number of years.
118
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Who Loses with Inflation?
• Debtors pay back dollars worth less in
purchasing power than those borrowed.
• Corporations that can quickly raise the
prices on their goods may have revenue
gains greater than their increases in costs,
providing additional profits.
119
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Who Loses with Inflation?
• Wage earners sometimes lose from inflation
because wages may rise at a slower rate
than the price level.
• The redistributional impact of inflation is not
the result of conscious public policy; it just
happens.
120
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Who Loses with Inflation?
• The uncertainty that inflation creates can
also discourage investment and economic
growth.
• When inflation rates are high, they also tend
to vary considerably, which creates a lot of
uncertainty.
• Moreover, inflation can raise one nation’s
price level relative to price levels in other
countries.
121
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Who Loses with Inflation?
• In turn, this shift can make financing the
purchase of foreign goods difficult, or it can
decrease the value of the national currency
relative to that of other countries.
122
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• A slow predictable rate of inflation makes
predicting future price increases relatively
easy.
• Consequently, setting interest rates will be
an easier task and the redistribution effects
of inflation will be minimized.
123
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PHOTO ILLUSTRATION BY CENAGE / © JULIA ROBERTSON/GETTY IMAGES
Costs of High Inflation
Costs of High Inflation
• High and variable inflation rates make it
almost impossible to set long-term contracts
because prices and interest rates may be
changing by the day, or even by the hour in
the case of hyperinflation—extremely high
rates of inflation for sustained periods of
time.
124
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Costs of High Inflation
• In its extreme form, inflation can lead to a
complete erosion of faith in the value of the
pieces of paper we commonly call money.
• Unchecked inflation can feed on itself and
may ultimately lead to hyperinflation of 300
percent or more per year.
125
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Costs of High Inflation
• Most economists believe we can live quite
well in an environment of low, steady
inflation, but no economist believes we can
prosper with high, variable inflation.
126
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Other Costs of Inflation
• This includes the cost incurred by firms as
a result of being forced to change prices
more frequently.
• These costs are called menu costs; they
are the costs of changing posted prices.
127
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Other Costs of Inflation
• The shoe-leather cost of inflation is the
cost of going to and from the bank to check
on your assets (so often that you wear out
the leather on your shoes).
• Specifically, high rates of inflation erode the
value of a currency, which means that
people will want to hold less currency.
128
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Other Costs of Inflation
• That is, the higher inflation rates lead to
higher nominal interest rates, which may
induce more individuals to put money in the
bank rather than allowing it to depreciate in
their pockets.
• The effects of shoe-leather costs of inflation
are modest in countries with low inflation
rates but can be quite large in countries with
high inflation.
129
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Do Creditors Always Lose
during Inflation?
• Usually, lenders are able to anticipate
inflation with reasonable accuracy.
• If the inflation rate is anticipated
accurately, new creditors will not lose nor
will debtors gain from a change in the
inflation rate.
130
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Do Creditors Always Lose
during Inflation?
• However, nominal interest rates and real
interest rates do not always run together.
• For example, in periods of high unexpected
inflation, the nominal interest rates can be
high when the real interest rates are low or
even negative.
131
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Protecting Ourselves
from Inflation
• Increasingly, groups try to protect
themselves from inflation by means of
cost-of-living clauses in contracts.
• Many long-term contracts between firms
and unions include a cost of living
allowance (COLA) that automatically
increases when the consumer price index
(CPI) increases.
132
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Protecting Ourselves from
Inflation
• With these clauses, laborers automatically
get wage increases that reflect rising prices.
• The same is true of many pensioners,
including those on Social Security.
• Personal income taxes also are now
indexed (adjusted) for inflation.
133
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Protecting Ourselves from
Inflation
• However, some of the tax code is still not
indexed for inflation.
– These factors affect the incentives to work,
save, and invest.
• Some argue for indexing everything,
meaning that all contractual arrangements
would be adjusted frequently to take
account of changing prices.
134
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Protecting Ourselves from
Inflation
• Such an arrangement might reduce the
impact of inflation, but it would also entail
additional contracting costs (and not every
good—most notably, currency—can be
indexed).
135
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Protecting Ourselves
from Inflation
• An alternative approach has been to try to
stop inflation through various policies
relating to the amount of government
spending, tax rates, and the amount of
money created.
• Wage and price controls—legislation
limiting wage and price increases—offer
still another approach to the inflation
problem.
136
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Section 5
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Economic Fluctuations
138
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Section 6
SECTION 6 QUESTIONS
139
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Economic Fluctuations
• The aggregate amount of economic
activity in the United States and most
other nations has increased markedly
over time, even on a per capita basis,
indicating economic growth.
• Short-term fluctuations in the level of
economic activity also occur.
140
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Short-Term Fluctuations
in Economic Growth
• These short-term fluctuations are
sometimes called business cycles.
• Over a long period, the economic activity
line slopes upward, indicating increasing
real output.
• Over short periods, however, downward,
as well as upward, output changes occur.
141
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Short-Term Fluctuations
in Economic Growth
• Business cycles refer to the short- term ups
and downs in economic activity, not to the
long-term trend in output, which in modern
times has been upward.
142
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Exhibit 11.12: Business Cycles and
Economic Growth
143
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The Phases of a Business
Cycle
• A business cycle has four phases:
– Expansion
– Peak
– Contraction
– Trough
144
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The Phases of a Business
Cycle
• The period of expansion is when output
(real GDP) is rising significantly.
– During the expansion phase, unemployment is
falling and both consumer and business
confidence are high.
– Investment and expenditures for expensive
durable consumer goods rises.
145
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The Phases of a Business
Cycle
• The peak is the point in time when the
expansion comes to an end, when output is
at the highest point in the cycle.
• The contraction is a period of falling real
output and is usually accompanied by rising
unemployment and declining business and
consumer confidence.
146
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The Phases of a Business
Cycle
• The contraction phase is measured from the
peak to the trough—the point in time when
output stops declining and business activity
is at its lowest point in the cycle.
– Investment spending and expenditures on
consumer durable goods fall sharply in a typical
contraction.
147
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The Phases of a Business
Cycle
• The contraction phase is also called
recession, a period of significant decline in
output and employment.
• Unemployment is relatively high at the
trough, although the actual maximum
amount of unemployment may not occur
exactly at the trough.
148
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The Phases of a Business
Cycle
• Often, unemployment remains fairly high
well into the expansion phase.
• The expansion phase is measured from the
trough to the peak.
149
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Exhibit 11.13: Four Phases of a Business
Cycle
150
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How Long Does a
Business Cycle Last?
• Since the term business cycle does not
have the regularity that the term cycle
implies, economists often use the term
economic fluctuation.
• In addition, economic fluctuations are
almost impossible to predict.
• The contraction phase is one of recession,
a decline in business activity.
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How Long Does a Business
Cycle Last?
• A severe recession is called a depression.
• A prolonged expansion in economic activity
is sometimes called a boom.
– The National Bureau of Economic Research
(NBER) Business Cycle Dating Committee
determined that a recession began in March
2001, ending an expansion beginning March
1991, due to the September 11, 2001 attack.
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Exhibit 11.14: A
Historical Record
of U.S.
Recessions,
1920–2009
SOURCES: National Bureau of Economic Research, Inc.,
Business Cycle Expansions and Contractions, U.S.
Department of Commerce. Washington, D.C., December 1,
2008. Available at http://www.nber.org/cycles.html
(accessed March 18, 2010).
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Seasonal Fluctuations
Affect Economic Activity
• Business activity, whether measured by
production or by the sale of goods, tends
to be high in the two months before the
winter holidays and somewhat lower in the
summer, when many families are on
vacation.
• Within individual industries, of course,
seasonal fluctuations in output often are
extremely pronounced, agriculture being
the best example.
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Seasonal Fluctuations
Affect Economic Activity
• Key economic statistics, such as
unemployment rates, are seasonally
adjusted, meaning the numbers are
modified to account for normal seasonal
fluctuations.
• Thus, seasonally adjusted unemployment
rates in summer months are below actual
unemployment rates, because employment
is normally high in summertime due to the
inflow of school-age workers into the labor
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force.
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Forecasting Cyclical
Changes
• Businesses, government agencies, and,
to a lesser extent, consumers rely on
economic forecasts to learn of
forthcoming developments in the business
cycle.
– If it looks as if the economy will continue in an
expansionary phase, businesses may expand
production to meet a perceived forthcoming
need; if it looks as if contraction is coming,
businesses may decide to be more cautious.
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Forecasting Models
• Using theoretical models, economists gather
statistics on economic activity in the
immediate past, including, for example,
consumer expenditures, business
inventories, the supply of money,
governmental expenditures, tax revenues,
and so on.
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Forecasting Models
• Using past historical relationships between
these factors and the overall level of
economic activity (which form the basis of
the economic theories), they formulate
econometric models.
• Statistics from the immediate past are
plugged into the model, and forecasts are
made.
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Leading Economic
Indicators
• One less sophisticated but useful forecasting tool is
watching trends in leading economic indicators.
– Some types of economic activity change before the
economy as a whole changes.
– About a dozen such leading indicators exist,
including the lengths of the average workweek, the
size of the nation’s money supply, prices of
common stocks, the number of new businesses
formed, and new orders for plants and equipment.
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Leading Economic
Indicators
• The Department of Commerce combines all
these into an index of leading indicators.
– If the index rises sharply for two or three
months, it is likely, but uncertain, that increases
in the overall level of activity will follow.
• Although the composite index of leading
economic indicators has never failed to give
some warning, the lead time has varied
widely.
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Leading Economic
Indicators
• This variance in lead time can cause
particular policy problems.
• Specifically, the use of leading economic
indicators to predict future trends can make
policy decisions less accurate.
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Leading Economic
Indicators
• If the federal government responds with
policies to combat the recession as soon as
the leading economic indicators begin
predicting a recession, then the recession
that would have occurred may fail to
materialize.
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Leading Economic
Indicators
• On the other hand, a self-fulfilling prophecy
may result if businesses respond with
cutbacks in orders for plants and equipment
as soon as the leading economic indicators
begin predicting a recession.
• The economic indicators do provide a
warning of a likely downturn, but they do not
provide accurate information on the depth or
duration of the downturn.
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Section 6
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