Download Business Cycles, Unemployment, & Inflation

Chapter: 8
Unemployment
and
Inflation
Krugman/Wells
©2009  Worth Publishers
Two major economic problems resulting
from Business cycles
1. Unemployment
The Costs of Unemployment are
• The loss of output for the Economy and loss of income for
the individual.
– Okun's law: For every 1% increase in the unemployment
rate, Real GDP declines by 2%
– Leads to increases in Poverty
• Loss of Human Capital
– Human capital is the skills & knowledge of workers
• Social and Political problems
2. Inflation: An increase in the overall Price level as
measured by a price index.
Sometime referred to as an increase in the cost of living.
Defining Unemployment
• Employment is the number of people currently
employed in the economy, either full time or part time.
• Unemployment is the number of people who are
actively looking for work but aren’t currently employed.
• The labor force is equal to the sum of employment
and unemployment.
• Official unemployment statistics are done by
– Bureau of Labor Statistics (BLS) {www.bls.gov}
– Every month, the U.S. Census Bureau surveys 60,000
households to establish the sex, age, and job market
status of each member of the household.
– Called the Current Population Survey (CPS)
Measuring Unemployment
BLS definitions of employment (during the survey week):
Worked at least 1 hour for pay or profit outside the home
or inside the home for pay or
Worked 15 hours or more in a family owned business or
Have a job, but did not work in the survey week due to
illness or vacation, etc.
BLS definitions of unemployed (during the survey week):
• Do not have a job, and are available for work...
…and have actively looked for work the past 4 weeks
•
Register at employment office
•
Looking through the help wanted ad's
•
Waiting to start a new job or recall from layoff
If not in either category then the person is
classified as not in the Labor force.
Measuring Unemployment
Working Age Population = 238.1
Not in LF + Labor Force
Under 16 and
(154.1)
(84.0)
Institutionalized
(72.3)
Not in the
Labor Force
(84.0)
Total
Population
(310.4)
Employed
(139.2)
Unemployed(14.86)
14.86 = 9.6%
154.1
Labor
Force
(154.1)
Interpretation: The
percentage of the
labor force that is
unemployed
BLS data: Aug 2010
Under 16 and
Institutionalized
(72.3)
Not in the
Labor Force
(84.0)
Total
Population
(310.4)
Employed
(139.2)
154.1
= 64.7%
238.1
Interpretation:
How much of the
Labor eligible population
Force desires to take
(154.1) part as potential
workers in the
economy
Unemployed(14.86)
BLS data: Aug 2010
Long term economic growth
leads to more jobs. Population
increase also will lead to more
employment
There are always some jobs that are destroyed; but during
expansions more jobs are created than destroyed.
Source:BLS
The average
participation rate has
increased:59 to 66.5%
The labor force
participation rate of men
has decreased: 83 to 72%
The labor force
participation rate of
women has increased:
38 to 59.5%
since 1960
The unemployment rate 1961 - 2010
1. Unemployment rises during recessions
2. Unemployment declines during expansions
3. Unemployment is lowest at the peak of a business cycle
Unemployment rate 2000 – August 2010
Source:BLS
Recession
MI
U.S.
Economics in Action: Rocky Mountain Low
• In addition to estimating the unemployment rate for the
nation as a whole, the U.S. government also estimates
unemployment rates for each state.
• In July 2007 the unemployment rate in Montana, like
that in other mountain states, was very low: just 2.7%.
Meanwhile, Michigan had a 7.2% unemployment rate.
• Montana was doing well mainly because the state’s
booming oil business was creating new jobs even as
the state’s aging population reduced the size of the
labor force. Michigan was at the opposite extreme.
• Layoffs by auto manufacturers, the traditional
mainstay of Michigan’s economy, had given the state
the highest unemployment rate in the nation: 7.2% in
July 2007.
Source: St. Louis Federal Reserve: GEOFRED
Unemployment Rate
• Workers can become unemployed for a variety of
reasons and some are unemployed for short or long
periods of time.
Three basic reasons for why workers become unemployed:
1. Job Losers: Workers who lost their last job
involuntarily usually because their last job was
eliminated.
2. Job Leavers: Workers who quit their last job.
A small part of the unemployment rate is from job
levers, about 1% and it stays constant over the
business cycle.
3. New entrants & Re-entrants: people just entering the
labor force for the first time or coming back after an
absence and are looking for jobs.
Labor Market Flows
Unemployment
ends when a
person is
hired or
recalled….
…or drops
out of the
labor force
Job losers and job leavers become unemployed or leave the
labor force.
Entrants and reentrants become unemployed or get jobs.
Unemployment Rate
Defining who is employed, unemployed, or not in the
labor force is somewhat of a judgment call.
There is no such thing as a perfect economic measure.
So the BLS has more than one measure of
unemployment based on the following problems:
• Discouraged workers are nonworking people who
are capable of working but have given up looking for a
job given the state of the job market.
• Marginally attached workers would like to be
employed and have looked for a job in the recent past
but are not currently looking for work.
• Underemployment is the number of people who work
part time because they cannot find full-time jobs.
Unemployment Rate
Alternative Measures of Unemployment, 1994-2008
Percentage of
labor force
12%
10
8
6
4
2
1994
1996
1998
2000
2002
2004
2006
2008 Year
These broader measures show a higher unemployment rate—but
they move closely in parallel with the standard rate.
Unemployment Rate
Alternative Measures of Unemployment
Unemployment Rate
Growth and Changes in Unemployment, 1949-2007
When Real GDP increases, the
unemployment rate goes down
and when Real GDP decreases
unemployment goes up.
Change in unemployment
rate (percentage
points)
4
3
2
1
Real GDP growth rate
0
−1
−2
−3
−4
−2
0
2
3.4 4
Average growth rate, 1949–2007
6
8
10%
Unemployment Rate
When Real GDP increases, the
unemployment rate goes down
and when Real GDP decreases
unemployment goes up.
The Nature of unemployment
• FRICTIONAL Unemployment is unemployment
due to the time workers spend in job search.
– People are either voluntarily changing jobs, or
entering the workforce to start new jobs, or
reentering the workforce.
• These are qualified workers and their
unemployment does not last a long time.
• The reason they are unemployed is that they can’t
be immediately matched up with potential
employers because of a lack of information in the
job market.
– Why? Information is costly.
The Nature of unemployment
Distribution of the Unemployed by Duration in 2000
In years when the unemployment
rate is low, most unemployed
workers are unemployed for only a
short period.
In 2000, a year of low
unemployment, 45% of the
unemployed had been
unemployed for less than 5 weeks
and 77% for less than 15 weeks.
The Nature of unemployment
• Structural unemployment is unemployment that
results when there are more people seeking jobs in a
labor market than there are jobs available at the
current wage.
Wage
Rate
Structural
unemployment
WF
WE
QD
Labor If the wage rate firms pay
Supply exceeds the market
equilibrium wage rate, WE, the
number of workers, QS, who
would like to work at that
minimum wage is greater than
Minimum
the number of workers, QD,
wage
demanded at that wage rate.
This surplus of labor is
considered structural
Labor
Demand unemployment.
QE
QS
Quantity of Labor
Structural Unemployment
• Minimum wages - a government-mandated floor on
the price of labor.
• Unions - by bargaining for all a firm’s workers
collectively (collective bargaining), unions can often
win higher wages from employers than the market
would have otherwise provided when workers
bargained individually.
• Efficiency wages - wages that employers set above
the equilibrium wage rate as an incentive for better
performance.
• Side effects of government policies - public policies
designed to help workers who lose their jobs;
– these policies can lead to structural unemployment as
an unintended side effect by lowering the cost of being
unemployed.
Structural Unemployment
• Those who are most likely not to be able to find the
scarce jobs are those with a lack of marketable skills
from changes in the Economy.
• Changes in the economy can come from:
Technological change
Consumer demand changes
International competition
• The workers who have lost jobs find their skills are not
in demand and tend to be unemployed for long
periods of time, six months or more.
– These workers need retraining, additional education, or
a new geographic location. It is a long term problem.
Structural Unemployment in Eastern Germany
• A spontaneous popular uprising in 1989 overthrew the
communist dictatorship in East Germany.
• After reunification, employment in East Germany
plunged.
– The economy of the former East Germany has remained
persistently depressed, with an unemployment rate of
more than 16% in 2008.
– East Germany found itself suffering from severe structural
unemployment.
• When Germany was reunified, it became clear that
workers in East Germany were much less productive
than their cousins in the west.
• The result has been a persistently large mismatch
between the number of workers demanded and the
number of those seeking jobs.
The Natural Rate of Unemployment
• The natural rate of unemployment is the normal
unemployment rate around which the actual
unemployment rate fluctuates.
• It is the unemployment rate that arises from the effects
of frictional plus structural unemployment.
• It is considered to be the unemployment rate that
exists when the economy is at Full Employment
• Cyclical unemployment is a deviation in the actual
rate of unemployment from the natural rate.
• It can be positive or negative
– When it is positive the actual unemployment rate is
greater than the natural rate of unemployment. Usually
cause by a recession.
– Since recessions are temporary, cyclical unemployment
will not always exist in the economy.
The Natural Rate of Unemployment
• Natural unemployment =
Frictional unemployment + Structural unemployment
• Cyclical unemployment =
Actual unemployment - Natural unemployment
• The natural unemployment rate does change over
time, but does so gradually. It depends on :
1. Demographics of the Labor Force
Amount of younger vs. older workers
2. Institutional changes
Amount of Labor Unionization
Technological changes in labor market: i.e. internet searching
3. Government Polices
Unemployment compensation
Job Training & employment subsidies
Natural Unemployment around the OECD
The figure shows average unemployment, which is a
rough estimate of the natural rate of unemployment
Natural Rate of Unemployment
• The natural unemployment rate is currently estimated
between 4.8 - 5.8%.
• The level of output associated with full employment
(the natural rate of unemployment) is called:
POTENTIAL OUTPUT or GDP
− The level of output that would exist if the economy were
at Full Employment.
• When Real GDP is different from Potential GDP we
say there is a GDP gap (like in a recession)
• If Real GDP is greater than Potential GDP the unemployment
rate is below the natural rate of unemployment.
• If Real GDP is less than Potential GDP the unemployment
rate is above the natural rate of unemployment.
– Cyclical unemployment exists only when Real GDP is below
Potential GDP.
Source:Congressional Budget Office
Bureau of Economic Analysis
What is Inflation?
• Inflation can be defined as an increase in the price
level measured by a price index or a decline in the
value of a unit of money.
• It is the rate of change that is important, not the actual
price level.
• An economy can function at any price level, but it is
difficult for to function well if average prices are rising
or falling rapidly.
• Calculating real values is important
Real Values
• As a worker you are interested in your pay. But it is
not the amount of money that is important but what
you can buy with it.
• That means your nominal pay relative to the average
price level is what matters. If your nominal wage
nominal wage
real wage =
price index
increases faster than
prices you are better off.
% in real wage = % in Nominal wage - Inflation rate
• Key insight - Not everyone loses with inflation
• Those who’s nominal wages increase faster than inflation
will be better off.
• Those who’s nominal wages increase slower than inflation
will be worse off.
• Problem: It can be very difficult to forecast inflation which
means you don’t know if you will win or lose.
Example: Top 24 Films,Adjusted for Inflation
Title
Year of Release Estimated Domestic Gross in 2010 $ Millions
1)Gone with the Wind 1939 $1,606 21) Fantasia
1941 $660
2) Star Wars IV
1977 $1,416 22)The Godfather
1972 $627
3)The Sound of Music 1965
$1,132
23) Forrest Gump
1999 $624
4)E.T.
1982
$1,127
1964
$621
5)The 10 Command. 1956
$1,041 24) Mary Poppins
1999 $614
6) Titanic
1998
$1,020 25) The Lion King
7)Jaws
1975
$1,018
8)Doctor Zhivago
1965
$986
9)The Exorcist
1973
$879
10)Snow White
1937
$866
11)101 Dalmations
1961
$794
12)Empire Strikes Back 1980
$780
13)Ben-Hur
1959
$779
14)Avatar
2009
$773
15)Return of the Jedi 1983
$748
16)The Sting
1973
$709
17) Raiders of Lost Ark 1981
$701
18)Jurrassic Park
1993
$685
19)The Graduate
1967 $680
20) Star Wars I
1999
$674
Real Values
Source: Box Office Mojo
Real Values
First Oil Shock
Second Oil Shock
A Brief History of Inflation
in the United States with
Time series graphs
1. Inflation seems to be positively
correlated with output. It has
increased during past expansions
and fallen during recessions.
2.The inflation rate the past 50
years averages around 3%.
“Core” Inflation is used by the Federal
Reserve as a measure of how well
Monetary Policy is doing at curbing
inflationary pressures
Energy Prices tend to be
very volatile, much more
than prices of retail goods
Costs of Inflation
Long-term contracts are generally written in dollar terms
That is loans and bonds are paid off years into the future
Loans and bonds are quoted with nominal interest rates –
you pay back in dollars and are paid back in dollars
Question: How much are those dollars worth in the future?
It depends on the expected inflation rate.
Need a real value: real interest rate which is the amount
earned or paid after adjusted for inflation.
How much purchasing power is earn or paid
real interest rate = nominal interest rate – expected inflation
rate it is very difficult to accurately forecast the expected
Since
inflation rate winners & losers are created with unexpected
inflation.
If inflation is greater than expected the debtors win and
creditors lose (pay back loans with less valuable money)
Costs of Inflation
real interest rate = nominal interest rate – expected inflation
rate
If creditors
could accurately forecast inflation in the future
debtors couldn’t benefit since creditors would demand
higher nominal interest rates to compensate them for the
loss in the value of money.
That is nominal interest rates have to include an inflation
premium to compensate creditors for the risk they take if
inflation is higher than expected.
It must be at least the expected inflation rate.
Examples:
1. Adjustable interest rates on loans allows creditors to
change the interest rate periodically.
2. Governments issue inflation indexed bonds where the
principal is adjusted based on changes in the CPI so your
purchasing power is guaranteed.
Nominal interest rates can never be negative
However, real interest rates, especially
short term rates, can occasionally be
negative
Source: Federal Reserve Bank of St. Louis
Costs of Inflation
• Shoe-leather costs are the increased costs of more
frequently going to the bank to get money since you will
want to hold onto less of it on a daily basis.
• Menu cost is the real cost of changing a listed price.
– cost of printing new menus
– cost of printing & mailing new catalogs
– cost of changing tags on items is a store
• The higher is inflation, the more frequently firms must
change their prices and incur these costs.
• Unit-of-account costs arise from the way inflation
makes money a less reliable unit of measurement.
– Distorts the allocation of goods and resources which reduce
the efficiency of the economy.
– Hard to do long term financial planning
– Unfair tax treatment: pay taxes on nominal gains, not real
gains
Economics in Action
Israel’s Experience with Inflation
• In the mid-1980s, Israel experienced a “clean”
inflation: there was no war, the government was
stable, and there was order in the streets.
• But policy errors led to very high inflation.
• The shoe-leather costs of inflation were substantial.
Israelis spent a lot of time moving money in and out of
bank accounts that provided high enough interest
rates to offset inflation.
• Businesses made efforts to minimize menu costs. For
example, restaurant menus often didn’t list prices.
• It was hard for Israelis to make decisions because
prices changed so much and so often.
Another way to estimate how bad
inflation is to use the Rule of 70
Rule of 70: 70 / Annual inflation rate =
Approximate # of years for the price level to
double.
Example: If the inflation rate is 2% per year then it
would take 70/2 = 35 years for the price level to
double
Causes of Inflation
• How Inflation is initiated
1. Desired Spending is greater than ability of the
economy to produce the necessary of goods and
services(demand pull).
"Too much money chasing too few goods"
2. A rise in per unit production costs which causes
firms to raise prices(cost push).
a. Wage increases without productivity increases
b. Supply shock: decline in the supply of an important
input such as oil or food.
Inflation and Deflation
Disinflation is the process of bringing the inflation rate
down
It usually results in a temporarily large increase in the
unemployment
rate
Inflation
The Cost of Disinflation
rate
Inflation
rate
12%
16%
14
12
10
10
8
8
6
6
4
2
1978
1980
1982
1984
1986
1988
Year
Summary
1. Inflation and unemployment are the main concerns of
macroeconomic policy.
2. Employment is the number of people employed;
unemployment is the number of people unemployed and
actively looking for work. Their sum is equal to the labor
force, and the labor force participation rate is the
percentage of the population age 16 or older that is in the
labor force.
3. The unemployment rate can overstate because it counts as
unemployed those who are continuing to search for a job
despite having been offered one (that is, workers who are
frictionally unemployed). It can understate because it
ignores frustrated workers, such as discouraged workers,
marginally attached workers, and the underemployed.
Summary
4. The unemployment rate is affected by the business cycle.
The unemployment rate generally falls when the growth
rate of real GDP is above average and generally increases
when the growth rate of real GDP is below average.
5. Job creation and destruction, as well as voluntary job
separations, lead to job search and frictional
unemployment. In addition, a variety of factors such as
minimum wages, unions, efficiency wages, and
government policies designed to help laid-off workers
result in a situation in which there is a surplus of labor at
the market wage rate, creating structural unemployment.
As a result, the natural rate of unemployment, the sum of
frictional and structural employment, is well above zero,
even when jobs are plentiful.
Summary
6. The actual unemployment rate is equal to the natural rate
of unemployment plus cyclical unemployment.
7. The natural rate of unemployment changes over time.
8. Policy makers worry about inflation as well as
unemployment.
9. Inflation does not, as many assume, make everyone poorer
by raising the level of prices. That's because wages and
incomes are adjusted to take into account a rising price
level, leaving real wages and real income unaffected.
However, a high inflation rate imposes overall costs on the
economy: shoe-leather costs, menu costs, and unit-ofaccount costs.
Summary
10. Inflation can produce winners and losers within the
economy, because long-term contracts are generally
written in dollar terms. Loans typically specify a nominal
interest rate, which differs from the real interest rate due
to inflation. A higher-than-expected inflation rate is good
for borrowers and bad for lenders. A lower-than expected
inflation rate is good for lenders and bad for borrowers.
11. Disinflation is very costly, so policy makers try to prevent
inflation from becoming excessive in the first place.