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Unemployment and Inflation

Chapter 23

© 2006 Thomson/South-Western

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Costs of Unemployment

Personal CostLoss of paycheckLoss of self-esteemIncrease in stress related psychological

problemsIncrease in incidence of crime, suicide, and

mental illness

Economic CostLoss in output

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Measuring Unemployment

Civilian Noninstitutional Adult Population All civilians 16 years of age and older Excludes institutionalized in prisons or mental

hospitals Excludes those in military

Labor force Those in the adult population who are either working

or looking for work

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Measuring Unemployment

Unemployed Those with no job who are looking for work

Unemployment rate Measures the percentage of those in the labor force

who are unemployed Equals the number unemployed divided by the

number in the labor force Does not include discouraged workers

Discouraged workers Those who are no longer looking for work but are

unemployed

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Exhibit 1: The Adult Population Sums the Employed, the Unemployed, and Those Not in the Labor Force

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Labor Force Participation Rate

The number in the labor force divided by the adult population

On average, two out of three adults are in the labor force

Increased from about 60% in 1970 to approximately 67% in 1990 and has remained relatively constant since

Convergence of the participation rates of men and women over last 40 years as more women enter the labor force

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Trend of Unemployment Rate

Decline in the unemployment rate over last 20 years Overall growth in the economy Relatively fewer teenagers in the work force

Unemployment rate says nothing about who is unemployed or for how long – differs across

RaceGenderAgeGeographical areaOccupational group

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Exhibit 2: The U.S. Unemployment Rate Since 1900

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Exhibit 3: Unemployment Rates for Various Groups

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Exhibit 3: Unemployment Rates for Various Groups

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Exhibit 4: Unemployment Rates Differ Across U.S. Metropolitan Areas

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Sources of Unemployment

FrictionalSeasonalStructuralCyclical

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Frictional Unemployment

Caused by time required to bring together labor suppliers and labor demanders Employers need time to learn about the talent

available Job seekers need time to learn about employment

opportunities

Generally short-term and voluntary

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Seasonal Unemployment

Caused by seasonal changes in labor demand during the year

To eliminate the impact of such changes, monthly unemployment statistics are seasonally adjusted, which smoothes out these factors

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Structural Unemployment

Exists because unemployed workers often Do not have the skills demanded by employers, or Do not live where their skills are in demand

Occurs because changes in tastes, technology, taxes, or competition reduce the demand for certain skills and increase the demand for other skills

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Cyclical Unemployment

Fluctuates with the business cycle, increasing during contractions and decreasing during expansions

Means the economy is operating inside its PPF

Government policies to stimulate aggregate demand recessions is aimed at reducing this type of unemployment

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Full Employment

Occurs only if there is no cyclical unemployment Occurs when the only unemployment is

frictional, structural, or seasonalDoes not mean zero unemploymentFrictional, seasonal, and structural

unemployment can still occur

Occurs when from 4% to 6% of the labor force is unemployed

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Unemployment Compensation

Cash transfers for those who lose their jobs and actively seek employment

Applies to unemployed workers who meet certain qualifications

Problems with unemployment compensation:Workers who receive benefits tend to search

less actively than those who don’tMay reduce the urgency of finding work

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International Comparisons

Why are unemployment rates so high in Europe? Ratio of unemployment benefits to average pay is

higher Unemployment benefits last longer, sometimes

years, so workers have less incentive to find new jobs

Government regulations make employers in Europe reluctant to hire new workers because firing them is difficult

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Exhibit 5: In the Last Two Decades, Unemployment Rates Fell in the United States, Rose in Japan, and

Remained High in Europe

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Problems with Unemployment Figures

Understate the actual amount of unemployment because they do not include discouraged workers and underemployed

Underemployment occurs when people are counted as employed even if they

can find only part-time jobs orAre vastly overqualified for their job

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Problems with Unemployment Figures

Tend to overstate unemployment because Employment insurance and most welfare programs

require recipients to seek employment Some who would prefer to work part time can find

only full-time work Some are forced to work overtime and weekends, but

would prefer to work fewer hours People in the underground economy may not readily

acknowledge such jobs because their intent is to evade taxes

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Inflation

Inflation: a sustained increase in the average price level

Hyperinflation: extremely high inflation Deflation: a sustained decline in the

average price levelDisinflation: a reduction in the rate of

inflation

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Inflation

Inflation is typically measured annually

Annual inflation rate is the percentage increase in the average price level from one year to the next

Two sources of inflationDemand-pull inflationCost-push inflation

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Exhibit 6a: Inflation Caused by Shifts of AD and AS Curves

Increase in the AD curve pulls up the price level. To generate continuous demand-pull inflation, the AD curve must keep shifting outward along a given AS curve

Increase in costs of production push up the price level. To generate continuous cost-push inflation, the AS curve must keep shifting to the left along a given AD curve.

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Exhibit 7a: Consumer Price Index Since 1913

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Exhibit 7b: CPI Since 1913 – Annual Percentage Change

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Anticipated versus Unanticipated Inflation

Unanticipated inflation creates more problems for the economy than does anticipated inflation

To the extent that inflation is higher or lower than anticipated, it arbitrarily creates winners and losers If it is higher than expected, the winners are all

those who had contracted to pay a price that anticipates lower inflation

The losers are all those who agreed to sell at that price

If inflation is lower is lower than expected, the situation is reversed

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Transaction Costs of Inflation

When prices are stable, people correctly believe they can predict future prices and can plan accordingly But, if inflation changes unexpectedly, planning gets

harder which undermines the ability of money to serve as a link between the present and the future

When dealing with the rest of the world, they must also anticipate how the value of the dollar might change relative to foreign currencies

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Obscures Relative Price Changes

Relative prices describe the exchange rate between goods—how much one good costs compared to another

Inflation does not necessarily cause the change in relative prices, but it can obscure them

Occurs because of the greater uncertainty about the price of one good relative to another

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Inflation Across Metropolitan Areas

Inflation rates differ across regions mostly because of differences in housing prices, which grow faster in some places than in others

Federal government tracks separate CPIs for each of 26 metropolitan areas.

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Exhibit 8: Average Annual Inflation from 1994 to 2004 Differed Across U.S. Metropolitan Areas

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Inflation Across CountriesExhibit 9: Inflation Rates in Major Economies Have Trended

Lower Over the Past Two Decades

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Inflation and Interest Rates

Interest is the dollar amount paid by borrowers to lenders because lenders must be rewarded for forgoing present consumption

The interest rate is the interest per year as a percentage of the amount loaned

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Exhibit 10: The Market for Loanable Funds

Greater the interest rate, the greater the reward for loaning money: supply curve slopes downwardThe higher the interest rate, the higher cost of borrowing – the quantity of loanable funds demanded decreases as the interest rate increases, other things constant: demand curve for loanable funds is downward slopingEquilibrium interest rate is at the intersection of the supply of and demand for loanable funds

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Interest Rates

Nominal interest rate Measures interest in terms of the current dollars

paid The interest rate that appears on the borrowing

agreement The rate quoted in the news media

Real interest rate Equals the nominal rate of interest minus the

inflation rate Expressed in dollars of constant purchasing power

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Interest Rates

With no inflation, the nominal and real interest rates would be identical

With inflation, the nominal interest rate exceeds the real interest rate If the inflation rate is high enough, the real interest

rate can actually be negative The nominal interest would not even offset the loss

in spending power because of inflation – lenders would lose purchasing power

Why lenders and borrowers are concerned more about the real interest rate than the nominal interest rate

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Interest Rates

The higher the expected rate of inflation, the higher the nominal rate of interest that lenders require and that borrowers are willing to pay

Expected real interest rate equals the nominal rate of interest minus the expected inflation rate

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Why is Inflation Unpopular?

Problems with unanticipated inflationHits those whose incomes are fixed in

nominal termsArbitrarily redistributes income and wealth

from one group to anotherReduces the ability to make long-term plansForces buyers and sellers to pay more

attention to prices - less time for production - overall productivity of economy falls

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COLA

Cost of Living Adjustment: the increase in a transfer payment or wage that reflects the increase in the price level