Chapter 7 THE MACROECONOMY: Unemployment and Inflation

  1. How is the unemployment rate defined and measured?
  2. What is the cost of unemployed resources?
  3. What is inflation? Why is it a problem?
  4. What is frictional unemployment? And why is it not harmful?

Unemployment is the number of adults (16 and over) who are willing able to work and actively seeking jobs though they could not find one.

The population is divided into three groups: those under age 16 or institutionalized those not in the labor force, which includes the sum of the employed and the unemployed.

Labor force = all U.S. residents – residents under 16 years of age – institutionalized adults - adults not looking for work. You are in the labor force if you are working or actively seeking work but did not find one. Therefore, labor force is the sum of the employed and the unemployed.

In 1997 total population 267,90,000

Less under 16 and/or institutionalized -64,767,000

Less not in labor force -66,837,000

Equals labor force 136,297,000

Employed 129,558,000

Unemployed 6,739,000

Unemployment rate = (6,739,000)/(136,297,000)*100=4.9%.

Full time students, homemakers and retiree are excluded from the labor force.

Therefore, unemployed rate is the percentage of the labor force that is not working. Take look at the historical prospective of unemployment rates from 1890 to the present time on p.143 of your textbook. Unemployment rate was very low less than 2% during WWI and WWII, but higher than 25% during great depression.

Unemployed criteria: A job looser is a person who was involuntarily laid off (40-60)% of the unemployed.

A job leafier is a person who voluntarily ended employment (10-15)%

Duration of unemployment: the duration of unemployment is inversely related to the overall level of economic activity. That is as economic activity contracts, cyclical unemployment increases and as growth occurs cyclical unemployment decreases. The U.S. Bureau of labor statistics (BLS) determines who is employed and who is not by a nationwide random survey.

Discouraged workers (hidden unemployment) are individuals who have stop seeking for jobs because they believe that they can not get jobs. The number of discouraged workers is large during recession than prosperity. By not counting discouraged workers as unemployed it understates the unemployment rate.

Official data include that all part-time workers as fully employed. However, some economist argue that people who work part time, but are willing to work full time should be considered as semi-hidden unemployed. Therefore, the BLS data understates the unemployment rate.

Labor participation rate is the proportion of working age persons who are in the labor force.

Labor force participation rose from around 60% in 1950 to about 70% today.

Types of unemployment:

  1. Frictional unemployment: those searching for jobs or waiting to take jobs soon. The problem is that individuals do not have information about job vacancies that can fit their qualifications (e.g. after your graduation you are looking around to what offer you will take).
  2. Structural unemployment is due to changes in the structure of the economy or demand for labor. For example, the changes may be due to technological change when certain skills become obsolete (unneeded). The change may be also due to geographic distribution of jobs.
  3. Seasonal unemployment is the unemployment that fluctuates with the seasons of the year.
  4. Cyclical unemployment is caused by the recession phase of the business cycle (deficit demand unemployment).

Full employment is the level of frictional and structural unemployment. Full employment does not mean zero unemployment. The full employment of unemployment rate is also referred to as the natural rate of unemployment.

The natural rate of unemployment is the unemployment that would exist in the absences of cyclical unemployment. The natural rate of unemployment is achieved when labor markets are in balance. That is the number of job seekers equals the number of job vacancies. At this point the economy’s potential output is being achieved. The natural rate of unemployment is not fixed but depends on the demographic make up of the labor force and the laws and customs of the nations. Wait unemployment is unemployment that is caused by wage rigidities (minimum wage laws and negotiated wages by labor unions). What is the value of the natural rate of unemployment in the U.S.?

In the 1950s and 1960s the council of economic advisors agreed on 4%, whereas 1970s that rate went up to 5%. The rate again changed to 6-7% in the early 1980s and 5% by the late 1980s. Particularly 1986, the council agreed on 6.5% and today it is less than 5%. Therefore, the natural rate of unemployment varies over time within a range from 4-7%. The recent drop in the natural rate of 6.5% to less than 5% was de to the aging of the work force and increased competition in product and labor markets. It will also vary across countries, as labor markets and macroeconomic policies differ.

What is the cost of unemployed resources?

The cost of being unemployed is more than the loss of income and status suffered by the person who is out of work. If resources are unemployed, the economy will operate inside its production possibility curve (that you have seen in chapter 2) rather than on the curve. This loss of output can be measured in terms of the Gross Domestic Product (GDP) gap. GDP gap = potential real GDP – actual GDP. Potential GDP is the level of output produced (non-labor resources are fully utilized) at the natural rate of unemployment (= unemployment rate). Potential GDP measures our capability of producing at the natural rate of unemployment. Therefore, the cost of unemployment equals GDP gap. The gap widens in times of economic contractions (recessions) and narrows in times of economic expansions. This economic measurement is known as the Okura’s law. He described the relationship between unemployment and GDP: forever 1% of unemployment above the natural rate, a 2% GDP gap occurs. Non economic costs include loss of self-respect and social pressure.

Inflation: is the sustained rise in the overage level of prices. That is when the average of all prices of goods and services is rising. Inflation is measured by the percentage change in prices level. Prices of some goods rise faster than others, which means that relative prices are changing at the same time that absolute prices are rising. The measured inflation rate records the average change in absolute prices. To measure inflation, subtract last year’s price index from this year’s price index and divide by last year’s indexes, then multiply by 100 to express as a percentage.

Purchasing power of money is the amount of goods and services it can buy or the dollar value in terms of buying goods and services (real value of $ = $1/ Price level). Therefore, during inflation the purchasing power of a dollar falls, and vice versa for deflation.

Deflation is a situation where the average of all prices of goods and services is falling.

International comparison of inflation rates for five industrial nations (U.S., U.K., France, Japan and Germany). Although in the late 1970d, U.S. inflation rates increased to double-digit inflation (13-13%), inflation rate came back to 2-4% over the last 10 years (1987-1997). In this period, inflation rates of U.S. were neither high nor low relative to other industrial nations. In 1996, some nations experienced double-digit and even triple-digit inflation: annual inflation rate in Venzuela, 120%; in Bulgaria, 123%; in Turkmaistan, 992%; and Angola 4145%. In 1993 annual inflation rate in all industrial nations, 2.8%; all developing nations, 52.9; in Brazil, 2,148%; and in Zair, 1,987%%; in U.S., 3%; and Japan, 1.3%.

Inflation can also be measured by computing a price index. Price index = cost of market basket in current year (1999) divided by cost of market basket in base year 1986. That is the cost of a market basket today expressed as a percentage of the cost of that market basket in the base year.

Types of price indexes:

Causes of inflation:

  1. Demand- pulls inflation (inflation as a result from demand side). That is spending increases faster than production, will cause the average level of prices to rise. For example in resources are fully employed (i.e. the economy is producing at maximum capacity), in the short run it may not be possible to increase output to meet the increased demand. The rest will be that rising prices ration the goods and services.
  2. Cost- pushes inflation supply side): firms raise prices to avoid losses because of rise in per- unit production costs.

Anticipated VS unanticipated inflation: If the rate of inflation that most of the people expect matches the actual inflation rate, then inflation is fully anticipated. If the actual rate of inflation is greater than the expected one, then inflation is not anticipated (you have unanticipated inflation). Individuals can protect themselves from inflation if it is anticipated. The problem is that both anticipated and unanticipated can not be calculated.

Inflation and interest rate: Nominal interest rate is the market interest rate expressed in today’s dollars.

Real interest rate: the nominal interest rate minus the anticipated rate of inflation. The real rate of interest can be positive, negative or zero.

Redistribute effects of inflation: If nominal income rises faster than prices, then your real income will increase (real wage = W/P).

  1. Fixed –income groups will be hurt because their nominal income does not rise in inflationary times, for example, private pension, families living on fixed welfare.
  2. Savers( or lenders, creditors) will be hurt by unanticipated inflation, because interest rate my not cover the cost of inflation. Note that the U.S. has indexed social security benefits, which means that these payments increase when consumer price index increases.

However, borrowers (debtors) can be helped by unanticipated inflation, because their interest rate payments may be less than the inflation rate. Therefore, they borrowed dear money and are paying back cheap dollars that have less purchasing power. Protecting against inflation can be done when inflation is anticipated because lenders start increasing nominal interest rates by the amount of expected inflation. Similarly, workers demand cost of living adjustments ( COLAs). That is an increase in wages to cover the price level increases.

What is business cycle (fluctuations): Business cycle is pattern of rising real GDP followed by falling real GDP( the ups and downs of the economic activity). The business cycle contains 4 phases:

The expansion (boom) is when real GDP is increasing; the peak, which marks the end of an expansion and the beginning of a contractions. The contraction (recession) is when real GDP is falling; and the trough, which marks the end of a contraction and the beginning of an expansion.

A depression is a prolonged period of severe economic contractions( more than one year).

Leading indicators: a variable that changes before real output changes. For example of new orders for industries, have new building permit signal new construction, the prices of stocks, and so on.

External shocks (Factors that can increase or decrease in the level of economic activity)

-Wars: stimulates demand for goods and services and leads to an economic expansion

-Weather conditions: a bad weather (or hurricanes) can influence agricultural output and hence can lead to a recession.

- Oil shocks: in the 1970-75 and 1979-80, OPEC countries increased international price of oil, which led to recession.