Chapter: 8

Krugman/Wells

©2009 Worth Publishers

Unemployment

and

Inflation

Two major economic problems resulting from Business cycles

1. UnemploymentThe 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 orWorked 15 hours or more in a family owned business orHave 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

TotalPopulation (310.4)

Under 16 and Institutionalized (72.3)

Not in the Labor Force (84.0)

Employed (139.2)

Unemployed(14.86)

Labor Force(154.1)

Working Age Population = 238.1238.1

BLS data: Aug 2010

Not in LF (84.0)

Labor Force (154.1)+

14.86154.1

= 9.6%

Interpretation: The percentage of the labor force that is unemployed

TotalPopulation (310.4)

Under 16 and Institutionalized (72.3)

Not in the Labor Force (84.0)

Employed (139.2)

Unemployed(14.86)

Labor Force(154.1)

BLS data: Aug 2010

154.1 238.1

= 64.7%

Interpretation: How much of the eligible population desires to take part as potential workers in the economy

There are always some jobs that are destroyed; but during expansions more jobs are created than destroyed.

Long term economic growth leads to more jobs. Population increase also will lead to more employment

The labor force participation rate of men has decreased: 83 to 72%

The average participation rate has increased:59 to 66.5%

The labor force participation rate of women has increased: 38 to 59.5%since 1960

Source:BLS

The unemployment rate 1961 - 2010

1. Unemployment rises during recessions2. Unemployment declines during expansions3. Unemployment is lowest at the peak of a business cycle

Unemployment rate 2000 – August 2010

Recession MI U.S.

Source:BLS

• 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.

Economics in Action: Rocky Mountain Low

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

Job losers and job leavers become unemployed or leave the labor force.

Entrants and reentrants become unemployed or get jobs.

Unemployment ends when a person is hired or recalled….

…or drops out of the labor force

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

1994 1996 1998 2000 2002 2004 2006 2008

Year

12%

10

8

6

4

2

Percentage of labor force

Unemployment Rate

These broader measures show a higher unemployment rate—but they move closely in parallel with the standard rate.

Alternative Measures of UnemploymentUnemployment Rate

Growth and Changes in Unemployment, 1949-2007

−4 − 2 0 2 3.4 4 6 8 10%

Real GDP growth rate

4

3

2

1

0

−1

−2

−3

Change in unemployment

rate (percentagepoints)

Average growth rate, 1949–2007

Unemployment Rate

When Real GDP increases, the unemployment rate goes down and when Real GDP decreases unemployment goes up.

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.

Distribution of the Unemployed by Duration in 2000

The Nature of unemployment

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.

• 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.

The Nature of unemployment

WageRate

Quantity of Labor

Labor Demand

LaborSupply

QEQD

WE

WF

Minimumwage

QS

Structuralunemployme

nt

If the wage rate firms pay exceeds the market equilibrium wage rate, WE, the number of workers, QS, who would like to work at that minimum wage is greater than the number of workers, QD, demanded at that wage rate. This surplus of labor is considered structural unemployment.

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.

• 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

• 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.

Structural Unemployment in Eastern Germany

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.

• 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 ForceAmount of younger vs. older workers

2. Institutional changesAmount of Labor UnionizationTechnological changes in labor market: i.e. internet searching

3. Government PolicesUnemployment compensation Job Training & employment subsidies

The Natural Rate of Unemployment

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 GDPPOTENTIAL 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.

real wage = nominal wage

price index

If your nominal wage 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.

Title Year of Release Estimated Domestic Gross in 2010 $ Millions1)Gone with the Wind 1939 $1,6062) Star Wars IV 1977 $1,416 3)The Sound of Music 1965 $1,1324)E.T. 1982 $1,1275)The 10 Command. 1956 $1,041 6) Titanic 1998 $1,0207)Jaws 1975 $1,018 8)Doctor Zhivago 1965 $9869)The Exorcist 1973 $87910)Snow White 1937 $866 11)101 Dalmations 1961 $794 12)Empire Strikes Back 1980 $78013)Ben-Hur 1959 $77914)Avatar 2009 $77315)Return of the Jedi 1983 $74816)The Sting 1973 $70917) Raiders of Lost Ark 1981 $70118)Jurrassic Park 1993 $68519)The Graduate 1967 $68020) Star Wars I 1999 $674

Example: Top 24 Films,Adjusted for Inflation

21) Fantasia 1941 $660 22)The Godfather 1972 $62723) Forrest Gump 1999 $62424) Mary Poppins 1964 $62125) The Lion King 1999 $614

Source: Box Office Mojo

Real Values

First Oil Shock

Second Oil Shock

Real Values

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 InflationLong-term contracts are generally written in dollar termsThat is loans and bonds are paid off years into the futureLoans and bonds are quoted with nominal interest rates –

you pay back in dollars and are paid back in dollarsQuestion: 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

Since it is very difficult to accurately forecast the expected 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 Inflationreal 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

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.

Economics in Action

Rule of 70: 70 / Annual inflation rate = Approximate # of years for the price level to double.

Another way to estimate how bad inflation is to use the Rule of 70

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

The Cost of Disinflation

Year 1978 1980 1982 1984 1986 1988

16%

14

12

10

8

6

4

2

Inflation rate

12%

10

8

6

Inflation rate

Disinflation is the process of bringing the inflation rate down

It usually results in a temporarily large increase in the unemployment rate

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-of-account 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.

Summary