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1 Chapter 7 The Macroeconomy: Unemployment, Inflation, and Deflation Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-2 Introduction How does the U.S. government measure the overall level of prices? Why doesn’t the U.S. government use Wal-Mart prices in calculating inflation? This chapter will help you answer these questions. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-3 Learning Objectives Explain how the U.S. government calculates the official unemployment rate Discuss the types of unemployment Describe how price indexes are calculated and define the key types of price indexes

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1

Chapter 7

The Macroeconomy: Unemployment, Inflation, and Deflation

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-2

Introduction

How does the U.S. government measure the overall level of prices?

Why doesn’t the U.S. government use Wal-Mart prices in calculating inflation?

This chapter will help you answer these questions.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-3

Learning Objectives

• Explain how the U.S. government calculates the official unemployment rate

• Discuss the types of unemployment

• Describe how price indexes are calculated and define the key types of price indexes

2

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-4

Learning Objectives (cont'd)

• Distinguish between nominal and real interest rates

• Evaluate who looses and who gains from inflation

• Understand key features of business fluctuations

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-5

Chapter Outline

• Unemployment

• The Major Types of Unemployment

• Full Employment and the Natural Rate of Unemployment

• Inflation and Deflation

• Anticipated versus Unanticipated Inflation

• Changing Inflation and Unemployment: Business Fluctuations

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-6

Did You Know That...

• Trying to understand and better forecast labor employment and the overall performance of the national economy is a central objective of macroeconomics?

• This branch of economics seeks to explain and predict movements in unemployment, the average level of prices, and the total production of goods and services?

3

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-7

Unemployment

• Unemployment

Total number of adults (aged 16 years or older) willing and able to work and who are actively looking for work and have not found a job

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-8

Unemployment (cont'd)

• Labor ForceIndividuals aged 16 years or older who either have jobs or who are looking and available for jobs; the number of employed plus the number of unemployed

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-9

Unemployment (cont'd)

• Question

What are the costs of unemployment?

4

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-10

Unemployment (cont'd)

• Answers

Lost outputDuring early 2000s, unemployment rate rose by 2 percentage points

Factory output was 80% of potential

Lost output was $200 billion of goods and services that could have been produced

Personal psychological impact

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-11

Source: U.S. Department of Labor, Bureau of Labor Statistics

Figure 7-1 More Than a Century of Unemployment

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-12

Figure 7-2 Adult Population

5

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-13

Unemployment (cont'd)

• The unemployment rate is the percentage of the measured labor force that is unemployed.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-14

152.7* = 145.4 + 7.3

Unemployment (cont'd)

*U.S., millions of people; as of 2007

Labor force = The employed + The unemployed

Unemployment rate = x 100UnemployedLabor force

= x 100 = 4.8%7.3152.7

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-15

Unemployment (cont'd)

• StockThe quantity of something, measured at a given point in time—for example, an inventory of goods

• FlowA quantity measured over time, such as the income you make per year, or the number of individuals fired every month

6

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-16

Unemployment (cont'd)

• Categories of individuals without work

Job loser

Reentrant

Job leaver

New entrant

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-17

Unemployment (cont'd)

• Job Loser

An individual whose employment was involuntarily terminated or who was laid off

40–60% of the unemployed

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-18

Unemployment (cont'd)

• Reentrant

An individual who has worked a full-time job before but left the labor force and has now reentered it looking for a job

20–30% of the unemployed

7

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-19

Unemployment (cont'd)

• Job Leaver

An individual who voluntarily quit 10 to 15% of the unemployed

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-20

Unemployment (cont'd)

• New Entrant

An individual who has never worked a full-time job for two weeks or longer

10 to 15% of the unemployed

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-21

Unemployment (cont'd)

• Duration of unemploymentMore than a third of job seekers find work within one month.

Approximately another third find employment within a second month.

About a sixth are still unemployed after six months.

Average duration is just over 15 weeks throughout the last 15 years.

8

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-22

Figure 7-3 The Logic of the Unemployment Rate

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-23

Unemployment (cont'd)

• Question

What is likely to happen to the duration of unemployment during a downturn in the economy?

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-24

Unemployment (cont'd)

• Discouraged WorkersIndividuals who have stopped looking for a job because they are convinced they will not find a suitable one

• QuestionHow does the existence of discouraged workers bias the unemployment rate?

9

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-25

Unemployment (cont'd)

• Labor Force Participation Rate

The proportion of noninstitutionalized working-age individuals who are employed or seeking employment

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-26

The Major Types of Unemployment

• The major types of unemployment

Frictional

Structural

Cyclical

Seasonal

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-27

The Major Types of Unemployment (cont'd)

• Frictional Unemployment

Results from the fact that workers must search for appropriate job offers

This takes time, so they remain temporarily unemployed

10

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-28

The Major Types of Unemployment (cont'd)

• Structural Unemployment

Results from a poor match of workers’abilities and skills with current requirements of employers

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-29

The Major Types of Unemployment (cont'd)

• Cyclical Unemployment

Results from business recessions that occur when aggregate (total) demand is insufficient to create full employment

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-30

The Major Types of Unemployment (cont'd)

• Seasonal Unemployment

Results from the seasonal pattern of work in specific industries

11

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-31

International Example: Challenges of Measuring the Unemployment Rate in China• Measurement of China’s labor force and

unemployment rate fails to encompass all of the roughly 115 million people who migrate from rural areas.

• In addition, China’s government has not yet developed a way to determine how many millions of people laid off from state-owned firms have obtained positions with private firms.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-32

Full Employment and the Natural Rate of Unemployment

• Question

Does full employment mean that everybody has a job?

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-33

Full Employment and the Natural Rate of Unemployment (cont'd)

• Full Employment

An arbitrary level of unemployment that corresponds to “normal” friction in the labor market

12

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-34

Full Employment and the Natural Rate of Unemployment (cont'd)

• Natural Rate of UnemploymentThe unemployment rate that is estimated to prevail in the long-run macroeconomic equilibrium

Should not reflect cyclical unemployment

When seasonally adjusted, the natural rate should include only frictional and structural unemployment.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-35

Inflation and Deflation

• InflationA sustained increase in the average of all prices of goods and services in an economy

• DeflationA sustained decrease in the average of all prices of goods and services in an economy

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-36

Inflation and Deflation (cont'd)

• Purchasing Power

The value of money for buying goods and services

Varies with prices and income

13

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-37

Inflation and Deflation (cont'd)

• Nominal valuePrice expressed in today’s dollars

• Real valueValue expressed in purchasing power, adjusted for inflation

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-38

Price index = × 100Cost today of market basket

Cost of market basket in base year

Inflation and Deflation (cont'd)

• Measuring the rate of inflation

Price IndexThe cost of today’s market basket of goods expressed as a percentage of the cost of the same market basket during a base year

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-39

Inflation and Deflation (cont'd)

• Market BasketRepresentative bundle of goods and services

• Base YearThe point of reference for comparison of prices in other years

14

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-40

Table 7-1 Calculating a Price Index for a Two-Good Market Basket

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-41

Inflation and Deflation (cont'd)

• Real-world price indexes

Consumer Price Index (CPI)

Producer Price Index (PPI)

GDP deflator

Personal Consumption Expenditure (PCE)

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-42

Inflation and Deflation (cont'd)

• Consumer Price Index (CPI)

A statistical measure of a weighted average of prices of a specified set of goods and services purchased by wage earners in urban areas

Market basket of goods and services of typical consumer

15

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-43

Inflation and Deflation (cont'd)

• Producer Price Index (PPI)A statistical measure of a weighted average of prices of goods and services that firms produce and sell

Used as a short-run leading indicator (before CPI)

PPIs forFoodstuffsIntermediate goodsFinished goods

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-44

Inflation and Deflation (cont'd)

• GDP Deflator

A price index measuring the changes in prices of all new goods and services produced in the economy

Broadest measure of prices; reflects both price changes and the public’s market responses to those price changes

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-45

Inflation and Deflation (cont'd)

• Personal Consumption Expenditure (PCE) Index

A statistical measure of average price using annually updated weights based on consumer spending

Primary inflation index used by the Federal Reserve

16

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-46

Figure 7-4 Inflation and Deflation in U.S. History

Source: U.S. Department of Labor, Bureau of Labor Statistics

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-47

Anticipated versus Unanticipated Inflation

• Anticipated versus unanticipated inflation

To determine who is hurt by inflation we distinguish between the two types.

The effects of inflation on individuals depend upon which type of inflation exists.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-48

Anticipated versus Unanticipated Inflation (cont'd)

• Anticipated InflationThe inflation rate that we believe will occur

• Unanticipated InflationInflation at a rate that comes as a surprise

17

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-49

Anticipated versus Unanticipated Inflation (cont'd)

• Inflation and interest rates

Nominal Rate of InterestThe market rate of interest expressed in today’s dollars

Real Rate of InterestThe nominal rate of interest minus the anticipated rate of inflation

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-50

Anticipated versus Unanticipated Inflation (cont'd)

• Real interest rate

Nominal interest rate = 10%

Expected inflation rate = 6%

Real rate = 10% – 6% = 4%

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-51

Anticipated versus Unanticipated Inflation (cont'd)

• Does inflation necessarily hurt everyone?

Inflation affects people differently

• Unanticipated inflationCreditors lose

Debtors gain

18

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-52

Anticipated versus Unanticipated Inflation (cont'd)

• Protecting against inflation

Cost-Of-Living Adjustments (COLAs)Clauses in contracts that allow for increases in specified nominal values to take account of changes in the cost of living

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-53

Anticipated versus Unanticipated Inflation (cont'd)

• The resource cost of inflation

Repricing or Menu Cost of InflationThe cost associated with recalculating prices and printing new price lists when there is inflation

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-54

Policy Example: How Pervasive Is “Inflation Inequality” in the United States?

• Inequality based on consumption of fuel, education, and health care

• Households facing higher inflation do so for a short period of time.

• To the extent inflation inequality exits, it is neither pervasive nor persistent.

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Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-55

Changing Inflation and Unemployment: Business Fluctuations

• Business Fluctuations

The ups and downs in business activity throughout the economy

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-56

Changing Inflation and Unemployment: Business Fluctuations (cont'd)

• Expansion

A business fluctuation in which the pace of national economic activity is speeding up

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-57

Changing Inflation and Unemployment: Business Fluctuations (cont'd)

• Contraction

A business fluctuation during which the pace of national economic activity is slowing down

20

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-58

Changing Inflation and Unemployment: Business Fluctuations (cont'd)

• RecessionA period of time during which the rate of growth of business activity is consistently less than its long-term trend or is negative

• DepressionAn extremely severe recession

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-59

Figure 7-5 The Idealized Course of Business Fluctuations

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-60

Figure 7-6 National Business Activity, 1880 to the Present

21

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-61

Changing Inflation and Unemployment: Business Fluctuations (cont'd)

• Leading Indicators

Events that have been found to occur before changes in business activity

Economic downturns often followReduction in the average workweek

Rise in unemployment insurance claims

Decrease in prices of raw materials

Drop in the quantity of money circulating

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-62

Issues and Applications: Wal-Mart, Product Quality, and the CPI

• Wal-Mart offers lower prices on most food items.

• The Bureau of Labor Statistics (BLS) uses prices charged at a nearby Kroger.

• As far as the BLS is concerned, lower Wal-Mart prices must reflect lower quality.

• BLS quality adjustments may result in an upward bias in the rate of CPI inflation.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-63

Summary Discussion of Learning Objectives

• How the U.S. government calculates the official unemployment rate

Percentage of the total number of adults willing and able to work who are actively looking for work but have not found a job

• The major types of unemploymentFrictional StructuralCyclicalSeasonal

22

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-64

Summary Discussion of Learning Objectives (cont'd)

• Full employmentArbitrary level of unemployment

Corresponds to “normal” friction in labor market

• Natural rate of unemploymentEstimated to prevail in the long-run macroeconomic equilibrium

All workers and employers adjust to any changes in economy

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-65

Summary Discussion of Learning Objectives (cont'd)

• How price indexes are calculated and key price indexes

Multiply 100 times the ratio of the cost of a market basket of goods in the current year to the cost of the same basket in a base year

Key price indexesCPIPPIGDP deflatorPCE

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-66

Summary Discussion of Learning Objectives (cont'd)

• Nominal versus real interest ratesNominal rate is the market rate expressed in current dollars.

Real rate is net of inflation.

Hence the real interest rate equals the nominal interest rate minus the expected inflation rate.

23

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-67

Summary Discussion of Learning Objectives (cont'd)

• Losers and gainers from inflation

Creditors lose as a result of unanticipated inflation.

Borrowers gain.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7-68

Summary Discussion of Learning Objectives (cont'd)

• Key features of business fluctuations

Increases and decreases in business activity

Expansion from previous trough to new peak

Contraction from previous peak to new trough

End of Chapter 7The Macroeconomy: Unemployment, Inflation, and Deflation