Chapter 9: Unemployment and In�ation

Yulei Luo

SEF of HKU

February 1, 2016

Learning Objectives

1. Measuring the Unemployment Rate, the Labor ForceParticipation Rate, and the Employment�Population Ratio.

2. Types of Unemployment.

3. Explain what factors determine the unemployment rate.

4. Measuring In�ation.

5. Using Price Indexes to Adjust for the E¤ects of In�ation.

6. Distinguish between the nominal interest rate and the realinterest rate.

7. Does In�ation Impose Costs on the Economy?

DOL�s Bureau of Labor Statistics (BLS), HouseholdSurvey (60,000 households)

I Each month, the U.S. Bureau of the Census conducts theCurrent Population Survey to collect data needed to computethe unemployment rate.

I Household members of �working age� (16+ years old).I Asked about employment during �reference week�.I Also asked about recent job-search activities.

I Employed people: If they worked during the week before thesurvey or if they were temporarily away from their job becausethey were ill, on vacation, on strike, or for other reasons.

I Unemployed people: If they did not work in the previous week,but were available for work and had actively looked for workat some time during the previous four weeks.

I Labor force: The sum of employed and unemployed workers inthe economy.

I Unemployment rate: The percentage of the labor force that isunemployed.

I Discouraged workers: People who are available for work, butwho have not looked for a job during the previous four weeksbecause they believe no jobs are available for them.

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August 913 Civilian Working-Age Population

Discouraged workers: People who are available for work, but have not looked for a job during the previous four weeks because they believe no jobs are available for them.

The employment status of the civilian working-age population, August 2013

Figure 9.1

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Unemployment Rate

The employment status of the civilian working-age population, August 2013

Figure 9.1

Based on the CPS estimates, we calculate several important macroeconomic indicators.

• The most-watched is the unemployment rate:

ratent Unemployme100forceLabor

unemployed ofNumber =×

%3.7100million 155.5

million 11.3=×

This most-common measure of unemployment is known formally as BLS series U-3.

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Labor Force Participation and Employment-Population

Also important are the labor force participation rate (the percentage of the working-age population in the labor force)…

rateion participat forceLabor 100population age-Working

forceLabor =×

%2.63100million 245.9million 155.9

=×

… and the employment-population ratio (the percentage of the working-age population that is employed):

ratio population-Employment100population age-Working

Employment=×

%6.58100million 245.9million 144.2

=× The employment status of the civilian working-age population, August 2013

Figure 9.1

The Household Survey

I BLS classi�es people who do not have a job and who are notactively looking for a job as not in the labor force.

I On a Friday early in each month the US DOL reports itsestimate of the previous month�s unemployment rate. It willa¤ect investors�views on the health of the economy.

I The unemployment rate measures the percentage of the laborforce that is unemployed:

Unemployment rate =Number of unemployed

Labor force(1)

I The labor force participation rate measures the percentage ofthe working-age population that is in the labor force:

Labor force participation rate =Labor force

Working-age population(2)

An example: What happens if you include the military?

I People on active military service are not included in theemployment, labor force, or working-age population totalscompiled in the BLS survey.

I Suppose now people in the military were included in thesestatistics, what happens to the unemployment rate and thelabor participation rate?

I We can use expressions (1) and (2) to answer these questions.

Problems with measuring the unemployment rate

I Although the BLS reports the unemployment rate measuredto the tenth of a percentage point, it is not a perfect measureof the current state of joblessness in the economy.

I Understate the degree of jobless: di¢ cult to distinguishbetween the unemployed and people who are not in laborforce. E.g., in recession an increase in discouraged workers isnot counted as unemployed as more people stop activelylooking for a job then. In addition, part-time workers wholook for full-time are counted as employed.

I Overstate: BLS doesn�t verify the responses of interviewees.Some people who claim to be unemployed and actively lookingfor work may not be actively looking. May claim not to beworking to evade taxes or keep criminal activity unnoticed.

I The UER provides some useful information about theemployment situation in the country, but it is far from anexact measure of joblessness in the economy.

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Alternative Measures of Unemployment: U-6

Some people suggest that we should include discouraged workers and underemployed workers in the unemployment statistics, to create a broader measure of unemployment.

• The BLS measures this, calling it BLS series U-6.

The official unemployment rate and a broad measure of the unemployment rate, 1996-2013

Figure 9.2

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Trends in Labor Force Participation

The labor force participation rate of adult men has declined gradually since 1948…… but it has increased significantly for adult women, making the overall rate higher today than it was then.

Trends in the labor force: participation rates of adult men and women since 1948

Figure 9.3

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Makingthe

ConnectionIs Falling Labor Force Participation Bad?

Politicians often like to point to a “falling labor force participation rate” as a strongly negative sign for the economy.

• Is this necessarily true?

The two major reasons why the LFPR for men has fallen over the last several decades are:

• Men have been going to school for longer and retiring earlier than before (why?)

• Increases in Social Security Disability Insurance availability have allowed people with disabilities to stop work

Whether these are good or bad is a value judgment.

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Unemployment Rates for Different Groups

Unemployment rates vary by ethnic group…… and by education level.• These two observations are statistically

related.

Unemployment rates in the United States, August 2013

Figure 9.4

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How Long Are People Typically Unemployed?

Long periods of unemployment are bad for workers, as their skills decay and they risk becoming discouraged and depressed.

• During the Great Depression of the 1930s, some people were unemployed for years at a time.

Since World War II, average lengths of unemployment have been relatively low; but that changed dramatically with the 2007-2009 recession.

How Long Are People Typically Unemployed?I During the Great Depression of the 1930s, some people wereunemployed for years at a time.

I In the modern U.S. economy, the typical unemployed personstays unemployed for a relatively brief period of time.

I In April 2007� which was during a period of economicexpansion� 82% of the people who were unemployed hadbeen unemployed for less than six months.

I In September 2011, after the end of the 2007� 2009recession, but during a time when the economy was growingslowly, only 55% of the unemployed had been jobless for lessthan six months.

I The average period of unemployment was only 17 weeks inApril 2007 but was 41 weeks in September 2011.

I The severity of unemployment during and after the2007� 2009 recession was a sharp break from the normalU.S. experience.

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Makingthe

ConnectionThe Employment Situation Following the 2007-2009 Recession

The fall of the employment–population ratio may give an even better indication of how weak the U.S. labor market was during and after the 2007–2009 recession.

• Explaining these changes is a top priority for labor economists.

The Establishment Survey: Another Measure ofEmployment

I In addition to the household survey, the BLS uses theestablishment survey, sometimes called the payroll survey, tomeasure total employment in the economy (300,000establishments).

I The establishment survey provides information on the totalnumber of persons who are employed and on a companypayroll.

I The establishment survey has the following four drawbacks:I It does not provide information on the number of self-employedpersons because they are not on a company payroll.

I It may fail to count some persons employed at newly opened�rms that are not included in the survey.

I It provides no information on unemployment.I Its initial employment values can be signi�cantly revised asdata from additional establishments become available.

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Comparing the Household and Establishment Surveys

The table below gives the data from the July and August 2013 household and establishment surveys:

Even if all surveys are truthfully and accurately answered, we do not expect the numbers to be identical between the two surveys:

• Different groups are measured

• All surveys have measurement errors

But we get a more complete picture by considering both surveys.

Household and establishment survey data for July and August 2013

Table 9.1

Household Survey Establishment Survey

July August Change July August Change

Employed 144,285,000 144,170,000 –115,000 135,964,000 136,133,000 169,000

Unemployed 11,514,000 11,316,000 –198,000

Labor force 155,798,000 155,486,000 –312,000

Unemployment rate 7.4% 7.3% –0.1%

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Revisions to Employment Numbers

Over time, the BLS adjusts its estimates of employment and unemployment for previous months. Revisions sometimes take place years later.The large negative revisions were because the BLS underestimated the severity of the 2007-2009 recession.

Revisions to employment changes, as reported in the establishment survey

Figure 9.5

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Job Creation and Destruction

Jobs are continually being created and destroyed in the U.S. economy. In 2012, about 27.8 million jobs were created, while about 25.5 million jobs were destroyed.This is a natural and normal process for the economy.The table shows jobs created and destroyed over a three-month period from September to December 2012.

Establishments creating and eliminating jobs, September-December 2012

Table 9.2

Number of Jobs

Establishments Creating Jobs

Existing establishments 5,752,000

New establishments 1,299,000

Establishments Eliminating Jobs

Existing establishments 5,180,000

Closing establishments 1,203,000

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U.S. Annual Unemployment Rate over Time

Unemployment rates rise when the economy is faltering, and fall when the economy is doing well. But they never fall to zero.

• To understand why, we will examine the types of unemployment.

The annual unemployment rate in the United States, 1950-2012

Figure 9.6

Frictional Unemployment and Job Search

I Most workers spend at least some time engaging in jobsearch, just as most �rms spend time searching for a newperson to �ll a job opening.

I Frictional unemployment: Short-term unemployment thatarises from the process of matching workers with jobs.

I Frictional unemployment occurs mostly because of job search:entering or re-entering the labor force, or being between jobs.

I It also occurs because of seasonal unemployment: some jobs�uctuate in availability due to seasonal demand, likeski-instructor or farm-work.

I Seasonal unemployment refers to unemployment due tofactors such as weather, variations in tourism, and othercalendar-related events.

I Because seasonal unemployment can make the unemploymentrate seem arti�cially high during some months and arti�ciallylow during other months, the BLS reports two unemploymentrates each month� one that is seasonally adjusted and onethat is not.

I Some frictional unemployment actually increases economice¢ ciency by allowing for better job matches.

I Structural Unemployment: Unemployment that arises from apersistent mismatch between the skills and attributes ofworkers and the requirements of jobs.

I Structural unemployment is associated with longerunemployment spells. Workers who are structurallyunemployed may require retraining in order to obtain�modern� jobs.

I Cyclical Unemployment: Unemployment caused by a businesscycle recession.

I In normal recoveries after a recession, unemployment due tocyclical factors will fall.

I When the economy moves into recession, many �rms �nd theirsales falling and cut back on production. As production falls,they start laying o¤ workers.

I Full employment: When the only remaining unemployment isstructural and frictional unemployment.

I The �uctuations around this normal rate are mainly due to thechanges in the level of cyclical unemployment.

I Natural rate of unemployment (NRU): The normal rate ofunemployment, consisting of structural unemployment plusfrictional unemployment.

I In the US, most economists estimate the rate to be around 5%.I The NRU is also sometimes called the full-employment rate ofunemployment.

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Makingthe

ConnectionHow Should We Categorize Unemployment at Caterpillar?

In 2013, Caterpillar announced layoffs at its South Milwaukee plant. • Did this increase frictional,

structural, or cyclical unemployment?

This is generally a hard question to answer; we need to look closely at this specific plant:• The South Milwaukee plant manufactured mining equipment.• Prices for mining products were in decline, decreasing demand

for Caterpillar’s mining machinery. But sales of other equipment remained strong.

• The laid-off workers were likely specialists at making mining equipment; so they are probably structurally unemployed.

Government Policies and the Unemployment Rate

I Governments often attempt to directly in�uenceunemployment.

I Example: The government�s Trade Adjustment Assistanceprogram o¤ers training to workers whose �rms laid them o¤ asa result of competition from foreign �rms. This would reducestructural unemployment.

I Other policies try to reduce frictional unemployment: bysubsidizing new hires.

I However some other government policies probably increaseunemployment: Unemployment insurance and Minimum wagelaws.

I Unemployment Insurance and Other Payments to theUnemployed: The opportunity cost of continuing to search fora job is the salary you are giving up at the job you could havetaken.

I (Conti.) In the U.S. and most other industrial countries, theunemployed are eligible for unemployment insurance (UI)payments from the government, which help the unemployedmaintain their income and spending, lessening the personalhardship of being unemployed and also helping to reduce theseverity of recessions.

I In the US, UI and other payments to the unemployed are equalto about half of the average wage.

I UI helps the unemployed maintain their income and spending,which lessens the personal hardship of being unemployed andalso helps reduce the severity of recessions.

I Advantages: UI helps the unemployed maintain their incomeand spending, which lessens the personal impact ofunemployment and also helps reduce the severity of recessions.

I Disadvantages: The unemployed can spend more timesearching for better jobs because they receive these UIpayments and then increase the unemployment rate in theeconomy.

Minimum Wage Laws

I In 1938, the U.S. federal government enacted a nationalminimum wage law.

I The current level of MW in the U.S. is $7.25 per hour (At�rst, it is $0.25 per hour. After in�ation-adjusted, it becomes$4.15 per hour). In November 2010, legislators of the HongKong Government agreed to set a minimum wage level ofHK$28 ($4.70).

I If the MW is set above the market wage determined by thedemand and supply of labor, labor supply is greater than labordemand. Some unemployed workers would have beenemployed if there were no minimum wage. Consequently, theunemployment rate will be higher than it would be without aminimum wage.

I Economists agree that the current minimum wage is abovethe market wage for some workers, but they disagree on theamount of unemployment that has resulted.

Labor Unions

I Organizations of workers that bargain with employers forhigher wages and better working conditions for their members.

I In unionized industries (automobiles, steel, and telecom.), thewage is usually above what otherwise would be the marketwage. This above-market wage leads to fewer workers hired inthose industries.

I But the e¤ect of the overall unemployment rate is minorbecause only 9% of workers are unionized.

E¢ ciency Wages

I A higher-than-market wage paid by a �rm to increase workerproductivity.

I The reason is that in many business situations, it is di¢ cult tomonitor workers. (workers can hidden their activities.) Hence,many �rms must rely on workers being motivated enough towork hard.

I By paying a wage above the market wage, the �rm raises thecosts to workers of losing their jobs.

I Minimum wage laws, unions, and e¢ ciency wages can causeeconomies to experience some unemployment even whencyclical unemployment is zero.

Measuring In�ation

I The prices of most goods and services rise over time. As aresult, the cost of living rises. E.g., in 1914, Ford�s $5-a-daywage is extremely high, today it is only the level of minimumwage.

I Price level: A measure of the average prices of goods andservices in the economy.

I In�ation rate: The percentage increase in the price level fromone year to the next.

πt+1 =pt+1 � pt

pt,

where pt is the price level at time t and πt is the in�ationrate at time t.

I (Cont.) Measuring the price level: The GDP de�ator is abroadest measure because it includes the price of every �nalgood and service.

I But it is too broad for some purposes. E.g., if we need toknow the impact of in�ation on the typical household, it ismisleading.

I The consumer price index (CPI) is a better measure for thecost of living of the typical urban family with four.

The Consumer Price Index (CPI)

I One year is chosen as the base year, and the value of the CPIis set to 100 for that year.

I In any other year, the CPI is equal to the ratio of the dollaramount necessary to buy the market basket of goods in thatyear divided by the dollar amount necessary to buy the samemarket basket in the based year, multiplied by 100.

I CPI is also called the cost-of-living index.

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Consumer Price Index

The consumer price index is a measure of the average change over time in the prices a typical urban family of four pays for the goods and services they purchase.

The chart shows the composition of the basket of goods used to create the CPI. This basket of goods derives from a survey of 14,000 households by the BLS.

The CPI market basket, December 2012

Figure 9.7

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A Simple CPI Calculation

The table above gives the information we need to create the CPI in 2014 and 2015, using the basket of goods from 1999.

Base Year (1999) 2014 2015

Product Quantity Price Expenditures Price

Expenditures(on base-year

quantities) Price

Expenditures (on base-year

quantities)Eye examinations 1 $50.00 $50.00 $100.00 $100.00 $85.00 $85.00

Pizzas 20 10.00 200.00 15.00 300.00 14.00 280.00

Books 20 25.00 500.00 25.00 500.00 27.50 550.00

TOTAL $750.00 $900.00 $915.00

Formula Applied to 2014 Applied to 2015

120100750$900$

=×

122100

750$915$

=×

CPI = 100year base in the esExpenditur

yearcurrent in the esExpenditur×

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A Simple CPI Calculation—continued

Based on these data, the inflation rate from 2014 to 2015 is the percentage change in the CPI:

%7.1100120

120122=×

−

Since the CPI measures consumer prices, it is often referred to as the cost-of-living index. CPI-inflation is sometimes used to generate “fair” increases in wages for workers, and government benefits.

Formula Applied to 2014 Applied to 2015

120100750$900$

=×

122100

750$915$

=×

CPI = 100year base in the esExpenditur

yearcurrent in the esExpenditur×

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Using Price Indexes to Adjust Prices

Suppose your mother received a salary of $25,000 in 1987. This would have bought much more than a salary of $25,000 in 2012.

We can use the CPI to estimate the purchasing power of that $25,000 in 2012 dollars:

×=

1987in CPI2012in CPI dollars 1987in Valuedollars 2012in Value

000,50$114230 000,25$ ≈

×=

So $25,000 in 1987 would have bought about as much as $50,000 in 2012.

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Nominal and Real ValuesThe current standard base “year” for the CPI is an average of 1982-1984 prices.

Values like wages in current-year dollars are called nominal variables. When we adjust them for inflation, by dividing by the current year’s price index and multiplying by 100, we convert them to real variables.

Example: Caterpillar employees signed a contract freezing wages until 2018. How much less will their wages be worth then?

YearNominal Average Hourly Earnings

CPI(1982–1984 = 100)

Real Average Hourly Earnings(1982–1984 dollars)

2013 $27.00 233 $11.59

2018 27.00 260 (est) 10.38

If the CPI rises to 260, then Caterpillar employees will receive a real wage decrease of:

%4.1010059.11$

59.11$38.10$−=×

−

Is the CPI Accurate?I CPI is the most widely used measure of in�ation, so it isimportant that it be as accurate as possible. 4 factors make itoverstate the true in�ation rate (CPI overstates true in�ationby 0.5 to 1 percentage point):1. Substitution bias: In constructing the CPI, the BLS assumesthat consumers purchase the same monthly amount of eachproduct in the market basket, but consumers actually buyfewer of those products that increase most in price.

2. Increase in quality bias: Increases in the prices of the productspartly re�ect their improved quality and partly are purein�ation. It is di¢ cult to separate the two factors.

3. New product bias: For many years, the BLS updated themarket basket of goods used in computing the CPI only every10 years, which excluded new products introduced betweenupdates.

4. Outlet bias: Because the BLS continued to collect pricestatistics from traditional full-price retail stores, the CPI didnot re�ect the prices some consumers actually paid at discountstores and over the Internet.

The Producer Price Index (PPI)

I PPI: An average of the prices received by producers of G&S atall stages of the production process.

I It is conceptually similar to the CPI, in that it uses a basket ofgoods, but the goods are those used by producers.

I The PPI includes the prices of intermediate goods such ascotton, steel, and raw materials.

I If the prices of these goods rise, the cost to �rms of producing�nal products will rise, which may lead �rms to increase theprices of products purchased by consumers.

I Changes in PPI can be used to predict future movements inthe CPI.

Real versus Nominal Interest Rates

I Nominal interest rate: The stated interest rate on a loan.I Real interest rate: The nominal interest rate minus thein�ation rate. It provides a better measure of the true cost ofborrowing and the true return to lending than does thenominal interest rate.

I For low rates of in�ation, a convenient approximation for thereal interest rate is: Real interest rate = Nominal interest rate- In�ation rate

I De�ation: A decline in the price level, i.e., negative in�ation.

I (Cont.) Holding the nominal interest rate constant, the higherthe in�ation rate, the lower the real interest rate.

I E.g., if both of you and the person to whom you lend $1000expected the in�ation rate to be 2%, you both expected thereal interest rate to be 4% if the nominal interest rate is 6%.If the actual in�ation rate turns out to be 4%, the real ratewill be 2%: That�s good news for your borrower but bad newsfor you.

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U.S. Nominal and Real Interest Rates

The chart shows the interest rate on three-month treasury-bills, a good measure of the nominal interest rate.

The real interest rate adjusts them for changes in the CPI.Notice that in 2009, the real interest rate was above the nominal interest rate. This was because the change in the CPI was negative then, indicating a rare deflation, or decrease in the price level.

Nominal and real interest rates, 1970-2013

Figure 9.8

Does In�ation Impose Costs on the Economy?

I In�ation A¤ects the Distribution of Income: In�ation does notreduce the a¤ordability of goods and services to the averageconsumer because an expected in�ation rate of 10% will raisethe average price of goods and services by 10%, but it willalso raise average incomes by 10%.

I However, it still imposes costs on the economy.I It is unlikely that everyone�s wages would increase at the samerate. Many people have long-term contracts specifying theirwage in nominal terms, for example.

I Also, nominal assets like cash decrease in value when there issigni�cant in�ation. If you hold much of your wealth in cash,then in�ation causes a signi�cant decrease in real wealth foryou.

I (Conti.) The extent to which in�ation redistributes incomedepends in part on whether the in�ation is anticipated� inwhich case consumers, workers, and �rms can see it comingand can prepare for it� or unanticipated� in which case theydo not see it coming and do not prepare for it.

I The problem with anticipated In�ation: Paper money losessome of its value so that anyone holding paper money will �ndthat its purchasing power decreasing by the in�ation rate. Inaddition, �rms need to reprint their price catalog listing morefrequently.

I Menu costs The costs to �rms of changing prices.

I The problem with unanticipated In�ation: When the actualin�ation rate turns out to be very di¤erent from the expectedin�ation rate, some people gain, and other people lose. Thisoutcome seems unfair to most people because they are eitherwinning or losing only because something unanticipated hashappened. This apparently unfair redistribution is a keyreason why people dislike unanticipated in�ation.

What�s so Bad about De�ation?

I What if an economy begins to experience falling prices �de�ation?

I Should falling prices encourage consumers to increase theirspending as G&S become less expensive? According to twoimportant de�ationary episodes: the U.S. during the 1930sand Japan during the 1990s, the answer is No. The mainreason is that many consumers in the face of de�ation werewaiting for prices to go even lower.

I Waiting for falling prices was also a problem for the U.S.housing market in the late 2000s. When housing prices beganto decline, many potential buyers postpones purchases in theexpectation that prices would continue to fall.

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Makingthe

ConnectionWhat’s So Bad about Falling Prices?

Deflation is much more dangerous for an economy than inflation.Why? Suppose you are considering buying a car. You know the car will be cheaper next year, so you delay purchasing. But if everyone does the same, then many purchases are postponed, firms stop producing, people become unemployed, etc.This can create a dangerous downward-spiral, delaying economic recovery. Economists believe this occurred after the Great Depression of the 1930s, and also in Japan in the 1990s.There were concerns that significant periods of deflation might have followed the recession of 2007-2009. but fortunately that did not occur.

Common Misconceptions to Avoid

I Many economic indicators like the unemployment rate areonly created from sample data, so they are not exactmeasures of economic well-being.

I The BLS does not estimate separately the causes ofunemployment; but these are still useful to understand.

I The price level compares prices in a given year to those in abase year; in�ation represents changes in price levels.