Unemployment and Inflation

Chapter 8

SECOND CANADIAN EDITION

MACROECONOMICSPaul Krugman | Robin Wells

Iris Au | Jack Parkinson

© 2014 Worth Publishers

• How unemployment is measured• The economic significance of the

unemployment rate• Types of unemployment: frictional,

structural and cyclical. • Non-cyclical unemployment: the natural

rate of unemployment

• Inflation adjustment: calculating real values.

• The economic costs of inflation• How inflation and deflation create

winners and losers

WHAT YOUWILL LEARN

IN THIS CHAPTER

Unemployment Rate

• Employment is the number of people currently employed in the economy, either full time or part time.

December 2014: 17,953,600

• Unemployment is the number of people who are actively looking for work but aren’t currently employed.

December 2014: 1,271,800

• The labour force is equal to the sum of employment and unemployment.

December 2014: 19,225,400

(Data source: Labour Force Survey for December 2014)

The unemployment rate is the percentage of the total number of people in the labour force who are unemployed.

• The labour force participation rate is the percentage of the population aged 15 and older that is in the labour force.

(December 2014: 100 x (19,225,400 / 29,190,000) = 65.9%)

(December 2014: 100 x (1,271,800/19,225,400)= 6.6%)

Unemployment Rate

Labour Force Survey• Monthly survey of 56,000 households.

• Basic labour market statistics: employment, unemployment, labour force, unemployment rate.

• Also has information on job characteristics: occupation, industry, hours of work, wages, etc.

• And information on personal characteristics: age, sex, education level, family status, geographic location, etc.

• Most recent results, first Friday of the month (Statistics Canada The Daily, see the link on the course site)

19461949

19521955

19581961

19641967

19701973

19761979

19821985

19881991

19941997

20002003

20062009

20120

2

4

6

8

10

12

14

Canadian Unemployment Rate 1946-2014

%

Unemployment Rate 1946-2014

• Most recent recessions: 2008-09, early-1980s, early-1990s.

Why do we care about unemployment?• An indicator of individual well-being.

Effects of income (current and future), self-esteem, etc.

• An indicator of national economic well-being: A measure of underperformance: economy could produce

more output and income if unemployment was lower.

• An indicator of the state of the economy. The unemployment rate moves with the business cycle. High unemployment can indicate structural economic

problems.

Unemployment Definition: Omissions

• Official definition: the unemployed are not working and arelooking for work.

Official definition omits:Discouraged workers: not working, want to work and are capable of working but have given up looking for work because of a lack of jobs.

Marginally attached workers: not working, want to work, but are not looking for work because they are waiting for a job to start.

Underemployment: -people who work part time because they cannot find full-time jobs.

- people who do not fully use their skills in their current job.

Supplementary Unemployment Rates

Unemployment Profile: Canada, 2014

Highs and Lows of the Unemployment Rate (%): October 2014

Canada 6.0 Men 6.2Women 5.8

Province: Age:Nfld. 10.7 15-19 17.1PEI 7.9 20-24 9.6NS 7.9 25-44 5.2NB 8.6 45+ 4.7Quebec 6.9Ontario 6.1 Highest Education level:Manitoba 4.7 Below HS 12.1Sask. 2.9 HS 6.8Alberta 4.2 College 4.6BC 5.7 University 4.6

Source: Statistics Canada, CANSIM database.

National Unemployment Rates: Fall 2014• Who is highest?

Greece 25.9% Egypt 13.1%Spain 24.0% Italy 12.6%South Africa 25.4% Poland 11.3%

• Who has low unemployment?Thailand 0.8% (!!) S. Korea 3.2%Singapore 1.9% Japan 3.6%Malaysia 2.7% China 4.1%

• Some Others?US 5.8%, Germany 6.7%, UK 6.0%, India 8.8%

(Source: The Economist Economic and Financial Indicators)

Unemployment and Recessions

Unemployment varies with the Business Cycle

• Unemployment rises during recessions, falls gradually during a recovery.

• Unemployment lowest when the economy is booming.

• Cyclical fluctuations in the economy are an important cause of unemployment levels and changes.

• Real GDP growth rates and unemployment rate changes are positively related (see next slide).

Growth and Changes in Unemployment

ECONOMICS IN ACTION

We Don’t Want Our Youth to be NEET

• Those who are aged between 15 and 29, and are Neither Enrolled in school, nor Employed, nor in Training are referred as the “NEET” group.

• The NEET rate measures the percentage of youth who are at risk of becoming discouraged and disengaged, perhaps leading to reduced educational attainment, lack of satisfactory employment opportunities, and other related social problems as a consequence.

ECONOMICS IN ACTION

• Some have argued that the civil unrest and regime changes that occurred in 2010 to 2012 in Tunisia, Egypt, Libya, Yemen, and other countries were due to a high NEET rate.

• Are high NEET rates always a problem? may be caused by young people who choose to travel, take parental leave, do volunteer work.

• In 2009, the NEET rate in Canada was 13.3% (quite low).

• Current high unemployment rate countries like Spain have high NEET rates. Does this signal future unrest?

ECONOMICS IN ACTION

We Don’t Want Our Youth to be NEET

Classifying Unemployment: Three Types

• Frictional unemployment is unemployment due to the time workers spend in job search.

• Structural unemployment is unemployment that results when workers are unable to fill available jobs due to mismatch in skills or locations, or unable to get a job at the prevailing wage.

• Cyclical unemployment is unemployment that arises due to business cycle downturns (recessions).

Frictional Unemployment• There is substantial turnover in the Canadian labour market.

Large numbers of workers enter or leave the labour market each month or move between jobs.

Some employers are expanding, others are shrinking; some new businesses start-up others go out of business.

• Matching workers looking for work with employers looking for workers takes time giving frictional unemployment

• Level of frictional unemployment depends on the efficiency of the search and matching process. Likely at least 2%-3% of frictional unemployment in Canada. Has information technology reduced frictional unemployment? Frictional unemployment is likely to be short duration.

Net Labour Market Flows in 2007

Net flows for E, U and NLF are small compared to number in E,U, NLF.Gross flows (arrows) for U are large vs. number unemployed (40% leave U for either E or NLF in a typical month). Other flows: 2%-4% of source state.

Three Labour force states: Employed (E), Unemployed (U), Not-in-labour-force (NLF)

Distribution of the Unemployed by Duration, 2007

The typical unemployed person had been unemployed 14 weeks or less in 2007. Typical for an economy not in a recession.

Structural Unemployment: Possible Causes• Structural unemployment:

lack of suitable jobs for the available workers. lack of suitable workers for the available jobs. mismatch: workers and job opening differ in skills or

location.• Why?

Changes in structure of the economy: simultaneous decline in some industries or regions and expansion in others.

Government policies that slow adjustment may create it as an unintended consequence e.g. unemployment insurance; policies to keep people in declining regions or declining industries.

Institutions or policies that keep wages higher than equilibrium levels may also promote it (see below).

Structural Unemployment

The Effect of a Minimum Wage on a labour Market

Quantity of labour

Wage Rate Structural

unemployment

Minimum

wage

𝑊 𝐹

𝑊 𝐸

𝑄𝐸𝑄𝐷 𝑄𝑆

Structural Unemployment and Wages

• Minimum wage—a government-mandated floor on the price of labour. Each province and territory sets its own minimum wage. In January 2015, the minimum wage in Canada is between$10.00 in New Brunswick and $11 in Ontario and Nunavut.

• Unions—by bargaining for all of 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.

(could act like a minimum wage)• Efficiency wages—wages that employers set above the

equilibrium wage rate as an incentive for better performance.

The Natural Rate of Unemployment

• The natural rate of unemployment is the normal unemployment rate around which the actual unemployment rate fluctuates.

Natural unemployment = Frictional unemployment + Structural

unemployment

• Cyclical unemployment is a deviation in the actual rate of unemployment from the natural rate.

• Actual unemployment = Natural unemployment + Cyclical

unemployment

GLOBAL COMPARISON: Natural Unemployment Around the OECD

Changes to the Natural Rate of Unemployment• Why does the natural rate of unemployment change?

Demographics: more frictional unemployment if the share of young workers is high (younger: higher turnover)

Policy changese.g. more generous unemployment insurance or higher minimum

wages may raise the natural rate (Canada 1970s)

Structural changes interacting with policies and institutions. Technological change or globalization destroy some jobs and

create others. Adjustment to large changes can raise structural unemployment (more so if policies and institutions slow adjustment).

Canadian Labour Force Makeup

Canadian Natural Rate of Unemployment (NAIRU)

24

68

10

12

%

1946 1956 1966 1976 1986 1996 2006

Unemployment rate NAIRU ms=6,7

Figure 1: Canada Unemployment Rate and NAIRU 1946-2011

Labour Markets and the Circular Flow Diagram

• Labour markets are factor markets: households supply their time to businesses or governments (demand).

• Labour demand: Slopes down in wages: less demanded if labour is more costly (less

profitable to hire, incentives to substitute other inputs for labour); more demand if labour is more productive (shift labour demand right).

• Labour supply: households can supply labour and earn wages or use it for non-work (leisure).

Choice depends on which is of most value to worker.e.g. More supplied if wages are higher; less supplied if need the wage

income less or if have high alternative uses for time.

• Unemployment in supply-demand? (Supply=Demand – no unemployment!) Wages too high? (see minimum wage diagram) Disequilibrium? slow adjustment to equilibrium.

ECONOMICS IN ACTION

Structural Unemployment in Eastern Germany

• An 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 to the west.

ECONOMICS IN ACTION

Structural Unemployment in Eastern Germany

• The result has been a persistently large mismatch between the number of workers demanded and the number seeking jobs.

• How does the labour market respond? Migration: workers migrate from East to West. Wages: wages may fall to make hiring lower-productivity East

German workers more attractive.

• Government: what to do? Encourage migration? Boost East German productivity (infrastructure, investment, retraining)? Encourage West German businesses to locate in East?

Nominal and Real Values• The purchasing power of money changes over time because

the prices of the goods and services bought with these money changes. e.g. if prices double over time a given money payment will only

buy half as many goods or services.

• To accurately compare money payments across time these payments must be adjusted for changes in prices. - money payments that have been adjusted for changing

prices are in “real” terms.- money payments that have not been adjusted for changing

prices are in “nominal” or current dollar terms.

Inflation Adjustment: Calculating Real Values

• The real wage is the nominal wage rate divided by the price level.

• Real income is nominal income divided by the price level.

Example: Real wage = Nominal wage x (inflation adjustment factor) Inflation adjustment factor = (Price level in Base yr.)/ (Price level in current yr.)

Year Minimum CPI Real Minimum Wage Wage (Base yr.=2002) (2002 dollars)

1966 $1.00 17.5 $1 x (100/17.5) = $5.712014 $11.00 125.9 $11x(100/125.9)=$8.74

(recall: CPI=100 in its base year)

• The real interest rate is the nominal interest rate minus the rate of inflation.

Inflation Rate• Inflation rate: percentage increase in the price level

between two time periods.

• Period: usually an annual inflation rate.

Inflation rate = 100 x (Price index in yr. 2)-(Price index in yr. 1) (Price index in yr. 1)

e.g. CPI in June 2014: 125.9 and June 2013: 123.0

Inflation rate June 2013-June 2014 = 100 x (125.9-123.0)/123.0 = 2.36%

• Deflation? Negative inflation (price level falling)

Inflation and Deflation

Inflation in Canada since 1960• What do we see in the previous chart?

High inflation in the 1970s (later: oil shocks and macro policy)

Inflation fell sharply in the early-1980s and early-1990s recessions (also fell in the milder 2008-09 recession).

Low, quite stable inflation since the mid-1990s.(later: Bank of Canada was inflation

targetting)

No deflation in this period. last serious deflation in Canada in 1930s.Modern deflations: Japan since 1990; will the Euro-zone see

deflation in 2015?

Economic Costs of Inflation

• Inflation reduces the purchasing power of money. In periods of high inflation people avoid holding money; Time, effort and resources involved in doing so are called

Shoe-leather costs.

• Menu costs refer to the real costs of changing listed prices. Uses resources that can’t be used for something else.

• Inflation makes money a less reliable unit of measurement. Value is uncertain. A price rises: is it an increase in the real price or just inflation?

Buyers and seller may mistakes that make them worse off.

Inflation and Deflation Problems

• Arbitrary redistribution is another consequence of inflation. Contracts often specify future money payments. Inflation reduces the value of a future payment. Debt contracts (loans, bonds): lenders lose, borrowers gain. Labour contracts: workers lose, employers gain. People on fixed incomes (often pensioners) lose. Deflation: opposite distribution effects to those of inflation.

• Indexing is a way to correct the effect of inflation on the purchasing power of a unit of currency.

e.g. a labour contract could tie future wage increases to future inflation.

The Cost of Disinflation

- Disinflation is the process of bringing the inflation rate down.

- Disinflation may require a costly recession as in the early 1980s and early 1990s.

ECONOMICS IN ACTION

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 (more than 10% a month).

• 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.

ECONOMICS IN ACTION

Israel’s Experience with 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.

e.g. did a high price for a good mean it was more expensive in real terms or did it just reflect

inflation?

Summary

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 labour force, and the labour force participation rate is the percentage of the population age 15 and older that is in the labour force.

Summary

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.

Summary

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 labour 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.

Summary

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 which is adjusted for 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.

• Employment• Unemployment• labour force• labour force participation

rate• Unemployment rate• Discouraged workers• Marginally attached workers• Underemployment• Job search• Frictional unemployment• Structural unemployment• Efficiency wages

• Natural rate of unemployment

• Cyclical unemployment• Real wage• Real income• Shoe-leather costs• Menu costs• Unit-of-account costs• Nominal interest rate• Real interest rate• Disinflation

Key Terms