Chapter 9

Unemployment and Inflation

Chapter Outline9.1 Measure the Unemployment Rate, the Labor Force Participation Rate, and the Employment–Population Ratio9.2 Types of Unemployment9.3 Measure Inflation9.4 Use Price Indexes to Adjust for the Effects of Inflation9.5 Cost of Inflation on the Economy

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Labor force The sum of employed and unemployed workers in the economy.

9.1 Measure Unemployment Rate, Labor Force Participation Rate and Employment-to-Population Ratio

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 Household SurveyEach month, the U.S. Bureau of the Census conducts the Current Population Survey (often referred to as the household survey) to collect data needed to compute the unemployment rate.

People are considered employed if they worked during the week before the survey or if they were temporarily away from their jobs because they were ill, on vacation, on strike, or for other reasons.

People are considered unemployed if they did not work in the previous week but were available for work and had actively looked for work at some time during the previous four weeks.

The Department of Labor’s Bureau of Labor Statistics (BLS) classifies people who do not have a job and who are not actively looking for a job as not in the labor force.

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Figure 9.1

The Employment Status of the Civilian Working-Age Population, September 2011

In September 2011, the working-age population of the United States was 240.1 million. The working-age population is divided into those in the labor force (154.0 million) and those not in the labor force (86.1 million). The labor force is divided into the employed (140.0 million) and the unemployed (14.0 million). Those not in the labor force are divided into those not available for work (79.9 million) and those available for work but not currently working (6.2 million).Finally, those available for work but not in the labor force are divided into discouraged workers (1.0 million) and those not currently looking for work for other reasons (5.2 million).

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

• Labor force participation rate. The percentage of the working-age population in the labor force:

ratent Unemployme100forceLabor

unemployed ofNumber

Labor Market Measures

Using the numbers from Figure 9.1, we can calculate the unemployment rate for September 2011:

%1.9100million 154.0

million 14.0

rateion participat forceLabor 100population age-Working

forceLabor

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For September 2011, the labor force participation rate was

%1.64100million 240.1

million 154.0

• The employment–population ratio. The percentage of the working-age population that is employed:

ratio populationEmployment100population age-Working

Employment

For September 2011, the employment–population ratio was

%3.58100million 240.1

million 140.0

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In the BLS household survey, people on active military service are not included in the totals for employment, the labor force, or the working-age population. Suppose people in the military were included in these categories. How would the unemployment rate, the labor force participation rate, and the employment–population ratio change?

What Happens if You Include the Military?Solved Problem 9.1

Solving the Problem

Step 1: Review the chapter material.

Step 2: Show that including the military decreases the measured unemployment rate.The unemployment rate is calculated as

100forceLabor

unemployed ofNumber

Including people in the military would increase the number of people counted as being in the labor force but would leave unchanged the number of people counted as unemployed.Therefore, the unemployment rate would decrease.

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What Happens if You Include the Military?Solved Problem 9.1

Step 3: Show that including the military increases both the measured labor force participation rate and the measured employment–population ratio.The labor force participation rate is calculated as

100population age-Working

forceLabor

and the employment–population ratio is calculated as

100population age-Working

Employment

Including people in the military would increase the number of people in the labor force, the number of people employed, and the number of people in the working-age population all by the same amount. This change would increase the labor force participation rate and the employment–population ratio because adding the same number to both the numerator and the denominator of a fraction that is less than one increases the value of the fraction.

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What Happens if You Include the Military?Solved Problem 9.1

Step 3: Show that including the military increases both the measured labor force participation rate and the measured employment–population ratio.For example, if half of 100 million people in the working-age population are in the labor force, not counting 1 million people in the military, the labor force participation rate excluding the military is

%501000100,000,00

50,000,000

and the labor force participation rate including the military is

%5.501000101,000,00

51,000,000

A similar calculation shows that including the military would increase the employment–population ratio.

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Problems with Measuring the Unemployment Rate

Although the BLS reports the unemployment rate measured to the tenth of a percentage point, it is not a perfect measure of the current state of joblessness in the economy.

One problem that the BLS confronts is distinguishing between the unemployed and people who are not in the labor force.

Other measurement problems can cause the measured unemployment rate to overstate the true extent of joblessness because the household survey does not verify the responses of people included in the survey.

The unemployment rate provides some useful information about the employment situation in the country, but it is far from an exact measure of joblessness in the economy.

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Figure 9.2 The Official Unemployment Rate and a Broad Measure of the Unemployment Rate, 1994–2011

The red line shows the usual measure of the unemployment rate. The blue line shows what it would be if the BLS had counted as unemployed all people who were available for work but not actively looking for jobs and all people who were in part-time jobs but wanted full-time jobs. The difference between the measures was particularly large during the 2007–2009 recession and the weak recovery that followed. Shaded areas indicate months of recession.

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Figure 9.3 Trends in the Labor Force: Participation Rates of Adult Men and Women since 1948

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.

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How Unusual Was the Unemployment Situation Following the 2007–2009 Recession?

Makingthe

Connection

The average period of unemployment was twice as high following the 2007–2009 recession as following any other recession since the end of World War II.

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How Unusual Was the Unemployment Situation Following the 2007–2009 Recession?

Makingthe

Connection

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.

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Figure 9.6 The Annual Unemployment Rate in the United States, 1950–2010

The unemployment rate rises during recessions and falls during expansion. Shaded areas indicate recessions.

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The Establishment Survey: Another Measure of Employment

In addition to the household survey, the BLS uses the establishment survey, sometimes called the payroll survey, to measure total employment in the economy.

The establishment survey provides information on the total number of persons who are employed and on a company payroll.

The establishment survey has the following four drawbacks:

1. It does not provide information on the number of self-employed persons because they are not on a company payroll.

2. It may fail to count some persons employed at newly opened firms that are not included in the survey.

3. It provides no information on unemployment.

4. Its initial employment values can be significantly revised as data from additional establishments become available.

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Table 9.1 Household and Establishment Survey Data for August and September 2011Household Survey Establishment Survey

August September Change August September Change

Employed139,627,00

0140,025,000 398,000 131,231,000 131,334,000 103,000

Unemployed 13,967,000 13,992,000 25,000

Labor force153,594,00

0154,017,000 423,000

Unemployment rate 9.1% 9.1% 0%

Despite its drawbacks, the establishment survey has the advantage of being determined by actual payrolls rather than by unverified answers, as is the case with the household survey.

Note: The sum of employed and unemployed may not equal the labor force due to rounding.

The discrepancy between the two surveys is partly due to the slightly different groups they cover and partly to inaccuracies.

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Frictional Unemployment and Job Search

Frictional unemployment Short-term unemployment that arises from the process of matching workers with jobs.

Most workers spend at least some time engaging in job search, just as most firms spend time searching for a new person to fill a job opening.

Seasonal unemployment refers to unemployment due to factors such as weather, variations in tourism, and other calendar-related events.

Because seasonal unemployment can make the unemployment rate seem artificially high during some months and artificially low during other months, the BLS reports two unemployment rates each month—one that is seasonally adjusted and one that is not.

9.2 Types of Unemployment

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Natural rate of unemployment The normal rate of unemployment, consisting of frictional unemployment plus structural unemployment.

Full Employment

Cyclical unemployment Unemployment caused by a business cycle recession.

When the only remaining unemployment is structural and frictional unemployment, the economy is said to be at full employment.

The natural rate of unemployment is also sometimes called the full-employment rate of unemployment.

Structural unemployment Unemployment that arises from a persistent mismatch between the skills and attributes of workers and the requirements of jobs.

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Unemployment Insurance and Other Payments to the Unemployed The opportunity cost of continuing to search for a job is the salary you are giving up at the job you could have taken.

In the United States and most other industrial countries, the unemployed are eligible for unemployment insurance payments from the government, which help the unemployed maintain their income and spending, lessening the personal hardship of being unemployed and also helping to reduce the severity of recessions.

Many high-income countries also have generous social insurance programs that allow unemployed adults to receive some government payments even after their eligibility for unemployment insurance has ended.

Because the opportunity cost of job search is lower in Canada and the countries of Western Europe, most economists believe that unemployed workers in those countries search longer for jobs, leading to higher unemployment rates.

During the 2007–2009 recession, however, unemployment rates were lower in Canada and Germany than in the United States.

Government Policies and the Unemployment Rate

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Minimum Wage Laws In 1938, the federal government enacted a national minimum wage law requiring firms to pay workers at least $0.25 per hour; by 2011, the lowest legal wage firms could pay workers was $7.25 per hour.

If the minimum wage is set above the market wage determined by the demand and supply of labor, the quantity of labor supplied will be greater than the quantity of labor demanded.

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

Efficiency wage A higher-than-market wage that a firm pays to increase worker productivity.

Labor UnionsLabor unions are organizations of workers that bargain with employers for higher wages and better working conditions for their members. About 9 percent of workers outside the government sector are unionized.

Minimum wage laws, unions, and efficiency wages can cause economies to experience some unemployment even when cyclical unemployment is zero.

Efficiency Wages

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Price level A measure of the average prices of goods and services in the economy.

Inflation rate The percentage increase in the price level from one year to the next.

Because the GDP deflator includes the price of every final good and service, it is the broadest measure of the price level we have and may not clearly indicate how inflation affects the typical household.

In this chapter, we focus on measuring the inflation rate by changes in the consumer price index because these changes come closest to measuring changes in the cost of living as experienced by the typical household.

A third measure of inflation is the producer price index.

9.3 Measure Inflation

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Figure 9.7The CPI Market Basket, December 2010

The Bureau of Labor Statistics surveys 30,000 households on their spending habits. The results are used to construct a market basket of goods and services purchased by the typical urban family of four. The chart shows these goods and services, grouped into eight broad categories. The percentages represent the expenditure shares of the categories within the market basket. The categories of housing, transportation, and food make up about three-quarters of the market basket.

Consumer price index (CPI) An average of the prices of the goods and services purchased by the typical urban family of four.

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Base Year (1999) 2012 2013

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

Steps to construct the Consumer Price IndexStep 1: Identify the Market Basket – the quantities of goods and services consumed by a typical household in the base year. Step 2: Compute the cost of consuming the market basket in the base year and other years.Step 3: Compute the CPI following the formula:CPI in year t = (Cost of the Market Basket in year t / Cost of the market basket in base year) x 100

CPI is also referred to as the cost-of-living index.

Assuming that households buy the same market basket of products each month, the quantities of the products purchased in 2012 and 2013 are irrelevant in calculating the CPI. The numbers in the table can give us the CPI for those years.

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Formula Applied to 2012 Applied to 2013

120100750$

900$

122100750$

915$

CPI = 100year base in the esExpenditur

yearcurrent in the esExpenditur

The values of 120 and 122 are index numbers, which means they are not measured in dollars or any other units. The CPI is intended to measure changes in the price level over time. Thus, the inflation rate in 2013 would be the percentage change in the CPI from 2012 to 2013:

%7.1100120

120122

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Is the CPI Accurate?

Substitution bias. In constructing the CPI, the BLS assumes that consumers purchase the same monthly amount of each product in the market basket, but consumers actually buy fewer of those products that increase most in price.

Increase in quality bias. The BLS attempts to make adjustments so that only the pure inflation part of price increases is included in the CPI, but some price increases are included that partly reflect an improved quality of products.

Outlet bias. Because the BLS continued to collect price statistics from traditional full-price retail stores, the CPI did not reflect the prices some consumers actually paid at discount stores and over the Internet.

New product bias. For many years, the BLS updated the market basket of goods used in computing the CPI only every 10 years, which excluded new products introduced between updates.

There are four biases that cause changes in the CPI to overstate the true inflation rate by 0.5 percentage point to 1 percentage point, according to most economists, which the BLS continues to take steps to reduce:

Producer price index (PPI) An average of the prices received by producers of goods and services at all stages of the production process.

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1984in CPI

2010in CPI dollars 1984in Valuedollars 2010in Value

By using the CPI, we can calculate what $20,000 in 1984 was equivalent to in terms of 2010 purchasing power.

The consumer price index is 104 for 1984 and 219 for 2010, so, on average, prices were 219/104=2.1 times higher in 2010 as in 1984:

115,42$104

219 000,20$

9.4 Using Price Indexes to Adjust for the Effects of Inflation

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Real Values vs. Nominal Values

Economic variables that are calculated in current-year prices are referred to as nominal variables.

For example, your salary/earning each year is in nominal term; the amount of tuition you just paid was in nominal value; the amount you paid to watch a movie at celebration cinema is nominal, and etc.

For some purposes, we are interested in tracking changes in an economic variable over time.

In that case, to correct for the effects of inflation, we need the real variables.

Real Value of a variable in year t = (Nominal value of the variable in year t / price index of year t) x 100

Real variable gives the value of a variable measured in base year prices. Once we convert all years’ nominal values into their real values, all based on the base year prices, we can compare them.

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YearNominal Average Hourly

EarningsCPI

(1982–1984 = 100)

2008 $21.62 216.2

2009 22.21 215.9

2010 22.59 218.6

In addition to data on employment, the BLS establishment survey gathers data on average hourly earnings of production workers—all workers, except for managers and professionals—which are a broad measure of the typical worker’s income. Use the information in the following table to calculate real average hourly earnings for each year.

Calculating Real Average Hourly EarningsSolved Problem 9.5

Solving the Problem

Step 1: Review the chapter material.

Step 2: Calculate real average hourly earnings for each year.To calculate real average hourly earnings for each year, divide nominal average hourly earnings by the CPI and multiply by 100. For example, real average hourly earnings for 2008 are equal to

00.10$1002.216

62.21$

What was the percentage change in real average hourly earnings between 2009 and 2010?

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YearNominal Average Hourly Earnings

CPI(1982–1984 = 100)

Real Average Hourly Earnings(1982–1984 dollars)

2008 $21.62 216.2 $10.00

2009 22.21 215.9 10.29

2010 22.59 218.6 10.33

Calculating Real Average Hourly EarningsSolved Problem 9.5

These are the results for all three years:

Step 3: Calculate the percentage change in real average earnings from 2009 to 2010.This percentage change is equal to

%4.010029.10$

29.10$33.10$

We can conclude that real average hourly earnings increased slightly between 2009 and 2010.For purposes of calculating the change in the value of real average hourly earnings over time, the base year of the price index doesn’t matter. To prove it, try calculating real average hourly earnings for 2009 and 2010 in 2010 dollars, and then calculate the percentage change. Unless you make an arithmetic error, you should find that the answer is still 0.4 percent.

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Nominal interest rate The stated interest rate on a loan.

Approximately,

Real interest rate = Nominal interest rate − Inflation rate

Deflation A decline in the price level.

Real interest rate The nominal interest rate corrected for the effect of inflation.

The interest rate is the cost of borrowing funds, expressed as a percentage of the amount borrowed.

The real interest rate provides a better measure of the true cost of borrowing and the true return from lending than does the nominal interest rate, because it is measured in terms of purchasing power.

Real Interest Rate vs. Nominal interest rate

Disinflation A decline in the inflation, while the price level still rises.

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Figure 9.8 Nominal and Real Interest Rates, 1970–2010

The real interest rate is equal to the nominal interest rate minus the inflation rate. The real interest rate provides a better measure of the true cost of borrowing and the true return on lending than does the nominal interest rate. The nominal interest rate in the figure is the interest rate on three-month U.S. Treasury bills. The inflation rate is measured by the percentage change in the CPI from the same quarter during the previous year.

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Inflation Affects the Distribution of Income

Menu costs The costs to firms of changing prices.

The Problem with Unanticipated Inflation

The extent to which inflation redistributes income depends in part on whether the inflation is anticipated—in which case consumers, workers, and firms can see it coming and can prepare for it— or unanticipated—in which case they do not see it coming and do not prepare for it.

When the actual inflation rate turns out to be very different from the expected inflation rate, some people gain, and other people lose.

For example, lenders lose and debtors gain; workers lose and employers gain; retirees on pensions lose and their former employers gain, etc.

Even when inflation is perfectly anticipated, some individuals will experience a cost.

9.5 Cost of Inflation to the Economy

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What’s So Bad about Falling Prices?

1929 1930 1931 1932 1933

Nominal interest rate 5% 5% 5% 5% 5%

Change in the consumer price index

0 −2.3 −9.0 −9.9 −5.1

Real interest rate 5 7.30 14.00 14.90 10.10

The deflation of the 1930s hurt the U.S. economy because it may have led some consumers to postpone purchases and because it increased the burden on borrowers.The figure shows annual changes in the consumer price index. Suppose that in 1929 you had borrowed money for five years at a nominal interest rate of 5 percent. The table below uses the actual deflation rate in each year to calculate the resulting real interest rates on your loan:

0

2 -