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Unemploymentand Inflation

FERNANDO QUIJANO, YVONN QUIJANO,

AND XIAO XUAN XU

P R E P A R E D B Y

In early June 2008, the Bureau of Labor Statistics (BLS) announced thatthe unemployment rate for May 2008 was 5.5 percent.

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● labor forceThe total number of workers, both the employed and the unemployed.

EXAMINING UNEMPLOYMENT6.1

How Is Unemployment Defined and Measured?

● unemployment rateThe percentage of the labor force that is unemployed.

labor force = employed + unemployed

unemployed

labor forceunemployment rate = 100

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● labor force participation rateThe percentage of the population over 16 years of age that is in the labor force.

EXAMINING UNEMPLOYMENT6.1

How Is Unemployment Defined and Measured?

labor force 100

population 16 years and olderlabor force participation rate =

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. EXAMINING UNEMPLOYMENT6.1

How Is Unemployment Defined and Measured?

FIGURE 6.1Unemployment Data, May 2008Approximately 66 percent of the civilian population is in the labor force. The unemployment rate in May 2008 was 5.5 percent.

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In 1948, the labor force participation rate for women 20 years and older was 32 percent. By 1970, it had grown to 43 percent, and by 1997 it had reached 60 percent. Since 1997, the figure has remained virtually constant at 60 percent. Explanations:

• Women may simply have run out of available time.

• Even with new technology, housework and childcare do take time.

Conclusion: Because women provide more household services than men, it is understandable why their labor force participation may have reached a peak.

AFTER GROWING SHARPLY, WOMEN’S LABOR FORCE PARTICIPATION HAS LEVELED OFF

APPLYING THE CONCEPTS #1: What do the recent data show about trends in the percentage of women who are

working?

A P P L I C A T I O N 1

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. EXAMINING UNEMPLOYMENT6.1

How Is Unemployment Defined and Measured?

FIGURE 6.2Unemployment Rates in Developed CountriesAmong the developed countries, unemployment rates vary substantially.

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. EXAMINING UNEMPLOYMENT6.1

Alternative Measures of Unemployment and Why They Are Important

● discouraged workersWorkers who left the labor force because they could not find jobs.

FIGURE 6.3Alternative Measures of Unemployment, May 2008Including discouraged workers, marginally attached workers, and individuals working part time for economic reasons substantially increases measured unemployment in 2008 from 8.49 million to 15.14 million.

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The federal Disability Insurance program provides income to nonelderly workers who are deemed unable to engage in substantial employment.

Economists David Autor and Mark Duggan studied the impact of this program on labor force participation.

They found that the changes in the rules administering the program, the increased generosity of the benefits of the program for low-skilled workers, and the increase in the value of health care services all contributed to an increase in participation in this program.

Since these workers, a portion of whom would have been unemployed, were no longer in the labor force, the economists estimated that the effect of the Disability Insurance program was to lower the measured unemployment rate by 0.5 percent, a very large effect.

MORE DISABILITY, LESS UNEMPLOYMENT?APPLYING THE CONCEPTS #2: Does more liberal

disability insurance decrease measured unemployment?

A P P L I C A T I O N 2

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. EXAMINING UNEMPLOYMENT6.1

Who Are the Unemployed?

FIGURE 6.4Selected U.S. Unemployment Statistics, Unemployment Rates for May 2008The incidence of unemployment differs sharply among demographic groups.

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. EXAMINING UNEMPLOYMENT6.1

Who Are the Unemployed?

● seasonal unemploymentThe component of unemployment attributed to seasonal factors.

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. CATEGORIES OF UNEMPLOYMENT6.2

Types of Unemployment: Cyclical, Frictional, and Structural

● cyclical unemploymentUnemployment that occurs during fluctuations in real GDP.

● frictional unemploymentUnemployment that occurs with the normal workings of the economy, such as workers taking time to search for suitable jobs and firms taking time to search for qualified employees.

● structural unemploymentUnemployment that occurs when there is a mismatch of skills and jobs.

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. CATEGORIES OF UNEMPLOYMENT6.2

The Natural Rate of Unemployment

● natural rate of unemploymentThe level of unemployment at which there is no cyclical unemployment. It consists of only frictional and structural unemployment.

● full employmentThe level of unemployment that occurs when the unemployment rate is at the natural rate.

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. THE COSTS OF UNEMPLOYMENT6.3

● unemployment insurancePayments unemployed people receive from the government.

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How do we balance the benefits and costs of unemployment insurance?

Suppose the government provided all unemployed workers a payment equal to their previous salary as long as they remained unemployed:

• This would prevent unemployed workers from suffering any financial hardship.

• Very few workers would return to work if the government were paying them their full salaries.

• Result: excessive unemployment.

States recognize this and replace only a fraction of a worker’s prior salary—typically about 40 percent.

Economist Jonathan Gruber of MIT attempted to calculate the optimal amount of unemployment insurance.

• Result: Looking at both the costs and the benefits of unemployment insurance, Gruber found that the optimal level of insurance was probably somewhat lower (closer to 30 percent) than the current 40 percent provided by the states.

FINDING THE OPTIMAL LEVEL OF UNEMPLOYMENT INSURANCE

APPLYING THE CONCEPTS #3: What are the costs of eithertoo high or too low levels of unemployment insurance?

A P P L I C A T I O N 3

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. THE CONSUMER PRICE INDEX AND THE COST OF LIVING6.4

● Consumer Price IndexA price index that measures the cost of a fixed basket of goods chosen to represent the consumption pattern of a typical consumer.

The CPI index for a given year, say year K, is defined as

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. THE CONSUMER PRICE INDEX AND THE COST OF LIVING6.4

FIGURE 6.5Components of the Consumer Price Index (CPI)Rent and food and beverages make up 44 percent of the CPI basket. The remainder consists of other goods and services.

The CPI versus the Chain Index for GDP

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. THE CONSUMER PRICE INDEX AND THE COST OF LIVING6.4

Problems in Measuring Changes in Prices

● cost-of-living adjustments (COLAs)Automatic increases in wages or other payments that are tied to the CPI.

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Each year, the federal government increases Social Securitypayments to the elderly by the same rate as the increase inprices measured by the Consumer Price Index.

Reason for this adjustment: to make sure the elderly, whose other income tends to be fixed, do not suffer from cost-of-living increases.

Problem: we actually overcompensate the elderly for price changes and thus increase their benefits in real terms.

• Economists believe the CPI overstates actual price increases by between 0.5 and 1.5 percent a year.

• If we reduced this adjustment for Social Security by 1 percent, it would save $42 billion over a five-year period!

Proponents for the elderly claim this is a misleading argument. Why?

USING THE CPI TO ADJUST SOCIAL SECURITY BENEFITSAPPLYING THE CONCEPTS #4: Are Social Security payments

properly adjusted for changes in the cost of living?

A P P L I C A T I O N 4

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. INFLATION6.5

● inflation rateThe percentage rate of change in the price level.

inflation rate = percentage rate of change of a price index

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. INFLATION6.5

Historical U.S. Inflation Rates

FIGURE 6.6Price Index for U.S. GDP, 1875–2007After remaining relatively flat for 60 years, the price level began to steadily increase after World War II.The price of a postage stamp in 1940 and 2007 illustrates the change in the overall price level that occurred.

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. INFLATION6.5

Historical U.S. Inflation Rates

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. INFLATION6.5

Historical U.S. Inflation Rates FIGURE 6.7U.S. Inflation Rate, 1950–2007, Based on Chain-Weighted Price IndexInflation reached its highest peaks in the postwar era during the decade of the 1970s when the economy was hit with several increases in oil prices. In recent years, the inflation rate has been relatively low.

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. INFLATION6.5

The Perils of Deflation

● deflationNegative inflation or falling prices of goods and services.

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. THE COSTS OF INFLATION6.6

● anticipated inflationInflation that is expected.

● unanticipated inflationInflation that is not expected.

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. THE COSTS OF INFLATION6.6

● menu costsThe costs associated with changing prices and printing new price lists when there is inflation.

● shoe-leather costsCosts of inflation that arise from trying to reduce holdings of cash.

Anticipated Inflation

● hyperinflationAn inflation rate exceeding 50 percent per month.

Unanticipated Inflation

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anticipated inflation

Consumer Price Index (CPI)

cost-of-living adjustments (COLAs)

cyclical unemployment

deflation

discouraged workers

frictional unemployment

full employment

hyperinflation

inflation rate

labor force

labor force participation rate

menu costs

natural rate of unemployment

seasonal unemployment

shoe-leather costs

structural unemployment

unanticipated inflation

unemployment insurance

unemployment rate

K E Y T E R M S