Unemployment and Inflation

Costs of Unemployment • Personal Cost • Loss of paycheck • Loss of self-esteem • Increase in stress related psychological problems • Increase in incidence of crime, suicide, and mental illness • Economic Cost • Loss in output

Measuring Unemployment • Civilian Noninstitutional Adult Population • All civilians 16 years of age and older • Excludes institutionalized in prisons or mental hospitals • Excludes those in military • Labor force • Those in the adult population who are either working or looking for work

Measuring Unemployment • Unemployed • Those with no job who are looking for work • Unemployment rate • Measures the percentage of those in the labor force who are unemployed • Equals the number unemployed divided by the number in the labor force • Does not include discouraged workers • Discouraged workers • Those who are no longer looking for work but are unemployed

Exhibit 1: The Adult Population Sums the Employed, the Unemployed, and Those Not in the Labor Force

Labor Force Participation Rate • The number in the labor force divided by the adult population • On average, two out of three adults are in the labor force • Increased from about 60% in 1970 to approximately 67% in 1990 and has remained relatively constant since • Convergence of the participation rates of men and women over last 40 years as more women enter the labor force

Trend of Unemployment Rate • Decline in the unemployment rate over last 20 years • Overall growth in the economy • Relatively fewer teenagers in the work force • Unemployment rate says nothing about who is unemployed or for how long – differs across • Race • Gender • Age • Geographical area • Occupational group

Exhibit 2: The U.S. Unemployment Rate Since 1900

Exhibit 3: Unemployment Rates for Various Groups

Exhibit 4: Unemployment Rates Differ Across U.S. Metropolitan Areas

Sources of Unemployment • Frictional • Seasonal • Structural • Cyclical

Frictional Unemployment • Caused by time required to bring together labor suppliers and labor demanders • Employers need time to learn about the talent available • Job seekers need time to learn about employment opportunities • Generally short-term and voluntary

Seasonal Unemployment • Caused by seasonal changes in labor demand during the year • To eliminate the impact of such changes, monthly unemployment statistics are seasonally adjusted, which smoothes out these factors

Structural Unemployment • Exists because unemployed workers often • Do not have the skills demanded by employers, or • Do not live where their skills are in demand • Occurs because changes in tastes, technology, taxes, or competition reduce the demand for certain skills and increase the demand for other skills

Cyclical Unemployment • Fluctuates with the business cycle, increasing during contractions and decreasing during expansions • Means the economy is operating inside its PPF • Government policies to stimulate aggregate demand recessions is aimed at reducing this type of unemployment

Full Employment • Occurs only if there is no cyclical unemployment • Occurs when the only unemployment is frictional, structural, or seasonal • Does not mean zero unemployment • Frictional, seasonal, and structural unemployment can still occur • Occurs when from 4% to 6% of the labor force is unemployed

Unemployment Compensation • Cash transfers for those who lose their jobs and actively seek employment • Applies to unemployed workers who meet certain qualifications • Problems with unemployment compensation: • Workers who receive benefits tend to search less actively than those who don’t • May reduce the urgency of finding work

International Comparisons • Why are unemployment rates so high in Europe? • Ratio of unemployment benefits to average pay is higher • Unemployment benefits last longer, sometimes years, so workers have less incentive to find new jobs • Government regulations make employers in Europe reluctant to hire new workers because firing them is difficult

Exhibit 5: In the Last Two Decades, Unemployment Rates Fell in the United States, Rose in Japan, and Remained High in Europe

Problems with Unemployment Figures • Understate the actual amount of unemployment because they do not include discouraged workers and underemployed • Underemployment occurs when • people are counted as employed even if they can find only part-time jobs or • Are vastly overqualified for their job

Problems with Unemployment Figures • Tend to overstate unemployment because • Employment insurance and most welfare programs require recipients to seek employment • Some who would prefer to work part time can find only full-time work • Some are forced to work overtime and weekends, but would prefer to work fewer hours • People in the underground economy may not readily acknowledge such jobs because their intent is to evade taxes

Inflation • Inflation: a sustained increase in the average price level • Hyperinflation: extremely high inflation • Deflation: a sustained decline in the average price level • Disinflation: a reduction in the rate of inflation

Inflation • Inflation is typically measured annually • Annual inflation rate is the percentage increase in the average price level from one year to the next • Two sources of inflation • Demand-pull inflation • Cost-push inflation

Exhibit 6a: Inflation Caused by Shifts of AD and AS Curves Increase in the AD curvepulls up the price level. To generate continuous demand-pull inflation, the AD curve must keep shifting outward along a given AS curve Increase in costs of production push up the price level. To generate continuous cost-push inflation, the AS curve must keep shifting to the left along a given AD curve.

Exhibit 7a: Consumer Price Index Since 1913

Exhibit 7b: CPI Since 1913 – Annual Percentage Change

Anticipated versus Unanticipated Inflation • Unanticipated inflation creates more problems for the economy than does anticipated inflation • To the extent that inflation is higher or lower than anticipated, it arbitrarily creates winners and losers • If it is higher than expected, the winners are all those who had contracted to pay a price that anticipates lower inflation • The losers are all those who agreed to sell at that price • If inflation is lower is lower than expected, the situation is reversed

Transaction Costs of Inflation • When prices are stable, people correctly believe they can predict future prices and can plan accordingly • But, if inflation changes unexpectedly, planning gets harder which undermines the ability of money to serve as a link between the present and the future • When dealing with the rest of the world, they must also anticipate how the value of the dollar might change relative to foreign currencies

Obscures Relative Price Changes • Relative pricesdescribe the exchange rate between goods—how much one good costs compared to another • Inflation does not necessarily cause the change in relative prices, but it can obscure them • Occurs because of the greater uncertainty about the price of one good relative to another

Inflation Across Metropolitan Areas • Inflation rates differ across regions mostly because of differences in housing prices, which grow faster in some places than in others • Federal government tracks separate CPIs for each of 26 metropolitan areas.

Exhibit 8: Average Annual Inflation from 1994 to 2004 Differed Across U.S. Metropolitan Areas

Inflation Across CountriesExhibit 9: Inflation Rates in Major Economies Have Trended Lower Over the Past Two Decades

Inflation and Interest Rates • Interest is the dollar amount paid by borrowers to lenders because lenders must be rewarded for forgoing present consumption • The interest rate is the interest per year as a percentage of the amount loaned

Exhibit 10: The Market for Loanable Funds • Greater the interest rate, the greater the reward for loaning money: supply curve slopes downward • The higher the interest rate, the higher cost of borrowing – the quantity of loanable funds demanded decreases as the interest rate increases, other things constant: demand curve for loanable funds is downward sloping • Equilibrium interest rate is at the intersection of the supply of and demand for loanable funds

Interest Rates • Nominal interest rate • Measures interest in terms of the current dollars paid • The interest rate that appears on the borrowing agreement • The rate quoted in the news media • Real interest rate • Equals the nominal rate of interest minus the inflation rate • Expressed in dollars of constant purchasing power

Interest Rates • With no inflation, the nominal and real interest rates would be identical • With inflation, the nominal interest rate exceeds the real interest rate • If the inflation rate is high enough, the real interest rate can actually be negative • The nominal interest would not even offset the loss in spending power because of inflation – lenders would lose purchasing power • Why lenders and borrowers are concerned more about the real interest rate than the nominal interest rate

Interest Rates • The higher the expected rate of inflation, the higher the nominal rate of interest that lenders require and that borrowers are willing to pay • Expected real interest rate equals the nominal rate of interest minus the expected inflation rate

Why is Inflation Unpopular? • Problems with unanticipated inflation • Hits those whose incomes are fixed in nominal terms • Arbitrarily redistributes income and wealth from one group to another • Reduces the ability to make long-term plans • Forces buyers and sellers to pay more attention to prices -less time for production - overall productivity of economy falls

COLA • Cost of Living Adjustment: the increase in a transfer payment or wage that reflects the increase in the price level

Unemployment and Inflation