Chapter 10 Inflation and Unemployment

1. Chapter 10Inflation and Unemployment Elby, Carol, Timothy, Suki and Carmen

2. Learning Objectives: With this chapter, we will learn: • about inflation, how it is measured, and its effect on nominal and real incomes • the official unemployment rate, the different types of unemployment, and the definition of full employment

3. Consumer Price Index The Consumer Price Index (CPI): • Is used to measure inflation and monitor price changes in a representative “shopping basket” of consumer products • It also compares the prices of the current year with the bas year Item weights: • are fractions that represents the total cost of the “shopping basket” of consumer goods used to calculate CPI Base year: • is the survey year used as a point of comparison to subsequent years

4. Simple Consumer Price Index Figure 10.1 on Page 223 Results of 2003 Survey Quantity Consumed per Month Item Weights Expenditure per Month Prices Hamburgers Milkshakes $2.00 $1.00 $20 $30 $50 10 30 $20 ÷ $50 = 0.4 $40 ÷ $50 = 0.6 Expenditure per Month has increased $3.50 Prices in 2004 Prices 2004 Price 2003 Quantity Hamburgers Milkshakes $2.20 $1.05 $2.20 x 10 = $22.00 $1.05 x 30 = $31.50 $53.50 That is annual inflation of 7% (3.50 ÷ 50) x 100 = 7% The Consumer Price Index now moves from 100 to 107. The Prices has increased

5. Normal Versus Real Income Consumer Price Index is useful in helping consumers determine the cost of living(the amount consumers must spend on the range of good and services they buy) Nominal Income expressed in common dollars Real Income  expressed in base year dollars Real Income =

6. Normal Versus Real Income Similar Example on Worksheet, Page 2 If Emily’s monthly income increased from $200 to $280, while the CPI rises from 100 to 120. Will Emily be able to have enough purchasing power to keep up with inflation? Increase rate of Wei Ling’s Income: (Price Increase)/(Price of Base Year) x 100 ($80/ $200) x 100 = 40% Now compare with the CPI increase (20% inflation rate) Since Emily’s income by 40%, Emily will have enough purchasing power to keep up with inflation.

7. Limitations of the CPI The consumer price index cannot be used as effectively due to these cases. Consumer differences : • consumer differences, since it is based on the consumption patterns of an average household Changes in spending patterns • changes in spending patterns since it uses base-year quantities Product quality • improvements in product quality

8. The GPD Deflator • Indicates the price changes for all goods and services produced in the economy • It weights them in terms of the economy’s total output • Frequent updating increases the accuracy of the GDP deflator, however the values of GDP are available slower than the CPI • Compares prices in the current year with those in a base year

9. Calculating the GDP DeflatorExample of Worksheet, Page 3 Below is an economy that produces only calculators. The reference year is 2003, where the GDP Deflator is 100; calculate the GDP Deflator for each subsequent year. Output x Reference Year Price Output x Current Price 25,000 x $18 = 450,000 120   $375,000  30,000 x $22 = 660,000  $450,000 146.67 Annual Output at Current Price Output at Reference Year Therefore, the value of the GDP Deflator increased inproportion with the prices of the economy’s output X 100

10. Nominal versus Real GDP • Nominal GDPis expressed in current dollars and indicates the purchasing power of an entire economy • Real GDPis expressed in reference year dollars

11. Finding Real Gross Domestic Product [(700.50) ÷ (92.68)] x 100 = 755.83 [(1154.9) ÷ (107.48)] x 100 = 1074.5

12. Inflation’s Effect Inflation redistributes purchasing power among different groups within the economy: Incomes Cost of Living Adjustment: • Terms in contracts for income adjustments to accommodate changes in price levels Full indexation • Nominal income that automatically rises with the inflation rate Partial indexation • Nominal income rises at less than the inflation rate Fixed incomes • Nominal income that stays constant regardless of the rate of inflation

13. Borrowing and Lending Inflation can also redistribute purchasing power between borrowers and lenders • borrowers win if actual inflation > anticipated inflation • lenders win if actual inflation < anticipated inflation • borrowers and lenders are unaffected if actual inflation = anticipated inflation

14. Borrowing and Lending Interest rate is established in financial markets • Nominal interest rate is the interest rate expressed in money terms • Real interest rate is the nominal interest rate minus the rate of inflation Real Interest Rate = Nominal Interest Rate – Rate of Inflation • A percentage built into a nominal interest rate to anticipate the rate of inflation for the loan period is known as inflation premium

15. Labour Force Survey Labour Force Population: • All residents of Canada (15 years old and above), excluding those living in Northwest, Nunavut and Yukon Territories Labour Force: • Is made up of people in the labour force population that have jobs or are seeking jobs Participation Rate: • Is the percentage of the entire labour force population that makes up the labour force

16. Official Unemployment RateExample on Worksheet, Page 5 • Once the labour force has been determined, its members can be divided into those who are employed and those who are unemployed • Official Unemployment Rate is the percentage of the unemployed people in the entire labour force

17. Example Question Using the following information to determine a) the labour force b) the labour force population c) the official unemployment rate. Unemployed members of the labour force 2.3 million Total Population 15 years of age and over 58.9 million Participation Rate 64% Workers with full-time jobs 21.4 million Part-time workers who do not wish to have full time jobs 4.2 million Part-time workers who wish to have full-time jobs 3.5 million Total population less than 15 years of age 14.6 million

18. Finding the labour force A) The labour force is found by adding the number of unemployed members of the labour force, workers with full-time jobs, part-time workers who wish to have full-time jobs, and part-time workers who do not wish to have full-time jobs. (2.3 million + 21.4 million + 3.5 million + 4.2 million) = 31.4 million Labour Force = 31.4 million Remember, the labour force is made up of people who have jobs or are seeking jobs.

19. Finding the labour force population B) The labour force population is found by rearranging the formula used to find the participation rate, by dividing the labour force by the participation rate Participation Rate = x 100 (31.4 million/64%) = 49.1 million Labour Force Population = 49.1 million

20. Finding the official unemployment rate C) The official unemployment rate is found by dividing the total number of unemployed members of the labour force by the labour force, then multiplying by 100 Unemployment Rate = x 100 (2.3 million/31.4 million) x 100 = 7.3% Unemployment Rate = 7.3%

21. Drawbacks of the Official Unemployment Rate • UNDEREMPLOYMENT is when workers are not fully utilizing their skills and education in their jobs. The rate sometimes understates unemployment by ignoring this factor. • Unemployment statistics do not consider people who give up on looking for jobs after searching for a job without luck. These people are called DISCOURAGED WORKERS and are not considered part of the labor force. • Some people are not honest when responding to Statistics Canada’s labor market survey stating that they are looking for work when they are not. DISHONESTY may overstate employment.

22. Types of Unemployment FRICTIONAL UNEMPLOYMENT: • Workers who are temporarily between jobs or starting to look for a first job STRUCTURAL UNEMPLOYMENT: • A mismatch between people and jobs. This type of unemployment occurs primarily because of gradual changes in the economy. CYCLICAL UNEMPLOYMENT: • Due to fluctuations in output and spending; causes unemployment to rise and fall. SEASONAL UNEMPLOYMENT: • Canadian industries such as agriculture, construction, and tourism.

23. The Rise in the Natural Unemployment Rate • In recent decades Canada’s estimated natural unemployment rate rose because of several main trends • structural change, with shrinking manufacturing and expanding services • past reforms to unemployment insurance (some of which have been reversed) • higher minimum wages in many provinces

24. Full Employment • is the highest expectation of employment for the economy as a whole that also includes natural unemployment • Natural Unemployment Rate, which includes frictional and at least some structural unemployment • Canada is presently associated with an unemployment rate between 6% and 7%

25. Factors affecting Unemployment Trends In recent decades Canada’s estimated natural unemployment rate rose because of several main trends • structural change, with shrinking manufacturing and expanding services • past reforms to unemployment insurance (some of which have been reversed) • Changing participation rates (increasing young people in labour force) • higher minimum wages in many provinces

26. The Costs of Unemployment • High unemployment hurts individuals and the Canadian economy as a whole • The cost of unemployment for the entire economy can be measured by the difference between actual real output and potential output which is the real output associated with full employment

27. Okun’s Law Potential Output: the real output or gross domestic product associated with full employment. For every percentage point that the unemployment rate exceeds the natural unemployment rate, the gap between potential output and actual output is 2.5%. For example: • In 2002, the real GDP in 1997 dollars was $1074.5 billion • The assumed natural unemployment rate is was 6.5% • The unemployment rate was 7.7% (7.7%-6.5%) x (2.5%) $1074.5 x 3% = (1.2 x 2.5) = 32.2 billion = 3% Therefore, in 1997 dollars, the real GDP could have been 32.3 billion higher.

28. End of Chapter 10Inflation & Unemployment Elby, Carol, Timothy, Suki and Carmen