Chapter 8 Unemployment and Inflation



I.                  UNEMPLOYMENT


A.   Unemployment has obvious costs:


1.     Personal- loss of paycheck, loss of personal identity, linked to crime, suicide, heart disease, and mental illness.

2.     Costs to society- less goods/services produced.


B.    Measuring Unemployment:


Adult population – civilian (non-military), non-institutional (not in mental hospital or prison), adult (16 or over) population.


Labor Force – Those in the adult population either working or looking for work.


-You are counted as unemployed if you have no job but have looked for work at least once during the preceding four weeks.


Unemployment Rate – percentage of those in the labor force who are unemployed.

          = Number of people without jobs, looking for work/ # in labor force.



Productive Capacity depends on the proportion of adults in the labor force.


Labor Force Participation Rate – Ratio of adult population in the labor force to total adult population.



Not counted:

1.     retired

2.     chose to stay home, care for children

3.     full-time students

4.     do not want to work

5.     unable to work

6.     discouraged worker – A person who has dropped out of the labor force because of lack of success in finding a job.

7.     Part-time workers – counted as employed even if they would like to work full-time.


A.   How well does the unemployment rate measure unemployment?


1.     Because the unemployment rate does not count 6,7 à it may underestimate the true extent of unemployment.


Official data also ignores the problem of Underemployment – A situation in which workers are overqualified for their jobs or work fewer hours than they would prefer.


2.     On the other hand, because benefits require that people look for work, some people may be pretending to search. Their inclusion tends to overstate the official unemployment figures.


**Most experts tend to believe that unemployment figures underestimate the level of unemployment.






B.    What the unemployment rate does not tell us.



1.     Unemployment Rate does not tell us who is unemployed.


-Unemployment rates higher among African Americans than whites.

-Unemployment rates higher among teenagers than those over 20.

-First dismissed in recession (less training), move in and out of job market because of school, etc.


2.     Unemployment Rate does not tell us how long people remain unemployed.

1998- average duration 14.5 weeks.

Typically, a rise in unemployment rate reflects both a larger number of unemployed and a longer duration of unemployment.


3.     Unemployment Rate does not show the differences in unemployment across the country.



C.   Types of Unemployment


1.     Frictional Unemployment – Unemployment that arises because of the time needed to match qualified job seekers with available job openings.


Workers do not always accept the first job they get. Employers do not always hire the first applicant. The time required for labor suppliers and labor demanders  together results in frictional unemployment. Usually short-term, voluntary.


2.     Structural Unemployment – Unemployment that arises because

1.     The skills demanded by employers do not match the skills of the unemployed, or

2.      The unemployed do not live where the jobs are located.


This type of unemployment arises from a mismatch of skills or geographic location.


Structural unemployment occurs because changes in tastes, technology, taxes, or competition reduce the demand for certain skills and increase the demand for other skills. Workers may be stuck with skills that are no longer demanded. Workers must seek jobs elsewhere or develop skills that are in demand. This is not easily done. Costs of moving may be so high that unemployed remain where they are, and remain structurally unemployed.



3.     Seasonal Unemployment – Unemployment caused by seasonal shifts in labor supply and demand.


During winter, what happens to the demand for lifeguards, golf instructors, etc..?



4.     Cyclical Unemployment – Unemployment that fluctuates with the business cycle, increasing during recessions and decreasing during expansions.


Government policies to stimulate Aggregate Demand during recessions are aimed at reducing cyclical unemployment.


D.   What is Full Employment?


Even in what would be considered a healthy economy, there will always be some unemployment (frictional, structural, and seasonal).


The economy is considered to be in FULL EMPLOYMENT if there is no cyclical unemployment. Estimates range from 4 to 6%.


More than ½ of those people unemployed have quit their last job or are new entrants or reentrants into the labor force.


E.    Why is being unemployed today different than it was during the Great Depression?


1.     More homes have two people working, so if one is unemployed, the other is still likely to have a job. (That job will likely provide health insurance, benefits.)


2.     Unemployment Benefits – Cash transfers provided to unemployed workers who actively seek employment and who meet other qualifications.


Congress passed the Social Security Act of 1935 that provided unemployment insurance financed by a tax on employers.


-     Benefits generally available for 6 months, does not cover those reentering the labor force or new entrants, does not cover those who quit or were fired from their last job for excessive absenteeism or theft.


-         Usually pays ½ of a person’s take-home pay.


(about 50% of unemployed workers receive benefits)


Advantages of Unemployment insurance – allows for a higher-quality search. An unemployed worker need not take the first job he or she is offered. A better search leads to a better match, promoting economic efficiency.


Disadvantages of Unemployment insurance – People tend to search “less actively” if they have benefits. This leads to longer duration of unemployment.



F.    International Comparisons of Unemployment


1.     Unemployment rates tend to be higher in the U.K.- ratio of unemployment benefits to average pay are higher. Unemployment benefits extend longer than 6 months.


2.     Difficult to make comparisons between countries because of different definitions of unemployment and different methods for collecting data. Some countries also have laws limiting layoffs and other policies/laws that could affect the unemployment rate.



I.                  INFLATION


A.   What is inflation?

1.     Inflation – A sustained increase in the average level of prices.

2.     Hyperinflation –A very high rate of inflation


What are the problems associated with the hyperinflation?


3.     Deflation  - A sustained decrease in the price level


Example: A deflation occurred during the Great Depression.


4.     Disinflation – A reduction in the rate of inflation


The annual inflation rate is the percentage increase in the price level between one year and the next.


B.    Sources of Inflation


1.     Demand-pull inflation – A sustained rise in the price level caused by increases in aggregate demand.


Rising inflation in the 1960s resulted from demand-pull inflation.


2.     Cost-push inflation – A sustained rise in the price level caused by reductions in aggregate supply.



1974, 1975 crop failure and decreases in the supply of oil reduced AS.


C. Problems with Inflation


1.     Anticipated v. Unanticipated Inflation


Unanticipated inflation creates more problems for the economy than does anticipated inflation.


Inflation higher than expected à Winners are those who contracted to pay a price that doesn’t reflect the higher inflation. Losers are those who agreed to sell at that price.


Inflation lower than expected à Winners are those who contracted to sell at a given price that anticipates higher inflation. Losers are those who agreed to buy at that price.


Example:      -Inflation next year is expected to be 3%.

-You agree to work next year for a nominal wage 3% higher than your wage this year. (Expect real wage to be unchanged)


What if inflation is 5%?  Your real wage will fall. Your employer is the winner, and you are the loser.


What if inflation is 2%? Your real wage will increase. You are the winner, and your employer is the loser.


These arbitrary gains and losses associated with unanticipated inflation are one of the reasons inflation is not good.


2.     Transaction Costs of Variable Inflation:


Inflation creates uncertainty about the purchasing power of the dollar. Planning becomes difficult. Managers must shift attention from production to anticipating the effects of inflation. The transaction costs of drawing up contracts increases as inflation becomes more unpredictable.


3.     Inflation Obscures Relative Price Changes


Even with no inflation, the prices of some goods go up while the prices of other goods goes down. Their relative prices change. These relative price changes are important for allocating resources efficiently.


If all prices moved together, producers could link the selling price to the overall inflation rate. But prices do not move together.


Example:  Suppose an employer agrees to raise wages in accordance with the inflation rate. But the price of this employer’s product grows more slowly than the inflation rate.  It will be difficult for this employer to pay the cost-of-living increase.


C.   Inflation and Interest Rates


Interest – The dollar amount paid by borrowers to lenders to forgo present consumption.


Interest Rate – Interest per year as a percentage of the amount loaned.


Interest Rate = 5% à interest = $5 per year on a $100 loan.


The greater the interest rate à the greater the reward for lending money


The higher the interest rate à the greater the opportunity cost of borrowing


The Market for Loanable Funds


Nominal Interest Rate – The interest rate expressed in current dollars as a percentage of the amount loaned; the interest rate on a loan agreement.


Real Interest Rate – The interest rate expressed in dollars of constant purchasing power as a percentage of the amount loaned; the nominal rate of interest minus the inflation rate.


          Real Interest Rate = Nominal Interest Rate – Inflation Rate


No inflation à Real interest rate = nominal interest rate


The real interest rate is known only after the fact.  So lenders and borrowers make their decisions based on the expected real interest rate.


** Why do we care about the real interest rate?


Suppose I borrow $1000 at a rate of 5% for 1 year. At the end of the year, I pay back $1050.


The average cost of a meal this year is $10.

With no inflation, I’m giving up 5 meals next year to borrow this money.

If inflation is 3%, the average cost of a meal is now $10.30. So I’m giving up only 4 meals next year to borrow this money. The $50 I owe has lost value.


From the lender’s point of view, the return on that money is only 5%-3% = 2% (the real interest rate.) Because the money they earn in interest has less purchasing power.