The big picture marcoeconomics 12e parkin chapter 05

 The natural unemployment rate is the unemployment rate at full employment; it is comprised of frictional and structural unemployment.. Three Labor Market Indicators  The unemployment

T h e B i g P i c t u r e

Where we have been:

Chapter 5 finishes introducing macroeconomic issues and describing how key macroeconomic variables are measured The link developed in this chapter between employment and real GDP is an important concept that helps serve

as a foundation for the presentation of the aggregate production function in the next chapter Perhaps more significantly, the explanation of the natural rate of unemployment and its relationship to potential GDP are important

building blocks for the AS-AD model developed in Chapter 10 and the Phillips

curve framework developed in Chapter 12 These topics also recur in Chapters

13 and 14 when fiscal and monetary policy is covered

Where we have been:

This chapter increases students’ understanding of the types and sources of unemployment It also provides students with detail on the use of the CPI to measure inflation Alternative price measures also are introduced

N e w i n t h e Tw e l f t h E d i t i o n

The content in Chapter 5 is substantially the same as in the 11th edition The multiple graphs and data in this chapter have all been updated through 2014 The current event topic, which can be found in the ‘Economics in the News’ section, discusses improvements in unemployment along with labor force participation in the United States for 2014 The Worked Problem describes 5 people’s labor-market situation and then asks how the BLS would classify each person and what

happens to the labor force, unemployment rate, and labor force participation rate

if the people’s situation changes To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems

5 MONITORING JOBS AND INFLATION**

C h a p t e r

39

Monitoring Jobs and Inflation

 The unemployment rate, the employment-to-population ratio, and the labor force participation rate are key labor market indicators

 The natural unemployment rate is the unemployment rate at full employment; it is comprised of frictional and structural unemployment

 The unemployment rate fluctuates over the business cycle

 The price level and the inflation rate are measured using the CPI as well as other price indexes

I Employment and Unemployment

Current Population Survey

 The U.S Census Bureau measures the population, labor force, and amount of

employment The working-age population is the total number of people aged 16

years and over who are not in jail, a hospital, or some other form of institutional

care The labor force is the sum of the employed and the unemployed.

 Unemployment occurs when someone who wants a job cannot find one To be

counted as unemployed, a person must be available for work and must be in one of three categories:

 Without work but has made specific efforts to find a job within the previous four weeks

 Waiting to be called back to a job from which he or she has been laid off

 Waiting to start a new job within 30 days

Ask the students, “If I was to assign a homework assignment of estimating the

unemployment rate in your city, how would you do it?” You will probably get an answer of

“Google it,” but tell them that this is not an Internet mining project! Try to have some of your students suggest an in-person survey or a phone survey Now you can walk through some of the issues economists face with data collection (questions to ask, sample size, bias, etc.) Discuss how a grocery store may be a decent place to get a random sample of people from all demographics and how a phone survey might miss some poor,

unemployed person without a phone or students who do not have a land-based phone

Three Labor Market Indicators

 The unemployment rate is the percentage of the people in the labor force who are

unemployed It equals Number of people unemployed

Labor force 100 and Labor force = Number of people employed + Number of people unemployed Between 1980 and

2014 the unemployment rate averaged 6.5 percent

 The employment-to-population ratio is the percentage of people of working age

who have jobs It equals Number of people employed

Working-age population 100. In recent years the employment-to-population ratio has been about 62 percent It has fallen since 2000 and in June 2014 was 59 percent

 The labor force participation rate is the percentage of working-age population

who are members of the labor force It equals Labor force

Working-age population 100. The labor force participation rate has been declining since it reached about 67 percent in

2000 and in June 2014 was 62.9 percent

Jobs and home production It is interesting to ask students to think about appropriate

measures of labor force participation over long periods of time or in very different

economic arrangements The technical definition involves spending time working for gain,

or seeking work for gain In the United States, this usually equates to work outside the

home Ask students whether women who are unpaid family workers on farms are in or out

of the labor force; and then ask whether they are if they don’t work outside the home, but

cook, make and wash clothing, and otherwise maintain the household for a family

 Marginally attached workers are people who are available and willing to work

but currently are neither working nor looking for work These workers often

temporarily leave the labor force during a recession and decrease the labor force

participation rate Because they are no longer counted as unemployed, marginally

attached workers lower the unemployment rate A discouraged worker is a

marginally attached worker who has stopped looking for work because of repeated

failures to find a job

find full time work These workers are not unemployed by the U-3 standard but are

considered “part-unemployed.”

 Marginally attached workers (and discouraged workers) as well as economic

part-time workers who want a full-part-time job are not counted as unemployed in the official unemployment rate

Real World Examples from the Class: Ask the class if anyone has an example of a

‘discouraged worker’ or someone who has taken a part-time job even though he or she

wants a full-time job It would be unusual if no one had a story to tell

Alternative Measures of Unemployment

The BLS creates several alternative measures of unemployment to take account of the

long-term unemployed (who lose the most from unemployment) and marginally

attached workers:

 U–1: includes only those unemployed for 15 weeks as unemployed

 U–2: includes only job losers as unemployed

 U–3: the official unemployment rate

 U–4: adds discouraged workers to the official unemployment rate

 U–5: adds all marginally attached workers to the official unemployment rate.

 U–6: adds part-time workers who want full-time jobs to the U-5 unemployment rate

 Long-term unemployment (U–1) and unemployed job losers (U–2) are about 40

percent of the unemployed on average but 60 percent in a deep recession

 Adding discouraged workers (U–4) makes very little difference to the

unemployment rate, but adding all marginally attached workers (U–5) adds

about one percentage point

 A really big difference is made by adding the economic part-time workers (U–6)

In June 2014, adding these workers to the U-5 unemployed increased the

underemployed rate to 12 percent

II Unemployment and Full Employment

Types of Unemployment

 Frictional unemployment is the unemployment that arises from normal labor

turnover These workers are searching for jobs The unemployment related to this

search process is a permanent phenomenon in a dynamic, growing economy

Frictional unemployment increases when more people enter the labor market or

when unemployment compensation payments increase

 Structural unemployment is the unemployment that arises when changes in

technology or international competition change the skills needed to perform jobs or change the locations of jobs Sometimes there is a mismatch between skills

demanded by firms and skills provided by workers, especially when there are great technological changes in an industry Structural unemployment generally lasts longer than frictional unemployment Minimum wages and efficiency wages create structural unemployment

 Cyclical unemployment is the fluctuating unemployment over the business cycle

Cyclical unemployment increases during a recession and decreases during an expansion

Identifying frictional, structural, and cyclical unemployment Ask your class if

anyone they know has been laid off Then discuss whether losing a job creates frictional, structural, or cyclical unemployment Look at your local examples If you live in a steel-producing or car manufacturing area, for example, you can talk about local structural unemployment arising from the closing of factories due to international competition For cyclical unemployment, ask students how they think the business cycle and cyclical

unemployment is related to full-time enrollments at higher education institutions Students often don’t think there is any relationship But nationally during a recession, the growth rate of full-time enrollments increases Ask students if they can explain this relationship The answer is that during a recession and due to the increase in cyclical unemployment, the opportunity cost of school decreases This is a great way to keep students thinking about marginal benefits and costs

Work through each type of employment asking whether it is good or bad for society (call to their attention that it is usually bad for the individual, but may be good long term for society)

 Frictional? Good because a healthy, dynamic, economy needs new entrants

to the labor force , such ascollege graduates, and freedom for people to quit a job they don’t like

 Structural? Good because a healthy, growing economy has technological

change that makes some jobs obsolete

 Cyclical? Bad because it is unfortunate to have unemployment strictly

because of the cyclical nature of the economy If it were possible to maintain the same level of economic growth with less fluctuation, we would have less cyclical unemployment with a higher level of welfare Can and should the cycle be managed? This is a big question in Macroeconomics that we will continue to tackle!

“Natural” Unemployment

 Natural unemployment is the unemployment that arises from frictions and structural change when there is no cyclical unemployment—when all the unemployment is frictional and structural Natural unemployment as a percentage of the labor force is

called the natural unemployment rate.

 Full employment is defined as a situation in which the unemployment rate equals

the natural unemployment rate

What Determines the Natural Unemployment Rate?

 The Age Distribution of the Population An economy with a young population has a

large number of new job seekers every year and has a high level of frictional

unemployment

 The Scale of Structural Change The scale of structural change is sometimes small but sometimes there is a technological upheaval When the pace and volume of

technological change and when the change driven by international competition

increase, natural unemployment rises

 The Real Wage Rate The natural unemployment rate increases if minimum wage is

raised to exceed the equilibrium wage rate or if more firms use an efficiency wage (a

wage set above the equilibrium real wage to enable the firm to attract the most

productive workers and motivate them to work hard and discourage them from

quitting)

 Unemployment Benefits Unemployment benefits increase the natural unemployment rate by lowering the opportunity cost of job search

There are two controversies that surround the natural unemployment rate The first is the

use of the term “natural,” which offends many who believe any unemployment is always a bad thing From the perspective of an unemployed individual who has yet to find the job he

or she wants, unemployment is bad However, there is some level of unemployment that is good for society because it will help create more productive matches between firms and

workers and allow for technological changes that lead to economic growth The second

controversy is what level of unemployment corresponds to the natural rate Because this

number is unobserved, it must be estimated Some estimates imply the natural rate is

stable and changes only slowly over time Others imply that most of the fluctuations in

unemployment are “natural” These differences are important for macroeconomic policy

because one of the typical goals of policy is to keep the unemployment rate from making

wide swings around the natural rate

Real GDP and Unemployment Over the Cycle

 When the economy is at full employment, the unemployment rate equals the natural unemployment rate and real GDP equals potential GDP When the unemployment

rate is greater than the natural unemployment rate, real GDP is less than potential

GDP And when the unemployment rate is less than the natural unemployment rate, real GDP is greater than potential GDP The gap between real GDP and potential GDP

is called the output gap.

Students often have an innate sense of an asymmetry in business cycle fluctuations

around potential GDP In particular, students often think that the economy is almost always below potential GDP It is important for students to understand that it is possible for the

economy to temporarily rise above potential GDP so that the unemployment rate is less

than natural unemployment rate One (small) example of this state of affairs occurred in

Silicon Valley in the late 1990s when workers who became dissatisfied with a job could quit and be assured of a new job (often at higher pay!) within a few days Indeed, firms paid for expensive radio advertisements “begging” for workers to apply for jobs

III The Price Level, Inflation, and Deflation

The price level is the average level of prices The average level of prices can be rising,

falling, or stable Inflation occurs when the price level persistently rises; deflation occurs

when the price level persistently falls The inflation rate is the percentage change in the

price level

Why Inflation and Deflation are Problems

 Unexpected inflation or deflation is a problem for society because they redistribute

income and wealth Unexpected inflation benefits workers and borrowers;

unexpected deflation benefits employers and lenders They motivate people to divert resources from producing goods and services to forecasting and protecting

themselves from the inflation or deflation

 Unexpected deflation hurts businesses and households that are in debt (borrowers) who in turn cut their spending A fall in total spending brings a recession and rising unemployment

 Hyperinflation is an inflation rate of 50 percent a month or higher

The Consumer Price Index

 The Consumer Price Index (CPI) is a measure of the average of the prices paid by

urban consumer for a fixed “basket” of consumer goods and services The CPI is calculated monthly by the Bureau of Labor Statistics

 The CPI is defined to equal 100 for a period called the reference base period The

current reference base period is 1982-1984, so the average CPI during that period was 100

 In June 2014, the CPI was 237.7 Thus, since 1982-84, prices increased by 137.7 percent

In June 2008, the CPI was 218.8 so the economy experienced deflation between June 2008 and June 2009 Deflation is very uncommon but it does occur

Constructing the CPI

 The BLS conducts an infrequent survey of consumers to determine the average

“basket” of goods and services purchased by urban household Then each month the BLS records the prices of goods and services in the basket, keeping the

representative items as similar as possible in consecutive months The BLS uses the fixed basket quantities and the recorded

prices to determine the cost of the basket

each month The CPI for the month equals

100 multiplied by the ratio of the cost in the

current month to the cost in the base

period

 For example, suppose the initial survey

shows that the CPI basket is 2 books and 20 coffees The initial base period prices and quantities are in the table to the right In this base period, say 2005, the cost of the CPI basket is $100

 Next suppose that the BLS survey taken one month in 2015 reveals that the price of

a book is $35 and the price of a coffee is $3

These 2015 prices and the initial base

period quantities are in the table to the

right In this period the cost of the CPI

basket is $130

 Using these data, the CPI equals ($130 

$100)  100, or 130 So between the base

period and the current period, the CPI has risen by 30 percent

Measuring the Inflation Rate

 The inflation rate is the percentage change in the price level from one year to the

next In a formula,

Inflation rate  CPI this year - CPI last year

CPI last year







100.

 In June 2014, the CPI was 237.7 In June 2013, the CPI was 232.9 Using the formula, between 2013 and 2014, the inflation rate was 2.1%

The Biased CPI

 The CPI has four biases that lead it to overstate the inflation rate The biases are:

 New Goods Bias: New goods are often more expensive than the goods they replace

 Quality Change Bias: Sometimes price increases reflect quality improvements (safer cars, improved health care) and should not be counted as part of inflation

Item Quantit

y Price

Cost (dollars) Book

Coffe

Item Quantit

y

Pric e

Cost (dollars) Book

s

2 $35 $70 Coffe

e

20 $3 $60

 Commodity Substitution Bias: Consumers substitute away from goods and

services with large relative price increases

 Outlet Substitution Bias: When prices rise, people use discount stores more

frequently and convenience stores less frequently

The Magnitude and Consequences of the Bias

 The Boskin Commission in 1996 estimated the bias overstates the inflation rate by

about 1.1 percentage points a year

 Any bias in the CPI matters because many contracts and payments are indexed to

the CPI, including Social Security Close to 1/3 of government outlays are linked to

the CPI

In terms of government outlays linked to the CPI, such as Social Security, a bias of 1

percent amounts to close to a trillion dollars in additional expenditures over a decade

Politically, it is hard to adjust social security payments for the bias, so the current plan is

reduce the measurement bias in the CPI, for instance by revising the basket more

frequently to reflect new goods and substitution changes In 2010, President Obama

proposed a two year wage freeze on all federal employees Their pay is traditionally linked

to the CPI and this freeze was estimated to save the federal government $2 billion dollars!

Alternative Price Indexes

 Three alternative to the CPI are:

 Chained CPI: The chained CPI is calculated similarly to chained GDP (discussed in the Mathematical Note to the previous chapter.) The chained CPI incorporates

both new goods and the substitution of one good for another and so overcomes

these sources of bias But the difference between the chained CPI and regular CPI

is small: on average, since 2000 the chained CPI is 0.7 percentage points lower

per year

 Personal Consumption Expenditure Deflator (PCE deflator): The deflator from

nominal and real consumption expenditure The PCE deflator equals

Nominal consumption expenditure

Real consumption expenditure 100. The basket of goods in the PCE deflator is

broader than the basket in the CPI because it includes all consumption

expenditure

 GDP Deflator: Similar to the PCE deflator, the GDP deflator is from nominal and

real GDP The GDP deflator equals Nominal GDP

Real GDP 100. The difference between the GDP deflator and regular CPI is small: on average, since 2000 the GDP

deflator is 0.4 percentage points lower per year

Core CPI Inflation

 The inflation rate is often volatile To strip out the volatile elements and focus on the underlying trend inflation, the core inflation rate is used The core inflation rate is

the CPI inflation rate excluding volatile elements The core CPI inflation rate equals

the percentage change in the CPI excluding food and fuel prices

Real Variables in Macroeconomics

 Real variables are measured in constant prices and can be considered to be

measured in units of “goods and services.” In general nominal variables, such as the nominal wage rate and nominal GDP, are deflated to become real variables using

the formula real variable = Nominal variable

Price level 100. The exception to this rule is the nominal interest rate (In two chapters the students see that the real interest rate = nominal interest rate  inflation rate.)

The Economics in the News discusses “Job Growth in the Recovery.” It shows how the unemployment rate has fallen but there has been little change in the labor force participation rate

A d d i t i o n a l P r o b l e m s

Michigan now holds a dubious record: It leads the U.S in joblessness The

state’s unemployment rate was 8.5% in May while the U.S unemployment

rate was only 5.5% The reason is clear: Detroit’s emphasis on big trucks and sport-utility vehicles has turned sour But even though the official

unemployment numbers look awful, the reality is worse The official number

does not reflect those who have given up looking for a job

Business Week, June 24, 2008

In 2010, at 13.6 percent of the state’s labor force, Michigan had the nation’s

highest official unemployment rate But in 2012, Michigan’s unemployment

rate fell to 9 percent, a larger fall than that in the United States as a whole

Around 11,000 businesses in Michigan produce high-tech scientific

instruments and components for defense equipment, energy plants, and

medical equipment

a Why was the reality of the unemployment problem in Michigan actually

worse than the 8.5 percent unemployment rate statistic in 2008?

b Was this higher unemployment rate in Michigan frictional, structural, or

cyclical? Explain

c What factor led to the favorable 2012 employment results in Michigan

compared to the U.S average? Was this a frictional, structural or cyclical

factor? Explain

2 The Great Inflation Bias

In 1996 the Boskin Commission was established to determine the accuracy of the CPI The commission concluded that the CPI overstated inflation by 1.1% The commission described four biases in the way the CPI was determined

Fortune, April 3, 2008

a What are the main sources of bias that are generally believed to make the

CPI overstate the inflation rate? By how much did Boskin estimate the CPI

overstates the inflation rate?

b Do the substitutions among different kinds of meat make the CPI biased up

or down?

c Why does it matter if the CPI overstates or understates the rate of inflation?

S o l u t i o n s t o A d d i t i o n a l P r o b l e m s

1 a The unemployment problem is worse than the 8.5 percent unemployment rate

indicates for three reasons First, the unemployment rate does not include

marginally attached workers, such as discouraged workers Second, the

unemployment rate does not include part-time workers would want full-time jobs

Finally the unemployment rate counts only workers who are currently unemployed If

a company has announced that it will be laying off workers in the future, its workers are measured as employed even though they will shortly join the ranks of the

unemployed

b The higher unemployment rate in Michigan is structural Consumers are decreasing the number of U.S.-made large cars in favor of foreign-made smaller cars And to the extent that consumers are buying U.S.-made cars, they are generally smaller cars,

many of which are not manufactured in Michigan So the skills possessed by

Michigan workers are not the skills needed for jobs and the location of workers in Michigan is not the location of available jobs

c The improved labor statistics for Michigan reflected a structural factor in that

industries with goods in high demand were able to move to Michigan and use

retrained skilled workers for their production

2 a The Boskin Commission presented four reasons why the CPI overstates the inflation

rate The four sources of bias are the new goods bias (new goods often cost more than the good they replace); quality change bias (price hikes might reflect quality changes); commodity change bias (changes in relative price lead consumers to switch away from goods and services whose price has risen more rapidly than other goods and services); and, outlet substitution bias (people buy from lower-priced sources when prices rise) The Boskin Commission estimated that the CPI overstates the inflation rate by 1.1 percentage points

b Substitutions among different types of meat biases the CPI upward because the CPI ignores these substitutions For instance, if the price of beef rises and the price of chicken does not change, then consumers respond by switching from beef to

chicken Consumers will eat (approximately) the same amount of protein as before but the substitution of chicken for beef means that their expenditure on protein will not change by the full amount of the price rise for beef The CPI ignores this

substitution and assumes that people buy the same amount of beef as before Therefore the CPI erroneously reports that expenditure on protein has risen by the full amount of the price hike of beef The article says that when consumers respond

to a change in relative price by switching from one type of meat to another, the price

of the new type can’t be compared to the price of the old type because consumers prefer the old type of meat to the new one However the article’s statement can’t be literally true because consumers generally cannot think the second type of meat ranks at zero compared to the first type of meat Hence allowing for no substitution biases the CPI upward because consumers will substitute from one meat to another when relative prices change

c Many decisions depend on the CPI and any errors in the CPI will lead to errors in these decisions For instance, some wage contracts are linked to the CPI If the CPI overstates inflation, then the firms pay too much and some workers might lose their jobs if the firm decides to fire them Conversely if the CPI understates inflation, then workers are paid too little Additionally the government links about a third of its expenditures, including Social Security payments, to the CPI, If the CPI overstates inflation, then government outlays rise more rapidly than justified whereas if the CPI understates inflation, then outlays do not rise enough to offset the true inflation rate

A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s

1 Should discouraged workers be counted as part of the unemployment

rate? By definition, discouraged workers should not be counted as “officially”

unemployed because they are not searching for employment However, the real issue is whether the definition is appropriate On the one hand, these people have given up looking for a job because they cannot find one On the other hand, because these people have given up looking for a job they are quite unlikely to find one Discouraged workers are different from other unemployed workers because discouraged workers are unlikely to find work since they have stopped search All in all, it is probably better that

discouraged workers not be counted directly with other unemployed workers because their low likelihood of finding work makes them fundamentally different than other unemployed workers