5 MONITORING JOBS

AND INFLATION
After studying this chapter, you will be able to:
 Explain why unemployment is a problem and
how we measure the unemployment rate and
other labor market indicators

 Explain why unemployment occurs and why it is

present even at full employment

 Explain why inflation is a problem and how we

measure the inflation rate

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© 2016 Pearson Education
 Employment and Unemployment

What kind of job market will you enter when you graduate?
The class of 2014 had a tough time:
In July 2014, 10 million Americans wanted a job but
couldn’t find one and 8 more had given up looking for a
full-time job and taken a part-time job.
Even thought U.S. economy creates lots of jobs (139
million people had jobs during the recession of 2009),
but in recent years, the population has grown faster than
the number of jobs, so unemployment is a serious
problem.

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 Employment and Unemployment

Why Unemployment Is a Problem

Unemployment results in
 Lost incomes and production
 Lost human capital
The loss of income is devastating for those who bear it.
Employment benefits create a safety net but don’t fully
replace lost wages, and not everyone receives benefits.
Prolonged unemployment permanently damages a
person’s job prospects by destroying human capital.

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 Employment and Unemployment

Current Population Survey

The population is divided into two groups:
1. The working-age population—the number of people
aged 16 years and older who are not in jail, hospital, or
some other institution
2. People too young to work (under 16 years of age) or in
institutional care

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 Employment and Unemployment

The working-age population is divided into two groups:

1. People in the labor force
2. People not in the labor force
The labor force is the sum of employed and unemployed
workers.

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 Population Labor Force Categories

Population

Working-age Young people or in

population institutional care

People in People not in

labor force labor force

To be counted as unemployed, a person must available

for work and fall in one of these categories:
Employed Unemployed
1. Without work but has made specific efforts to
find a job within the previous four weeks.
2. Waiting to be called back for a job from which
he/she has been laid off.
3. Waiting to start a new job within 30 days.
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 Three Labor Market Indicators
1 2 3

Unemployment rate Employment-to- Labor force

Population ratio participation rate
= (Number of people
unemployed)/ = (Number of people = (Labor force)/
employed)/ (Working-age
(Labor force)
(Working-age population)
x 100 population) x 100
x 100

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 1 The Unemployment Rate

The amount of unemployment is an indicator of the extent to

which people who want jobs but can’t find them.

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑜𝑝𝑙𝑒 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

The unemployment rate = 𝑥100
𝐿𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒

In June 2014, the labor force was 156 million and

9.7 million were unemployed, so the unemployment rate was
6.2 percent.

The unemployment rate increases in a recession and reaches

its peak value after the recession ends.
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 Unemployment and Recession

Figure 22.2 shows the unemployment rate: 1980–2014.

The unemployment rate increases in a recession.

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 2 The Employment-to-population ratio

The employment-to-population ratio is the percentage

of the working-age population who have jobs.

The employment-to-population ratio

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑜𝑝𝑙𝑒 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
= 𝑥 100
𝑊𝑜𝑟𝑘𝑖𝑛𝑔−𝑎𝑔𝑒 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

In June 2014, the employment was 146.3 million and the

working-age population was 248 million.
The employment-to-population ratio was 59 percent.

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 3 The Labor Force Participation Rate

The labor force participation rate is the percentage of the

working-age population who are members of the labor force.

The labor force participation rate

𝐿𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒
= 𝑥 100
𝑊𝑜𝑟𝑘𝑖𝑛𝑔−𝑎𝑔𝑒 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

In June 2014, the labor force was 156 million and the
working-age population was 248 million.
The labor force participation rate was 62.9 percent.

© 2016 Pearson Education

 Other Definitions of Unemployment
Part-time workers who want full-
Marginally attached workers
time jobs

• A person who currently is neither • Many part-time workers want to work

working nor looking for work but part time, but some part-time workers
has indicated that he or she wants would like full-time jobs and can’t find
and is available for a job and has them.
looked for work sometimes in the
recent past. • In the official statistics, these workers
are called economic part-time workers
• A marginally attached worker who and they are partly unemployed.
has stopped looking for a job
because of repeated failure to find
one is called a discouraged worker. Most Costly Unemployment
• This group does not include in
unemployment rate because they • All unemployment is costly but mostly
haven’t made specific efforts to find costly is the long-term unemployment that
a job within the past four weeks. results from job loss.

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Unemployment and Full Employment

Unemployment can be classified into three types:

 Frictional unemployment
 Structural unemployment
 Cyclical unemployment

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 Three types of
Unemployment

Frictional Structural Cyclical

unemployment unemployment unemployment

- The higher than normal

unemployment at a business
cycle trough and lower than
“Natural” normal unemployment at a
business cycle peak.
unemployment
- A worker who is laid off during
recession will be rehired when
• The unemployment that arises from frictions and economy expand.
structural change when there is no cyclical
unemployment.
*Full employment is defined as a situation in which
the unemployment rate equals the natural
unemployment rate.
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 Frictional Unemployment

 Frictional unemployment is unemployment that arises

from normal labor market turnover.
• The creation and destruction of jobs requires that unemployed
workers search for new jobs.

• Increases in the number of people entering and reentering the

labor force and increases in unemployment benefits raise
frictional unemployment.

 Frictional unemployment is a permanent and healthy

phenomenon of a growing economy.

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 Structural Unemployment

Structural unemployment is
 unemployment created by changes in technology and
foreign competition that change the skills needed to
perform jobs or the locations of jobs.

 Structural unemployment lasts longer than frictional

unemployment.

 Painful for old workers – force them retired earlier, or

take a lower-skilled or lower-paying jobs.

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 Cyclical Unemployment

Cyclical unemployment is the higher than normal

unemployment at a business cycle trough and lower than
normal unemployment at a business cycle peak.

A worker who is laid off because the economy is in a

recession and is then rehired when the expansion begins
experiences cyclical unemployment.

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 “Natural” Unemployment
 Natural unemployment is the unemployment that arises
from frictions and structural change when there is no
cyclical unemployment.

Frictional
unemployment

Natural
unemployment
Structural
unemployment

 The natural unemployment rate is "natural

unemployment" as a percentage of the "labor force".
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 Unemployment and Full Employment

Full employment is defined as the situation in which the

unemployment rate equals the natural unemployment rate.

When the economy is at full employment, there is no

cyclical unemployment or, equivalently, all unemployment
is frictional and structural.

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 Unemployment and Full Employment

The natural unemployment rate changes over time and is

influenced by many factors. The important factors are:

 The age distribution of the population

 The scale of structural change
 The real wage rate
 Unemployment benefits

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 Real GDP and Unemployment over the
cycle
• The quantity of real GDP produced at full employment is
Potential GDP. Potential GDP corresponds to the capacity
of the economy to produce output on a sustained basis.

Output Gap = Real GDP - potential GDP

• Over the business cycle, real GDP fluctuates around

potential GDP, thus output gap fluctuates.
• As the output gap fluctuates, the unemployment rate
fluctuates around the natural unemployment rate.

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 Output Gap and Unemployment Rate
Figure 5.5 illustrate the fluctuations
of output gap and unemployment
rate in U.S. between 1980-2014.
(a) As real GDP fluctuates
around potential GDP,
(b) the unemployment rate
fluctuates around the natural
unemployment rate.
 In recession, cyclical unemp
increase, output gap negative.
 At business cycle peaks, unemp
rate falls, output gap positive.

© 2016 Pearson Education

Three possible scenarios:
1. At full employment,
 unemp rate=natural unemp rate
 real GDP=potential GDP
 output gap=0

2. Unemp rate < natural unemp rate

Real GDP > potential GDP
Output gap = positive

3. Unemp rate > natural unemp rate

Real GDP < potential GDP
Output gap = negative

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© 2016 Pearson Education
 What will it really cost you to pay off
Student loan
your student loan?

Parents’ life
saving

 All depends on what happens to the price level.

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 Price Level, Inflation, and Deflation

 The price level is the average level of prices and the

value of money.
 A persistently rising price level is called inflation.
 A persistently falling price level is called deflation.

Measure the inflation or deflation rate

Price level is important

Distinguish between money values and

real values of economic variables

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 Why Inflation and Deflation Are Problems?

Low, steady, and anticipated inflation or deflation is not a

problem.
Unpredictable inflation or deflation is a problem because it
 Redistributes income
 Redistributes wealth
 Lowers real GDP and employment
 Diverts resources from production

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 Why Inflation and Deflation Are Problems?

Unpredictable changes in the inflation rate redistribute

income in arbitrary ways between employers and workers
and between borrowers and lenders.
A high inflation rate is a problem because it diverts
resources from productive activities to inflation forecasting.
From a social perspective, this waste of resources is a
cost of inflation.
At its worst, inflation becomes hyperinflation—an inflation
rate that is so rapid that workers are paid twice a day
because money loses its value so quickly.

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 Consumer Price Index (CPI)

The Consumer Price Index (CPI) measures the average

of the prices paid by urban consumers for a “fixed” basket
of consumer goods and services.
Practically, CPI tells you about the value of the money in
your pocket.

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 Reading the CPI Numbers

The CPI is defined to equal 100 for the reference base

period.
Currently, the reference base period is 19821984.
That is, for the average of the 36 months from January
1982 through December 1984, the CPI equals 100.
In June 2014, the CPI was 237.7.
This number tells us that the average of the prices paid by
urban consumers for a fixed basket of goods was 137.7
percent higher in June 2014 than it was during
19821984.

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 How to Construct the CPI?

Constructing the CPI involves three stages:

 Selecting the CPI basket

 Conducting a monthly price survey
 Calculating the CPI

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 The CPI Basket

Figure 5.6 illustrates the

CPI basket in 2016.
Housing is the largest
component, 42.6%.
Transportation and food
and beverages are the
next largest components.
All other components
account for 27.4 percent
of the basket.

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 The Monthly Price Survey

Every month, Bureau of Labor Statistics employees check

the prices of the 80,000 goods in the CPI basket in 30
metropolitan areas.

The CPI aims to measure price changes, it is important

that the prices recorded each month refer to exactly the
same item.

BLS records the changes of quality or packaging so that

the price changes can be isolated from other changes.

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 Calculating CPI

1. Find the cost of the CPI basket at base-period prices.

2. Find the cost of the CPI basket at current-period prices.
3. Calculate the CPI for the current period.

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 Calculating CPI

Let’s work an example of

the CPI calculation.
In a simple economy,
people consume only
oranges and haircuts.
The CPI basket is
10 oranges and 5 haircuts.
The cost of the CPI basket
in the base period (2017)
was $50.

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© 2016 Pearson Education
 Calculating CPI

Table 5.1(b) shows the

fixed CPI basket of goods.
It also shows the prices in
the current period.
The cost of the CPI basket
at current-period (2018)
prices is $70.

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 Calculating CPI

𝑪𝒐𝒔𝒕 𝒐𝒇 𝒃𝒂𝒔𝒌𝒆𝒕 𝒂𝒕 𝒄𝒖𝒓𝒓𝒆𝒏𝒕−𝒑𝒆𝒓𝒊𝒐𝒅 𝒑𝒓𝒊𝒄𝒆𝒔

CPI = 𝒙 𝟏𝟎𝟎
𝑪𝒐𝒔𝒕 𝒐𝒇 𝒃𝒂𝒔𝒌𝒆𝒕 𝒂𝒕 𝒃𝒂𝒔𝒆−𝒑𝒆𝒓𝒊𝒐𝒅 𝒑𝒓𝒊𝒄𝒆𝒔

CPI = ($70 ÷ $50)  100 = 140

The CPI is 40% higher in the current period (2018) than it

was in the base period (2017).

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 Calculating Inflation Rate

• The major purpose of the CPI is to measure inflation.

• The inflation rate is the percentage change in the price

level from one year to the next.

𝑪𝑷𝑰 𝒕𝒉𝒊𝒔 𝒚𝒆𝒂𝒓−𝑪𝑷𝑰 𝒍𝒂𝒔𝒕 𝒚𝒆𝒂𝒓

Inflation rate = 𝒙 𝟏𝟎𝟎
𝑪𝑷𝑰 𝒍𝒂𝒔𝒕 𝒚𝒆𝒂𝒓

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 Inflation Rate

Figure 5.7 shows the

relationship between the price
level and the inflation rate.
The inflation rate is
 High when the price level is
rising rapidly.
 Low when the price level is
rising slowly.
 Negative when the price
level is falling.

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 The Biased CPI

The CPI might overstate the true inflation rate for four
reasons:

 New goods bias

 Quality change bias
 Commodity substitution bias
 Outlet substitution bias

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 The Biased CPI
New Goods Bias
New goods that were not available in the base year
appear and, if they are more expensive than the goods
they replace, they put an upward bias into the CPI. i.e:
typewriter and computer.

Quality Change Bias

Quality improvements occur every year. Part of the rise in
the price is payment for improved quality and is not
inflation.
The CPI counts all the price rise as inflation. In this case,
CPI overstates inflation.
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 The Biased CPI

Commodity Substitution Bias

The market basket of goods used in calculating the CPI is
fixed and does not take into account consumers’
substitutions away from goods whose relative prices
increase.

i.e. price of beef , people buy more chicken

and less beef. Chicken price has not changed,
but CPI ignores the substitution
of chicken for beef, it says the
Price of chicken has increased.

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 The Biased CPI
Outlet Substitution Bias
As the structure of retailing changes, people switch to
buying from cheaper sources. i.e. Store A has promotion,
people choose to buy things in Store A rather than other
stores. But the CPI does not take account of this outlet
substitution.

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 The Consequences of CPI Bias

is used to adjust Tax brackets

CPI Social Security checks

Wage rates

rents

The Magnitude of the Bias

• On average, CPI overstates inflation by 1.1% a year.
• That is, if CPI rises by 3.1%, the inflation rate will be 2%
a year.

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 The Consequences of CPI Bias

Some Consequences of the Bias

 Distorts private contracts.
 Increases government outlays (close to a third of
federal government outlays are linked to the CPI).

*A bias of 1 percent is small, but over a decade adds up to

almost $1 trillion of additional expenditure.

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 Alternative Price Indexes

CPI is one of the price level index. Because of the bias

in CPI, other measures are used for some purposes.
 Chained CPI
 Personal consumption expenditure deflator
 GDP deflator

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 Alternative Price Indexes

Chained CPI
The chained CPI is a price index that is calculated using a
similar method to that used to calculate chained-dollar real
GDP described in Chapter 21.

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 Alternative Price Indexes
Personal Consumption Expenditure Deflator
𝑵𝒐𝒎𝒊𝒂𝒍 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆
The PCE deflator = 𝒙 𝟏𝟎𝟎
𝑹𝒆𝒂𝒍 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆

PCE deflator is a broader measure of the price level than

the CPI because it includes all consumption expenditure.

GDP Deflator
GDP deflator is like the PCE deflator except it includes the
prices of all goods and services that are counted in GDP.
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷
GDP deflator = 𝒙 𝟏𝟎𝟎
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷

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 Core Inflation and Stick-price Inflation
• The core inflation rate attempts to reveal the underlying
inflation trend.
• The core inflation rate is calculated as the percentage
change in the PCE index excluding the volatile elements
(food and fuel).
• If the relative prices of the excluded items are changing,
the core inflation rate will be a biased measure of the
inflation.

Thus, a new method of revealing the inflation trend is to

calculate the sticky-price inflation rate, which is the rate at
which infrequently adjusted prices are changing.

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 CPI, Core and Stick-price Inflation
Figure 5.8 graphs the
measured inflation
rates.

The core inflation rate

is below the CPI
inflation.

The sticky-price
inflation rate fluctuated
less than the CPI
inflation rate, but they
have a similar average.
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