Stone ch16 lecture_powerpoints

16

COREECONOMICS

Gerald Stone

Measuring Inflation and Unemployment

© 2008 Worth Publishers ▪ CoreEconomics ▪ Stone 2 of 2

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ter16 • Inflation

• Unemployment • Unemployment and the Economy

Chapter Outline


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ter16 • At the end of this chapter, the student will be

able to: Distinguish between the price level and the rate of

inflation Describe commonly used measures of inflation Identify the weaknesses of the CPI as a measure of

inflation Explain the way the unemployment rate is calculated Identify the underlying causes of unemployment

Learning Objectives


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Economic Indicators

• Every month, the Department of Labor through its Bureau of Labor Statistics issues updates on unemployment and the price level.

• Both numbers are considered important indicators of how the economy is doing and where it is headed. Stock markets can immediately change direction on the release of this data.


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Inflation

• Around the middle of each month, the Bureau of Labor Statistics announces the change in retail prices over the previous month. These updates in the Consumer Price Index provide us with our principal measure of inflation. Note that the price level is the absolute level of a

price index, whether this is the Consumer Price Index (retail prices), the Producer Price Index (wholesale prices), or the GDP Deflator (average price of all items in GDP).

The rate of inflation is the annual rate of increase in the price level.


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Definition of Terms

• Disinflation: A reduction in the rate of inflation. Note that an economy going through disinflation may still be facing inflation, but it will be at a declining rate.

• Deflation: A decline in overall prices throughout the economy. This is the opposite of inflation.

• Hyperinflation: An extremely high rate of inflation. At first, this was defined as an inflation rate of at least 50% a month. Today, most economists refer to inflation above 100% a year as hyperinflation. Hungary experienced the highest rate of inflation on record during World War II.


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Measures of Inflation

• Price Indexes (computed by the Bureau of Labor Statistics) The Consumer Price Index (CPI) is a measure of

the average change in prices paid by urban consumers for a typical market basket of consumer goods and services.

The Personal Consumption Expenditures Index (PCE) measures changes in the cost of consumer items in the GDP accounts.


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Measures of Inflation

• Price Indexes (computed by the Bureau of Labor Statistics) The Producer Price Index (PPI), originally known

as the Wholesale Price Index (WPI), measures the average changes in the prices received by domestic producers for their output.

The GDP Deflator is a measure of the average change in prices of the components in GDP.


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Types of Price Indexes

• A cost-of-living index (COLI) compares the cost of maintaining the same standard of living in the current and base periods.

• A cost-of-goods index (COGI), in contrast, merely measures the cost of a fixed bundle of goods and services from one period to the next. Such an index is calculated by dividing the market basket’s cost in the current period by its cost in the base period. The current CPI is a cost-of-goods index, since it measures changes in the cost of a fixed basket of goods.


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The Consumer Price Index

• The BLS does not have enough resources to price all goods and services in retail outlets, so it uses three scientifically selected sample groups to approximate the spending behavior of urban consumers.

• Goods and services are divided into categories, with each category specifying over 200 items for monthly price collection. After these data have been checked for accuracy, the data from the three surveys are combined, weighted, and used to compute the index.


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Drawbacks of the CPI

• The CPI uses a fixed market basket determined by consumer expenditures surveys that are often 3 to 5 years old. Inherent in a fixed market basket approach is the

assumption that, as prices change, consumers will continue to purchase the same combination of goods as before.

We know, however, that when the price of one good rises, consumers will substitute other goods that have fallen in price, or at least did not rise as much.

To the extent that the CPI does not account for product substitution, it will overstate inflation.


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• In a given year, about 30% of the products in the market basket will disappear from store shelves. Data collectors can directly substitute other products for roughly two-thirds of these products. That means nearly a third of the dropped products, or 10% of

the original market basket, must be replaced by products that have been improved or modified in some important way.

• There are also challenges posed by new products that do not fit properly into any existing category, and so they are overlooked or added into the index at an arbitrary time.


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• The BLS must adjust its selection of retail outlets frequently in response to store closures. When a new retail store enters the sample, it may

sell some product that the store it replaces sold at a different price. The BLS assumes this price difference reflects the differences in the quality of the shopping experience at the two stores and does not change the CPI.

• The current CPI does not track changes in medical costs paid by Medicare, Medicaid, or employer-financed health insurance policies.


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Personal Consumption Expenditures Index

• The major difference between the CPI and the PCE is the weightings of individual components. For example, the PCE has a heavier weighting on

medical care, apparel, and recreation, and lighter weights on food and housing.

The CPI is a fixed market basket that is updated every two years based on surveys, while the PCE, based on GDP components, is updated each period.


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Producer Price Index

• The PPI contains: Price indexes for roughly 500 mining and

manufacturing industries, including over 10,000 indexes for specific products and product categories

Over 3,200 commodity price indexes organized by type of product and end use

Nearly 1,000 indexes for specific outputs of industries in the service sector, and other sectors that do not produce physical products

Several major aggregate measures of price changes, organized by stage of processing, both commodity-based and industry-based


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GDP Deflator

• The GDP Deflator (shown in Figure 2) is our broadest measure of inflation. It is an index of the average prices for all goods and services in the economy, including consumer goods, investment goods, government goods and services, and exports.


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Escalation and Deflation

• Price indexes are used for two primary purposes: escalation and deflation.

• An escalator agreement modifies future payments, usually increasing them, to take the effects of inflation into account.

• Deflating a series of data with an index involves adjusting some nominal value for the impact of inflation, thereby creating what economists call a real value.


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The Consequences of Inflation

• Your attitude toward inflation will depend in large part on whether you live on a fixed income, whether you are a creditor or debtor, and whether you have properly anticipated inflation.

• Debtors benefit from unanticipated inflation; the real value of their payments declines as their wages rise with inflation. Many homeowners in the 1970s and 1980s saw the value of

their real estate rise from inflation while their mortgage payments remained fixed. At the same time, average incomes rose partly due to inflation. The result was that a smaller part of the typical family’s income was needed to pay the mortgage, and thus the real value of mortgages had declined.


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Hyperinflation

• Hyperinflation is an extremely high rate of inflation, above 100 percent per year.

• The causes of hyperinflation are usually an excess of government spending over tax revenues coupled with the printing of money to finance these deficits.

• When hyperinflation is at its worst, workers are paid hourly and they make purchases immediately. Eventually, the monetary system breaks down and barter takes over. People become unwilling to accept money in exchange for goods or services.


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Checkpoint Inflation

• Inflation is a measure of the change in the cost of living.• Inflation, a general rise in prices throughout the

economy, is measured using price indexes.• Disinflation is a reduction in the rate of inflation, while

deflation is a decline in overall prices in the economy.• Hyperinflation is an extremely high rate of inflation.• The Consumer Price Index (CPI) measures inflation for

urban consumers and is based on a survey of a fixed market basket of goods and services each month.

• The Personal Consumption Expenditures index (PCE) is based on consumer expenditures in the GDP accounts.


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Checkpoint Inflation

• The Producer Price Index (PPI) measures price changes for the output of domestic producers.

• The GDP Deflator is the broadest price index and covers all goods and services in GDP.

• Escalator clauses adjust payments such as wages to account for inflation.

• Inflation affects people on fixed incomes and creditors negatively, but benefits debtors and those who anticipate inflation correctly.

• Hyperinflation is typically caused by excessive government spending that is financed by printing money.


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The Historical Record of Unemployment

• U.S. unemployment has varied from a high of 25% of the labor force in the middle of the Great Depression to a low of just over 1% during World War II. For the past fifty years, unemployment has tended to hover around the 5 – 6% range, although it approached 10% during the 1981-83 recession.

• Unemployment for college graduates has consistently been extremely low, coming in at 1.5% in the year 2000.


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Measuring Unemployment

• Every month the Census Bureau, as part of the Current Population Survey, contacts roughly 60,000 households to determine their economic activity. The sample group is drawn from over 700 geographical areas intended to represent the entire United States.

• The Census Bureau does not directly ask interviewees if they are employed. Rather, it asks a series of questions designed to elicit information that permits the Bureau of Labor Statistics to determine by its own standards their employment status.


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Unemployment Statistics

• The three major monthly numbers the BLS reports are the size of the labor force, the number of people employed, and the number unemployed.

• The unemployment rate is the number of people unemployed divided by the labor force. When the Department of Labor announces its results

each month, commentators often note that these numbers understate unemployment, since they do not include chronically unemployed workers who have grown so discouraged they have dropped out of the labor force.


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Underemployment

• Some workers are underemployed in that they are forced to take jobs which do not fully use their education, background, or skills.

• These workers are still counted as employed for the purposes of the BLS reports.


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Checkpoint Unemployment

• People are counted as employed if they worked for income during the survey week.

• People are unemployed if they do not have a job, but are available for work and have been actively seeking work in the previous four weeks.

• The labor force is the sum of the employed and unemployed. The unemployment rate is the unemployed divided by the labor force.

• Unemployment statistics do not account for underemployed and discouraged workers.


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Unemployment and the Economy

• Inevitably, our economy will contain some unemployment. People who are reentering the workforce or entering it for the first time will often find that landing their first job offer can take some time.

• Gathering information and searching for good opportunities can extend the duration of unemployment.


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• Unemployment can occur because wages are artificially set above the market clearing or equilibrium wage. Both minimum wage laws and union bargaining can have this effect, helping those workers who are employed to earn more, but also shutting some potential workers out of jobs.


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• Employers often keep wages above market equilibrium to reduce turnover, boost morale, and increase employee productivity.

• These efficiency wages give employees an incentive to work hard and remain with their present employers, since at other jobs they could get only market wages. These higher wages, however, can also prevent employers from hiring new workers, thus contributing to unemployment.


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• Fluctuations in the business cycle will also generate unemployment. When the economy falls into a recession, sales decline and employers are forced to lay off workers, so unemployment grows.


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Types of Unemployment

• People moving from one job to the next are said to be frictionally unemployed.

• Frictional unemployment is natural for our economy and, indeed, necessary and beneficial. People need time to search for new jobs, and employers need time to interview and evaluate potential new employees.


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• Structural unemployment is roughly the opposite of frictional unemployment. Whereas frictional unemployment is assumed to be of rather short duration, structural unemployment is usually associated with extended periods of unemployment.

• Structural unemployment is caused by changes in the structure of consumer demands or technology.


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• Cyclical unemployment is the result of business cycle effects. If there is a decline in investment or consumer spending, we would expect the rate of economic growth to slow, in which case the economy would probably enter a recession. Cyclical unemployment is the difference between the current unemployment rate and what it would be at full employment.

• Frictional and structural unemployment are difficult problems and macroeconomic policies provide only limited relief. Cyclical unemployment, most economists agree, is where public policymakers can have their greatest impact.


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The Natural Rate of Unemployment

• Economists often refer to the natural rate of unemployment as the non-accelerating inflation rate of unemployment (NAIRU). This is the unemployment level where inflationary

pressures in the economy are at their minimum.


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The Natural Rate of Unemployment

• Full employment, or the natural rate of unemployment, is determined by such institutional factors as the presence or absence of employment agencies and their effectiveness.

• For many technology workers, internet employment agencies like Monster.com represent efficient job search engines. Other factors might include the demographic makeup of the labor force and the incentives associated with various unemployment benefit programs.


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Checkpoint Unemployment and the Economy

• Frictional unemployment is inevitable and natural for any economy as people change jobs and businesses open and close.

• Structural unemployment is typically caused by changes in consumer demands or technology. It is often of long duration and often requires that the unemployed become retrained for new jobs.

• Cyclical unemployment is the result of fluctuations in the business cycle. Unemployment rises during recessions, and then falls when an expansion ensues.

• Macroeconomic policies have their greatest effect on cyclical unemployment.

• Full employment is typically defined as that level where cyclical unemployment is at the level associated with a low non-accelerating inflation rate.


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The Jobless Recovery

• The United States economy went through a recession in 2001 and early 2002. It has since experienced a sustained recovery. We expect job loss in a recession and job creation in a recovery.

• Some have claimed that this was a “jobless recovery” because job loss continued even after the recession ended. The claim was that 2.7 million jobs were lost between January, 2001 and the end of 2003.


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The Jobless Recovery

• There are two surveys used to estimate the number of jobs in the economy: The Household Survey The Payroll Survey They reveal different growth trends

• The slow employment growth in this recovery may be the result of high productivity increases and the shift to self-employment by many high tech workers laid off when the dot.com bubble burst in the late 1990s.


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Chapter Summary

• Inflation is a general rise in prices throughout the economy. Disinflation is a reduction in the rate of inflation, whereas deflation is a decline in the overall price level. Hyperinflation is an extremely high rate of inflation.

• The Consumer Price Index (CPI) is a measure of the average change in prices paid by urban consumers for a market basket of consumer goods and services.

• The Personal Consumption Expenditures index (PCE) measures the change in prices of consumption expenditures in the GDP accounts and is used by the Federal Reserve as its primary measure of inflation because it is broader than the CPI.


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Chapter Summary

• People who live on fixed incomes and creditors are harmed by unanticipated inflation, since it decreases the purchasing power of their incoming funds. By the same token, inflation helps debtors: it decreases the real value of their debts.

• Every month the Bureau of Labor Statistics contacts roughly 60,000 households to determine the economic activity of people during the calendar week in which the twelfth day of the month falls. It asks a series of questions that allows a determination of how large the labor force is and whether people are employed or unemployed .


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Chapter Summary

• Unemployment can result from wage levels that are sometimes kept artificially high to reduce turnover or improve morale. It is also caused by changes in the structure of an industry, downturns in the business cycle, and people entering the workforce or switching jobs and needing time to find work.

• Economists often refer to the natural rate of unemployment as the non-accelerating inflation rate of unemployment (NAIRU). This is defined as the unemployment rate most consistent with a low rate of inflation.

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