W H AT I S E C O N O M I C S ?

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C h a p t e r

MONITORING JOBS

5 AND INFLATION**

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The Big Picture
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 (from Chapter 4) is an
important concept that helps serve as a foundation for the presentation of
the aggregate production function in the next chapter.

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.
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.

New in the Thirteenth Edition

The content in Chapter 5 is substantially the same as in the 12th edition with a
few nice improvements. The multiple graphs and data in this chapter have all
been updated through 2017. An update to the Boskin commission bias
analysis includes modifications made since 1996 to lower the size of the bias.
The inflation section now includes the Sticky-Price estimate of inflation to
complement the discussion about the core inflation rate. Economics In Action
takes an interesting look at full employment issues. The current event topic,
which can be found in the ‘Economics in the News’ section, discusses the
relationship between labor force participation and the unemployment rate
during the move to full employment.

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Lecture Notes
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
Number of people
unemployed
are unemployed. It equals  100 and Labor force
Laborforce
= Number of people employed + Number of people unemployed. Between 1980
and 2017 the unemployment rate averaged 6.4 percent.
 The employment-to-population ratio is the percentage of people of working
Numberof people
employed
age who have jobs. It equals  100
. In recent years
Working- age
population
the employment-to-population ratio has been about 62 percent. It has fallen
since 2000 and in June 2017 was 60 percent.

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

Laborforce
who are members of the labor force. It equals  100.
Working - agepopulation
The labor force participation rate has been declining since it reached about 67
percent in 2000 and in June 2017 was 62.7 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.
 Economic part-time workers are people who are working part-time but would like
to 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-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.

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 A really big difference is made by adding the economic part-time workers (U–
6). In June 2017, adding these workers to the U-5 unemployed increased the
underemployed rate to 8.5 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!

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“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

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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 2017, the CPI was 245.0. Thus, since 1982-84, prices increased by 145.0
percent.

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.

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 For example, suppose the initial Cost

survey shows that the CPI basket Item Quantit Pric (dollars)
is 2 books and 20 coffees. The y e
initial base period prices and Book 2 $30 $60
quantities are in the table to the s
right. In this base period, say Coffe 20 $2 $40
2005, the cost of the CPI basket is e
$100.
 Next suppose that the BLS survey taken one month in 2017 reveals that the
price of a book is $35 and the price Cost
of a coffee is $3. These 2017 prices Item Quantit Pric (dollars)
and the initial base period y e
quantities are in the table to the Book 2 $35 $70
right. In this period the cost of the s
CPI basket is $130. Coffe 20 $3 $60
 Using these data, the CPI equals e
($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
 CPI thisyear 
- CPI lastyear
the next. In a formula, Inflation 
rate  
  100
.
 CPI lastyear 
 In June 2017, the CPI was 245. In June 2016, the CPI was 241. Using the formula,
between 2017 and 2016, the inflation rate was 1.7%.
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.
 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. The BLS has now corrected much of the
bias with more frequent expenditure surveys to avoid substitution bias and by
using statistical methods to lessen new goods and quality change bias. The bias
in today’s CPI is almost certainly less than it was in 1996, but some remains.
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.

Alternative Price Indexes

 Three alternative to the CPI are:

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 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
Nominalconsumptio
n expenditur
e
 100
. The basket of goods in the PCE
Realconsumptio
n expenditur
e
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
Nominal GDP
and real GDP. The GDP deflator equals  100. The difference
RealGDP
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 and Sticky-Price 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.
 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
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
Nominalvariable
using the formula real variable =  100
. The exception to this
Pricelevel
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 at Full Employment.” It shows how
the unemployment rate and labor force participation rate have interacted with each
other as the economy reached full employment.

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Additional Problems
1. Michigan: Unemployment Record Holder
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?
d. What steps has the BLS taken since 1996 to lower the bias?

Solutions to Additional Problems

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

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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.
d. The BLS has now corrected much of the bias with more frequent expenditure
surveys to avoid substitution bias and by using statistical methods to lessen new

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goods and quality change bias. The bias in today’s CPI is almost certainly less
than it was in 1996, but some remains.

Additional Discussion Questions

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.
2. What harm is there in calling a part-time worker that wants full-
time work unemployed? Unlike discouraged workers or marginally
attached workers, these people are employed. Interpretation of these
statistics needs to be mindful that people may have a distorted view of
what they want versus what they will do. The U-3 standard is based on
their current situation and gives us actual knowledge of the current state
of employment. The U-6 measure, which includes these part-time workers,
might have more uncertainty in its level. Nonetheless, it is helpful to see
how all of the various alternative measures compare and useful data can
be obtained from all of them.
3. “Unemployment is bad for the unemployed individual and bad for
the nation. Hence the government should force the unemployment
rate to 0 percent.” Comment on this assertion, discussing both its
feasibility and its desirability. The assertion is highly unfeasible. The
laws necessary to drive the unemployment rate to 0 percent would be
draconian. For instance, no college student would be allowed to graduate
until he or she had a job lined up. Once employed, workers would be
forbidden to change jobs unless they had another job already arranged.
Furthermore consumers would be forbidden to change their consumption
baskets because if enough people changed, a firm might go bankrupt…
allowing its workers to become unemployed. The assertion is similarly
undesirable. Some unemployment is productive for the individual because
it allows the worker to leave one job from which he or she is dissatisfied, to
look for another job that will be a better match for the worker’s talents and
skills.
4. How can the unemployment rate be less than the natural rate? The
unemployment rate can be less than the natural unemployment rate when
the cyclical unemployment rate is negative. This outcome can occur when
the economy is in a strong expansion. When the economy is growing
rapidly, unemployed workers find jobs quickly. In many instances the

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match between worker and job will be poor: The firm is eager to find a
worker and the worker accepts the offered job to end his or her spell of
unemployment. But then as time passes the match is discovered to be
poor—the worker does not perform well and/or dislikes the job. This
situation is bad for the business and bad for the worker.
5. How do you think the business cycle affects the duration of
unemployment? On the average, unemployment has a longer duration in
recessions and a shorter duration in expansions.
6. Why is a change in the age structure of the population, increasing
the proportions of young or old workers in the labor force, likely
to change the natural unemployment rate? When the proportion of
young workers increases, the natural unemployment rate rises because
young workers change jobs more frequently than experienced workers. As
these young workers change their jobs, frictional unemployment and,
therefore, natural unemployment rise. Older workers are less prone to
change jobs because they have had more time to find a good job match.
The frictional unemployment rate is lower and so, too, is the natural
unemployment rate when the proportion of old workers in the labor force is
higher.
7. What is the natural unemployment rate? What is the controversy
concerning its measurement? The natural unemployment rate is the
unemployment rate when the economy is at full employment. The natural
rate is comprised of frictional and structural unemployment. One
controversy arises because it is difficult to measure frictional and structural
unemployment. Another controversy arises because the issue of whether
discouraged workers and marginally attached workers should be included
in the natural rate is unclear. While the number of these workers can be
measured with reasonable accuracy, whether they should be included in
the natural rate is controversial.

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