Chapter 9

Unemployment and Inflation

Chapter Outline
9.1 Measure the Unemployment Rate, the Labor
Force Participation Rate, and the Employment
Population Ratio
9.2 Types of Unemployment
9.3 Measure Inflation
9.4 Use Price Indexes to Adjust for the Effects of
Inflation
9.5 Cost of Inflation on the Economy

9.1 Measure Unemployment Rate, Labor Force

Participation Rate and Employment-toPopulation Ratio

The Household Survey

Each month, the U.S. Bureau of the Census conducts the Current
Population Survey (often referred to as the household survey) to
collect data needed to compute the unemployment rate.
People are considered employed if they worked during the week
before the survey or if they were temporarily away from their jobs
because they were ill, on vacation, on strike, or for other reasons.
People are considered unemployed if they did not work in the
previous week but were available for work and had actively looked for
work at some time during the previous four weeks.
Labor force The sum of employed and unemployed workers in the
economy.
The Department of Labors Bureau of Labor Statistics (BLS) classifies
people who do not have a job and who are not actively looking for a
job as not in the labor force.
Discouraged workers People who are available for work but have not
looked for a job during the previous four weeks because they believe
no jobs are available for them.
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Figure 9.1

The Employment
Status of the
Civilian WorkingAge Population,
InSeptember
September2011
2011,
the working-age
population of the
United States was
240.1 million.
The working-age
population is
divided into those
in the labor force (154.0 million)
and those not in the labor force (86.1 million).
The labor force is divided into the employed (140.0 million)
and the unemployed (14.0 million).
Those not in the labor force are divided into those
not available for work (79.9 million)
and those available for work but not currently working (6.2 million).
Finally, those available for work but not in the labor force are divided into
discouraged workers (1.0 million)
and those not currently looking for work for other reasons (5.2 million).
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Labor Market Measures

The unemployment rate.

The percentage of the labor

force that is unemployed:

Number of unemployed
100 Unemployme nt rate
Labor force
Using the numbers from Figure 9.1, we can calculate the
unemployment rate for September 2011:

14.0 million
100 9.1%
154.0 million

Labor force participation rate.

The percentage of

the working-age population in the labor force:

Labor force
100 Labor force participat ion rate
Working - age population
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For September 2011, the labor force participation rate was

154.0 million
100 64.1%
240.1 million

The employmentpopulation ratio.

The
percentage of the working-age population that is employed:

Employment
100 Employment population ratio
Working - age population

For September 2011, the employmentpopulation ratio was

140.0 million
100 58.3%
240.1 million
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Solved Problem 9.1

What Happens if You Include the Military?
In the BLS household survey, people on active military service are not included
in the totals for employment, the labor force, or the working-age population.
Suppose people in the military were included in these categories.
How would the unemployment rate, the labor force participation rate, and the
employmentpopulation ratio change?

Solving the Problem

Step 1: Review the chapter material.
Step 2: Show that including the military decreases the measured unemployment
rate.
The unemployment rate is calculated as

Number of unemployed
100
Labor force
Including people in the military would increase the number of people counted as
being in the labor force but would leave unchanged the number of people
counted as unemployed.
Therefore, the unemployment rate would decrease.
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Solved Problem 9.1

What Happens if You Include the Military?
Step 3: Show that including the military increases both the measured labor force
participation rate and the measured employmentpopulation ratio.
The labor force participation rate is calculated as

Labor force
100
Working - age population
and the employmentpopulation ratio is calculated as

Employment
100
Working - age population
Including people in the military would increase the number of people in the
labor force, the number of people employed, and the number of people in the
working-age population all by the same amount.
This change would increase the labor force participation rate and the
employmentpopulation ratio because adding the same number to both the
numerator and the denominator of a fraction that is less than one increases the
value of the fraction.
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Solved Problem 9.1

What Happens if You Include the Military?
Step 3: Show that including the military increases both the measured labor force
participation rate and the measured employmentpopulation ratio.
For example, if half of 100 million people in the working-age population are in the
labor force, not counting 1 million people in the military, the labor force
participation rate excluding the military is

50,000,000
100 50%
100,000,000
and the labor force participation rate including the military is

51,000,000
100 50.5%
101,000,000
A similar calculation shows that including the military would increase the
employmentpopulation ratio.

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Problems with Measuring the Unemployment

Rate
Although the BLS reports the unemployment rate measured to the
tenth of a percentage point, it is not a perfect measure of the current
state of joblessness in the economy.
One problem that the BLS confronts is distinguishing between the
unemployed and people who are not in the labor force.
Other measurement problems can cause the measured
unemployment rate to overstate the true extent of joblessness
because the household survey does not verify the responses of
people included in the survey.
The unemployment rate provides some useful information about the
employment situation in the country, but it is far from an exact
measure of joblessness in the economy.

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Figure 9.2

The Official Unemployment Rate and a Broad Measure of the

Unemployment Rate, 19942011

The red line shows the usual measure of the unemployment rate.
The blue line shows what it would be if the BLS had counted as unemployed all
people who were available for work but not actively looking for jobs and all
people who were in part-time jobs but wanted full-time jobs.
The difference between the measures was particularly large during the 2007
2009 recession and the weak recovery that followed.
Shaded areas indicate months of recession.
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Figure 9.3

Trends in the Labor Force: Participation Rates of Adult Men and Women
since 1948

The labor force participation rate of adult men has declined gradually since
1948,
but it has increased significantly for adult women, making the overall rate
higher today than it was then.

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Making
the

Connection

How Unusual Was the Unemployment Situation

Following the 20072009 Recession?

The average period of unemployment was twice as high following the

20072009 recession as following any other recession since the end of
World War II.

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Making
the

Connection

How Unusual Was the Unemployment Situation

Following the 20072009 Recession?

The fall of the employmentpopulation ratio may give an even better

indication of how weak the U.S. labor market was during and after the
20072009 recession.
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Figure 9.6

The Annual Unemployment Rate in the United States, 1950

2010

The unemployment rate rises during recessions and falls during expansion.
Shaded areas indicate recessions.
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The Establishment Survey: Another Measure of Employment

In addition to the household survey, the BLS uses the establishment
survey, sometimes called the payroll survey, to measure total
employment in the economy.
The establishment survey provides information on the total number
of persons who are employed and on a company payroll.
The establishment survey has the following four drawbacks:
1. It does not provide information on the number of self-employed
persons because they are not on a company payroll.
2. It may fail to count some persons employed at newly opened firms
that are not included in the survey.
3. It provides no information on unemployment.
4. Its initial employment values can be significantly revised as data
from additional establishments become available.
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Despite its drawbacks, the establishment survey has the advantage of

being determined by actual payrolls rather than by unverified answers,
as is the case with the household survey.

Table 9.1

Household and Establishment Survey Data for August and

September 2011
Household Survey
Establishment Survey
August

September

Change

Employed

139,627,00
0

140,025,000

398,000

Unemployed

13,967,000

13,992,000

25,000

Labor force

153,594,00
0

154,017,000

423,000

August

September

Change

131,231,000 131,334,000

103,000

Note: The sum of employed and unemployed may not equal the labor
Unemployment
9.1%
9.1%
0%
force
due torate
rounding.
The discrepancy between the two surveys is partly due to the slightly
different groups they cover and partly to inaccuracies.

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9.2 Types of Unemployment

Frictional Unemployment and Job
Search

Most workers spend at least some time engaging in job search, just
as most firms spend time searching for a new person to fill a job
opening.

Frictional unemployment

Short-term unemployment that

arises from the process of matching workers with jobs.

Seasonal unemployment

refers to unemployment due to

factors such as weather, variations in tourism, and other calendarrelated events.
Because seasonal unemployment can make the unemployment rate
seem artificially high during some months and artificially low during
other months, the BLS reports two unemployment rates each month
one that is seasonally adjusted and one that is not.

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Structural unemployment

Unemployment that arises

from a persistent mismatch between the skills and attributes of
workers and the requirements of jobs.

Cyclical unemployment

Unemployment caused by a

business cycle recession.

Full
Employment
When
the only remaining unemployment is structural and frictional
unemployment, the economy is said to be at full employment.

Natural rate of unemployment

The normal rate of

unemployment, consisting of frictional unemployment plus structural
unemployment.
The natural rate of unemployment is also

full-employment rate of
unemployment.
sometimes called the

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Government Policies and the Unemployment

Rate
Unemployment
Insurance and Other Payments to the
Unemployed The opportunity cost of continuing to search for a job
is the salary you are giving up at the job you could have taken.
In the United States and most other industrial countries, the
unemployed are eligible for unemployment insurance payments from
the government, which help the unemployed maintain their income
and spending, lessening the personal hardship of being unemployed
and also helping to reduce the severity of recessions.
Many high-income countries also have generous social insurance
programs that allow unemployed adults to receive some government
payments even after their eligibility for unemployment insurance has
ended.
Because the opportunity cost of job search is lower in Canada and the
countries of Western Europe, most economists believe that
unemployed workers in those countries search longer for jobs, leading
to higher unemployment rates.
During the 20072009 recession, however, unemployment rates were 20 of

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Minimum Wage Laws

In 1938, the federal government

enacted a national minimum wage law requiring firms to pay workers
at least $0.25 per hour; by 2011, the lowest legal wage firms could
pay workers was $7.25 per hour.
If the minimum wage is set above the market wage determined by
the demand and supply of labor, the quantity of labor supplied will be
greater than the quantity of labor demanded.
Economists agree that the current minimum wage is above the
market wage for some workers, but they disagree on the amount of
unemployment that has resulted.

Labor Unions
Labor unions are organizations of workers that bargain with
employers for higher wages and better working conditions for their
members. About 9 percent of workers outside the government sector
are unionized.

Efficiency Wages

Efficiency wage A higher-than-market wage that a firm pays to

increase worker productivity.
Minimum wage laws, unions, and efficiency wages can cause
economies to experience some unemployment even when cyclical
is aszero.
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9.3 Measure Inflation

Price level A measure of the average prices of goods and services
in the economy.
Inflation rate The percentage increase in the price level from one
year to the next.
Because the GDP deflator includes the price of every final good and
service, it is the broadest measure of the price level we have and may
not clearly indicate how inflation affects the typical household.
In this chapter, we focus on measuring the inflation rate by changes in
the consumer price index because these changes come closest to
measuring changes in the cost of living as experienced by the typical
household.
A third measure of inflation is the producer price index.

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Consumer price index (CPI) An average of the prices of the goods

and services purchased by the typical urban family of four.
Figure 9.7
The CPI Market
Basket, December
2010
The Bureau of Labor
Statistics surveys
30,000 households on
their spending habits.
The results are used
to construct a market
basket of goods and
services purchased
by the typical urban
family of four.
The chart shows these
goods and services,
grouped into eight
broad categories.
The percentages represent
the expenditure shares of the
categories within the market basket.
The categories of housing, transportation, and food make up about threequarters of the market basket.
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Steps to construct the Consumer Price Index

Step 1: Identify the Market Basket the quantities of goods and services
consumed by a typical household in the base year.
Step 2: Compute the cost of consuming the market basket in the base
year and other years.
Step 3: Compute the CPI following the formula:
CPI in year t =
(Cost of the Market Basket in year t / Cost of the market basket in base
year) x 100
CPI is also referred
as
the cost-of-living index.
Base to
Year
(1999)
2012
Product

Price

Expenditures
(on base-year
quantities)

$100.00

$85.00

$85.00

15.00

300.00

14.00

280.00

25.00

500.00

27.50

550.00

Price

Expenditures

Price

$50.00

$50.00

$100.00

Pizzas

20

10.00

200.00

Books

20

25.00

500.00

Eye
examinations

TOTAL

Quantity

$750.00

Expenditures
(on base-year
quantities)

2013

$900.00

$915.00

Assuming that households buy the same market basket of products each
month, the quantities of the products purchased in 2012 and 2013 are
irrelevant in calculating the CPI. The numbers in the table can give us
the
CPI
for those
years.
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Formula

Expenditur es in the current year

CPI = Expenditur es in the base year 100

Applied to 2012

Applied to 2013

$900

100 120
$
750

$915

100 122
$
750

The values of 120 and 122 are index numbers, which means they are not
measured in dollars or any other units.
The CPI is intended to measure changes in the price level over time. Thus,
the inflation rate in 2013 would be the percentage change in the CPI from
2012 to 2013:

122 120

100 1.7%
120

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Is the CPI
Accurate?
There
are four biases that cause changes in the CPI to overstate the
true inflation rate by 0.5 percentage point to 1 percentage point,
according to most economists, which the BLS continues to take steps
to reduce:
Substitution bias. In constructing the CPI, the BLS assumes
that consumers purchase the same monthly amount of each product in
the market basket, but consumers actually buy fewer of those
products that increase most in price.
Increase in quality bias. The BLS attempts to make
adjustments so that only the pure inflation part of price increases is
included in the CPI, but some price increases are included that partly
reflect an improved quality of products.
New product bias. For many years, the BLS updated the
market basket of goods used in computing the CPI only every 10
years, which excluded new products introduced between updates.

Outlet bias.

Because the BLS continued to collect price

statistics from traditional full-price retail stores, the CPI did not reflect
the prices some consumers actually paid at discount stores and over
the Internet.
Producer price index (PPI) An average of the prices received
by producers of goods and services at all stages of the production
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9.4 Using Price Indexes to Adjust for the Effects

of Inflation
By using the CPI, we can calculate what $20,000 in 1984 was
equivalent to in terms of 2010 purchasing power.
The consumer price index is 104 for 1984 and 219 for 2010, so, on
average, prices were 219/104=2.1 times higher in 2010 as in 1984:

CPI in 2010

CPI
in
1984

Value in 2010 dollars Value in 1984 dollars

219
$42,115
104

$20,000

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Real Values vs. Nominal Values

Economic variables that are calculated in current-year prices are
referred to as nominal variables.
For example, your salary/earning each year is in nominal term; the
amount of tuition you just paid was in nominal value; the amount you
paid to watch a movie at celebration cinema is nominal, and etc.
For some purposes, we are interested in tracking changes in an
economic variable over time.
In that case, to correct for the effects of inflation, we need the

real

variables.
Real Value of a variable in year t
= (Nominal value of the variable in year t / price index of year t) x
100
Real variable gives the value of a variable measured in base year
Once
we convert
all years nominal values into their real
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Solved Problem 9.5

Calculating Real Average Hourly Earnings
In addition to data on employment, the BLS establishment survey gathers data
on average hourly earnings of production workersall workers, except for
managers and professionalswhich are a broad measure of the typical
workers income.
Use the information in the following table to calculate real average hourly
earnings for each year.
Year

Nominal Average Hourly

Earnings

CPI
(19821984 = 100)

2008

$21.62

216.2

2009

22.21

215.9

2010

22.59

218.6

What was the percentage change in real average hourly earnings between 2009
and 2010?

Solving the Problem

Step 1: Review the chapter material.

Step 2: Calculate real average hourly earnings for each year.
To calculate real average hourly earnings for each year, divide nominal average
hourly earnings by the CPI and multiply by 100.
For example, real average hourly earnings for 2008 are equal to
$21.62

100 $10.00
216.2
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Solved Problem 9.5

Calculating Real Average Hourly Earnings
These are the results for all three years:
Year

Nominal Average
Hourly Earnings

CPI
(19821984 = 100)

Real Average Hourly Earnings

(19821984 dollars)

2008

$21.62

216.2

$10.00

2009

22.21

215.9

10.29

2010

22.59

218.6

10.33

Step 3: Calculate the percentage change in real average earnings from 2009 to
2010.
This percentage change is equal to
$10.33 $10.29

100 0.4%
$
10
.
29

We can conclude that real average hourly earnings increased slightly between
2009
and 2010.
For purposes of calculating the change in the value of real average hourly
earnings over time, the base year of the price index doesnt matter.
To prove it, try calculating real average hourly earnings for 2009 and 2010 in
2010 dollars, and then calculate the percentage change.
Unless you make an arithmetic error, you should find that the answer is still 0.4
percent.
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Real Interest Rate vs. Nominal interest rate

The interest rate is the cost of borrowing funds, expressed as a
percentage of the amount borrowed.

Nominal interest rate

Real interest rate

The stated interest rate on a loan.

The nominal interest rate corrected for

the effect of inflation.

imately,

interest rate = Nominal interest rate Inflation rate

The real interest rate provides a better measure of the true cost of
borrowing and the true return from lending than does the nominal
interest rate, because it is measured in terms of purchasing power.

Deflation

A decline in the price level.

Disinflation
rises.

A decline in the inflation, while the price level still

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Figure 9.8

Nominal and Real Interest Rates,

19702010
The real interest rate is equal to the nominal interest rate minus the
inflation rate.
The real interest
rate provides a
better measure of
the true cost of
borrowing and
the true return on
lending than does
the nominal
interest rate.
The nominal
interest rate in the
figure is the
interest rate on
three-month U.S.
Treasury bills.
The inflation rate
is measured by
the percentage
change in the CPI
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9.5 Cost of Inflation to the

Economy
Inflation Affects the Distribution
of Income

The extent to which inflation redistributes income depends in part on

whether the inflation is anticipatedin which case consumers,
workers, and firms can see it coming and can prepare for it or
unanticipatedin which case they do not see it coming and do not
prepare for it.
Even when inflation is perfectly anticipated, some individuals will
experience a cost.
Menu costs The costs to firms of changing
prices.

The Problem with Unanticipated Inflation

When the actual inflation rate turns out to be very different from the
expected inflation rate, some people gain, and other people lose.
For example, lenders lose and debtors gain; workers lose and
employers gain; retirees on pensions lose and their former
employers gain, etc.
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Whats So Bad about Falling Prices?

The deflation of the 1930s
hurt the U.S. economy
2 because it may have led
some consumers to
0
postpone purchases and
because it increased the
burden on borrowers.
The figure shows annual
changes in the consumer
price index.
Suppose that in 1929 you
had borrowed money for
five years at a nominal
interest rate of 5 percent.
The table below uses the
actual deflation rate in
1929
each year to calculate the
Nominal interest
resulting
real rate
interest rates 5%
on
your
Change
in loan:
the
0

1930

1931

1932

1933

5%

5%

5%

5%

9.0

9.9

5.1

14.00

14.90

10.10

2.3

consumer price index

Real interest rate

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