Unemployment and Inflation: © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O'Sullivan & Sheffrin

Unemployment and
Inflation
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan &
Sheffrin
What Is Unemployment?
The unemployed are those
individuals who do not currently
have a job but who are actively
looking for work.
The employed are individuals who
currently have jobs.
Together, the employed and
unemployed comprise the labor
force.
Sheffrin
Unemployment Measures
Labor Force
Labor Force == employed
employed ++ unemployed
unemployed

The unemployment rate is the percentage of people in
the labor force who are unemployed.
Unemployment Number of Unemployed

Rate =
Labor Force
Sheffrin
 The working age population includes
individuals 16 years of age and older
who can legally work in the U.S.
 The labor force participation rate is
the ratio of people in the labor force to
the working-age population.
Labor Force Labor Force

=
Participation Population 16 and
Rate over
Sheffrin
 For example, suppose an economy consists of:
 200,000 individuals 16 years and older.
 122,000 employed.
 8,000 unemployed.
Labor Force = (122,0000 + 8,000) = 130,000

Labor Force 130,000
= = 65%
Participation 200,000
Rate
Unemployment 8,000
Rate = = 6.15%
© 2005 Prentice Hall Business Publishing
Sheffrin 130,000
Survey of Economics, 2/e O’Sullivan &
Unemployment Data, January 2003
U.S. civilian population over 16 years of age

219,897,000
Labor force
145,838,000 Not in the labor
force
Employed Unemployed 74,059,000
137,536,000 8,302,000
Labor force participation rate 64.12%

Unemployment rate 5.7%
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin
Unemployment Rates (2003)
Country Unemployment Rate (%)

United States 5.7
Belgium 10.8
Sweden 5.1
France 9.1
Italy 8.9
Spain 12.1
United Kingdom 5.1
Netherlands 4.3
Japan 5.5
Australia 6.1
Who Are the Unemployed?

The Bureau of Labor Statistics conducts a
monthly survey of households to determine who is employed, unemployed,
or not in the labor force.
 It is difficult to determine if someone is truly looking for work, therefore,
to distinguish between those people who are unemployed and those who
are not in the labor force.
Sheffrin
 People who were looking for work in
the recent past but did not find work
and stopped looking are considered
discouraged workers.
 Discouraged workers are not counted
as unemployed, but considered to
have dropped out of the labor force.
Sheffrin
Workers who hold part-time jobs
but would prefer to have full-time
jobs, and workers holding jobs far
below their capabilities are called
the underemployed.
It is also difficult to distinguish
between employed and
underemployed workers.
Sheffrin
Unemployment Rates
Selected Unemployment Rates, January

2003 (in percent)
Total 5.7
Males 20 years and older 5.4
Female, 20 years and older 4.7
Both sexes, 16-19 years 16.8
White 5.1
African American 10.3
White, 16-19 years 15.2
African American, 16-19 years 30.4
Married men 3.5
Married women 3.8
Women maintaining families 8.0
Types of Unemployment
Cyclical unemployment is the
result of fluctuations in real GDP.
Unemployment rises when real GDP
falls, and falls when the economy
improves.
 Frictional unemployment occurs
naturally in the economy. It refers to
the time it takes to find an
Sheffrinappropriate job.
Types of Unemployment
Structural unemployment
refers to the mismatch between
job openings and the skills of
workers seeking jobs.
It is difficult to draw the line
between frictional and structural
unemployment. Are workers from
the “old economy” able to find jobs
in the “new economy”?
Sheffrin
The Natural Rate of Unemployment
When the economy is at full

employment, the unemployment
rate is not zero, but equal to the
natural rate of unemployment.

The natural rate of unemployment consists
of frictional and structural unemployment. It is the unemployment that
exists when actual GDP is equal to potential GDP—there is no cyclical
unemployment.
Sheffrin
In the United States, economists

estimate that the natural rate of
unemployment is between 4.0%
and 5.5%. In Europe it is between
7% and 10%.
The economy needs some
frictional unemployment to
operate efficiently.
Sheffrin
 When the growth rate of real GDP slows down relative to its long-run
trend, the actual unemployment rate exceeds the natural rate of
unemployment—cyclical
unemployment rises.
 On the other hand, if economic growth
is too rapid, the economy will
“overheat” and cyclical
unemployment will be negative.
Sheffrin
The Costs of Unemployment
 Excess unemployment cause both society
and individuals to suffer:
 Excess unemployment means the economy is no
longer producing at its potential, i.e., some of
society’s resources are being wasted;
 Lower employment translates into reduced
income and immediate hardship for individuals,
especially those with fixed obligations;
 Unemployment cost can also linger into the
future. Some skills are likely to be lost as a
result of prolonged unemployment;
 Unemployment can impose psychological
costs, i.e., divorce, crime, suicide, … etc.
© 2005 Prentice Hall Business Publishing
Sheffrin
Survey of Economics, 2/e O’Sullivan &
Unemployment and Inflation
 When the economy is “overheated,”
and unemployment rates are low, firms
will find it difficult to recruit workers,
and competition among firms will lead
to increases in wages.
 As wages increase, increases in prices
soon follow. The sign of overheating
will be a general rise in prices for the
entire economy, or inflation.
Sheffrin
The Consumer Price Index
 The Consumer Price Index (CPI) is an index
that measures changes in a fixed “basket of
goods” which contains items purchased by
the typical consumer.
 The CPI is a measure of the value of money
over time.
 Reality PRINCIPLE
What matters to people is the real
value or purchasing power of money
Sheffrin
or income, not its face value.
 The CPI index for a given year, say year K, is defined as:
CPI in Cost of Basket in Year K

= × 100
Year K Cost of Basket in base Year
Sheffrin
Example:
 Cost of basket in 1992, the base year = $200
 Cost of same basket in 1997 = $250
$200
C P I in 1 9 9 2 = x 100 = 100
$200
$250
C P I in 1 9 9 7 = x 100 = 125
$200
Prices increased an average of 25% over this

five-year period.
Sheffrin
The CPI and the Standard of Living
 Suppose you have $300 in 1992. How much would you need to be able
to have the same standard of living in 1997?
 Using the ratio of the CPI in 1997 to the CPI in 1992:
125  You need $375 in 1997

300 x = 375 just to maintain what
100
was your standard of
living in1992.
Sheffrin
Components of the CPI, 1992
Components of the CPI
Medical (5.00%) Other services (7.00%)

Transportation (7.00%)
Household services Food & beverage (18.00%)
(9.00%)
Apparel (6.00%)
Rent (26.00%)
Non-durables (11.00%)
Durables (11.00%)
Sheffrin
The CPI Versus the GDP
Deflator
Both the CPI and the GDP deflator
(including the more recent chain
price for GDP) are measures of the
average prices for the economy.
The CPI includes goods produced in
prior years, as well as imported
goods, while the GDP deflator does
not.
Sheffrin
Problems in Measuring Changes in Prices
The CPI tends to overstate true
changes in the cost of living because
it does not allow for the share of the
goods whose prices have risen to
decline in the typical basket of goods
used by the Commerce Department.
 In reality, all indexes tend to overstate actual price changes, primarily because
we have a difficult time measuring quality improvements

in goods and services.
Sheffrin
The CPI Tends to Overstate Price Changes
Economists believe that the

inflation rate is overstated by
between 0.5% and 1.5% each year.
This means that cost-of-living
adjustments to wages and social
security payments based on
changes in the CPI tend to be
larger than they should be.
Sheffrin
Inflation
 The percentage rate of change of a price index is the inflation rate.
 Example:
 Price index in a country in 1998 = 200
 Price index in 1999 = 210
(2 1 0 - 2 0 0 )
I n f la t io n r a t e = = .0 5 = 5 %
200
Conclusion: the country experienced a 5% inflation

rate.
Sheffrin
Inflation
 Inflation refers not to the level of prices, whether they are high or low, but
to their percentage change from one year to another.
 If prices are high but remain the same from one year to another, there
would be no inflation during that time.
 Historically, the price level did not have a trend prior to the 1940s. After
1940, the price level increased sharply.
Sheffrin
U.S. Inflation Rate, 1950-
2000
Sheffrin
Deflation
Deflation is a period during which
the average level of prices falls.
During the Great Depression,
between 1929 and 1933, average
prices fell 33%.
As the average level of prices falls,
wages tend to fall. Therefore,
deflation is a problem because
people may not be able to pay their
debts.
Sheffrin
The Costs of Inflation

Costs associated with anticipated inflation;
 Menu costs or costs associated with
physically changing prices;
 Shoe-leather costs that results from
holding less cash or the additional wear
and tear necessary to hold less cash (more
frequent trips to Banks and ATMs);
 Tax system and financial system do not
always fully adjust to anticipated inflation.
Sheffrin
The Costs of Inflation

When there is an unanticipated inflation, there
are winners & losers ;
 It causes unfair redistributions or

transfers of income between parties,
i.e, when inflation is higher than
everyone expected, buyer with fixed
dollar contracts would gain and sellers
making a contract in dollar terms would
lose;
 It also imposes real costs on the
economy. When people take actions based on beating inflation, the

economy becomes less efficient .

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Unemployment and

Unemployment Number of Unemployed

Labor Force Labor Force

Labor Force = (122,0000 + 8,000) = 130,000

U.S. civilian population over 16 years of age

Labor force participation rate 64.12%

Country Unemployment Rate (%)

Selected Unemployment Rates, January

When the economy is at full

In the United States, economists

CPI in Cost of Basket in Year K

Prices increased an average of 25% over this

125  You need $375 in 1997

Medical (5.00%) Other services (7.00%)

we have a difficult time measuring quality improvements

Economists believe that the

Conclusion: the country experienced a 5% inflation

are winners & losers ;

 It causes unfair redistributions or

economy. When people take actions based on beating inflation, the

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