Unemployment and Inflation. 1 of 29. Economics: Principles, Applications, and Tools O Sullivan, Sheffrin, Perez 6/e.

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1 1 of 29 2 of 29 In early June 2008, the Bureau of Labor Statistics (BLS) announced that the unemployment rate for May 2008 was 5.5 percent. P R E P A R E D B Y FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU 3 of 29 1

2 A P P L Y I N G T H E C O N C E P T S What do the recent data show about trends in the percentage of women who are working? After Growing Sharply, Women s Labor Force Participation Has Leveled Off Does more liberal disability insurance decrease measured unemployment? More Disability, Less? What are the costs of either too high or too low levels of unemployment insurance? Finding the Optimal Level of Insurance Are Social Security payments properly adjusted for changes in the cost of living? Using the CPI to Adjust Social Security Benefits 4 of 29 How Is Defined and Measured? labor force The total number of workers, both the employed and the unemployed. labor force = employed + unemployed unemployment rate The percentage of the labor force that is unemployed. unemployed unemployment rate = 100 labor force 5 of 29 How Is Defined and Measured? labor force participation rate The percentage of the population over 16 years of age that is in the labor force. labor force labor force participation rate = population 16 years and older of 29 2

3 How Is Defined and Measured? FIGURE Data, May 2008 Approximately 66 percent of the civilian population is in the labor force. The unemployment rate in May 2008 was 5.5 percent. 7 of 29 A P P L I C A T I O N 1 AFTER GROWING SHARPLY, WOMEN S LABOR FORCE PARTICIPATION HAS LEVELED OFF APPLYING THE CONCEPTS #1: What do the recent data show about trends in the percentage of women who are working? In 1948, the labor force participation rate for women 20 years and older was 32 percent. By 1970, it had grown to 43 percent, and by 1997 it had reached 60 percent. Since 1997, the figure has remained virtually constant at 60 percent. Explanations: Women may simply have run out of available time. Even with new technology, housework and childcare do take time. Conclusion: Because women provide more household services than men, it is understandable why their labor force participation may have reached a peak. 8 of 29 How Is Defined and Measured? FIGURE 6.2 Rates in Developed Countries Among the developed countries, unemployment rates vary substantially. 9 of 29 3

4 Alternative Measures of and Why They Are Important discouraged workers Workers who left the labor force because they could not find jobs. FIGURE 6.3 Alternative Measures of, May 2008 Including discouraged workers, marginally attached workers, and individuals working part time for economic reasons substantially increases measured unemployment in 2008 from 8.49 million to million. 10 of 29 A P P L I C A T I O N 2 MORE DISABILITY, LESS UNEMPLOYMENT? APPLYING THE CONCEPTS #2: Does more liberal disability insurance decrease measured unemployment? The federal Disability Insurance program provides income to nonelderly workers who are deemed unable to engage in substantial employment. Economists David Autor and Mark Duggan studied the impact of this program on labor force participation. They found that the changes in the rules administering the program, the increased generosity of the benefits of the program for low-skilled workers, and the increase in the value of health care services all contributed to an increase in participation in this program. Since these workers, a portion of whom would have been unemployed, were no longer in the labor force, the economists estimated that the effect of the Disability Insurance program was to lower the measured unemployment rate by 0.5 percent, a very large effect. 11 of 29 Who Are the Unemployed? FIGURE 6.4 Selected U.S. Statistics, Rates for May 2008 The incidence of unemployment differs sharply among demographic groups. 12 of 29 4

5 Who Are the Unemployed? seasonal unemployment The component of unemployment attributed to seasonal factors. 13 of CATEGORIES OF UNEMPLOYMENT Types of : Cyclical, Frictional, and Structural cyclical unemployment that occurs during fluctuations in real GDP. frictional unemployment that occurs with the normal workings of the economy, such as workers taking time to search for suitable jobs and firms taking time to search for qualified employees. structural unemployment that occurs when there is a mismatch of skills and jobs. 14 of CATEGORIES OF UNEMPLOYMENT The Natural Rate of natural rate of unemployment The level of unemployment at which there is no cyclical unemployment. It consists of only frictional and structural unemployment. full employment The level of unemployment that occurs when the unemployment rate is at the natural rate. 15 of 29 5

6 6.3 THE COSTS OF UNEMPLOYMENT unemployment insurance Payments unemployed people receive from the government. 16 of 29 A P P L I C A T I O N 3 FINDING THE OPTIMAL LEVEL OF UNEMPLOYMENT INSURANCE APPLYING THE CONCEPTS #3: What are the costs of either too high or too low levels of unemployment insurance? How do we balance the benefits and costs of unemployment insurance? Suppose the government provided all unemployed workers a payment equal to their previous salary as long as they remained unemployed: This would prevent unemployed workers from suffering any financial hardship. Very few workers would return to work if the government were paying them their full salaries. Result: excessive unemployment. States recognize this and replace only a fraction of a worker s prior salary typically about 40 percent. Economist Jonathan Gruber of MIT attempted to calculate the optimal amount of unemployment insurance. Result: Looking at both the costs and the benefits of unemployment insurance, Gruber found that the optimal level of insurance was probably somewhat lower (closer to 30 percent) than the current 40 percent provided by the states. 17 of THE CONSUMER PRICE INDEX AND THE COST OF LIVING Consumer Price Index A price index that measures the cost of a fixed basket of goods chosen to represent the consumption pattern of a typical consumer. The CPI index for a given year, say year K, is defined as 18 of 29 6

7 6.4 THE CONSUMER PRICE INDEX AND THE COST OF LIVING FIGURE 6.5 Components of the Consumer Price Index (CPI) Rent and food and beverages make up 44 percent of the CPI basket. The remainder consists of other goods and services. The CPI versus the Chain Index for GDP 19 of THE CONSUMER PRICE INDEX AND THE COST OF LIVING Problems in Measuring Changes in Prices cost-of-living adjustments (COLAs) Automatic increases in wages or other payments that are tied to the CPI. 20 of 29 A P P L I C A T I O N 4 USING THE CPI TO ADJUST SOCIAL SECURITY BENEFITS APPLYING THE CONCEPTS #4: Are Social Security payments properly adjusted for changes in the cost of living? Each year, the federal government increases Social Security payments to the elderly by the same rate as the increase in prices measured by the Consumer Price Index. Reason for this adjustment: to make sure the elderly, whose other income tends to be fixed, do not suffer from cost-of-living increases. Problem: we actually overcompensate the elderly for price changes and thus increase their benefits in real terms. Economists believe the CPI overstates actual price increases by between 0.5 and 1.5 percent a year. If we reduced this adjustment for Social Security by 1 percent, it would save $42 billion over a five-year period! Proponents for the elderly claim this is a misleading argument. Why? 21 of 29 7

8 6.5 INFLATION inflation rate The percentage rate of change in the price level. inflation rate = percentage rate of change of a price index 22 of INFLATION Historical U.S. Inflation Rates FIGURE 6.6 Price Index for U.S. GDP, After remaining relatively flat for 60 years, the price level began to steadily increase after World War II. The price of a postage stamp in 1940 and 2007 illustrates the change in the overall price level that occurred. 23 of INFLATION Historical U.S. Inflation Rates 24 of 29 8

9 6.5 INFLATION Historical U.S. Inflation Rates FIGURE 6.7 U.S. Inflation Rate, , Based on Chain-Weighted Price Index Inflation reached its highest peaks in the postwar era during the decade of the 1970s when the economy was hit with several increases in oil prices. In recent years, the inflation rate has been relatively low. 25 of INFLATION The Perils of Deflation deflation Negative inflation or falling prices of goods and services. 26 of THE COSTS OF INFLATION anticipated inflation Inflation that is expected. unanticipated inflation Inflation that is not expected. 27 of 29 9

10 6.6 THE COSTS OF INFLATION Anticipated Inflation menu costs The costs associated with changing prices and printing new price lists when there is inflation. shoe-leather costs Costs of inflation that arise from trying to reduce holdings of cash. Unanticipated Inflation hyperinflation An inflation rate exceeding 50 percent per month. 28 of 29 K E Y T E R M S anticipated inflation Consumer Price Index (CPI) cost-of-living adjustments (COLAs) cyclical unemployment deflation discouraged workers frictional unemployment full employment hyperinflation inflation rate labor force labor force participation rate menu costs natural rate of unemployment seasonal unemployment shoe-leather costs structural unemployment unanticipated inflation unemployment insurance unemployment rate 29 of 29 10