Chapter 7 The Anatomy of Inflation

and Unemployment

7-2

Introduction• So far have focused on how various economic factors

determine output, prices, unemployment, and inflation now examine the consequences of inflation and unemployment and the tradeoff between them

• Two major costs of unemployment:1. Lost production2. Undesirable effects on the distribution of income

• The costs of inflation depend on the type: Unanticipated inflation creates significant redistribution of

wealth Impact of anticipated inflation, especially of moderate levels,

is small

7-3

Unemployment• The greatest single cost of

unemployment is lost production people who don’t work don’t produce

• This cost is large: a recession can imply drop in GDP by 3-5%

• Okun’s law states that 1 extra point of unemployment costs 2% of GDP [See Figure 7-1]

• Costs are borne unevenly, and mainly by those who lose their jobs

• Workers just entering the labor force and teenagers are amongst the hardest hit

[Insert Figure 7-1 here]

7-4

Inflation• Costs of extremely high inflation are easy to see

• M lubricates the economy if P increase dramatically:• money is no longer a useful medium of exchange• output can drop substantially

• Costs of low, single-digit inflation are more difficult to identify

• Unanticipated inflation has distributional implications: • debtors benefit by repaying in cheaper dollars• creditors suffer by being repaid in cheaper dollars

7-5

The Anatomy of Unemployment• Research has revealed five key characteristics of

unemployment in the U.S.1. There are large variations in unemployment rates across groups

defined by age, race, or experience.2. There is high turnover in the labor market. Flows into and out

of employment and unemployment are high relative to the numbers of employed or unemployed.

3. A significant part of this turnover is cyclical: Layoffs and separations are high during recessions, and voluntary quits are high during booms.

4. Most people who become unemployed in any given month remain unemployed for only a short time.

5. Much of the U.S. unemployment consists of people who will be unemployed for quite a long time.

7-6

The Anatomy of Unemployment• The size of the labor force is

determined by surveys• Labor force = unemployed (U)

+ employed (E)• Unemployed is one who is

out of work and who either1. Has actively looked for work

during the previous 4 weeks OR

2. Is waiting to be recalled to a job after having been laid off

[Insert Table 7-2 here]

7-7

The Anatomy of Unemployment• Employed person is one who

during the reference week:1. Did at least one hour of work

for pay in the last week2. Worked at least 15 hours as an

unpaid worker for an enterprise owned by a family member OR

3. Was not working, but only temporarily absent from work (ex. vacation or maturity leave)

[Insert Table 7-2 here]

7-8

The Unemployment Pool• At any point in time there is a given number, or pool,

of unemployed people, and there are flows in and out of the unemployment pool.

• A person can become unemployed for one of four reasons:

1. New entrant or reentrant into the LF2. Person who quit a job in order to look for other employment and

may register as unemployed while searching3. Laid off worker (suspended without pay)4. Worker who lost a job (fired or firm closes)

7-9

The Unemployment Pool• There are three ways of moving out of the

unemployment pool:1. A person may be hired into a new job2. Someone laid off may be recalled 3. An unemployed person may stop looking for a job, and thus

move out of the labor force• Unemployment is rising when more people are entering

the pool than leaving

7-10

Variation in Unemployment Across Groups

• The aggregate unemployment rate tells us the share of the labor force that is unemployed

• The aggregate number conceals wide variations across various segments of the population

• Teenagers have much higher unemployment rates than older workers

• Black unemployment is higher than that of their white cohorts• Female unemployment was higher than male unemployment

through the 1970s, but currently approximately equal

7-11

Cyclical and Frictional Unemployment

• Frictional unemployment is the unemployment that exists when the economy is at full employment

• Results from the structure of the labor market, including: The nature of jobs in the economy Social habits Labor market institutions Frictional unemployment rate = natural rate of unemployment

• Cyclical unemployment is unemployment in excess of frictional unemployment

• Occurs when output is below the full employment level• The presence of cyclical unemployment indicates a downturn in

the economy

7-12

Labor Market Flows• Labor market turnover (flows

into and out of unemployment and employment and between jobs) is large

• Table 7-3 shows the average of monthly flows in 2005 into and out of employment within the manufacturing sector

[Insert Table 7-3 here]

People are taking and leaving jobs.People are taking and leaving jobs.

7-13

Duration of Unemployment• A spell of unemployment is a

period in which an individual remains continuously unemployed

• The duration of unemployment is the average length of time a person remains unemployed

• Table 7-4 shows the duration of unemployment for 2000 and 2003

[Insert Table 7-4 here]

7-14

Determinants of the Natural Rate• The determinants of the natural rate of unemployment, u*:

duration and frequency of unemployment• Duration of unemployment depends on cyclical factors and on

the structural characteristics of the labor market: The organization of the labor market, including the presence or

absence of employment agencies, youth employment services, etc. The demographic makeup of the labor force The ability and desire of the unemployed to keep looking for a

better job, which depends in part on the availability of unemployment benefits

7-15

Determinants of the Natural Rate• The determinants of the natural rate of unemployment, u*:

duration and frequency of unemployment• Frequency: the average number of times per period that workers

become unemployed• Two basic determinants of the frequency of unemployment:

Variability of the demand for labor across different firms The rate at which new workers enter the labor force, since new

potential workers begin as unemployed workers

The three determinants of duration and the two determinants of frequency of unemployment are the basic determinants of the natural rate of unemployment

• Different natural rates for the various demographic groups: natural rate aggregates u* across different groups

7-16

Estimates of the Natural Rate

[Insert Figure 7-3 here]

7-17

The Natural Rate vs the NAIRU• NAIRU: Non-accelerating inflation rate of

unemployment • Based on the Phillips Curve:

where t-1 is used to form expectations about current inflation

• NAIRU is the rate of unemployment such that inflation remains constant: t = t-1

)( *1 uutt

7-18

Hysteresis and the Rising Natural Rate of Unemployment

• Between 1973 and 1988 the U.S. unemployment rate stayed well above the estimated natural rate

WHY?• One explanation is unemployment hysteresis: extended

periods of high unemployment raise the natural rate• Unemployed might become accustomed to not working• Unemployed could become discouraged and stop seeking work• Long unemployment spells might signal to firms that a worker is

undesirable, and the firms might avoid hiring such workers

7-19

Hysteresis and the Rising Natural Rate of Unemployment

• Unemployment rates vary over time and across countries• European countries tend to have higher unemployment

than the US• This reflects more than different economic conditions• European labor markets more rigid, in part due to

institutions that make them so• Firing costs• More generous unemployment benefits• Minimum wage rules• Real-wage inflexibility ↔ strong unions• Low geographic and occupational mobility of labor

7-20

Unemployment Benefits• Unemployment benefits increase the rate of

unemployment in two ways:1. Unemployment benefits allow for longer job searches2. Lessens the severity of being in and out of jobs

• Unemployment benefits increase the measured unemployment rate through reporting effects

In order to collect unemployment insurance, a person must be considered “in the labor force,” or actively seeking work some seek work even if they do not really want the job to be counted as unemployed

One estimate suggests that reporting effects raise the unemployment rate by about half a percentage point

7-21

The Costs of Unemployment• Unemployed persons suffer both from their income loss

and from the related social problems that long periods of unemployment cause

• Costs of cyclical unemployment: Okun’s law tells us that every 1 point increase in unemployment

reduces output by 2 % points Distributional impact of unemployment may be more dire for some

groups than others (Ex. Teenagers vs. older workers) In addition to lost output from unemployment, there is reduced tax

revenuesSocial costs of unemployment: include increased divorce rates, suicide rates, depression,

…

7-22

The Costs of Inflation• Perfectly anticipated inflation: Suppose an economy has

been experiencing inflation of 5% and the anticipated rate of inflation is also 5%, then all contracts will build in the expected 5% inflation

• Nominal interest rates account for anticipated inflation• Long term labor contracts account for anticipated inflation• Tax brackets are typically adjusted to account for inflation Inflation has no real costs, except for two qualifications:

The costs of holding currency rise along with the rate of inflation, The demand for currency decreases Menu costs of inflation

7-23

The Costs of Inflation• Full adjustment to inflation not realistic imperfectly

anticipated• Most contracts are written in nominal terms

• If inflation is unexpectedly high, debtors repay loans in cheaper dollars

• If inflation in unexpectedly low, debtors repay loans in more valuable dollars (take a loss)

The possibility of unexpected inflation introduces an element of risk, which might prevent some from making some exchanges they otherwise would undertake

Unanticipated inflation redistributes wealth and income

7-24

The Benefits of (Low) Inflation• Greasing the wheels argument• Wages are downwards sticky in nominal terms

• During recession, workers may be willing to accept 0 wage growth but not a nominal wage cut

• Low to moderate inflation makes real wages downward flexible

• Whether these benefits are tangible is controversial

7-25

The Costs of Inflation: Empirical Evidence

• Robert Barro (Inflation and Economic Growth, 1995):• 10%-pt increase in inflation lowers growth by 0.2-0.3%-pt• Small effect but can lead to sizeable differences over longer

periods• Bruno and Easterly (Inflation and Growth: In Search of a

Stable Relationship, )• No relationship (neither positive nor negative) between growth

and inflation for low levels of inflation• Inflation>40% detrimental to growth

7-26

Unemployment, Inflation, and Happiness

• Both inflation and unemployment seen as lowering social welfare → Misery index: u+• MacCulloch and DiTella (2001, Preferences over Inflation and

Unemployment, AER)• Happiness data from surveys in 13 countries (Europe and US)• Unemployment lowers happiness more than inflation• Respondents would be indifferent between 1%-pt increase in unemployment

and 1.7%-pt increase in inflation • Winkelmann and Winkelmann (1998, Economica, Why Are

Unemployed So Unhappy?)• Unemployment lowers life satisfaction• Most of this is due to non-monetary effect of unemployment , not due to loss

of income

7-27

Inflation and Indexation• When inflation rates are high and uncertain, governments

issue indexed debt• A bond is indexed to the price level: either the interest rate or

the principle or both are adjusted for inflation (or bond value is linked to the exchange rate of a foreign currency)

• The holder of the indexed bond will typically receive interest equal to the stated real rate plus the actual inflation rate risk reducing

• Some formal labor contracts include cost of living adjustment (COLA) provisions

• Link increases in money wages to increases in the price level

7-28

Inflation and Indexation• Indexation may feed an inflation spiral

Shock causes inflation Wages and contracts are indexed More inflation follows

• Need to differentiate between supply and demand• Demand shock: “pure” inflation firms can afford to pay the

same real wages and will not be affected by indexation• Supply shock: real wages need to fall and full indexation

prevents this from happening Wage indexation complicates the economy’s adjustment

to supply shocks

7-29

Inflation and Indexation• Many have argued that the government should adopt

indexation on a broad scale, including bonds and the tax system because:

Inflation would be easier to live with Costs of unanticipated inflation would disappear

• Governments have been reluctant to index for three reasons:

1. Indexing makes it harder for the economy to adjust to shocks whenever changes in relative prices are needed

2. Indexing adds another layer of calculation to most contracts3. Indexation will weaken the political will to fight inflation, lead

to higher inflation, and perhaps make the economy worse off