Chapter 9

Business Cycles, Unemployment and Inflation

Determining Unemployment Rate

-- Monthly survey of 60,000 households conducted by the U.S. Bureau of Census (survey known as Current Population Survey)

-- Bureau of Labor and Statistics (BLS) analyzes data and calculates unemployment rate

Definitions used in analysis

Employed: worked during the previous week of the survey or was temporarily away from job because of illness, on vacation, on strike, etc

Unemployed: did not work in previous week but was available to work and had actually looked for work at some time during the previous four weeks.

Labor Force: sum of the # employed and # unemployed from survey

-- people who do not have a job and who are not actually looking for a job are not part of the labor force

Discouraged Workers: people available for work but have not looked for a job in the previous four weeks because they believe there is no job for them.

-- groups typically not in the labor force include the following:

• Retirees• Homemakers• Full time students• People on active military service• People in prison• People in mental hospitals

From the results of the survey:

Unemployment Rate = # Unemployed

# in Labor Force

# Unemployed__________

# Employed + # Unemployed

-- unemployment rate can be found at www.bls.gov. Data exists at national, state and local levels.

-- Current employment rate = _____

-- majority of those classified as unemployed were unemployed for six months

X 100

X 100

Issues w Unemployment Rate Derivation

1) Counts part-time workers as employed (may prefer to be full-time)

2) Economic Recessions leads to discouraged workers (not counted in labor force)

-- underestimates unemployment

3) Incorrect responses

Labor Force Participation Rate

-- % of working age population in the labor force

Labor Force Participation = # in Labor Force

Rate # Working Age Population

-- determines the amt of labor available in economy.

-- In Dec of 2007, the rate was 66.0%

X 100

Types of UnemploymentI] Frictional Unemployment -- Short-term unemployment arising from the process of matching people with jobs (people who are between jobs, who are first time workers or who are reentering the work force

Example: Jane, a mother, decides to return to work as a nurse after taking four years off to be with her child

Benefits-- People find jobs that better suits their interest and skills. This leads to higher productivity and earnings

II] Seasonal Unemployment-- Unemployment related to seasonal factors such as weather and

tourism-- Unemployment rates for the traditional seasonal months are reported

with seasonally adjusted rates

Examples: Construction workers and teachers

III] Structural Unemployment-- Unemployment from mismatches between workers’ skills and employers' requirements for the jobs-- Usually long term because it takes time to acquire skills and/or to relocate

IV] Cyclical Unemployment-- Unemployment caused by business cycles Recessions correspond to high unemployment Expansions correspond to low or "average“ unemployment

Full Employment • A situation where there is no cyclical unemployment (levels of

Frictional, Seasonal and Structural unemployment exist)• Economists believe that the full employment level is a level of

unemployment around 5.0% (% of unemployment makes up Frictional, Seasonal and Structural unemployment)

• Referred to as the natural rate of unemployment or Normal Unemployment

Example: If the unemployment rate = 8% and full employment is defined as an unemployment rate = 5.0%, how much cyclical unemployment exists?

Measuring Inflation

Inflation: % increase in the price level from one year to the next

Consumer Price Index (CPI)-- avg of the prices of the goods and services purchased by the typical family-- compiled by the Bureau Of Labor & Statistics (BLS)-- starts with a survey of households (Consumer Expenditure Survey) and their spending habits (recently updated to every 2 years)

Results in an array of goods/services (211 types) that make-up the Market Basket of Goods

8 categories of Goods (% of expenditures)1) Housing (42%)2) Transportation (17.4%)3) Food/Beverage (15.3%)4) Medical Care (6.1%)5) Education/Communication (5.8%)6) Recreation (5.7%)7) Apparel (3.8%)8) Other (3.8%)

Includes only the ordinary goods (i.e. lawn hoses, filters, pool supplies, etc would probably not be included)

Consumer Price Index (CPI), cont-- BLS employees also visit stores each month recording prices of the Market Basket of goods and services.-- Each price is given a weight equal to fraction of typical family’s budget spent on these items.-- Referred to as the cost of living index

Calculation:-- base year is typically the avg of prices between 1982 and 1984

CPI = Cost of Market Basket in Current Year Cost of Market Basket in Base Year

(ratio of the dollar amt necessary to buy the market basket of goods in current year divided by the dollar amt necessary to buy the market basket in base year)

-- assumes households buy the same amt of goods in time frames

x 100

Example: Assume the following

-- 1983 is the base year

-- 1983 Market Basket = $____ billion

-- 1990 Market Basket = $____ billion

CPI1990 = _____

=

Interpretation: It costs ____% more for the basket of goods in 1990 versus 1983

x 100

Example (Using Simple Budget) Assume 2000 is the base year and the typical family expenditures/month are the

following:

Exp 2007 2000

Pizza (20 each @ $10/pizza)

$ $

Rent $ $

Gasoline and Car Maintenance

$ $

Phone (basic serv + 10 long distance calls

$ $

TTLS

Calculate the CPI for 2007

CPI 2007 = _______ x 100

CPI CPI 20072007 = _______ = _______

Interpretation: Basket of goods in 2007 is Interpretation: Basket of goods in 2007 is ____% higher than in 2000____% higher than in 2000

Importance of CPI1) Calculating the inflation rate

-- % change in CPI from one period to the next-- measures how fast the avg price level is changingInflation Rate = (CPI Current Year - CPI Prior Year) / CPI Prior Year (or)

= [(CPI Current Year / CPI Prior Year ) – 1]

Describing Inflation Ratea) Inflation: Inflation Rate > 0

-- increasing avg price level

Disinflation: Inflation Rate > 0 but at a decreasing rate Eg) If in 1990, inflation rate = 3.8% and 1991 inflation

rate was 3.6%, we would say that in 1991 there was

disinflation

b) Deflation: Inflation Rate < 0-- decreasing avg price level

c) Stable Prices: Inflation Rate = 0

x 100

x 100

Example: Assume the following Years are sequentialYear CPI Inflation A 80 ---

B 100 ______ C 115 ______ D 110 ______

Identify Base year: ______Identify Inflationary year(s): _____Identify Deflationary year(s): _____

Interpretation: Cost of living increased by __% in year C or prices increased by __% from year B to year C

Inflation Rate (1951-2008) - Unadjusted

-2.0%0.0%2.0%4.0%6.0%8.0%

10.0%12.0%14.0%16.0%

Importance of CPI, cont.

2) Deflating Nominal Variables

-- converting variables from Nominal to Real Variables

-- adjustment of a variable for changes in the dollar’s

purchasing power

a) Nominal Variable: Variables measured in current

dollar values

b) Real Variable: Variables adjusted for changes in the price level

» Quantifies purchasing power

Real Value = Nominal Value

CPIx 100

Use of CPI and Real WageReal Wage: wage measured in terms of purchasing powerReal Wage Year A = Nominal Wage in Year A

CPI in Year AExample: GM Factory Worker

1974 Wage = $_____/hr2000 Wage = $_____/hrQ: Is this worker better off?

CPI 1974 = ____ CPI 2000 = ____

Real Wage 1974 = $_____/____x 100 = $_____

Real Wage 2000 = $____/____ x 100 = $_____

% change in real wage = ($____-$____)/$_____ = _____%

-- although nominal wage tripled, in terms or purchasing power, GM worker is worse off.

x 100

Importance of CPI, cont.

3) Index Payments

-- adjusting a nominal payment (such as income) to rise and fall with the CPI.

-- goal is for purchasing power to remain the same

-- many labor contracts’ annual salary adjustments are tied to the CPI.

-- also known as the cost of living adjustment

Example:

If you expect 3% inflation next year and if your salary is tied to the CPI, a salary of $30,000 will need to increase to _________

Importance of CPI, cont.4) Comparing Dollar Value From Different Years

-- on BLS website, known as inflation calculator.

Example: Salary of $30,000 in 1990 is equivalent to ______ in 2006.

CPI in 1990 = _____ CPI in 2006 = _____

[(CPI Current Year / CPI Prior Year ) – 1]

-- on avg, prices in 2006 were ____% higher than in 1990.

Value in 2006 $ = (Value in 1990 $) * Inflation = ______

A salary of $_______ would purchase same amt of goods as a 1990 salary of $30,000.

= 1.54x 100

Relationship Between Real Values, Nominal Values and Inflation Rate

Equation: %∆Real Value ≈ % ∆Nominal Value – Inflation Rate

Example: Employer and Labor Union negotiate a 3 year contract

A) Agreement is for real wage to remain constant, what should be the change in nominal wage?

-- If they expect a 3% inflation rate for each of the 3 years: %∆Real Value = % ∆Nominal – inflation rate

____ = % ∆Nominal -- _____ ____ = % ∆Nominal

B) Agreement is for real wage to increase 3% each year-- If they expect a 3% inflation rate for each of the 3 years:

%∆Real Value = % ∆Nominal – inflation rate ____ = % ∆Nominal -- _____

____ = % ∆Nominal

Accuracy of CPI1) Substitution Bias

-- Within the market basket, assumption is that consumers buy same amt of product each mth reality is that consumers buy more of products whose prices have ↓ and less of those whose prices ↑.

2) Increase in quality bias-- prices increase in some products because quality improves price inc may therefore be partly due to inflation and partly quality improvement.

3) New Product Bias-- market basket is updated periodically and new products introduced between updates may not be included for some time.

4) Outlet Bias-- consumers are buying goods from non-traditional services (i.e. internet, HSN, discount stores, etc) other than traditional full price retail stores prices consumers are actually paying may be different than gov’t data.

True Costs of Inflation1) Noise in the Price System

-- Inflation makes it difficult for buyers/sellers to interpret changes in price caused by changes in supply or general inflation-- can not react appropriately to market conditions

2) Distortion of Tax System Bracket Creep-- Without tax brackets being indexed to inflation, an increase in nominal income due to inflation would cause tax payers to pay an increased amt of taxes even though real income did not change-- Congress institutes bracket creep to deal with issue inc tax brackets equal to inflation

3) Unexpected Distribution of Wealth-- Inflation that is unexpected redistributes wealth from one group to another

Example: Union Contract-- If inflation (π) > Expected inflation hurts union workers (tied inc in wages to a level < true benefits corp inc in avg price level)

4) Interference With Long-Run Planning

-- planning for retirement can be tricky if you can’t forecast for inflation save too much or too little

Inflation and Real Interest Rate

Real Interest Rate ( r )-- annual % increase in real purchasing power of a financial asset

r = i – π where r = real interest ratei = nominal interest rateπ = inflation rate

Nominal Interest Rate: -- annual % increase in nominal value of a financial asset

Lender and Borrower Example

-- In general, when inflation is higher than expected, borrowers are better off and lenders are worse off

-- In general, when inflation is lower than expected, lenders are better off and borrowers worse off

Lender Worse Off / Borrowers Better OffLenders charge borrowers a 3% interest rate expecting a 1% inflation rate or to earn a real interest rate of 2%

If inflation = 10%, r = 3% - 10% or -7%

Producer Price Index (PPI)-- An avg of the prices received by producers of goods and

services at all stages of the production process-- Prices received for raw materials, intermediate goods

and finished products (up to wholesale)-- 1982 is base year-- If prices rise, cost of final goods and services will rise

(leading indicator)-- Measures price change from the perspective of the

seller.-- Most of the data is collected through a systematic

sampling of producers in manufacturing, mining, and service industries, and is published monthly by the Bureau of Labor Statistics.

PPI = Cost of Goods/Services in Current Year Cost of Goods/Services in Base Year

x 100