Chapter 7: The Macroeconomy – Unemployment, Inflation, and Deflation

Introduction

This chapter explores key macroeconomic issues: unemployment, inflation, deflation, and their measurement. Understanding these concepts is essential for analyzing the overall performance of an economy.

• Unemployment rate: The percentage of people eligible to be employed but who do not have a formal job.

• Informal work: Many individuals engage in informal work, which can bias official unemployment statistics.

Learning Objectives

• Explain how the U.S. government calculates the official unemployment rate.

• Discuss the types of unemployment.

• Describe how price indexes are calculated and define key types of price indexes.

• Evaluate who loses and who gains from inflation and distinguish between nominal and real interest rates.

• Understand key features of business fluctuations.

Unemployment

Definition and Economic Impact

Unemployment refers to adults (aged 16 years or older) who are willing and able to work, actively seeking employment, but have not found a job. High unemployment results in lost output and economic costs.

• Labor force: Individuals aged 16+ who are employed or actively seeking employment.

• Unemployment rate: The percentage of the labor force that is unemployed.

Measurement Concepts

• Stock: Quantity measured at a specific point in time (e.g., inventory).

• Flow: Quantity measured over a period of time (e.g., income per year).

Categories of Unemployed Individuals

• Job loser: Involuntarily terminated or laid off (40–60% of unemployed).

• Reentrant: Previously worked, left the labor force, now seeking work (20–30%).

• Job leaver: Voluntarily quit (10–15%).

• New entrant: Never worked a full-time job for two weeks or longer (10–15%).

Duration of Unemployment

• Over one-third find work within one month.

• Another third within two months.

• About one-sixth remain unemployed after six months.

• Average duration: 10–20 weeks since mid-1960s.

Discouraged Workers

• Discouraged workers: Individuals who stop looking for work because they believe no suitable jobs are available.

• Existence of discouraged workers biases the unemployment rate downward.

Labor Force Participation Rate

• Proportion of noninstitutionalized working-age individuals who are employed or seeking employment.

The Major Types of Unemployment

Overview

Unemployment is classified into three major types, each with distinct causes and policy implications.

• Frictional unemployment: Temporary unemployment due to job search and matching processes.

• Structural unemployment: Long-term unemployment from skill mismatches or changes in labor market policies and regulations.

• Cyclical unemployment: Unemployment resulting from economic recessions and insufficient aggregate demand.

Full Employment and Natural Rate of Unemployment

• Full employment: An arbitrary level of unemployment reflecting normal friction in the labor market.

• Natural rate of unemployment: The long-run equilibrium rate, including only frictional and structural unemployment (seasonally adjusted).

Inflation and Deflation

Definitions

• Inflation: Sustained increase in the average price level of goods and services.

• Deflation: Sustained decrease in the average price level.

Purchasing Power

• Value of money for buying goods and services; falls when prices rise if income remains constant.

Nominal vs. Real Values

• Nominal value: Price expressed in current dollars.

• Real value: Value adjusted for inflation, reflecting purchasing power.

Measuring Inflation: Price Indexes

• Market basket: Representative bundle of goods and services.

• Base year: Reference year for price comparisons.

• Price index formula:

Example Table: Calculating a Price Index

Key Price Indexes

• Consumer Price Index (CPI): Weighted average of prices for a set of goods and services purchased by urban wage earners.

• Producer Price Index (PPI): Weighted average of prices for goods and services produced and sold by firms; includes foodstuffs, intermediate goods, and finished goods.

• GDP Deflator: Measures price changes for all new goods and services produced in the economy; broadest measure.

• Personal Consumption Expenditure (PCE) Index: Uses annually updated weights based on consumer spending; primary inflation indicator for the Federal Reserve.

Limitations of Price Indexes

• Price indexes may not account for quality improvements or new products, leading to upward bias.

Anticipated Versus Unanticipated Inflation

Types of Inflation

• Anticipated inflation: Inflation rate expected to occur.

• Unanticipated inflation: Inflation rate that comes as a surprise.

Nominal and Real Interest Rates

• Nominal interest rate: Market rate expressed in current dollars.

• Real interest rate: Nominal rate minus expected inflation rate.

Example: If nominal rate = 5%, expected inflation = 3%, real rate = 2%.

Effects of Inflation

• Unanticipated inflation: Creditors lose, debtors gain.

• Cost-of-living adjustments (COLAs): Contract clauses to adjust nominal values for inflation.

• Menu costs: Costs of repricing and printing new price lists due to inflation.

Changing Inflation and Unemployment: Business Fluctuations

Business Fluctuations

Business activity in the economy experiences regular ups and downs, known as business fluctuations.

• Expansion: Economic activity speeds up.

• Contraction: Economic activity slows down.

• Recession: Period of negative or below-trend growth.

• Depression: Extremely severe recession.

Business Cycle Stages

• Peak: Highest point of economic activity before a downturn.

• Trough: Lowest point before recovery begins.

Leading Indicators

• Events that precede changes in business activity, such as reduced workweek, increased unemployment claims, falling raw material prices, and decreased money supply.

Issues & Applications

Informal Work and Labor Force Measurement

• Informal work is not included in official labor force and unemployment statistics.

• Accounting for informal work would increase labor force participation rate and decrease unemployment rate.

Summary of Key Concepts

• Official unemployment rate: Percentage of labor force actively seeking work but not employed.

• Types of unemployment: Frictional, structural, cyclical; full employment reflects normal friction.

• Price indexes: Calculated as the ratio of current to base year market basket costs, multiplied by 100.

• Nominal vs. real interest rates: Real rate subtracts expected inflation from nominal rate.

• Inflation effects: Creditors lose, borrowers gain from unanticipated inflation.

• Business fluctuations: Expansion and contraction cycles, with leading indicators predicting changes.