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RETP A HC
Unemployment and
Inflation
© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 1
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.
© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin
Unemployment Measures
L a b o er = F E o mr c p +l o U y en de m d p l o
 The unemployment rate is the
percentage of people in the labor force
who are unemployed.
U n e m p l o y e
U n e m n p t l or = a y t me e
L a b oe r f o r c
 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.
L a b oe r f o r
L a b o e r p f ao a r r t c i oc in =p r a t e
W o r k e i np go op a nug l
 For example, suppose an economy consists of:


200,000 individuals 16 years and older.

122,000 employed.
 8,000 unemployed.
L a b o er = F ( o1 r 2 c 2 + , 08 0, 0 0 =0 10 3) 0 , 0
1 3 0 , 0 0 0
L a b o er pf o a ra r c tt ii co i n p = r a t e = 6 5 %
2 0 0 , 0 0 0
8 , 0 0 0
U n e m n p t l o r y=a mt e e = 6 . 1 5 %
1 3 0 , 0 0 0
Unemployment Data, 1998
U.S. civilian population over 16 years of age

205,220,000
Labor force Not in the labor
137,673,000 force
67,547,000
Employed Unemployed
131,463,000 6,210,000
Labor force participation rate 67%
Unemployment rate 4.5%
Unemployment Rates Around the
World, 1999
Country Unemployment Rate (%)
United States 4.3
Belgium 12.7
Sweden 6.4
France 11.2
Italy 12.0
Spain 16.1
United Kingdom 6.0
Netherlands 3.2
Japan 4.9
Australia 7.2
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. The
interviewer relies on good-faith responses to the
questions.
Who Are the Unemployed?
 People who were looking for work in the recent

past but did not find work and stopped looking are
considered discouraged workers. These people
are not counted as unemployed, but considered to
have dropped out of the labor force.
 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 difficult to distinguish
between employed and underemployed workers.
Selected Unemployment Rates,
January 1999 (in percent)
Total 4.3
Male, 20 years and older 3.4
Female, 20 years and older 3.7
Both sexes, 16-19 years 15.5
White 3.8
African American 7.8
White, 16-19 years 13.0
African American, 16-19 years 29.8
Married men 2.3
Married women 2.8
Women maintaining families 6.3
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 appropriate 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”?
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.
 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.
 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.
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.
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 or income, not its
face value.
The Consumer Price Index
 The CPI index for a given year, say year K, is

defined as:
c o s t s o k f e b t aa i nr K y e
C P I ir n K = y e a x 1 = 0 10 0 0
c o s t s o k f e b t sa i ne yb ea a r
Example:
 Cost of basket in 1992, the base year = $200
 Cost of same basket in 1997 = $250
$ 2 0 0
Prices increased an
C P I i 2n = 1 9 9 x 1 = 0 10 0
0
$ 2 0 0
average of 25%
$ 2 5 0
C P I i 7n = 1 9 9 x 1 = 0 10 2 over
5 this five year
$ 2 0 0 period.
The Consumer Price Index 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:
 You need $375 in
1 2 5
3 0 0 x = 3 7 5 1997 just to maintain
1 0 0
what was your
standard of living
in1992.
Components of the CPI, 1992
C
omp
onen
tso
fth
eCP
I
M ed
ical(5
.00
% )
O
therserv
ices(7
.00
% )
T
ran
spo
rtatio
n(7
.00
% )
H
ouseh
oldserv
ices(9
.00
% ) F
ood&b
everag
e(1
8.0
0%)
A
pparel(6
.00
% )
R
ent(2
6.0
0%)
Non-d
u rab
les(1
1.0
0%)
D
urab
les(1
1.0
0% )
The CPI Versus the Chain Index for
GDP
 Both the CPI and the chain index (which
replaced the GDP deflator since 1996)
are measures of the average prices for
the economy.
 The CPI includes goods produced in prior
years, as well as imported goods, while
the chain price index does not.
The CPI Tends to Overstate Price
Changes
 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.
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.
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- 2 0 0 0 )
I n f l a r t a i ot = en = . 0 =5 5 %
2 0 0
 Conclusion: the country experienced a 5%
inflation rate.
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.
Price Index for GDP, 1875-1998
U.S. Inflation Rate, 1950-1998
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.
Looking Ahead
 The study of the economy when it

operates at or near full employment is
called classical economics.
 The study of business cycles, when the
economy deviates from full employment,
is called Keynesian economics—after
John Maynard Keynes, who made
fundamental contributions to economics.
Classical Versus Keynesian
Economics
 Classical economists believe that
economic fluctuations are short-lived and
that the economy has a strong tendency
to return to full employment.
 Keynesian economists believe that the
economy returns to full employment only
slowly, if at all, and emphasize the role of
economic fluctuations.

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21

 The unemployed are those individuals

 The working age population includes

 For example, suppose an economy consists of:

U.S. civilian population over 16 years of age

 The Bureau of Labor Statistics conducts a

 People who were looking for work in the recent

 Cyclical unemployment is the result of

 Structural unemployment refers to the

 When the economy is at full employment,

 In the United States, economists estimate

 When the growth rate of real GDP slows

 When the economy is “overheated,” and

 The Consumer Price Index (CPI) is an

 The CPI index for a given year, say year K, is

 The percentage rate of change of a price

 Inflation refers not to the level of prices,

 Deflation is a period during which the

 The study of the economy when it

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