Business Cycles, Unemployment and Inflation

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Chapter 9

• Business Cycles, Unemployment and Inflation

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• 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.

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• 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

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• 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
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• 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

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• 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
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• Types of Unemployment
• I 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

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• 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

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

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• 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)
• Housing (42)
• Transportation (17.4)
• Food/Beverage (15.3)
• Medical Care (6.1)
• Education/Communication (5.8)
• Recreation (5.7)
• Apparel (3.8)

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• 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 familys
• 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
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• 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
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• 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 _at_ 10/pizza)
Rent
Gasoline and Car Maintenance
Phone (basic serv 10 long distance calls
TTLS
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• Calculate the CPI for 2007
• CPI 2007 _______

x 100
CPI 2007 _______ Interpretation Basket of
goods in 2007 is ____ higher than in 2000
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• Importance of CPI
• Calculating the inflation rate
• -- change in CPI from one period to the next
• -- measures how fast the avg price level is
  changing
• Inflation Rate (CPI Current Year - CPI Prior
  Year) / CPI Prior Year
  (or)
• (CPI Current
  Year / CPI Prior Year ) 1
• Describing Inflation Rate
• a) Inflation Inflation Rate gt 0
• -- increasing avg price level
• Disinflation Inflation Rate gt 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 lt 0
• -- decreasing avg price level

x 100
x 100
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• Example Assume the following Years are
  sequential
• Year 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

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• Importance of CPI, cont.
• Deflating Nominal Variables
• -- converting variables from Nominal to Real
  Variables
• -- adjustment of a variable for changes in the
  dollars
• 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
• CPI

x 100
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• Use of CPI and Real Wage
• Real Wage wage measured in terms of purchasing
  power
• Real Wage Year A Nominal Wage in Year A
• CPI in Year A
• Example GM Factory Worker
• 1974 Wage _____/hr
• 2000 Wage _____/hr
• Q 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
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• 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 _________

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• Importance of CPI, cont.
• 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.

1.54

x 100
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• 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
• 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

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• Accuracy of CPI
• 1) 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 ?.
• 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.
• New Product Bias
• -- market basket is updated periodically and new
  products introduced between updates may not be
  included for some time.
• 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 govt data.

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• True Costs of Inflation
• 1) 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
• 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

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• 3) Unexpected Distribution of Wealth
• -- Inflation that is unexpected redistributes
  wealth from one group to another
• Example Union Contract
• -- If inflation (p) gt Expected inflation ?
  hurts union workers
• (tied inc in wages to a level lt true
  benefits corp
• inc in avg price level)
• Interference With Long-Run Planning
• -- planning for retirement can be tricky if you
  cant forecast for inflation ? save too much or
  too little

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• Inflation and Real Interest Rate
• Real Interest Rate ( r )
• -- annual increase in real purchasing power of
  a financial
• asset
• r i p where r real interest rate
• i nominal interest rate
• p inflation rate
• Nominal Interest Rate
• -- annual increase in nominal value of a
  financial asset

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• 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 Off
• Lenders 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

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• 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