Chapter 8: Unemployment and Inflation

Statistics Canada sorts working-age population (15+) into 3 categories:

1. Employed: working full-time or part-time at a paid job

2. Unemployed: not doing paid work and actively looking for a job

3. Not in the Labor Force: not employed, not unemployed (full-time student, homemaker, retiree)

• Labor Force: employed + unemployed

Unemployment Rate

The percentage of the labor force who are unemployed

Unemployment Rate = (Unemployed/Labor Force) x 100

Labor Force Participation Rate

The percentage of the working-age population in the labor force

Labor Force Participation Rate = (Labor Force/Working-Age Population) x 100

Unemployment Rate Misses…

1. Involuntary Part-Time Workers: part-time workers, would rather have full-time job, but cannot find one

2. Discouraged Workers: want to work but have given up actively searching for jobs

Labor Underutilization Rule

Unemployment rate including unemployed, involuntary part-time workers, and discouraged workers

Healthy and Unhealthy Types of Unemployment

1. Frictional

2. Structural

3. Seasonal

4. Cyclical

1. Frictional Unemployment

Due to normal labor turnover and job search

• Healthy; No problem to fix

2. Structural Unemployment

Due to technological change or international competition making workers skills obsolete

• Mismatch between skills workers have and skills new jobs require

• Creative destruction — good for economy but not for you personal

• Healthy; problem fixing = worker retraining

3. Seasonal Unemployment

Due to seasonal weather changes

• Healthy; no problem

4. Cyclical Unemployment

Due to business cycle fluctuations in economic activity

• Unhealthy; problem fixing = fiscal or monetary

Real GDP = Potential GDP

• No output gap

• Natural rate of unemployment — full employment; only frictional, structural, seasonal unemployment

• Cyclical unemployment = 0

Real GDP < Potential GDP

• Recessionary Gap

• Unemployment rate above natural rate

• On top of frictional, structural, seasonal unemployment, there is cyclical unemployment)

• The economy is underperforming and expands

Real GDP > Potential GDP

• Inflationary Gap

• Unemployment rate below natural rate

• Cyclical unemployment = 0

• More people are employed than usual

Inflation

Persistent rise in average prices and fall in value of money

• Your spend more to get same products/services as before

• Your money is worth less

Consumer Price Index (CPI)

Measure of average prices of fixed shopping basket of products/service

CPI = (cost in current year/cost in base year) x 100

Inflation Rate

Annual percentage change in Consumer Price Index (CPI)

Inflation Rate = [(CPI for current year - CPI for previous year)/CPI for previous year] x 100

Core Inflation Rate

Inflation excluding volatile (rapidly changing) categories

• Core inflation rate does not fluctuate as much as inflation because it removes volatile categories

• Core inflation rate > Inflation rate : Inflation rate of volatile categories < Overall inflation rate

• Core inflation rate < Inflation rate : Inflation rate of volatile categories > Overall inflation rate

Inflation is a worry because

• Falling value of money

• Reduces purchasing power of people with fixed income

• Unpredictable prices create risk and discourage business investment

• Expectations of inflation can cause inflation

• Bank of Canada aims for predictable inflation rates between 1% and 3%

Nominal Interest Rate vs. Realized Real Interest Rate

Nominal Interest Rate: observed interest rate

• Dollars received per year in interest as percentage of dollars saved

• Does not adjust for inflation

Realized Real Interest Rate: nominal interest rate adjusted for inflation

• = Nominal Interest Rate - Inflation Rate

Deflation

Persistent fall in average prices and rise in value of money

• Inflation rate becomes negative

• Consumers postpone spending, causing economic contraction, and increasing unemployment

• Deflation benefits savers, but hurts borrowers

• Deflation is worse than low inflation

Disinflation

Decrease in inflation rate OR slower rise in average price level

Quantity Theory of Money

• Increase in quantity of money causes an equal percentage increase in inflation

• Decrease in quantity of money causes an equal percentage decrease in inflation

• Takes equation M x V = P x Q; fixes V and fixes Q at potential GDP

• Therefore, increase in M causes and increase in P

• If real GDP were initially above potential GDP and could​ change, what do you think would happen when the quantity of money decreases​? – The price and real GDP could both decrease

• If real GDP were initially below potential GDP and could​ change, what do you think would happen when the quantity of money decreases​? – The price and real GDP could both increase

M x V = P x Q

M = quantity of money

V = velocity of money — the number of times a unit of money changes hands during a year (the number of times a unit of money is spent on final products/services

P = average prices — CPI

Q = aggregate quantity of real output — real GDP

• P x Q = nominal GDP

Phillips Curve

Graph showing inverse relation between unemployment and inflation

• If Phillips Curve is true, stagflation (direct relationship between unemployment and inflation) could never happen

• Suggests that a government trying to reduce inflation must accept higher unemployment (tradeoff)

• Consistent with the story of demand-pull inflation

Demand-Pull Inflation

Rising average prices caused by increases in demand

• Inflation and unemployment move at the different time (inverse relationship)

• Unemployment falls, inflation increases (when the economy expands and more people work, spending rises, firms raise wages to attract workers, and prices increase)

• Explains Phillips Curve’s trade-off between unemployment and inflation

• Expansion: demand is key force causing shortages and pulling up prices for inputs (wages) and outputs

Cost-Push Inflation

Rising average prices caused by decreases in supply

• Inflation and unemployment move at the same time (direct relationship)

• Does not fit Phillips Curve

• Can cause stagflation: combination of recession (unemployment) and inflation

• Caused by (negative) supply shocks

• Contraction: decrease in supply pushes up output prices,