Unemployment and Inflation

Measuring Labor-Market Indicators

• The U.S. Bureau of Labor Statistics surveys the civilian non-institutional working-age population (\ge16 years) categorizing them into: Employed, Unemployed (actively looked for work in previous 4 weeks), or Not in labor force (retired, students, discouraged workers).

• Discouraged workers are not counted as unemployed, which can understate joblessness.

• Key formulas (all \times 100 for percentages):
– Unemployment rate UR=\frac{\text{Unemployed}}{\text{Labor Force}}
– Labor-force participation rate LFPR=\frac{\text{Labor Force}}{\text{Working-Age Population}}
– Employment–population ratio EPR=\frac{\text{Employed}}{\text{Working-Age Population}}

Types of Unemployment

• Frictional unemployment: Short-term, from job search, includes seasonal unemployment.

• Structural unemployment: Persistent mismatch of skills/locations due to technological change or globalization, requiring retraining.

• Cyclical unemployment: Caused by business-cycle downturns, disappears in expansions.

• Natural rate of unemployment (NRU): un = uF + u*S (frictional + structural). Full employment occurs when actual unemployment equals NRU.

Government Policies & Labor-Market Frictions

• Unemployment insurance: Replaces wages, prolongs job search but improves match quality and can lead to higher measured unemployment.

• Social insurance (Europe/Canada): More generous benefits lead to higher average unemployment rates.

• Minimum-wage laws: If binding (above equilibrium) can cause structural unemployment among low-skill workers.

• Labor unions: Collective bargaining can raise wages, potentially creating structural unemployment.

• Efficiency wages: Firms voluntarily pay above market wages to boost productivity, leading to labor supply exceeding demand and potential unemployment.

Measuring the Price Level & Inflation

• Price level: Average of current prices for all final goods & services.

• Inflation rate: Percentage change in price level over time.

• Broad price indexes include:

  1. GDP Deflator: Measures prices of all domestically produced final goods/services.

  2. Consumer Price Index (CPI): Cost of a fixed market basket of goods/services purchased by typical urban households, widely used for cost-of-living adjustments.

  3. Producer Price Index (PPI): Prices received by domestic producers, an early indicator for CPI.

The CPI – Construction & Example

• CPI calculation involves:

  1. Fixing a basket of goods/services.

  2. Finding current prices monthly.

  3. Computing basket cost.

  4. Choosing a base year (index = 100 ).

  5. Computing CPI: CPIt=\frac{\text{Basket Cost}t}{\text{Basket Cost}_base}\times100

  6. Computing inflation: \pi t=\frac{CPIt-CPI{t-1}}{CPI{t-1}}\times100

CPI Biases – Why CPI Tends to Overstate True Inflation

• CPI typically overstates true inflation due to:

  1. Substitution bias: Fixed basket ignores consumer shifts to cheaper goods.

  2. Quality change bias: Imperfectly adjusts for product quality improvements.

  3. New product bias: New goods are not immediately included.

  4. Outlet bias: Doesn't fully capture shifts to discount/online retailers.