NZ

Macroeconomics: Monitoring Jobs and Inflation

Monitoring Jobs and Inflation

Understanding Unemployment

Why Unemployment Is a Problem

Unemployment leads to significant economic and personal hardships:

  • Lost incomes and production: Individuals lose wages, and the economy loses potential output of goods and services.

  • Lost human capital: Prolonged unemployment can permanently damage a person's job prospects as skills deteriorate, references become outdated, and self-confidence wanes. This destruction of human capital makes it harder to re-enter the workforce.

  • Employment benefits provide a safety net, but they rarely fully replace lost wages, and not everyone qualifies for them.

Measuring Unemployment and Labor Market Indicators

The U.S. Census Bureau conducts a monthly Current Population Survey to assess the U.S. labor force.

Population Breakdown

The population is categorized into two main groups:

  1. Working-age population: Individuals 16 years of age and older who are not institutionalized (e.g., in jail, hospitals).

  2. People too young to work (under 16) or in institutional care.

The working-age population is further divided:

  1. People in the labor force: The sum of employed and unemployed workers.

  2. People not in the labor force: This includes individuals who are not working and not actively looking for work.

Definition of "Unemployed"

To be counted as unemployed, a person must meet one of the following criteria:

  • Without work but has made specific efforts to find a job within the previous four weeks.

  • Waiting to be called back to a job from which they were laid off.

  • Waiting to start a new job within 30 days.

Example Data (June 2017)

  • Population: 325 million

  • Working-age population: 255 million

  • Labor force: 160 million

  • Employed: 153 million

  • Unemployed: 7 million

Three Key Labor Market Indicators

  1. The Unemployment Rate:

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

    • Formula: \text{Unemployment rate} = (\text{Number of people unemployed} \div \text{Labor force}) \times 100

    • Example (June 2017): (7 \text{ million} \div 160 \text{ million}) \times 100 = 4.4 \text{ percent}

    • Behavior: Typically increases during a recession and peaks after the recession ends.

  2. The Employment-to-Population Ratio:

    • Definition: The percentage of the working-age population who have jobs.

    • Formula: \text{Employment-to-population ratio} = (\text{Employment} \div \text{Working-age population}) \times 100

    • Example (June 2017): (153 \text{ million} \div 255 \text{ million}) \times 100 = 60 \text{ percent}

    • Trends: Both this ratio and the labor force participation rate trended upward before 2000 and downward after 2000.

  3. The Labor Force Participation Rate:

    • Definition: The percentage of the working-age population who are members of the labor force.

    • Formula: \text{Labor force participation rate} = (\text{Labor force} \div \text{Working-age population}) \times 100

    • Example (June 2017): (160 \text{ million} \div 255 \text{ million}) \times 100 = 62.7 \text{ percent}

Other Definitions of Unemployment

While the official unemployment rate (U-3) is widely used, it is considered an imperfect measure because it excludes certain groups, potentially understating labor underutilization.

  • Marginally attached workers: Individuals who are not currently working or looking for work but want and are available for a job, and have looked for work in the recent past.

    • Discouraged worker: A specific type of marginally attached worker who has stopped looking for a job due to repeated failures or belief that no suitable jobs are available.

  • Part-time workers who want full-time jobs (Economic part-time workers): These individuals are employed part-time but desire full-time employment and cannot find it. They are considered partly unemployed.

Costliest Unemployment

The most costly form of unemployment is long-term unemployment resulting from job loss.

Alternative Measures of Unemployment (U-1 to U-6)

The BLS provides six alternative measures to offer a more comprehensive view:

  • Narrower measures (U-1 and U-2): Focus on the personal cost of unemployment.

    • U-1: Those unemployed for 15 weeks or longer.

    • U-2: Unemployed job losers.

    • U-3: The official unemployment rate (all unemployed, as defined conventionally).

  • Broader measures (U-4, U-5, and U-6): Focus on assessing the full amount of unused labor resources.

    • U-4: U-3 + Discouraged workers.

    • U-5: U-4 + Other marginally attached workers.

    • U-6: U-4 + Part-time workers who want full-time jobs.

  • Observation: All these measures tend to increase together during recessions.

Types of Unemployment

Unemployment is classified into three main types:

  1. Frictional Unemployment:

    • Arises from normal labor market turnover, such as people entering, re-entering, or switching jobs.

    • It is a permanent and healthy phenomenon in a dynamic, growing economy, as job creation and destruction naturally occur.

    • Factors like increases in labor force entry/re-entry or unemployment benefits can increase frictional unemployment.

  2. Structural Unemployment:

    • Caused by changes in technology (e.g., automation) or foreign competition that alter the skills required for jobs or the geographic location of jobs.

    • Tends to last longer than frictional unemployment due to the need for retraining or relocation.

  3. Cyclical Unemployment:

    • The fluctuation in unemployment that occurs with the business cycle.

    • It is higher than normal during a business cycle trough (recession) and lower than normal during a business cycle peak (expansion).

    • Example: A worker laid off during a recession and rehired during an expansion experiences cyclical unemployment.

Natural Unemployment and Full Employment

  • Natural Unemployment: The unemployment that persists even when there is no cyclical unemployment. It is the sum of frictional and structural unemployment.

  • Natural Unemployment Rate: Natural unemployment expressed as a percentage of the labor force.

  • Full Employment: The situation where the unemployment rate equals the natural unemployment rate. At full employment, all unemployment is frictional and structural, with no cyclical unemployment.

Factors Influencing the Natural Unemployment Rate

This rate is not constant and is influenced by:

  • Age distribution of the population: Changes in the proportion of young workers (who tend to have higher frictional unemployment) can affect overall natural unemployment.

  • Scale of structural change: Rapid technological advancements or shifts in industries can increase structural unemployment.

  • Real wage rate: Wages above equilibrium levels can lead to some unemployment.

  • Unemployment benefits: Can impact the duration of job search and, thus, frictional unemployment.

Real GDP and Unemployment Over the Cycle

  • Potential GDP: The quantity of real GDP produced when the economy is at full employment. It represents the economy's sustainable capacity to produce output.

  • Output Gap: The difference between Real GDP and Potential GDP (\text{Real GDP} - \text{Potential GDP}).

  • Relationship: Over the business cycle, the output gap fluctuates, and the unemployment rate fluctuates around the natural unemployment rate.

    • When the output gap is negative (Real GDP < Potential GDP), the unemployment rate typically exceeds the natural unemployment rate.

    • When the output gap is positive (Real GDP > Potential GDP), the unemployment rate can fall below the natural unemployment rate.

Price Level, Inflation, and Deflation

Definitions

  • Price Level: The average level of prices in an economy and, inversely, the value of money.

  • Inflation: A persistently rising price level.

  • Deflation: A persistently falling price level.

Why We Measure the Price Level

We are interested in the price level for two main reasons:

  1. To measure the inflation rate or deflation rate.

  2. To distinguish between money (nominal) values and real values of economic variables (e.g., nominal wage vs. real wage).

Why Inflation and Deflation Are Problems

  • Low, steady, and anticipated inflation or deflation is generally not a significant problem.

  • Unpredictable inflation or deflation is problematic because it:

    • Redistributes income: Arbitrarily transfers wealth between employers and workers, and between borrowers and lenders (e.g., unexpected inflation benefits borrowers at the expense of lenders).

    • Redistributes wealth: Similar to income, it can shift wealth between different economic agents.

    • Lowers real GDP and employment: Uncertainty can discourage investment and consumption, leading to lower economic activity.

    • Diverts resources from production: Businesses and individuals spend resources trying to forecast inflation rather than on productive activities. This is considered a social cost.

  • Hyperinflation: An extreme form of inflation where the price level rises so rapidly that money loses its value almost instantly (e.g., workers may be paid twice a day).

The Consumer Price Index (CPI)

  • Definition: The Consumer Price Index (CPI) measures the average of the prices paid by urban consumers for a "fixed" basket of consumer goods and services.

Reading the CPI Numbers

  • Reference Base Period: The CPI is defined to equal 100 for a specific reference base period. Currently, this period is the average of the 36 months from January 1982 through December 1984.

  • Example (June 2017): The CPI was 245. This indicates that the average price of the fixed basket of goods was 145 percent higher in June 2017 than during the 1982-1984 base period.

Constructing the CPI

Its construction involves three main stages:

  1. Selecting the CPI basket:

    • Based on a Consumer Expenditure Survey, which is conducted infrequently (e.g., the current basket is based on data from 2016).

    • Key components (weights based on the illustration):

      • Housing: 42.6 percent (largest component)

      • Transportation: 15.3 percent

      • Food and beverages: 14.7 percent

      • Medical care: 8.5 percent

      • Education and communication: 7.0 percent

      • Recreation: 5.7 percent

      • Other goods and services: 3.2 percent

      • Apparel: 3.0 percent

  2. Conducting a monthly price survey:

    • BLS employees collect prices for the 80,000 goods in the CPI basket across 30 metropolitan areas every month.

  3. Calculating the CPI:

    • Step 1: Find the cost of the CPI basket at base-period prices.

    • Step 2: Find the cost of the CPI basket at current-period prices.

    • Step 3: Calculate the CPI for the current period using the formula:
      \text{CPI} = (\text{Cost of basket at current-period prices} \div \text{Cost of basket at base-period prices}) \times 100

CPI Calculation Example (Oranges and Haircuts)

Assume a simple economy with a CPI basket of 10 oranges and 5 haircuts.

  • Base Period (2017) Prices: Oranges: 1.00; Haircuts: 8.00

    • Cost of basket at base-period prices: (10 \times \$1.00) + (5 \times \$8.00) = \$10 + \$40 = \$50

  • Current Period (2018) Prices: Oranges: 2.00; Haircuts: 10.00

    • Cost of basket at current-period prices: (10 \times \$2.00) + (5 \times \$10.00) = \$20 + \$50 = \$70

  • CPI Calculation: \text{CPI} = (\$70 \div \$50) \times 100 = 140

    • This means the CPI is 40 percent higher in the current period than in the base period.

Measuring the Inflation Rate

  • Definition: The inflation rate is the percentage change in the price level from one year to the next.

  • Formula: \text{Inflation rate} = [(\text{CPI this year} - \text{CPI last year}) \div \text{CPI last year}] \times 100

  • Relationship with Price Level:

    • Inflation rate is high when the price level is rising rapidly.

    • Inflation rate is low when the price level is rising slowly.

    • Inflation rate is negative when the price level is falling (i.e., deflation).

The Biased CPI

The CPI may overstate the true inflation rate due to several biases:

  • New Goods Bias: New goods introduced after the base year are often more expensive than the goods they replace and, if they offer new functionality or greater utility, their entrance can impart an upward bias if the CPI formula doesn't fully account for the increased value.

  • Quality Change Bias: Each year, goods and services improve in quality. A portion of a price increase might be due to improved quality rather than pure inflation. The CPI often counts the entire price rise as inflation.

  • Commodity Substitution Bias: The CPI basket is fixed. It does not account for consumers' tendency to substitute away from goods whose relative prices have risen and towards relatively cheaper goods.

  • Outlet Substitution Bias: As the retail landscape changes, consumers may switch to cheaper retail outlets (e.g., discount stores, online retailers). The CPI, if it doesn't adequately capture these changes, can miss the effective price reduction.

Magnitude and Consequences of the Bias

  • Historical Estimate (1996): The CPI was estimated to overstate inflation by about 1.1 percentage points annually.

  • Consequences:

    • Distorts private contracts: Inflation-indexed contracts can be inaccurately adjusted.

    • Increases government outlays: Nearly a third of federal government outlays (e.g., Social Security benefits) are linked to the CPI, meaning the bias leads to higher government spending than necessary.

  • BLS Corrections: The Bureau of Labor Statistics has corrected much of this bias over time, but some still remains.

Alternative Price Indexes

Several alternative measures offer a different perspective on price level changes:

  • Chained CPI: A price index calculated using a method similar to chained-dollar real GDP, which accounts for substitution effects more effectively by updating the basket more frequently.

  • Personal Consumption Expenditure (PCE) Deflator:

    • Formula: \text{PCE deflator} = (\text{Nominal consumption expenditure} \div \text{Real consumption expenditure}) \times 100

    • Broader than the CPI as it includes all consumption expenditure and uses current consumption patterns.

  • GDP Deflator: Similar to the PCE deflator but includes the prices of all goods and services counted in GDP, not just consumption.

Core and Sticky-Price Inflation

These measures attempt to reveal the underlying inflation trend by excluding volatile price components:

  • Core Inflation Rate: Calculated as the percentage change in the PCE index, excluding the prices of food and fuel. These two categories are often excluded due to their high volatility.

    • Caveat: If the relative prices of food and fuel are persistently changing, core inflation might be a biased measure of the true underlying inflation.

  • Sticky-Price Inflation Rate: A newer method that focuses on the rate at which infrequently adjusted prices are changing. This aims to capture inflation trends that are not distorted by frequently fluctuating prices. While it fluctuates less than CPI inflation, it tends to have a similar average over time.