The Measure of Economic Health

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Part II Introduction to Macroeconomics

Chapter 4: Unemployment, Inflation, and Economic Fluctuations

4.1 Full Employment and Unemployment

4.2 Measuring Unemployment

4.3 Price Stability and Inflation

4.4 Measuring Inflation: Price Indexes

4.5 Fluctuations in Output, Employment, and Prices

Chapter 5: The Measure of Output, Income, and Economic Growth

5.1 Revisiting the Circular Flow Model

5.2 Measuring GDP and National Income

5.3 Real GDP, the GDP Deflator, and Economic Growth

Chapter 6: Aggregate Demand and Aggregate Supply 6.1 Aggregate Demand

6.2 Aggregate Supply

6.3 Macroeconomic Equilibrium and Changes in Equilibrium

6.4 The Classical and Keynesian Traditions and Views in the 21st Century

The next three chapters establish the foundation for the study of macroeconomics. Micro- economics focuses on choices made by individuals and businesses, whereas macroeconom- ics considers the aggregate, or total effects, of these choices on the economy. In the United States the primary macroeconomic issues concern total output and income, total employ- ment and unemployment, and price levels and inflation. In contrast, microeconomics is focused more narrowly on the quantities and prices of specific goods, such as pizzas or cell phones, and the employment of certain resources, such as farmland or software developers. If the price of eggs rises, it is a microeconomic matter. If the average price of everything rises, it is a macroeconomic problem.

Employment, inflation, and economic growth are the central concerns of macroeconom- ics. Chapter 4 discusses employment and unemployment, price stability and inflation, and the methods used to measure these important economic indicators. Chapter 5 explores the total level of output, or GDP, and how it is measured. We begin to look at how everything fits together and what leads to change by developing an aggregate model of economic activity called aggregate supply and aggregate demand in Chapter 6.

4 Unemployment, Inflation, and Economic Fluctuations

fizkes/iStock/Thinkstock

Learning Outcomes

After reading this chapter, you should be able to

• Identify and differentiate the three types of unemployment and explain the concept of full employment.

• Calculate the employment rate and understand the importance of the labor force participation rate.

• Explain inflation, deflation, and the importance of predictable changes in prices.

• Explain how price indexes are constructed and calculate the consumer price index and inflation.

• Summarize the different components of the business cycle and recent economic fluctuations in U.S. history.

Introduction

Introduction Grandparents stereotypically love to tell people about how back in their day, “candy bars were only a quarter!” But was 25 cents really so cheap? The cumulative inflation rate from 1950 to 2018 is around 940%, meaning a quarter in 1950 equates to over two dollars today ($2.60 to be exact).1 With most of our candy bars priced right at a dollar in the store, our grandparents were actually paying 160% more for their candy bars. Take pizza as another example. You can often get a pizza $10 or less. Watch commercials from the 1980s and you will regularly see ads for $15 pizzas. What happened? In 1997, Little Caesars introduced their $5 pizza. They said it would be for a limited time, but they are still offering $5 pizzas 20 years later. This brought the cost of pizza down for everyone else.

However, not everything has gotten cheaper. Tuition has risen over 230% in the past thirty years, from an average price of $3,000 per year to $10,000 per year now.2 Health care and housing costs have risen even more dramatically. So when you hear people talking about how college, housing, or medical bills were cheaper back in their day, that is verifiable. What about other items: a shirt, shoes, event tickets, a loaf of bread? These all make up what is known as the consumer price index (CPI). The CPI measures the average change in price in a basket of goods over time. It’s how we keep track of the true cost of a candy bar, a pizza, or open heart surgery over time.

What do people want from the economy as a whole? What are the macroeconomic goals? How can a nation measure whether it is better off or worse off than before? Two important measures of changes in economic well-being are the amount of output being produced and the amount of income house- holds receive. The level of income and output and the rate at which they grow are the central focus of macroeconomics.

The economic well-being of one household (or of all households taken together) depends on how much income that household earns and what that income can purchase. The ability of a household to earn income is closely tied to employment opportunities. While there are other sources of earnings, like rent and interest, wages and salaries make up the major-

ity of household income. Households in which people have jobs earn more on average than households without employed workers, and households with multiple earners have higher incomes than households with just one worker. The purchasing power of these incomes depends on the price level and the rate of inflation. While growth of total income and output is abstract to most people, the effects of unemployment and inflation on their economic well- being is much more direct and immediate. We begin our study of economics by focusing on employment, unemployment, and the two goals of price stability and inflation. The third goal, economic growth, is discussed in the next chapter.

1 US Inflation Calculator. (2018). Retrieved from https://www.usinflationcalculator.com/ 2 Martin, E. (2017, November 29). Here’s how much more expensive it is for you to go to college than it was for your parents. CNBC. Retrieved from https://www.cnbc.com/2017/11/29/how-much-college-tuition-has-increased-from-1988-to-2018.html

Richard Levine/age fotostock/Superstock

As the economy declined, many well- known companies had to close stores. As a result, the unemployment rate doubled between April 2008 and October 2009.

https://www.usinflationcalculator.com/

https://www.cnbc.com/2017/11/29/how-much-college-tuition-has-increased-from-1988-to-2018.html

Section 4.1 Full Employment and Unemployment

4.1 Full Employment and Unemployment The macroeconomic goal that has received the most attention in recent years is full employment. However, the precise amounts of employment and unemployment that constitute full employment are difficult to pinpoint. Full employment does not mean that everyone in the population is employed. One way of defining full employment is to iden- tify some level of unemployment as normal (acceptable or desirable) and only be con- cerned about unemployment in excess of that amount. A level of around 6% is currently considered normal. By this definition, an economy is at full employment when 94% of those who want to work are employed. Another definition of full employment is that the number of job seekers is approximately equal to the number of job vacancies—the U.S. job market index otherwise known as the help wanted index. Economists use the 94% standard because it is easier to measure and gives similar results to the other definition.

The value of normal unemployment may change over time. What is now considered normal— 6%—suggests a wide mismatch between available jobs and the skills that unemployed work- ers possess. For example, teachers who have been laid off will not be qualified to work in the booming health care sector. This is called a structural shift in the workforce.

Unemployment rates since 1950 are shown in Figure 4.1. Although each decade except the 1960s has seen a recession that drove unemployment above the norm, you can also see a

Figure 4.1: U.S. unemployment rates (percentage of the civilian labor force),

1950–2017

Since 1950 a gradual trend in unemployment rates can be observed, with peaks in the recessions of 1959–1960, 1970, 1974–1975, 1980–1982, 1990–1991, and 2007–2009.

From “Economic Report of the President,” by Council of Economic Advisers, 2012, Washington, DC: U.S. Government Printing Office. From “Unemployment Rate,” Labor Force Statistics from the Current Population Survey, by Bureau of Labor Statistics, 2018, Retrieved from https://data.bls.gov/timeseries/LNS14000000.

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Section 4.1 Full Employment and Unemployment

gradual rise in the average rate of unemployment. Unemployment averaged 4.5% in the 1950s, 4.8% in the 1960s, 6.1% in the 1970s, 7.3% in the 1980s, 5.8% in the 1990s, and 6% in the first decade of the 2000s. The 2008 recession wiped out around 8.3 million jobs, with the unemployment rate rising from 4.7% to 10.1% at its peak in 2009 before decreasing to 8.3% in January 2012. Since then the unemployment rate has trended steadily downward before hitting a low of 4.1% in January 2018 (Bureau of Labor Statistics, 2018a).

Frictional and Structural Unemployment

Although it may seem counterintuitive, it is not ideal to have a situation in which everyone is always employed. Some unemployment is desirable because there are new entrants into the labor force searching for jobs, some workers are between jobs, and other workers retire. A good example is when students graduate. Finding a job takes time, and during that time a per- son will be unemployed. Such short-term unemployment is called frictional unemployment.

Frictional unemployment is typically around 3% to 4% of the labor force (Warren, 1991). When immigration is temporarily higher or when there is a large number of high school and college graduates entering the labor force, frictional unemployment may be slightly higher. In January 2018, for example, frictional unemployment was responsible for just over 4% of all unemployment (Bureau of Labor Statistics, 2018b).

Another normal source of unemployment is a mismatch of workers and jobs commonly known as structural unemployment. There may be a surplus of aerospace engineers and a need for health care workers, or an excess of labor in Montana and a shortage of workers in Virginia. Whenever the available workers do not match the jobs in terms of skills or location, there is structural unemployment. This kind of unemployment tends to last longer than fric- tional unemployment because it takes longer for workers to retrain or relocate to match avail- able jobs. When plants close, either permanently or because the firm is moving production to another place, most of the workers eventually find other work. More recently, globalization and changes in technology have created additional challenges for people who are unemployed.

Although there is always a certain amount of struc- tural unemployment, it varies more from one time period to the next than frictional unemployment. When economists change the way they define full employment, it usually reflects changes in their estimate of structural unemployment.

Structural unemployment appears to be higher and longer lasting in recent years than in earlier periods because of major changes occurring in the economy. The shift from defense production to civilian pro- duction was painful for many workers, firms, and regions, because the products, services, and skills found in firms producing for the military are not

HoleInTheBucket/iStock/Thinkstock

Workers who are unemployed for structural reasons often face a skills gap, in which new jobs may require new skills that must be learned via training or acquired on the job.

Section 4.1 Full Employment and Unemployment

easily shifted into civilian uses. The globalization of both white-collar and blue-collar jobs in the early 2000s put a large number of workers out of jobs, and these displaced workers were slowly reabsorbed. The decline in direct manufacturing jobs has been partly offset by growth in service jobs, particularly in health care, but these workers are not easily transferred into very different lines of work due to their specialized training.

Some economists argue that both frictional and structural unemployment are higher than necessary because the government subsidizes unemployed people. Workers may take longer to search for a job when they can collect unemployment compensation and other benefits, and the cost of the search falls on taxpayers. Other economists argue that this effect may actually benefit both workers and society as a whole because workers who search longer may wind up with more suitable jobs, in which they can earn more and be more productive. Regardless of which view you hold, these programs probably raise the measured rate of unemployment.

In terms of public policy, frictional unemployment calls for better information and employ- ment services. Structural unemployment may imply a need for retraining and assistance in relocating. Because these kinds of policies try to make specific segments of the labor market work more efficiently, they are really closer to being microeconomic than macroeconomic. However, when structural unemployment results from massive shifts in patterns of govern- ment spending or from major changes in industrial structure, this kind of unemployment can be considered a macroeconomic issue.

Cyclical Unemployment

Some unemployment is related to declines in the level of aggregate output. This cyclical unemployment is a major policy concern in macroeconomics. In bad economic times, work- ers are laid off because of a general fall in demand or specifically as a function of the products they produce. Cyclical unemployment tends to be most severe in “heavy” industries (manu- facturing equipment and some consumer goods, such as cars and refrigerators). Macroeco- nomic policies intended to reduce cyclical unemployment try to create more jobs by increas- ing demand for total output. For example, the auto industry was particularly hard hit during 2008, so the government created a program called “cash for clunkers” designed to increase auto sales. The rebates were geared toward purchases of more fuel-efficient vehicles and likely helped reduce the impact of the recession on car manufacturers.

Seasonal Unemployment

Over the course of a year, a nation’s levels of employment (and unemployment) fluctuate due to seasonal events such as weather, harvests, major holidays, and the start and end of the academic year. For example, employment spikes in retail trade in the last 3 months of the year, when businesses expect a surge of holiday customers and increased sales (Bureau of Labor Statistics, 2017). In the summer, employment typically rises for 16- to 19-year-olds when students are out of school and have time to work. Seasonal changes like these follow a similar pattern from one year to the next, so we often adjust the numerical figures, such as the unemployment rate, to account for seasonal fluctuations.

Section 4.1 Full Employment and Unemployment

Productivity and Employment

One of the most important influences on long-run trends in employment is changes in worker productivity. Productivity is a measure of economic performance that shows changes in out- put per worker hour from one year to the next. When workers are more productive, firms will hire more of them. Real wages (wages that have been adjusted for inflation) and employment will rise together. (Real wages are used in contrast to nominal wages or unadjusted wages when calculating data. Real wages are measured in terms of the goods and services they will buy and provide a better representation of a worker’s wages.)

The productivity index for the United States for 1990–2016 is shown in Figure 4.2. The annual rate of growth of productivity was very high in the early postwar period. It slowed consider- ably in the 1970s and has remained low since that time, although it has always been higher in the two years immediately following a recession. The 1990–1991 recession showed the same pattern of improved productivity growth coming out of the recession. Much effort has been expended in trying to explain the slowdown in the growth of productivity in recent decades and to suggest ways to improve productivity. Inexperienced or poorly trained workers, low savings rates, and lack of investment in developing new products and technology have all been cited as possible causes. Other economists, however, have suggested that the high rates of increase in productivity of the early postwar period were not typical and that current rates are more normal.

Key Ideas: Kinds of Unemployment

Kind Normal rate Cause Policy

Frictional Around 4% New entrants; job leavers Improvement of labor- market information

Structural 1%–5% Returning workers; mismatch between workers and job skills or location

Retraining and relocation assistance

Cyclical 0–? Downturn in output Stabilization policy

Seasonal Varies annually Time of year None

Section 4.1 Full Employment and Unemployment

Costs of Unemployment

Why are macroeconomic policy makers concerned about the level of unemployment? First, unemployment is wasteful. If workers are unemployed, the economy is not operating on the production possibilities frontier. These workers could be producing goods and services. Although other resources can also be unemployed, policy makers and the public are usually more concerned about unemployed labor than idle capital or land because most households receive the largest share of their income from labor earnings.

The second reason for concern about unemployment is that the system of income distribu- tion in a market economy is very dependent on employment. If people do not have jobs, they do not earn income. People who are employed wind up supporting people who are unem- ployed through unemployment benefits, food stamps, and other social welfare programs. For people who are unemployed, a period without meaningful work or an opportunity to be

Figure 4.2: Productivity index, 2000–2016

The index of productivity per worker hour in the private sector has increased at an average rate of less than 2% in the past 16 years. The rapid growth rates of the early 2000s slowed down by 2005 but picked back up in 2009 and 2010 before dropping to 0.2% in 2016.

From “Table 1. Private Nonfarm Business Sector: Productivity and Related Measures for the 1987–2017 Period,” by Bureau of Labor Statistics, 2018, Retrieved from https://www.bls.gov/news.release/prod3.t01.htm.

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Section 4.2 Measuring Unemployment

self-supporting can also be psychologically demoralizing. Sociologists find more depression, addiction, spouse and child abuse, and other social problems in households where workers are unemployed for long periods of time.

Finally, unemployment is costly to workers in terms of future earnings. Each period of unem- ployment is a lost opportunity to develop skills and experience that may make a worker more valuable to an employer.

4.2 Measuring Unemployment The number of people who are unemployed as well as the number of people who are employed will grow with the population and with the fraction of the population that is of working age and employable. In order to make comparisons over time, it is more helpful to measure unem- ployment as a percentage of the labor force rather than to count the number of people who are unemployed. The unemployment rate is defined as the percentage of the labor force that wants to work but does not currently have a job. That is,

Unemployment rate = Unemployed workers Labor force × 100

where the labor force is sum of employed workers and unemployed workers.

The Labor Force and Unemployed Workers

The first step in measuring unemployment is to determine the size of the labor force. Until recently, only the civilian labor force was counted. Those who were employed in the military services were excluded. Newer measures include the military in the labor force.

The labor force consists of those who are working and those who are actively seeking work. A full-time homemaker, a child, a retiree, a full-time student, or anyone else not employed is not counted in either the numerator or the denominator of the unemployment rate. People who were seeking work but have given up and stopped looking are called discouraged workers and are also excluded from the calculation of unemployment. However, data is collected on discouraged workers. In January 2018 there were 451,000 discouraged workers in the United States. Although it is important to watch for large fluctuations in the number of discouraged workers, counting them as unemployed would increase the unemployment rate less than 0.002%—and remember, you are not unemployed by definition if you stop looking for work (Bureau of Labor Statistics, 2018b).

The measures of both the labor force and the number of people who are unemployed are obtained primarily from door-to-door surveys and payroll data from business firms (Flaim, 1989). Respondents in door-to-door surveys are only considered unemployed if they have made some effort to find work in the previous 4 weeks. Other data come from filing of unem- ployment claims at state employment offices. Because the Bureau of Labor Statistics cannot count the number of people who are unemployed directly, sometimes the figures reported immediately are later revised a great deal. One example of this occurred during the 1990–1991

Section 4.2 Measuring Unemployment

recession, when there appeared to be a major loss of jobs that did not actually occur. The people calculating employment and unemployment from payroll data were confusing the number of payroll checks with the number of people. Many people receive extra checks for bonuses and vacations. When those numbers drop, there appear to be fewer workers on the payroll. This source of error has now been corrected, but it illustrates the kinds of problems there are in collecting and interpreting unemployment data (Berry, 1993).

The unemployment rate is an imperfect indicator for other reasons as well. The omission of discouraged workers, for example, makes unemployment appear lower than it really is. Some workers may also be underemployed—working below their ability or for fewer hours than they would like. These workers, commonly referred to as involuntary part-time workers, are still counted as employed. On the other hand, some workers leave jobs, make a modest effort to find work in order to qualify for unemployment benefits, and avoid taking a job until their unemployment benefits run out. These people should probably not be counted as actively seeking work. Their inclusion overstates unemployment.

The Labor Force Participation Rate

The major source of short-term changes in unemployment is changes in total demand for labor that result from changes in total output. Over longer periods, total labor supply also affects the unemployment rate. An indicator that is helpful in sorting out the relative impor- tance of these two sources of changes in unemployment is the labor force participation rate. The labor force participation rate measures the fraction of the adult population that is employed or actively seeking work.

In 1948 the labor force participation rate was 59%. It remained near that level until the 1960s, when it began to rise. By 2009, 67% of the working-age population was in the labor force. The increase in the labor force participation rate resulted partly from a particularly large seg- ment of the population coming of age and partly from increased labor force participation by women. In the early 1960s, only 38% of adult women were in the labor force; by 2009, 60% were working or looking for work. Interestingly enough, the participation rate for men actu- ally fell from 84% in 1960 to 72% in 2009 (Bureau of Labor Statistics, 2018a).

Overall, this increased fraction of the population in the labor force meant that even though the U.S. unemployment rate was reaching new highs, the employment rate (the percentage of the population with jobs) was fairly stable. Part of the increase in unemployment was caused by the larger fraction of the population that was seeking employment. The added-worker effect, or the increased likelihood that married women would enter the labor market when their husbands became unemployed, may have also been a factor.

In the 1990s the growth in the labor force participation rate leveled off, and the labor force grew at an average rate of only 1.2% a year, compared to 2.3% in the 1980s (Fullerton, 1989). The main reason for slow growth was fewer new entrants to the labor force because of a smaller number of people in their late teens and early 20s. The labor force participa- tion rate stayed relatively stable in the 21st century before dipping 2.4% between 2010 and 2015 (see Figure 4.3). In more recent years, the labor participation rate has stayed relatively stable, at 62.9% in January 2017 and 62.7% a year later in January 2018 (Bureau of Labor Statistics, 2018a).

Section 4.2 Measuring Unemployment

Figure 4.3: Labor force participation rates, 1950–2016 and projected to 2060

The labor force is projected to get older until 2060. Why would an aging population lead to a projected decline in the labor force participation rate?

From “A Look at the Future of the U.S. Labor Force to 2060,” by M. Toossi, 2016, Retrieved from https://www.bls.gov/spotlight/2016 /a-look-at-the-future-of-the-us-labor-force-to-2060/home.htm.

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Policy Focus: Forecasting and the Leading Indicators

Before governments can try to control inflation or unemployment through stabilization policy, they have to be able to forecast the course of the business cycle. Economic forecasting is often not very accurate or very timely. Economists are very good at explaining what happened and why, but they are not nearly as successful as weather forecasters in predicting the future. (Remember, though, that weather forecasters only predict for 5 to 7 days ahead!)

The search for a forecasting tool has to be based in theory. Ideally, forecasters would like to find some variable, such as interest rates or grocery store sales or college enrollments, that has some systematic relationship to the ups and downs of the business cycle for some sound theoretical reason. Even better would be a variable that moved not only with the business cycle but actually ahead of it. Over many decades, forecasters have identified such variables. A group of 11 economic variables called the leading indicators is used for forecasting the ups and downs of the business cycle by policy analysts, business forecasters, and individuals. They are called leading indicators because they lead the business cycle, generally turning down 6 months before the peak or upper turning point and turning up 6 months before the trough or lower turning point. The ups and downs of the average of the leading indicators are reported monthly on the evening news, in the major newspapers, and on the Internet.

(continued)

https://www.bls.gov/spotlight/2016/a-look-at-the-future-of-the-us-labor-force-to-2060/home.htm

Section 4.3 Price Stability and Inflation

4.3 Price Stability and Inflation A second important macroeconomic goal is price stability. Both individual prices and the aver- age level of prices can either rise or fall. In recent years, however, the United States has experi- enced a continued rise in the general, or average, level of prices, which is called inflation. The measure of inflation is the change in the price index. A price index measures the price level in any year relative to some base year. The best known such measure is the consumer price index (CPI), commonly referred to as the cost-of-living index. The CPI measures the cost of a market basket of a selected array of consumer goods each year, much as consumers might compare the cost of the usual contents of their grocery cart each week at the supermarket. The percentage change in the CPI from one year to the next is the inflation rate.

The CPI tables were redesigned in August 2009 to focus on the price movements of three broad expenditure categories: food, energy, and all items less food and energy. Within these three broad categories, CPI item series are further divided into commodities and services. The Survey of Professional Forecasters projects that the CPI will grow at an average annual rate of 2.25% from 2018 through 2027 (Federal Reserve Bank of Philadelphia, 2018).

Policy Focus: Forecasting and the Leading Indicators (continued)

The leading indicators are the money supply, stock prices, consumer expectations, commodity (raw materials, farm products) prices, the average workweek, new unemployment claims, new building permits, new orders for consumer goods, new orders for investment goods, unfilled orders, and backlogged deliveries. If the average of these indicators rises for several months in a row, it is forecasting expansion in 6 months. If the average points consistently downward, it is hinting at recession. The leading indicators are far from perfect as a forecaster. Economists like to joke that this index forecast eight of the previous six recessions! Economists have other forecasting tools in their arsenal, including elaborate computer models and other techniques. But for rough estimates of the direction of the economy, policy makers in both government and business find that the leading indicators are a very useful forecasting tool.

Key Ideas: Ways to Measure Unemployment

• The unemployment rate is the percentage of the labor force that wants to work but does not currently have a job.

• The labor force participation rate measures the fraction of the adult population that is employed or actively seeking work.

Section 4.3 Price Stability and Inflation

The inflation rate from 1948 to 2017 is shown in Figure 4.4. You can see that prices were rela- tively stable until the 1970s. High inflation in the late 1970s and early 1980s increased aware- ness of the many problems caused by inflation, especially when it is unexpected. However, high inflation is not necessarily a bad thing, unless it is accompanied by slow growth. Lower inflation rates in the rest of the 1980s helped calm fears that high rates of inflation would become a permanent feature of the U.S. economy. Inflation was low in the early 1990s, pri- marily because of the 1990–1991 recession and the slow recovery, and remained low through the next 2 decades. The inflation rate dropped even lower as a result of the economic down- turn in 2007, before dipping into negative rates for several months in 2009. When inflation rates fall below 0%, this is called deflation. Deflation is a decrease in the general price level of goods and services. Inflation reduces the real value of money over time; conversely, deflation increases the real value of money. What this means is that you can buy more goods with the same amount of money over time. Why should you worry about deflation? Because it is indi- rectly related to unemployment. If people start anticipating falling prices, they become much less willing to spend or borrow money. When that happens, as Princeton University professor of economics Paul Krugman (2010) says in a New York Times article, “the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed.”

Fortunately for the U.S. economy, negative inflation rates, or deflation, did not last beyond 2009, and as of January 2018, the U.S. inflation rate was 2.1% (Bureau of Labor Statistics, 2018a).

Figure 4.4: U.S. inflation rate, 1948–2017

The rate of change in the CPI is shown for each year since 1948. Note the very low inflation rates during the 1950s, then a gradual rise in the 1960s, a sharp increase in 1975–1981, a drop after the 1980–1982 recession, and a drop after the 2007–2009 recession. Inflation has been low and stable in more recent years.

From “CPI-All Urban Consumers (Current Series),” by Bureau of Labor Statistics, 2018, Retrieved from https://data.bls.gov/ timeseries /CUUR0000SA0?output_view=pct_12mths.

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Section 4.3 Price Stability and Inflation

Gainers and Losers From Inflation

One reason why governments try to restrain inflation is that it causes an unintended and often undesirable redistribution of income and wealth. Redistribution is more likely to occur when inflation is unexpected. People make contracts and decisions on the assumption of an expected rate of inflation. Suppose, for simplicity, you are expecting zero inflation. You lend someone $100 for a year at an interest rate of 5%. This rate is enough to cover your risk of not being repaid and the cost of not using the money for a year, assuming no inflation. Then there is unexpected inflation of 10%. At the end of a year, you receive $105, but it will only purchase $95.45 in goods and services ($105/1.10). Who gained in this example? The borrower. If you had anticipated the inflation, you would have demanded a higher interest rate to cover the loss of purchasing power. Unexpected inflation redistributes income from lenders to borrowers.

Lenders and borrowers are not the only ones who are affected by income redistribution because of inflation. People who hold any kind of fixed-dollar assets, such as life insurance policies, lose purchasing power. People who hold real, physical assets, such as land, houses, or jewelry, often find that the value of those assets rises faster than the rate of inflation. As more people shift to real assets in response to expected inflation, the increase in demand for those assets will drive their prices up even faster than the inflation rate. Those assets that people buy as insur- ance against inflation are called inflation hedges. Buying the biggest house you could possibly afford was a popular inflation hedge in the 1970s and 1980s. Many home buyers were later able to sell their houses for much more than they paid for them, since house prices increased rapidly. This pattern ended in the late 1980s. In the 1990s the smaller number of new home buyers meant that average house prices were fairly stable or even falling. The housing market changed dramatically in the late 1990s and early 2000s as the credit market eased, allowing people to purchase homes with little or no income. Housing appreciated rapidly, leading to the bubble in the housing market shown in Figure 4.5. By late 2005 the rapid growth of investment in residential homes had come to an end, and over 10 years’ growth of investment in residen- tial houses was eliminated in just 3 years, from 2005 to 2008 (Byun, 2010).

Figure 4.5: U.S. home value index

This figure illustrates the housing market before and after the market bubble in 2007.

From “United States Home Prices & Values,” by Zillow, 2018, Retrieved from https://www.zillow.com/home-values/.

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https://www.zillow.com/home-values/

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Section 4.3 Price Stability and Inflation

Generally, common stocks—which represent ownership claims on the real, physical assets of firms—also do better than the inflation rate. One of the most common examples of an infla- tion hedge is gold. However, the future course of the price of any given stock is highly uncer- tain, even gold, making stocks a risky inflation hedge. Hedging against anticipated inflation is an important way to protect the value of assets, but there is no perfect instrument to use for that purpose.

Governments are often winners during times of inflation because state and federal income tax revenues tend to rise faster than the inflation rate. As prices rise, households’ dollar incomes also rise, even if the purchasing power of those incomes is unchanged. Taxpayers find them- selves in higher tax brackets, paying a higher percentage of their incomes in taxes. Changes in U.S. tax laws since 1986 have made federal income taxes less progressive, although some progressivity was restored in the 1993 and 2005 deficit reduction plans. In the future, the

government may stand to gain less from inflation. Since 1990 some aspects of the income tax code (brackets and personal exemptions) have been adjusted for infla- tion each year, making the federal govern- ment even less of a winner from inflation. However, even with these changes, the government will continue to reap gains in the form of increased revenues when there is inflation. This revenue gain will occur because there are still several rates and brackets in the federal income tax code and in many state income tax codes as well. Revenue from other taxes, such as sales taxes and property taxes, tends to lag behind inflation.

Market Signals, Inflation Psychology, and Menu Cost

In general, inflation confuses the market signals on which individuals rely to make good deci- sions about earning, spending, saving, and investing. It is difficult to tell what is happening to relative prices when all prices are moving at once. This confusion of signals due to inflation is a major problem in market economies.

Another problem from high rates of inflation is an inflation psychology that leads people to buy now before the price goes up. This expectation encourages consumption but discour- ages saving and investment. Saving and investment are important because they increase the nation’s stock of capital and result in a higher rate of economic growth. By discouraging sav- ing and investment, high rates of inflation can have a negative effect on economic growth.

A third problem is the menu cost of inflation. Have you ever gone into a restaurant and seen prices crossed out and written over? Such price changes happen more often with inflation. Firms have to get new menus, price lists, catalogs, and other price information printed more often. All of these adjustments use real resources that could be used more productively in other ways.

Hemera/Thinkstock

Ten years of housing appreciation was eliminated in just 3 years, from 2005 to 2008.

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Section 4.4 Measuring Inflation: Price Indexes

Should the Goal Be Zero Inflation?

Given all these drawbacks to inflation, why not try to reduce the inflation rate to zero? The first problem is that the measurement of inflation is not very precise. Therefore, what appears to be modest inflation of about 2% might actually be closer to zero inflation if the index were correctly computed (Altig, 2003). A stronger argument against the goal of zero inflation is that the costs of reducing the inflation rate to zero may be greater than the benefits. Often, moderate inflation is associated with rapid economic growth, which is usually considered a desirable goal. Since most of the problems from inflation are related to high rates of inflation, rapid inflation, or unexpected inflation, it can still be the case that a low and stable rate of inflation is desirable. Currently a rate of 2.5%–3.5% is considered optimal, although some economists disagree.

4.4 Measuring Inflation: Price Indexes A price index, like any index, is a weighted average. Index values are composites of many numerical values, which are assigned weights based on their relative importance. The abso- lute value of any index has little meaning. The relative value of an index—especially changes in the relative value—is important. The fact that the Dow Jones Industrial Average stock index passed the 25,000 mark in 2018, for example, doesn’t mean much unless you know what its value was in earlier years.

How Price Indexes Are Constructed

A price index is usually constructed by starting with a market basket or output mix in some benchmark, or base, year. Then the market cost of that basket is followed in succeeding years.

The most familiar price index is the CPI. The current CPI is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. Currently, CPI data are drawn from the Consumer Expenditure Survey for 2013–2014. How- ever, the reference base period for the CPI is 1982–1984. It is helpful to keep the reference period constant in order to simplify comparisons across time. For example, the CPI in 1983 would be 100 because it is a base year. If the CPI in 2018 is 249, we know that prices were 149% higher in 2018 than they were in 1983.

Key Ideas: What’s Wrong With Inflation?

The costs of inflation are

• unintended redistribution of income and wealth, • transfer of resources to government, • confused market signals, • lower levels of saving and investment (inflation psychology), and • menu costs.

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Section 4.4 Measuring Inflation: Price Indexes

To put it in context, suppose that a typical family bought 20 pounds of ground beef, three pairs of jeans, five rolls of paper towels, and 8 pounds of apples. Those goods and the amounts of each are used in computing the index. That basket of goods is then priced at regular intervals to see what is happening to the CPI, or the cost of living. Table 4.1 constructs a price index for those four items after determining their base-year and current-year prices.

Table 4.1: Computing a price index

Item Quantity (Q)

Year 1 price (P1)

Total value (Q × P1)

Year 2 price (P2)

Total value (Q × P2)

Ground beef 20 pounds $1.10 $22.00 $1.50 $30.00

Jeans 3 pairs $16.00 $48.00 $18.00 $54.00

Paper towels 5 rolls $0.60 $3.00 $0.50 $2.50

Apples 8 pounds $0.25 $2.00 $0.30 $2.40

Value of market basket $75.00 $88.90

Because the items in the market basket are the same for both years, the increase from $75.00 to $88.90 must be due entirely to price changes. The index is

88.90/75.00 = 1.19

or, as it is usually written, 118. This number means that prices rose, on the average, 18%. Note, however, that two prices rose more than 18%, one price rose less, and one price actually fell.

Uses for the CPI

Price indexes are useful for a number of purposes. If you are comparing job offers in different parts of the country, you will want to adjust salary offers to take into account differences in the local cost of living in each area. If you want to see if there has been any improvement since last year in your real income, or the purchasing power of what you earn, you need to adjust this year’s nominal income for price changes. Suppose, for example, that from 2010 to 2011 your nominal income rose from $20,000 to $21,200, a 6% increase. How much did your real income increase? Table 4.2 shows this calculation, using CPI indexes for which the base value is 100 for 1982–1984.

Table 4.2: Converting nominal income to real income

Year Income CPI Income in 1982–1984 dollars

2017 $20,000 130.7 $15,302

2018 $21,200 136.2 $15,565

Percentage increase in the price level: (136.2 – 130.7)/130.7 = 4.21%

Income increase in constant dollars: $263

Percentage increase in real income: $263/$20,000 = 1.32%

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Section 4.4 Measuring Inflation: Price Indexes

Note that the 6% increase in nominal income is slightly greater than the sum of the real increase of 1.32% and the price increase of 4.21%. This observation offers a shortcut for approximating a change in real income when inflation rates are not too high. You can approxi- mate real income changes using

% change Yr = % change Yn – % change P,

where Yr is the real income, Yn is the nominal income, and P is the price level. If the change in nominal income (6% in this case) and the change in the price level (4.2%) are known, then their difference will be approximately equal to the percentage change in real income.

Changes in the CPI are used to adjust poverty income levels, Social Security benefits, and wages for workers who have contracts providing for cost-of-living adjustments. Even where no contract is involved, the CPI plays a role in many wage negotiations and other business and personal decisions. Probably no other economic datum is quoted as often as the CPI.

Problems With the CPI

Because the CPI is used so widely, it is important to recognize its drawbacks and limitations. One of these is the fact that the market basket is fixed or changed very infrequently, on the basis of extensive consumer surveys. The 2017 CPI is based on a survey taken in 2013–2014. Since that time, changes in the age distribution of the population, changes in tastes and tech- nology, and development of new products have changed the mix of goods consumers buy. The more time that has passed since the survey that was used to find the weights, the more inac- curate the CPI becomes.

A second problem has to do with changes in relative prices. The CPI measures changes in the average price of a representative market basket of goods and services. If your household consumes those goods and services in about that proportion, then the CPI will reflect changes in your cost of living. If, however, you spend greater-than-average amounts on medical care and housing (whose prices have risen rapidly) and less-than-average amounts on clothing and furniture (whose prices have risen more slowly), then your personal price index will rise faster than the CPI. Using the CPI to compare incomes over time or to adjust wages or Social Security benefits is likely to lead to overadjusting at some times and undercorrecting for infla- tion at others.

Finally, the CPI cannot take into account the changes in household purchasing when the price of any good changes rapidly. For example, if the price of beef quadrupled in one year, many households would immediately substitute another meat, like chicken, since chicken would appear relatively cheaper. The CPI basket is only updated every 2 years, so any changes in purchasing behavior as a result of drastic price changes are often not accounted for in the CPI.

Other Price Indexes

There are two other widely used price indexes. One is the GDP deflator, used to adjust total output for inflation. GDP as a measure of total output will be discussed in the next chapter. This index has a broader base than the CPI because it reflects all of the goods and services produced

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Section 4.5 Fluctuations in Output, Employment, and Prices

in the economy, not just consumer goods. Unlike the CPI, the GDP deflator is a current-weights index. The weights for the various components are based on the proportions sold or produced in the current year, not a base year. Because the two indexes are calculated differently, the GDP deflator gives a different measure of inflation than the CPI does. The difference is partly due to the deflator’s broader coverage and partly due to the fact that it uses current weights rather than base-year weights.

Another major price index, the Producer Price Index, is actually a family of indexes. There are three indexes: one for raw materials, one for semifinished goods, and one for finished goods. These indexes show what is happening to prices paid by producers and wholesalers, which will eventually affect the prices of retail goods and services. The Producer Price Index is useful in forecasting changes in the CPI and the GDP deflator.

Key Ideas: Different Price Indexes

• The CPI is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services.

• The GDP deflator is based on all of the goods and services produced in the economy, making it a current-weights index.

• The Producer Price Index is based on the prices paid by producers and wholesalers, which will eventually affect the prices of retail goods and services.

4.5 Fluctuations in Output, Employment, and Prices The ups and downs of inflation and employment are not random. In fact, they tend to move in rather systematic fashion, related to changes in total output. In particular, the unemploy- ment rate and growth of output track each other quite closely, though in opposite directions. The inflation rate is less consistently related to the other two. Until the 1970s, inflation rates in the United States tended to be low when growth was slow and unemployment was high. Higher inflation rates went with rapid growth and low unemployment rates. From 1973 to 1982, however, the U.S. economy experienced slow growth, high unemployment, and high inflation all at once. In the 1990s there was a pattern of slow growth, low inflation, and relatively high unemployment. Since 2016 both inflation and unemployment have remained consistently low.

Over the course of a longer period, the major macroeconomic variables tend to move together in a rather predictable fashion, although not always in the “right” direction. When there is slow growth or even falling output, rising unemployment, or high inflation rates, the govern- ment often intervenes to try to correct the course of these variables. Stabilization policy consists of those actions of government designed to smooth out ups and downs in output, employment, and prices.

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Section 4.5 Fluctuations in Output, Employment, and Prices

An observed and repeated pattern of ups and downs in output, employment, and prices was named the business cycle in the 19th century. A simplified business cycle is shown in Figure 4.6. In the expansionary phase of the cycle (from upturn through peak), output increases, prices rise rapidly, and unemployment falls. Productivity tends to increase as the economy emerges from the trough of a recession. Firms have kept some workers on during the reces- sion but have not used them fully. As sales increase, firms employ these workers more fully, and productivity rises. As expansion continues, new and less experienced workers are hired. Then the increase in both productivity and output starts to slow, although employment con- tinues to rise.

Figure 4.6: A hypothetical business cycle

The business cycle shows fluctuations in the level of economic activity over time. In this hypothetical business cycle, the first peak and the trough are equal in magnitude, and the upturn and downturn take the same length of time. Actual cycles may be less symmetric, with upturns greater or smaller than downturns in size or duration. The cycle is measured from peak to peak. The trend line is the underlying growth rate of GDP.

Time0

Peak

Trough

Level of economic activity (real GDP)

E xp

an si

Recession

E xp

an si

Business cycle

Long-run

trend of

economic

activity

Recessions, Troughs, Expansions, and Peaks

As output reaches a high point, or peak, and turns down, prices tend to fall also, or at least to rise at a slower rate. The downturn of output is called a recession. Unemployment increases and income and output fall, until the lower turning point, or trough, when output reaches its lowest level. Then the process starts over again. The upturn from trough to peak is an expansion. A complete cycle goes from peak to peak or from trough to trough.

Each successive peak (and trough) should occur at a higher level of output because the busi- ness cycle is a fluctuation around a trend line of growing output over time. For example, a 6-year business cycle with a trend growth rate of output of 2% a year should see a final peak of output that is 12%–13% above the previous peak.

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Section 4.5 Fluctuations in Output, Employment, and Prices

In 1978 the National Bureau of Economic Research (NBER) established the Business Cycle Dating Committee, which has been formally announcing the determination of a peak or trough in economic activity since then. In September 2010 the NBER committee determined that a trough had occurred in June 2009, leading to a still-weak economy and lingering high unemployment but considerable expansion from the trough 15 months earlier.

U.S. Economic Fluctuations

Several business cycles in the United States can be identified in Figure 4.7, which shows unem- ployment rates and identification markers for recessions. There were particularly severe downturns in 1929–1939, 1974–1975, and 1980–1982. There was a modest but identifiable recession in 1990–1991, a brief and shallow recession in 2001, and a major worldwide reces- sion from 2007 to 2009.

Figure 4.7: Unemployment rate and recessions

How do you think the United States’ high unemployment rate affected other countries’ economic situation?

From “Unemployment Rate,” Labor Force Statistics from the Current Population Survey, by Bureau of Labor Statistics, 2018, Retrieved from https://data.bls.gov/timeseries/LNS14000000.

1929

Unemployment rate (percentage

of labor force)

Year 1939 1949 1959

Large recessions in:

The Great Depression

1973– 1975

1981– 1982 1990–

1991

2008– 2009

2010– 2011

1969 1979 1989 1999 2009 2017

The U.S. economy has experienced 33 recessions since record keeping began in 1854. On average, a recession has occurred in the United States every 4 to 5 years. The 1929–1939 recession was so severe it was given a special name: the Great Depression. A depression is a very severe recession. President Harry Truman once said that when your neighbor is out of work, that’s a recession; but when you lose your job, that’s a depression. In a depression, people suffer unemployment, inability to get credit, and losses of their homes, farms, savings, and businesses.

In more recent years the most significant change from the prewar period is that declining real output has been much less likely to be accompanied by a fall in prices. When prices have declined, they have not fallen nearly as much as in periods before World War II. A decline in economic activity that is not accompanied by a fall in the price level is referred to as

https://data.bls.gov/timeseries/LNS14000000

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Section 4.5 Fluctuations in Output, Employment, and Prices

stagflation. A combination of the words stagnation and inflation, this term means that the economy is stagnant (not growing), but there is inflation at the same time. In the 1974–1975 recession, prices con- tinued to rise sharply. Not until the relatively severe 1980–1982 recession did the rate of inflation fall sharply. Inflation rates remained low through the late 1980s and into the 1990s, and they even dipped into negative numbers in 2009 when a global reces- sion hit due to the subprime mortgage crisis, a global economic crisis, and the failure or collapse of many of the United States’ largest financial insti- tutions. As the economy recovered, inflation rates became positive and have stayed, on average, low and positive since 2010.

The Great Depression: A Case Study in Business Cycles

The Great Depression brought severe economic hardships to a large portion of the U.S. popu- lation. Real output fell by more than one third. Unemployment rose to almost 25% of the workforce in the depths of the Depression. Many jobs were converted to a part-time basis in order to spread the work among more people. In addition, banks were failing. Between 1929 and 1933 the number of commercial banks in the United States fell by one third. More than a fifth of all surviving banks had to suspend operations for some time because of financial problems. Few depositors ever recovered any of the funds they lost.

The effect on people went beyond economic hardships. The United States seemed to have lost its bright promise. People who had worked hard all their lives, had saved and planned for the future, and had believed in the work ethic found themselves wiped out. They lost homes, businesses, and jobs—through no fault of their own. Retired people found their stocks and bonds nearly worthless, and their savings vanished in bank failures. Many people’s self-image and status depend on their jobs, their success in the work world, and their ability to provide for their families. The Depression sowed doubt and fear among those who lost their jobs and those in danger of losing theirs.

The suffering during the Depression was not eased by programs available today, such as unemployment insurance, welfare, Social Security, and food stamps. These programs were in large part inspired by the experiences of the Depression. In 1933 people who were out of work had to rely mainly on private charity and relief from state and local governments, which were facing hard times themselves. Many city governments were unable to pay their bills because property owners had defaulted on local property taxes. Local governments were in no position to help their residents.

Economic conditions were no better abroad. The Depression affected every European coun- try. Banks failed, and the European financial system was badly shaken. The United States and European countries raised tariffs and took other antitrade measures in an effort to create jobs by substituting domestic production for imported goods. As a result, trade fell sharply.

Alex_Schmidt/iStock/Thinkstock

The S&P 500 declined 57% from its high of 1,576 in October 2007 to its low of 676 in March 2009. However, by January 2018 the S&P 500 had risen to a record high of 2,695.

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Section 4.5 Fluctuations in Output, Employment, and Prices

The Roosevelt administration tried to deal with both the immediate emergency and the long-term issues. People had to be put back to work and, in the meantime, given help. To put people back to work, President Franklin Roosevelt and his advis- ers experimented with emergency government hiring programs. This policy was one of the early instances of the proposal that government should be the employer of last resort for people who can- not find jobs elsewhere.

Beyond the emergency needs, the Roosevelt admin- istration felt that policies had to be adopted to ensure that the Great Depression would never hap- pen again. There should be programs to aid people in hard times as a matter of right, so they would not have to feel ashamed. The safety net of social welfare programs—such as Old-Age and Survivors Insurance (Social Security), Aid to Families With Dependent Children, and unemployment compensation—was created during this period. In addition, deposit insurance and other banking regulations were put in place to safeguard people’s savings.

Everett Collection/SuperStock

Unemployed New Yorkers demonstrate with signs in front of the Emergency Relief Building in 1935. Signs demand clothing, pay at union wages, and jobs for young people.

Global Outlook: The Depression in Europe and Canada

The Great Depression of the 1930s was felt in other countries as well. The triggering event for the United States was the stock market crash of Black Friday, October 29, 1929. In Europe it was the collapse of a major bank, the Kreditanstalt, in Austria in 1931. Other banks failed in its wake.

Two important conditions in the early 1930s made the Depression spread from country to country. The first was the international gold standard, which linked the banking systems of many countries. The gold standard limited the power of national banking systems to expand their money supply unless they had enough gold backing for any added currency. Nations that lost gold to foreigners were forced to contract their money supplies at a time when expansion of the money supply would have been a more suitable policy. As the Depression deepened, one country after another abandoned the gold standard, usually only after the domestic money supply had shrunk to a much smaller size.

The second condition was protectionism. Many countries, including the United States, reacted to falling output and rising unemployment by trying to keep jobs at home. They tried to substitute domestic production for imported goods by imposing high tariffs and other restrictions—a policy known as “beggar thy neighbor.” A few economists even argue that protectionism caused the Great Depression, although most would only argue that protectionism made the Depression even more severe. The physical volume of trade fell by one third in the early years of the Depression. Because of falling prices, the value of trade fell by two thirds.

(continued)

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Section 4.5 Fluctuations in Output, Employment, and Prices

Global Outlook: The Depression in Europe and Canada (continued)

The Depression’s effects in each country can be measured by what happened to output and unemployment during the worst period, 1929–1932. Partly because of their great prosperity in the 1920s, the United States and Canada experienced the largest declines in total output, measured in current dollars. The market value of output fell 25% in Canada and 26% in the United States in that worst period. Part of the decline was in real output, and part was due to falling prices. In Europe, where the 1920s had not been as prosperous, declines in the market value of output were less drastic but still striking: 12% in France, 16% in Germany, and 10% in Sweden. The unemployment statistics were even grimmer. (See Table 4.3 for unemployment rates in 1929 and 1932.)

The political effects of the Great Depression were far reaching. In the United States it led to an expanded role for government, including Social Security, unemployment compensation, welfare programs, and bank regulation. In Germany and Italy the frustrations of the Great Depression led to the rise of fascist governments under Hitler and Mussolini. Canada and many western European nations followed the same path as the United States in building a social safety net for those who lost their source of income. Most western European governments, however, went much further, creating welfare states that provided health care, public housing, income support programs, and similar services.

Table 4.3: Unemployment rates for 1929 and 1932

Year Germany Sweden United Kingdom Canada United States

1929 5.9% 2.4% 5.9% 2.9% 3.1%

1932 17.2% 6.8% 13.1% 17.6% 23.5%

Stabilization Policy and the Great Depression

The Depression greatly influenced the direction of future macroeconomic policy. Because the Depression was so severe in both length and depth, the Roosevelt administration tried many new programs and experimental policies. However, Roosevelt and his advisers developed their plans for government spending and government jobs to reduce unemployment during the Depression on a trial-and-error basis, with little theory behind them. In the meantime, economists had begun to provide theoretical reasons for the kinds of programs the United States was trying. In 1936 British economist John Maynard Keynes published The General Theory of Employment, Interest, and Money. At that time the Depression in the United States still had 5 more years to run before it would end as the country entered World War II. Recov- ery from the Depression was already progressing in the United Kingdom and some other countries, including Germany. Keynes, his theories, and his followers did not really have much influence on either the British or the U.S. recovery. However, the Depression convinced many people that Keynesian theory was right and that it provided sound guidelines for economic policy making. Not until the 1970s were there serious challenges to Keynesian ideas about macroeconomic policy.

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Section 4.5 Fluctuations in Output, Employment, and Prices

The Great Depression was a painful and difficult experience for almost all Americans. It forced economists and politicians to think more carefully about macroeconomics and economic pol- icy. In order to test these new ideas, it was necessary to have better measures of output and income than had been developed in the past. Beginning in the 1930s, economists devoted much more attention to measuring output and the components of output, in order to have the information needed to design and implement stabilization policies. The next chapter will address the measurement of output, employment, and economic growth.

Comparing the Great Depression and the Great Recession

We can identify some similarities between the Great Depression and the Great Recession of 2007–2009. In the Great Depression the Federal Reserve System had kept interest rates artificially low in the 1920s, creating a credit-induced speculative bubble. Wealthy investors gambled in the markets until 1929, when the Federal Reserve raised interest rates to halt the resulting boom, leading to the stock market crash in October 1929. The Great Recession was preceded by a similar environment. In the 1990s the government made home ownership more affordable with low interest rates and incentive programs for first-time buyers. These mortgages were often based on little more than stated income. When the housing market took a downturn, this “bad debt” left most U.S. banks on the verge of collapse.

The Great Depression and the Great Recession both experienced bank failures, high unem- ployment rates, and overall economic decline. However, relevant to the topics introduced in this chapter, the magnitude of these economic problems differs widely. The Great Depression saw 50% of banks fail, an unemployment rate of 25%, and an overall economic decline of 26.5%. In contrast, in the Great Recession only 0.6% of banks failed, unemployment hit 10% briefly in October 2009, and output declined approximately 3.5%. Although the total eco- nomic impact of the Great Recession, both domestically and internationally, was significant and caused widespread economic losses, it was nowhere near as destructive as it would have been if the United States had followed the same policy it did during the Great Depression. The quick action of the U.S. Treasury helped stabilize financial markets to keep the economy from falling apart. We will explore stabilization policies in greater detail in later chapters.

Key Ideas: Basics of the Business Cycle

• When output reaches a high point, it is at a peak. • When output reaches a low point, it is at a trough. • The upturn from trough to peak is called an expansion. • The downturn from peak to trough is called a recession. • A complete business cycle goes from peak to peak or from trough to trough.

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Conclusion

Conclusion There is no way to ensure that you will graduate during good times in the job market. Chances are that if jobs are easy to find, you will have to worry about inflation. Usually, if unemployment is low, the inflation rate tends to increase, while low inflation rates may be accompanied by higher-than-normal unemployment. Inflation and unemployment both affect the economic welfare of individual households in important ways. Inflation reduces the purchasing power of incomes in many households, while others gain. Unemployment means a loss of income both now and in the future because of lost opportunities to polish and upgrade skills on the job.

Inflation and unemployment are important macroeconomic policy issues because both are costly to society as a whole. Inflation confuses important market signals and creates menu costs. Unemployment means lost output and results in a burden on taxpayers to support unemployed workers while they are looking for work. Citizens measure the performance of their federal government by looking at how the economy is performing in terms of unem- ployment and inflation.

Key Ideas

1. Full employment is usually reached when about 94% of the labor force is employed. That is, there is a normal unemployment rate of about 6%. Normal unemployment is partly frictional (due to new entrants in the job market or workers between jobs) and partly structural (due to a mismatch between workers and job openings). Some changes in unemployment arise from changes in the size of the labor force relative to the population, rather than from changes in total output or the demand for labor. Unemployment in excess of a normal level is usually due to declines in real output. This kind of unemployment is called cyclical unemployment and is a macroeconomic policy concern. Unemployment is an important policy issue because it is costly to the economy as a whole in terms of lost output and income. Workers suffer not only from reduced income but also from psychological costs and lost opportunities to develop and maintain skills that increase their productivity and income in the future.

2. Unemployment is measured as the percentage of the labor force not working but actively seeking work. Inflation is measured by changes in a price index such as the CPI or the GDP deflator.

3. Inflation is a sustained general rise in the price level. Losers from inflation are lend- ers, people on fixed incomes, and taxpayers; gainers are borrowers, owners of real assets, and the government. Inflation is an important policy issue because it causes a redistribution of income and wealth, confuses market signals, discourages saving and investment, and creates menu costs.

4. Inflation is measured by changes in a price index, which measures the rise or fall in the cost of a market basket of goods and services. The best known index is the CPI. This index is used to adjust incomes to correct for inflation and to determine increases in wages and Social Security benefits.

5. Business cycles describe the ups and downs of output, employment, and prices. Dur- ing recessions, output and inflation fall while unemployment rises. During recover- ies and expansions, unemployment falls while output and inflation usually increase. The most significant business cycle in the 20th century was the Great Depression. It not only had important economic and political effects but also led to many changes in macroeconomic theory and policy.

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Conclusion

Critical-Thinking Questions

1. For each of the following people, is the person structurally unemployed, frictionally unemployed, or cyclically unemployed? a. a new college graduate seeking a first job b. a teenager who quit a fast-food job because she did not like the hours c. a farmer in Iowa who had to sell the farm because of inadequate demand for

farm products and who is looking for a different line of work in a different area d. a person with a PhD in classical languages, a field in which there are 100 appli-

cants for every available teaching position e. a person laid off because of a recession

2. Can you think of any benefits of having high rates of inflation? Of having high rates of unemployment?

3. Suppose another baby boom occurred and a significant number of parents dropped out of the labor force to stay home and care for their children. What would happen to the unemployment rate, the labor force participation rate, and the employment rate?

4. Explain this statement: “Everybody’s CPI is nobody’s CPI.” 5. Suppose there is a decline in real output. What would you expect to happen to

employment and to the inflation rate? Why? 6. How can you tell when an economy is in a recession? 7. Given the following information, compute the unemployment rate.

Civilian noninstitutional population: 186,393,000 Civilian labor force: 125,557,000 Total civilian employment: 117,342,000

Along with this information, consider an additional 1,688,000 people in the armed forces. What would happen to the unemployment rate if these people were counted?

8. Given the information in the table below, compute a price index for a 10-year-old child. This child receives a weekly allowance and would like to request a raise based on the increase in the cost of the market basket of goods purchased. By how much has the child’s cost of living risen?

Item Quantity Last year’s price This year’s price

Movie tickets 1 $6.00 $6.25

Soft drinks 3 $0.50 $0.50

Candy bars 4 $0.75 $0.80

Pencils 2 $0.15 $0.12

Comic books 2 $0.75 $0.85

9. Using the information presented in the figures in this chapter, see if you can trace the relationship between changes in output, consumer prices, and unemployment for each of the following years, all of which showed signs of a recession: 1955, 1958, 1961, 1970, 1974–1975, 1980, 1982, 1991, 2001, and 2007–2009.

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Conclusion

10. Try constructing an index of your own, using the following data. Suppose that 40% of the cost of car repairs is labor, 50% is parts, and 10% is miscellaneous. Suppose that in the first year the cost of labor is $50 an hour, parts cost an average of $70 each, and miscellaneous costs run about $25. In the second year, labor rises to $55, parts average $78, and miscellaneous costs are unchanged. What is your price index for car repairs? How much has the cost risen?

11. Use the given data to calculate the inflation rate between Year 1 and Year 2. Year 1, price index = 140 Year 2, price index = 155

12. Suppose that the government relaxes the limitations on physical immigration into the United States. What effect would that have on employment and unemployment? How would that effect be different from a rise in the birth rate?

13. Suggest three ways in which the Great Depression affected economic policy in the United States.

Key Terms business cycle Fluctuations in economic activity measured by the ups and downs in real output, employment, and prices.

consumer price index (CPI) A measure of the year-to-year increase in the price level based on the cost of a representative market basket of consumer goods.

cyclical unemployment Unemployment caused by fluctuations in the level of total output, or GNP.

deflation A decrease in the general price level of goods and services.

depression A very severe recession.

discouraged workers People who were seeking work but have given up and stopped looking.

expansion A period of growth in real out- put following a recession.

frictional unemployment Unemployment caused by workers temporarily between jobs or by new entrants to the labor force.

full employment The level of employment at which approximately 94%–95% of those who want to work are employed.

GDP deflator A current-weights index used to correct for price changes in the GDP.

inflation A rise in the general, or average, level of prices.

labor force Those who are working or actively seeking work.

labor force participation rate The fraction of the population over 16 years of age who are employed or actively seeking work.

peak The highest output level in a business cycle; the upper turning point.

price index A measure of changes in price levels from year to year.

Producer Price Index A group of three indexes for raw materials, semifinished goods, and finished goods that shows what is happening to prices paid by producers and wholesalers.

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Conclusion

productivity A measure of year-to-year changes in output per worker hour.

real income Income measured in terms of the goods and services it will buy.

real wages Wages measured in terms of the goods and services they will buy.

stabilization policy Government actions designed to dampen fluctuations in output, employment, and prices.

stagflation An economic condition of slow growth, high unemployment, and inflation.

structural shift A shift that occurs when an economy changes how it functions or operates.

structural unemployment Unemployment caused by a mismatch of the skills or loca- tion of unemployed workers and the skills required or locations of available jobs.

trough The lower turning point in a busi- ness cycle.

underemployed Pertaining to people working below their ability or for fewer hours than they would like.

unemployment rate The percentage of the labor force that wants to work but is not cur- rently employed.

4.1 Full Employment and Unemployment
4.2 Measuring Unemployment
4.3 Price Stability and Inflation
4.4 Measuring Inflation: Price Indexes
4.5 Fluctuations in Output, Employment, and Prices