In paper, Assess GDPs Importance. Examine the shortcomings of GDP in measuring a countrys economic health. Discuss using GDP to evaluate the business cycle. Examine factors

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

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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.

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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.

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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.

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89

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.

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91

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.

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92

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

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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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94

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

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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 unemplo

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