LECTURE ON: MACROECONOMICS (I) MAJOR CONCERNS: UNEMPLOYMENT & INFLATION

Transcription

1 filename: macro1.lwp 11/5/2015) (revised LECTURE ON: MACROECONOMICS (I) MAJOR CONCERNS: UNEMPLOYMENT & INFLATION Chapter Topics: 1. A Road Map for the Macroeconomics Section 2. The Main Concerns of Macroeconomics 3. Persistent High Unemployment 4. Measurement of Unemployment 5. Why is Natural Unemployment Rate So High? 6. Frictional Unemployment and Job Search 7. Costs of Recessions 8. The Consequences of Inflation 1 Introduction We now turn to the study of macroeconomics, which, unlike the microeconomics that we have been studying previously, is concerned with the performance of entire economies, no matter how small. Macroeconomics is the study of the interaction of many markets and how they work together to determine the answers that each nation s economy gives to some the basic questions that we asked at the beginning of the course. That macroeconomics is an important area of study should be clear to all, but let me show you a chart that illustrates just how important the macroeconomy has been in the last decade. The following chart shows median household income and the unemployment rate over the past decade. {Next Slide}

2 10/26/2017 Page 2 of 16 As you can see, there has been a sharp fall in median household income from January 2000 and a very sharp rise in unemployment that has persisted after the recession of officially ended. We will discuss the implications of these and other trends soon Before we start, I want to outline the course of my lectures and indicate the associated chapters in the Baumol-Blinder text (13th ed.): {Next Slide} Roadmap for Turchi's Lectures on Macroeconomics* The Issues: Inflation, Unemployment, & Recession Ch, The Central Concepts of Macroeconomic Analysis Ch. 25 The Aggregate Demand Curve not Including Government Ch 26 The Aggregate Supply Curve & General Equilibrium Ch 27 Adding the Government to the Aggregate Demand Side Ch 28, 30 The Organization of U.S. Macroeconomic Policy Ch 31 Fiscal Policy Ch 28, 33 Monetary Policy Ch 30, 31, 32 *With relevant chapters

3 10/26/2017 Page 3 of 16 My approach is to build a complete model of the macro economy before introducing government and discussing macroeconomic policy. {Next Slide} The textbook does not follow this outline exactly, but this chart will help you to associate the chapters related to the lectures. You will find a copy of this road map on the course web site. In particular, when we study macroeconomics we want to know how the economy acts to insure that: { All resources are fully employed, so that the economy is not operating inside its production possibilities curve, leaving productive resources, primarily labor, unemployed; { Price levels remain as stable as possible. Inflation has been a phenomenon of universal concern since the development of money, and the central macroeconomic issues have often been stated as the tradeoff between unemployment and inflation. 2 The Central Concerns of Macroeconomics Before we try to understand how the macro economy works in detail, we need to know more about the two central problems that it faces: unemployment and inflation. Unemployment is the state of desiring to work but not having a job. To be unemployed one must be in the labor force, the total quantity of people holding or seeking jobs. If you are not employed and are not actively seeking work, you are not unemployed, although some economists have emphasized that unemployed persons who have looked a long time for a job and have gotten demoralized often just quit looking. These people are called discouraged workers.

4 10/26/2017 Page 4 of 16 3 Inflation Inflation refers to a sustained increase in the general price level. People get concerned about the effects of inflation when they feel that their wealth or economic position is being adversely affected by a rapid rise in the price level. Inflation can have consequences much broader than the merely economic. For example, the German hyperinflation that occurred between December, 1922 and November, 1923 saw wholesale prices rise by almost 100 million percent. It s hard to conceive of what this means. Here, {next slide} for example, is a picture of a Five Million Reichsmark note that was printed in June, Scarcely, 6 months before, it would have been totally unnecessary to print such a bill; maybe 10 people in Germany would have been rich enough to carry one in their wallets. By June of 1923, the bill was needed just to carry out normal transactions; by December, 1923, it was worthless.

5 10/26/2017 Page 5 of 16 The German hyperinflation of 1923 destroyed the savings of the German middle class and is widely credited as being an important factor is opening the way for Hitler s rise to power in The high rates of inflation that existed in the United States at the end of the 1970s (ca 10 percent in 1980) are also credited with easing the election of Ronald Reagan in More recently, I acquired an even more impressive example of hyper-inflation, the One Hundred Trillion Dollar bill from the Reserve Bank of Zimbabwe: {Next Slide} Now, we re talking real money. First, we will discuss unemployment and then move to inflation. 4 Unemployment When we discussed the labor market, we defined equilibrium in that market as the point at which the supply of labor equals the demand for labor at a given wage rate. When the labor market is in equilibrium it does not appear that there should be any unemployment in the economy. However, even

6 10/26/2017 Page 6 of 16 when the economy is operating at what is commonly called full employment unemployment still exists. In fact the unemployment rate when the economy is operating at full capacity is generally still quite high -- somewhere between 5.5 and 6 percent. We define the natural rate of unemployment to be that rate of unemployment at which the economy is operating at full capacity with no tendency for inflation or deflation to occur. For years economists and policy makers have been concerned that even at full employment the natural rate of unemployment should still be in the range of 5.5 to 6 percent. This means that when the economy goes into a recession, the unemployment rate can climb much higher. Many periods of high actual unemployment above the natural unemployment rate have been the result of deliberate government anti-inflationary policy designed to decelerate inflation by holding actual unemployment above the natural rate. Types of Unemployment: Frictional Unemployment: Unemployment that occurs in the normal course of job search, by individuals who have voluntarily quit their jobs, are entering the labor force for the first time, or are reentering the labor force. This contributes to the natural unemployment rate. Structural Unemployment: Unemployment that occurs when there is a mismatch between the skill or location requirements of job vacancies and the present skills

7 10/26/2017 Page 7 of 16 or location of unemployed individuals. This also contributes to the natural unemployment rate. Cyclical Unemployment: Unemployment that is the difference between the actual and natural rates of unemployment. This is the kind of extra unemployment that occurs during recessions. MEASUREMENT OF UNEMPLOYMENT Questions asked: The Current Population Survey is performed each month on a rotating sample of 60,000 households (ca. 1 in every 1,400 households in the country). What was [each member of the household] doing last week -working, keeping house, going to school, or something else? (If not working) Did [he/she] have a job from which he was temporarily absent or on layoff last week? If a person is laid off or waiting for a new job to begin he is counted as unemployed. (If not working and not absent from a job) Has he/she been looking for work in the last four weeks? If the person has not been ill but has been making efforts to look for a job, he is counted as being unemployed. Based on the interview, the unemployment rate is computed for the civilian labor force. UERate Number of Unemployed Civilian Employed + Unemployed Problems with the definition: 1. The unemployment rate by itself is not a measure of the social distress caused by the loss of a job.

8 10/26/2017 Page 8 of The government s unemployment concept misses some of the people hurt by a recession. E.g., hours cut, full to part-time work, etc. 3. A person lacking a job must have performed particular specified actions to look for a job during the past four weeks. Discouraged workers simply disappear from the unemployment statistics because they no longer appear in the labor force. WHY IS THE NATURAL UNEMPLOYMENT RATE SO HIGH? The natural unemployment rate, U N, is determined by two basic factors: A. There is a mismatch of jobs and workers 1. Inflexibility of relative wages. For example wage rates are too high for teenagers because of minimum wage laws. Consequently they cannot find work. 2. A general lack of incentives for firms to train workers. Firms are reluctant to give training to workers who might quit immediately after being trained and go to work for a competitor. This is the issue of general vs. specific training. 3. Rational employer discrimination. Suppose employers routinely refuse to hire groups of people who exhibit an above average tendency to quit, e.g., teenagers, adult women. We say that this kind of discrimination is rational because its based on experience of employers about the costs of hiring these types of people. 4. Pure discrimination e.g., against blacks, women. This kind of discrimination is irrational because it is not based on the ability of the person to do the job. 5. Hit and miss availability of training in school. Some schools simply don t offer the kind of training that prepares people for jobs. 6. Difficulty of borrowing to finance human capital accumulation It s difficult for a motorcycle repairman to get a loan because his future income is open to question. On the

9 10/26/2017 Page 9 of 16 other hand, a medical student has little trouble financing his training because the lender knows that he ll get the money back. 7. Long adjustment lags in education. Students are still training for jobs that are irrelevant today. All of these factors make it difficult for some people to get work even in the best of times because for one reason or another they don t fit the job description very well. B. Turnover unemployment and job search The natural unemployment rate also remains high because of factors that (1) induce people to quit such as unemployment benefits, and (2) factors that induce people to search longer such as unemployment compensation (as long as you re on unemployment, you might just as well look a little longer) and dead-end jobs that are so unattractive to the searcher that he/she keeps looking longer in hopes of finding a better one. Possible policy solutions to reduce a high U N : 1. Training subsidies defuse the general training bind difficult to monitor firms to make sure that they actually use the voucher money for training and do not fire teenagers after voucher money is received. 2. Teenage minimum wage lower for teenagers 3. Better schooling. 4. Training loans payable on income tax forms 5. Reduce discrimination 6. National employment exchange

10 10/26/2017 Page 10 of Subsidized moves -- or tax incentives Wrong location problems: solutions: 1. A better national employment service 2. Moving subsidies or loans <What about Public Service Employment such as the Job Corps, or Youth Corps? Is it useful?> Only if they employ people who would not otherwise be employed if they simply bid away high wage, skilled workers from industry, they won t do any good. 5 The Costs of Recessions Even when the economy is operating at the natural level of employment or output (i.e., at full employment ) we have seen that the unemployment rate is too high; however, when the economy goes into recession cyclical unemployment, which had been close to zero, rises. This brings total unemployment to an even higher level. Remember, the overall unemployment rate has three components: Unemployment rate = Frictional + Structural + Cyclical and recession brings a rise in cyclical unemployment. All types of unemployment bring costs to the economy, but these costs are never more apparent than during a recession, because during recessions people who are normally working find themselves jobless. This group of individuals is much more politically active and much

11 10/26/2017 Page 11 of 16 more integrated than the structurally unemployed, and politicians pay more attention to them. The costs of recessions are: 1. Lost output. 2. Psychic costs of recession. <<Has anyone here been independent and unemployed?>> Suicide Rate, illness, incidence of spouse and child abuse higher in periods of high unemployment. The economic and social costs of unemployment are so high that there is a strong policy presumption to minimize cyclical unemployment and to undertake long term measures to reduce U N. The Democrats have traditionally been less willing to accept extended periods of high unemployment than have Republicans. Perhaps is has been because fewer Republicans (proportionally) have tended to be unemployed in recessions. 6 The Consequences of Inflation Inflation is felt primarily by owners of financial debt assets such as savings accounts, bonds, cash money, etc., not by workers whose only income is earned in the form of wages and who spend their entire wage income on consumption goods. {next slide} I carry this 10 million Turkish Lira note in my wallet because I like the feeling of having 10 million in my pocket!

12 10/26/2017 Page 12 of 16 But, if I d carried this bill around since October of 1993, I would have lost a considerable amount of purchasing power. Here s a graph that shows the decline in purchasing power of the Turkish Lira since October of {next slide} Value of Ten Million Turkish Lira in Dollars -- 10/21/ /18/03 Dollar Value of Ten Million TL $ $ /21/93 7/17/96 4/13/99 1/7/02 10/3/04 Date You ll note that the value in dollars of 10 Million TL dropped from $768 in 1993 to $7.18 on October 18, The drop in recent years has continued to be sharp, dropping by 50 percent since February, 2001 {next slide}:

13 10/26/2017 Page 13 of 16 Value of Ten Million Turkish Lira in Dollars -- 2/1/ /18/03 Dollar Value of Ten Million TL $14.80 $ /1/01 8/20/01 3/8/02 9/24/02 4/12/03 10/29/03 Date Now, I haven t been carrying this bill around since 1993, but I have had it for a couple of years during which it s lost one-half of its purchasing power in dollars. If I anticipate inflation s continuing in Turkey, I would be crazy to keep holding on to this bill. If you anticipate inflation, you can take steps to inoculate your assets against its harmful effects, as many Turks do today. Inflation is really damaging when it s unanticipated, as it was in Germany in The basic case against unanticipated inflation is, then, that it redistributes income from creditors (savers) to debtors without the creditors knowledge or consent. The middle class in post WW I Germany was devastated by inflation because much of its wealth was held in financial (as opposed to real) assets. This made the middle class much more receptive to the Nazis than they would have been.

14 10/26/2017 Page 14 of 16 However, workers often feel harmed by inflation even if their annual wage increases keep pace with inflation. The very poor are in general neither helped or hurt by inflation because they have neither assets or debts. In periods of high inflation, the opportunity cost of holding money rises as prices rise, and people are willing to hold less cash. This increases the inconvenience of making transactions, and results in more trips to the bank (the so-called shoe-leather cost of inflation. These shoe-leather costs can get extraordinarily high in a hyperinflation when people have to spend an extreme amount of effort getting rid of financial assets and turning them into real wealth that will appreciate in price as the inflation rages. (Germany 1923). Inflation and Interest Rates Suppose that you want to buy a car but are undecided about whether to buy it now or next year. If you buy the car now, it will cost you $10,000. If you wait for a year the car will cost 6% more, or $10,600. If you had the $10,000 in cash right now, and buried it in the back yard for a year, you would be $600 short when it came time to buy the car next year. You could loan the money to someone for a year. In fact, when you put your money in a bank that s exactly what you are doing! Let s say the bank pays you 5% interest for the year. At the end of the year you would have $10,500. You would still be short $100, because the interest rate was not as high as the inflation rate.

15 10/26/2017 Page 15 of 16 People who save money hope to do two things: (1) increase their spending power by earning interest, and (2) protect themselves from experiencing a loss in purchasing power of their money because of inflation. From our car example, we see that holding cash is not a good idea in a world of inflationary price increases. The longer you hold cash the less you can buy with it. If you invest the cash in a savings account you still may lose purchasing power, if the interest rate is below the inflation rate. If prices rise by 6% per year and the interest you get on your savings is 6%, then you can just maintain the purchasing power of your money. In order to increase the purchasing power of your money the interest rate must be higher than the inflation rate. DEFINITION: Nominal and Real Interest Rates The nominal interest rate (i) is the rate actually quoted by banks and negotiated in financial markets. The real interest rate (r) is what people actually pay on their borrowings or earn on their savings after deducting inflation. r i The real interest rate is what matters for investment and saving decisions. If the inflation rate is 6 % per year and my bank account pays 5% then the purchasing power of my money loses one percent per year: -1% = 5% - 6%, and the real interest rate that I receive is -1%. On the other hand, If I receive 8% in nominal interest on my money market

16 10/26/2017 Page 16 of 16 account while the inflation rate is only 5% then the real interest rate that I m receiving is +3% (= 8% - 5%). So, you see, inflation and interest rates are intimately connected; if the nominal interest rate is high enough, lenders will not lose from price inflation. If it is not high enough, then inflation hurts people who have wealth in the form of cash or savings.