CHAPTER 6: MONITORING CYCLES, JOBS, AND THE PRICE LEVEL

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1 Principles of Macroeconomics CHAPTER 6: MONITORING CYCLES, JOBS, AND THE PRICE LEVEL Learning Goals: A. A recession started in March 2001 and ended in November What defines a recession, who makes the decision that we are in one, and how? B. How do we measure unemployment and what other data do we use to monitor the labor market? C. Being employed alone does not determine standard of living; the cost of living also matters, so we also need to know what the Consumer Price Index is, and how that is measured and used. I. The Business Cycle A. The business cycle is the periodic but irregular up-and-down movement in production and jobs. This is measured by the fluctuations in the real GDP around potential GDP. 1. The National Bureau of Economic Research (NBER) defines a recession somewhat differently than the common definition. The NBER says A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade. 2. The NBER s Business Cycle Dating Committee identifies and dates them for the United State B. There are four phases of a cycle: (a) the peak or boom (b) a recession or contraction (c) a depression or trough (d) a recovery or expansion. Page 1 of 10

2 Principles of Macroeconomics C. Business Cycle Dates There have been 16 recessions and 17expansions since Page 2 of 10

3 II. Jobs and Wages Principles of Macroeconomics A. Population Survey 1. United States population is divided into two groups: a) The working-age population, which is the number of people aged 16 years and older who are not in jail, hospital, or other institution b) People too young to work (less than 16 years of age) or in institutional care. 2. The working-age population is divided into two groups: people in the labor force and people not in the labor force. 3. The labor force is the sum of employed and unemployed workers. 4. To be considered unemployed, a person must be: a) without work and have made specific efforts to find a job within the past four weeks, or b) waiting to be called back to a job from which he or she was laid off, or c) waiting to start a new job within 30 days. 5. See Figure 6.2 B. Three Labor Market Indicators 1. The unemployment rate is the percentage of the labor force that is unemployed. Unemployment rate = Number of people unemployed X 100 Labor force The unemployment rate peaks during recessions. 2. The labor force participation rate is the percentage of the working-age population that is in the labor force. Labor force participation rate = Labor force X 100 Working-age population Page 3 of 10

4 Principles of Macroeconomics The labor force participation rate has increased from 59 percent in the 1960s to 67 percent in the 1990s. The labor force participation rate for men has declined, but for women has increased. The labor force participation rate falls during recessions as discouraged workers leave the labor force. 1. The employment-to-population ratio is the percentage of working-age people who have jobs. Employment-to-population ratio = Number of people employed X 100 Working-age population The employment-to-population ratio has increased from 55 percent in the early 1960s to 62.6 percent in The employment-topopulation ratio has declined for men and increased for women. See Figures 6.3 and 6.4 C. Aggregate Hours are the total number of hours worked by all workers during a year. See figure 6.5 D. Real Wage Rate 1. The real wage rate is the quantity of goods and services that can be purchased with an hour s work. Real wage rate = Money wage rate x 100 Price level 2. Three measures used: a) hourly earnings in manufacturing b) wages and salaries / aggregate hours c) total labor compensation / aggregate hours Page 4 of 10

5 Principles of Macroeconomics The GDP Deflator is used to deflate all of the above measures. See Figure 6.6 Example of Calculating Unemployment Figures: You need to solve problem # 8, page 147 of your textbook. Page 5 of 10

6 III. Unemployment and Full Employment Principles of Macroeconomics A. The Anatomy of Unemployment 1. Three types of people are unemployed: a) Job losers are workers who have been laid off or fired and are searching for new jobs. b) Job leavers are workers who have voluntarily quit their jobs to look for new ones. c) Entrants and reentrants are people entering the labor force for the first time or returning to the labor force and searching for work. The primary source of reentrants is (formerly) discouraged workers. 2. People end a spell of unemployment for two reasons: a) Hired or recalled workers gain jobs. b) Discouraged unemployed workers withdraw from the labor force. See Figure 6.7 for the labor market flows See Figure 6.8 for unemployment by reason See Figure 6.9 for the duration of unemployment See Figure 6.10 for unemployment by demographic group B. Types of Unemployment Unemployment can be classified into three types: 1. Frictional unemployment is unemployment that arises from normal labor market turnover. 2. Structural unemployment is unemployment created by the incompatibility between the skills necessary to perform jobs and the locations of jobs, and the skills and location of the labor force. 3. Cyclical unemployment is the fluctuation in unemployment caused by the business cycle. C. Full Employment 1. Full employment occurs when there is no cyclical unemployment (or, when all unemployment is frictional or structural). 2. The unemployment rate at full employment is called the natural rate of unemployment. Page 6 of 10

7 Principles of Macroeconomics 3. The natural rate of unemployment is not zero because some jobs are always being created and destroyed and some people are always entering the labor force or changing jobs. D. Real GDP and Unemployment over the Cycle 1. Potential GDP is the quantity of real GDP produced at full employment. 2. It corresponds to the capacity of the economy to produce output on a sustained basis. 3. Over the business cycle, actual GDP fluctuates around potential GDP and the unemployment rate fluctuates around the natural rate of unemployment. IV. The Consumer Price Index A. The price level is the average level of prices and is measured by using a price index. The consumer price index, or CPI, measures the average level of the prices of goods and services consumed by an urban family. B. Constructing the CPI involves three stages: a) Selecting the CPI basket, the set of goods and services represented in the index and the weight on each. b) Conducting a monthly price survey. c) Using the prices and the contents of the basket to calculate the CPI. The formula is: CPI = Cost of a CPI basket at current period prices Cost of a CPI basket at base period prices x 100 The CPI is defined to equal 100 for the reference base period. Page 7 of 10

8 Example of constructing a CPI: Principles of Macroeconomics Page 8 of 10

9 C. Uses of the CPI Principles of Macroeconomics 1. The CPI is used to deflate nominal values. Deflation is the process of adjusting for inflation so as to compare nominal values over time. Nominal or monetary values are the dollar amounts received or paid. Real values are nominal values adjusted for inflation. Real value = Nominal value in dollars CPI x 100 Example: Year Nominal Income CPI Real Income 2000 $40, $40, $50, $67, $90, The CPI is used as a measure of payment escalator in monetary payments (for example in COLA clause, pension plans, social security payments). 3. Finally, the CPI is used to measure inflation. D. Measuring Inflation a. The main purpose of the CPI is to measure inflation. The inflation rate is the percentage change in the price level from one year to the next. Page 9 of 10

10 b. The inflation formula is: Principles of Macroeconomics Inflation rate = (CPI this year CPI last year) CPI last year x 100 c. Example: E. The Biased CPI The CPI may overstate the true inflation for four reasons: a) New goods bias b) Quality change bias c) Commodity substitution bias d) Outlet substitution bias A Congressional Advisory Commission estimated that the CPI overstates inflation by 1.1 percentage points a year. The bias in the CPI distorts private contracts, increases government outlays, and biases estimates of real earnings. To reduce the bias in the CPI, the BLS will undertake consumer expenditure surveys more frequently and revise the CPI basket every two years. Page 10 of 10