C9: What motivates

...Is that business cycles are a major pain

macroeconomists

Literally: Recessions (shaded areas) are correlated with higher divorce and
suicide rates, increased physical and mental illness, etc.
And variance (i.e. volatility) wastes resources expended to protect
ourselves (i.e., risk-avoiding strategies opportunity cost)
Annual growth
rate of real GDP
8

Long-run growth rate

(approx. 3%)

6
4
2
0
-2
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2009
Source: Economic Report of the President, various issues.

Some evidence

On general mental
health
And how 'bout property
crime and spouse
abuse?

Contrac
tio

Recessionary
trough

Trend line

Business
peak
on

Expansion
Peak
Contractio
n
Trough

Business
peak

n si

Real GDP

Exp
a

Phases of a
Business
Cycle:

Recessionary
trough

Time

Despite historic fluctuations, there has been an upward

trend in real GDP (generally, 3%/yr.) in the United States
and other industrial nations
Key issues: Can we foresee contractions? Can we head
them off with macro policy? Can we reduce variance?
3

Special concern: How business

cycles affect the labor market

Policy makers generally rank

unemployment as the most
harmful macro problem, ahead
of other macro issues such as
inflation, etc.;
As well see later in the
semester, thats had interesting
policy implications, and has
occasionally led to policies
which were ultimately harmful.

Preview: The Phillips Curve

controversy
4

Figure 9.1

Data from
Household Survey,
September 2011
In September 2011,
the working-age
population of the
United States was
240.1 million.
The working-age
population is
divided into those
in the labor force (154.0 million)
and those not in the labor force (86.1 million).
The labor force is divided into the employed (140.0 million)
and the unemployed (14.0 million).
Those not in the labor force are divided into those
not available for work (79.9 million)
and those available for work but not currently working (6.2 million).
Finally, those available for work but not in the labor force are divided into
discouraged workers (1.0 million)
and those not currently looking for work for other reasons (5.2 million).

We can use the information in Figure 9.1 to calculate three important

macroeconomic indicators:
The unemployment rate. The percentage of the labor force that is
unemployed:

Number of unemployed
100 Unemployment rate
Labor force
Using the numbers from Figure 9.1, we can calculate the unemployment rate
for September 2011:

14.0 million
100 9.1%
154.0 million
Labor force participation rate. The percentage of the working-age population
in the labor force:

Labor force
100 Labor force participation rate
Working - age population

For September 2011, the labor force participation rate was

154.0 million
100 64.1%
240.1 million
The employmentpopulation ratio. The percentage of the working-age
population that is employed:

Employment
100 Employment population ratio
Working - age population

For September 2011, the employmentpopulation ratio was

140.0 million
100 58.3%
240.1 million

Whats happened to labor force

participation recently? How would
you find out?

Thanks to the world-wide interweb and the

Bureau of Labor Statistics, most key up-tothe-minute macro data is at our fingertips
e.g., labor force particn (LFP) rate:
Bureau of Labor Statistics Data
Whats up with that? Discouragement?
What if LFP wasnt in the tank?

Whats wrong with the unemployment rate

as a gauge of the health of labor markets?

Given the discouraged

worker phenomenon, some
argue that the employment /
population ratio is a better
indicator of job availability than
the unemployment rate.

But this ratio misses the fact that

some workers withdraw from the
labor force because they dont
need/want to work (affluent? antimaterialistic?), not just because
theyre discouraged.

Bottom line: There are no

perfect performance measures,
Macro-wise.

Figure 9.2

The Official Unemployment Rate and a Broad Measure of the

Unemployment Rate, 19942011

The red line shows the usual measure of the unemployment rate.
The blue line shows what it would be if the BLS had counted as unemployed all people
who were available for work but not actively looking for jobs and all people who were in
part-time jobs but wanted full-time jobs.
The difference between the measures was particularly large during the 20072009
recession and the weak recovery that followed.
Shaded areas indicate months of recession.

Making
the

Connection

Note how the duration of unemployment spiked following

the 20072009 recession. Why?

The average period of unemployment was twice as high following the 20072009
recession as following any other recession since the end of World War II.

The Establishment Survey: A Backup Measure of Employment

In addition to the household survey, the BLS uses the establishment survey,
sometimes called the payroll survey, to measure total employment in the
economy.
The establishment survey provides information on the total number of persons
who are employed and on a company payroll.
The establishment survey has the following four drawbacks:
1.It does not provide information on the number of self-employed persons
because they are not on a company payroll.
2.It may fail to count some persons employed at newly opened firms that are
not included in the survey.
3.It provides no information on unemployment.
4.Its initial employment values can be significantly revised as data from
additional establishments become available.

Is Govt Stat-Keeping Like a Sausage Factory?

Despite its drawbacks, the establishment survey has the advantage of being
determined by actual payrolls rather than by unverified answers, as is the case with
the household survey.
Table 9.1 Household and Establishment Survey Data for August and September

2011

Household Survey
August

Establishment Survey

September

Change

Employed

139,627,00
0

140,025,000

398,000

Unemployed

13,967,000

13,992,000

25,000

Labor force

153,594,00
0

154,017,000

423,000

August

September

Change

131,231,000 131,334,000

103,000

Unemployment rate
9.1%
Note:
The sum of employed
and9.1%
unemployed0%
may not equal the labor force due
to rounding.

The discrepancy between the two surveys is partly due to the slightly different
groups they cover and partly to inaccuracies.

Figure 9.5

The Sausage Factory (cont.): Revisions to Employment Changes,

as Reported in the Establishment Survey

Over time, the BLS revises its preliminary estimates of changes in employment. During the
20072009 recession, many more jobs were lost than the preliminary estimates showed.
The green bars show months for which the BLS revised its preliminary estimates to show
fewer jobs lost (or more jobs created), and the red bars show months for which the BLS
revised its preliminary estimates to show more jobs lost (or fewer jobs created).

Deconstructing unemployment: 3 types

Frictional:
Caused by imperfect information and search costs.
Occurs because:
employers are not aware of all available workers
and their qualifications, and,
available workers are not fully aware of all the jobs
being offered by employers.
Structural:
Reflects an imperfect match of employee skills to skill
requirements of the available jobs.
Might be a function of the pace of technical change,
composition of labor force, or labor mkt regulations.
Cyclical:
Reflects business cycle conditions
When there is a general downturn in business activity,
cyclical unemployment increases.

What does full employment really mean?

Full Employment = Level of employment that

results from efficient use of resources; it allows
for some unemployment that results from
Search factors:

Structural factors:
dynamic changes in economy (technology,
demography);
institutional factors (wage controls, etc.).
But not cyclical factors: if theres no cyclical
unemployment, we say were at full employment

imperfect and costly information

Full employment (cont.)

Assertion: Were at full employment when

unemployment is at its natural rate, i.e.,
the unemployment rate 0

E.g., for efficiency reasons, you wouldnt want a

zero unemployment rate any more than youd
want a zero cab or apartment vacancy rate

UR = 0 inflexibility, inefficiency, mismatches, etc.

17

Full employment & the natural rate (cont.)

The Natural Rate of Unemployment:

The level of unemployment (> 0) that reflects

frictional and structural conditions in labor
markets.

Deviations of actual unemployment from the natural

rate thus reflect cyclical conditions.

And over time, cyclical influences tend to wash out, so the

long-run average unemployment rate tends to be equal to
the natural rate.

But what number is it? 5%? 6%? Dunno,

exactly. Has it risen lately? Mebbe.

Institutions and
unemployment

Frictional and structural unemp can be

greatly affected by govt policy:

UI and social insurance

Wage controls (minimum wages, living wage
laws at local level)
Labor cartels (unions)

Also, conventions in labor markets such as

efficiency wages
Henry Ford's $5 a Day Wages
19

Next key issue: the changing

value of the $ (or the , , ,
etc.)

We measure the value of production with

prices, and prices are denominated in
currencies, and the value of currencies are
constantly changing, relative to goods and
relative to each other!
So economists invented price indexes like
the CPI and GDP Deflator to keep track
We need to know how to use them

20

Calculating the rate of inflation is simple:

Inflation =
rate

This years
price index

Last years
price index

Last years
price index

* 100

Inflation = increase in the general level of prices;

Deflation = decrease in the general level of prices;
Disinflation = deceleration of inflation.

Note: The next half-dozen slides convey some

details about one key price index, the CPI. Im
gonna skim through em but spend more time
working through them on your own.

Consumer price index (CPI) An average of the prices of the goods and
services purchased by the typical urban family of four.
Figure 9.7
The CPI Market Basket,
December 2010

The Bureau of Labor

Statistics surveys
30,000 households on
their spending habits.
The results are used
to construct a market
basket of goods and
services purchased
by the typical urban
family of four.
The chart shows these
goods and services,
grouped into eight
broad categories.
The percentages represent
the expenditure shares of the
categories within the market basket.
The categories of housing, transportation, and food make up about three-quarters of the
market basket.

The value of the CPI is set equal to 100 for the base year. In any other year,
it equals the ratio of the dollar amount necessary to buy the market basket of goods
in that year divided by the dollar amount necessary to buy the market basket of
goods in the base year, multiplied by 100.
Because the CPI measures the cost to the typical family to buy a representative
basket of goods and services, it is sometimes referred to as the cost-of-living index.
The following table shows how the CPI is constructed, assuming that the market
basket has only three products:
Base Year (1999)

Product

Price

$100.00

$85.00

$85.00

15.00

300.00

14.00

280.00

25.00

500.00

27.50

550.00

Expenditures

Price

$50.00

$50.00

$100.00

Pizzas

20

10.00

200.00

Books

20

25.00

500.00

TOTAL

$750.00

Expenditures
(on base-year
quantities)

2013
Expenditures
(on base-year
quantities)

Price

Eye
examinations

Quantity

2012

$900.00

$915.00

Assuming that households buy the same market basket of products each month,
the quantities of the products purchased in 2012 and 2013 are irrelevant in
calculating the CPI. The numbers in the table can give us the CPI for those years.

Formula

Applied to 2012

Expenditures in the current year

100
CPI =
Expenditures in the base year

$900

100 120
$750

Applied to 2013

$915

100 122
$750

The values of 120 and 122 are index numbers, which means they are not measured
in dollars or any other units.
The CPI is intended to measure changes in the price level over time. Thus, the
inflation rate in 2013 would be the percentage change in the CPI from 2012 to 2013:

122 120

100 1.7%
120

Dont Let This Happen to You

Dont Miscalculate the Inflation Rate

Suppose you are given the data in the following table and are asked to calculate
Year
CPI
the inflation rate for 2010:
2009

216

2010

219

Because the inflation rate is the percentage increase in the price level from the
previous year, and not the percentage increase from the base year, the correct
calculation of the inflation rate for 2010 is:
219 216

100 1.4%
216

MyEconLab Your Turn: Test your understanding by doing related problem 4.5 at the end of this chapter.

Is the CPI Accurate?

There are four biases that cause changes in the CPI to overstate the true
inflation rate by 0.5 percentage point to 1 percentage point, according to most
economists, which the BLS continues to take steps to reduce:
Substitution bias. In constructing the CPI, the BLS assumes that consumers
purchase the same monthly amount of each product in the market basket, but
consumers actually buy fewer of those products that increase most in price.
Increase in quality bias. The BLS attempts to make adjustments so that only
the pure inflation part of price increases is included in the CPI, but some price
increases are included that partly reflect an improved quality of products.
New product bias. For many years, the BLS updated the market basket of
goods used in computing the CPI only every 10 years, which excluded new
products introduced between updates.
Outlet bias. Because the BLS continued to collect price statistics from
traditional full-price retail stores, the CPI did not reflect the prices some
consumers actually paid at discount stores and over the Internet.
Producer price index (PPI) An average of the prices received by producers of
goods and services at all stages of the production process.

Solved Problem 9.5

Calculating Real Average Hourly Earnings
In addition to data on employment, the BLS establishment survey gathers data on average
hourly earnings of production workersall workers, except for managers and
professionalswhich are a broad measure of the typical workers income.
Use the information in the following table to calculate real average hourly earnings for
each year.
Year

Nominal Average Hourly

Earnings

CPI
(19821984 = 100)

2008

$21.62

216.2

2009

22.21

215.9

2010

22.59

218.6

What was the percentage change in real average hourly earnings between 2009 and 2010?

Solving the Problem

Step 1: Review the chapter material.
Step 2: Calculate real average hourly earnings for each year.
To calculate real average hourly earnings for each year, divide nominal average hourly
earnings by the CPI and multiply by 100.
For example, real average hourly earnings for 2008 are equal to

$21.62

100 $10.00
216
.
2

Solved Problem 9.5

Calculating Real Average Hourly Earnings
These are the results for all three years:
Year

Nominal Average
Hourly Earnings

CPI
(19821984 = 100)

Real Average Hourly Earnings

(19821984 dollars)

2008

$21.62

216.2

$10.00

2009

22.21

215.9

10.29

2010

22.59

218.6

10.33

Step 3: Calculate the percentage change in real average earnings from 2009 to 2010.
This percentage change is equal to

$10.33 $10.29

100 0.4%
$
10
.
29

We can conclude that real average hourly earnings increased slightly between 2009
and 2010.
For purposes of calculating the change in the value of real average hourly earnings over time,
the base year of the price index doesnt matter.
To prove it, try calculating real average hourly earnings for 2009 and 2010 in 2010 dollars,
and then calculate the percentage change.
Unless you make an arithmetic error, you should find that the answer is still 0.4 percent.
MyEconLab Your Turn:

For more practice, do related problems 5.3, 5.4, 5.5, and 5.6 at the end of this chapter.

2 kinds of inflation to be aware of

Unanticipated inflation:
An increase in the price level that comes as
a surprise, at least for most individuals.
Anticipated inflation:
A widely expected change in the price level.
The former is a much larger problem than
the latter: If Im certain prices are going to
be twice as high next year, I can bargain for
my 100% raise and Im protected. But

Unanticipated inflation and

wealth
transfers transactors will

When lending/borrowing,

have to forecast the future purchasing power

of the dollars that will be repaid.
Interest rates we see (nominal) are the sum
of a real rate plus expected inflation:
inominal = ireal + expectd infln rate
Real-world example: my parents first
mortgage, at 3% from 1958-88.

But inflation over those 30 yrs.: 4.8%/year

So they borrowed at a negative real rate (-1.8%)
29

Wealth transfer effect

of unanticipated inflation, details

Heres Jane Q. Speculators balance sheet:

30

Wealth transfer effect (cont.)

Now theres an unanticipated 100% increase

in the price level of real (non-monetary)
assets. New balance sheet:

Key question: Whats Janes real net worth?

31

Taking advantage of
unanticipated inflation (or

disinflation
or adeflation)
Predicting inflation
tiny bit better than the
herd allows for massive wealth transfers

Unanticipated inflation: shifts wealth from lenders

to borrowers
Unanticipated disinflation or deflation: shifts
wealth from borrowers to lenders

Note: to benefit from such wealth transfers,

you can also simply invest in companies that
are either net borrowers or lenders
32

So inflation, being unpredictable,

will lead to lots of problems...

Since unanticipated inflation can shift so

much wealth this way, it increases risk and
reduces volume of many productive activities
It distorts the signals sent by prices, leading
to mistakes in resource allocation;
It forces people to spend less time producing
and more time trying to protect their wealth
and income from the uncertainty related to
price volatility

Current examples: Watch Venezuela and Argentina

So: What causes inflation? How can we

predict it better?

Nearly all economists believe that rapid expansion in the

money supply is the primary cause of inflation, at least in
the long run.
to understand macro fluctuations, study monetary
fluctuations (which will preoccupy us later weeks).
Flying kites made
of German
marks, 1920s