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Economics
6th edition

Chapter 9
Unemployment and Inflation

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Chapter Outline
9.1 Measuring the Unemployment Rate, the Labor Force
Participation Rate, and the Employment-Population Ratio
9.2 Types of Unemployment
9.3 Explaining Unemployment
9.4 Measuring Inflation
9.5 Using Price Indexes to Adjust for the Effects of Inflation
9.6 Nominal Interest Rates versus Real Interest Rates
9.7 Does Inflation Imposes Costs on the Economy?

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Measuring unemployment and inflation

Last chapter, we learned about how to measure total output—a
critical first step in understanding the economy.
In this chapter, we continue along these lines, learning about how
to measure unemployment and inflation.
These are very important and commonly-used macroeconomic
concepts; we want to solidify what they mean, so that we can talk
intelligently about them.

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9.1 Measuring the Unemployment Rate, the Labor Force

Participation Rate, and the Employment-Population Ratio

Define the unemployment rate, the labor force participationrate, and the employment–
population ratio and understand how they are computed
There are more than 300 million people in the United States, and
monitoring and reporting on their activities regularly would be very
difficult and costly.
Instead, the U.S. Department of Labor reports estimates of
employment, unemployment, and other statistics related to the
labor force each month.
Labor force: The sum of employed and unemployed workers in
the economy.
Of these statistics, the most watched is known as the
unemployment rate: the percentage of the labor force that is
unemployed.

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The household survey

Each month, the U.S. Bureau of the Census conducts the Current
Population Survey (a.k.a. the household survey).
• ~60,000 households selected to be “representative”
• Household members of “working age” (16+ years old)
• Asked about employment during “reference week”
• Also asked about recent job-search activities
People are then classified as:
• Employed: Worked 1+ hours in reference week (or were
temporarily away from their jobs).
• Unemployed: Someone who is not currently at work but who is
available for work and who has actively looked for work during
the previous month.
• Not in the labor force, if neither of the above apply
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Figure 9.1 The employment status of the civilian working-

age population, August 2015 (1 of 3)

Discouraged workers: People

who are available for work, but
have not looked for a job during
the previous four weeks because
they believe no jobs are available
for them.
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Figure 9.1 The employment status of the civilian working-

age population, August 2015 (2 of 3)

Based on the CPS estimates,

we calculate several important
macroeconomic indicators.
• The most-watched is the
unemployment rate:

Number of unemployed
× 100 = Unemployment rate
Labor Force
8.03 million
× 100 = 5.1%
157.07 million
This most-common measure of unemployment is known
formally as BLS series U-3.
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Figure 9.1 The employment status of the civilian working-

age population, August 2015 (3 of 3)
Also important are the labor-force participation rate:
the percentage of the working-age population in the
labor force…
Labor force
× 100 = LFPR
Working−age population
157.07 million
× 100 = 62.6%
251.10 million
… and the employment-population
ratio: the percentage of the working-age
population that is employed:
Employment
× 100 = Employment−population ratio
Working−age population
149.04 million
× 100 = 59.3%
251.10 million

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Problems with measuring the

unemployment rate
The unemployment rate measured by the BLS is not a perfect
measure of joblessness. Why?
• It may understate unemployment:
• Distinguishing between people who are unemployed and not
in the labor force requires judgment (should we exclude
“discouraged workers”?)
• Only measures employment, not intensity of employment
(full-time vs. part-time; some people are underemployed)
• It may overstate unemployment:
• People might claim falsely to be actively looking for work
• May claim not to be working to evade taxes or keep criminal
activity unnoticed
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Figure 9.2 The official unemployment rate and a broad

measure of the unemployment rate, 1998-2015

Some people suggest that we should include discouraged workers

and underemployed workers in the unemployment statistics, to
create a broader measure of unemployment.
• The BLS measures this, calling it BLS series U-6.
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Figure 9.3 Trends in the labor force: participation rates of

adult men and women since 1948

The labor force participation rate of adult men has declined

gradually since 1948…
… but it has increased significantly for adult women, making the
overall rate higher today than it was then.
• Recently, the rate for women has declined also.
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Making the Connection: Eight million

workers are missing!

While the unemployment rate returned to “normal” after the 2007-

2009 recession, the employment-population ratio did not. Why?
• Aging population (baby boomers reaching retirement)
• Long-term unemployment leading to skill-deterioration
• Affordable Care Act making access to health care easier
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Figure 9.4 Unemployment rates in the United States,

August 2015

Unemployment rates vary by ethnic group…

… and by education level.
• These two observations are statistically related.
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How long are people typically

unemployed?
Long periods of unemployment are bad for workers, as their skills
decay and they risk becoming discouraged and depressed.
• During the Great Depression of the 1930s, some people were
unemployed for years at a time.
Since World War II, average lengths of unemployment have been
relatively low; but that changed dramatically with the 2007-2009
recession.
• The average length of unemployment more than doubled, from
4 months to 10 months.

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The establishment survey

In addition to the household survey, the BLS also uses the
establishment survey, (a.k.a. the payroll survey).
This survey samples ~300,000 establishments, or places of
employment, about their employees. Disadvantages include:
• Self-employed people not surveyed (not on a company payroll)
• Newly-opened firms often omitted
• Information on employment only, not unemployment
• Numbers fluctuate depending on establishments included, often
requiring large revisions
However, a big advantage is that the data are determined by real
payrolls, not self-reporting like the household survey.

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Table 9.1 Household and establishment survey data for July

and August 2015

Even if all surveys are truthfully and accurately answered, we do

not expect the numbers to be identical between the two surveys:
• Different groups are measured
• All surveys have measurement errors
But we get a more complete picture by considering both surveys.

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Figure 9.5 Revisions to employment changes, as reported in

the establishment survey, 2007-2010

Over time, the BLS adjusts its estimates of employment and

unemployment for previous months. Revisions sometimes take
place years later.
• The large negative revisions were because the BLS
underestimated the severity of the 2007-2009 recession.
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Job creation and job destruction over

time
Jobs are continually being created and destroyed in the U.S.
economy.
• In 2014, about 29.1 million jobs were created, while about 26.1
million jobs were destroyed.
• This is a natural and normal process for the economy.
The BLS reports net changes in the number of people employed
and unemployed; this does not fully represent how dynamic the
U.S. job market really is.

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9.2 Types of Unemployment

Identify the three types of unemployment

The three types of unemployment are:

• Frictional unemployment: Short-term unemployment that
arises from the process of matching workers with jobs
• Structural unemployment: Unemployment that arises from a
persistent mismatch between the skills and attributes of
workers and the requirements of jobs
• Cyclical unemployment: Unemployment causes by a
business cycle recession

We will examine each in turn over the coming slides.

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Figure 9.6 The annual unemployment rate in the United

States, 1950-2014

Unemployment rates rise when the economy is faltering, and fall

when the economy is doing well. But they never fall to zero.
• The types of unemployment can help us to understand why.
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Frictional unemployment
Frictional unemployment: Short-term unemployment that arises
from the process of matching workers with jobs.
Frictional unemployment occurs mostly because of job search:
entering or re-entering the labor force, or being between jobs.
It also occurs because of seasonal unemployment: some jobs
fluctuate in availability due to seasonal demand, like ski-instructor
or farm-work.
• To control for this, the BLS releases raw and seasonally-
adjusted employment figures.
Some frictional unemployment actually increases economic
efficiency by allowing for better job matches.

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Structural unemployment
Structural unemployment: Unemployment that arises from a
persistent mismatch between the skills and attributes of workers
and the requirements of jobs.
Structural unemployment is associated with longer unemployment
spells.
Workers who are structurally unemployed may require retraining
in order to obtain “modern” jobs.

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Cyclical unemployment and the natural

rate of unemployment
Cyclical unemployment: Unemployment causes by a business
cycle recession.
In normal recoveries after a recession, unemployment due to
cyclical factors will fall.
When all unemployment is due to frictional and structural factors,
we say that the economy is at full employment. This means there
will always be some unemployment in the economy.
• Economists call this the natural rate of unemployment: The
normal rate of unemployment, consisting of frictional
unemployment and structural unemployment.
• The general consensus of economists is that the U.S. natural
rate of unemployment is somewhere between 5 percent and
5.5 percent.
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Making the Connection: How should we

categorize unemployment at JPMorgan Chase?
In 2015, JPMorgan Chase announced
it was laying off 5,000 employees,
averaging two tellers per branch.
• These tellers were unneeded due
to technological change; they are
likely structurally unemployed.
It also decided to exit certain lines of
business, including student loans.
• Other institutions will make student
loans; these workers are likely
frictionally unemployed.
• Given the state of the economy,
likely no cyclical unemployment.
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9.3 Explaining Unemployment

Explain what factors determine the unemployment rate

Governments often attempt to directly influence unemployment.

Example: The federal government’s Trade Adjustment Assistance
program offers training to workers whose firms laid them off as a
result of competition from foreign firms. This would reduce
structural unemployment.
Other policies try to reduce frictional unemployment, for example
by subsidizing new hires.
However some other government policies probably increase
unemployment, like
• Unemployment insurance, and
• Minimum wage laws
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Unemployment insurance
Suppose you have just lost your job. You want to find another, and
have two main options:
• Take a new low-paying job immediately, or
• Search for a better job
If unemployment insurance payments are available to you, you will
probably be more likely to choose the second option.
In the U.S., unemployment insurance payments are typically not
very generous, compared with other high-income countries; and
there are relatively short time-limits.
• Unemployment benefits are more generous, and
unemployment rates higher, in western European countries.
• Do you think these facts are related?

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Minimum wage laws

Federal minimum wage law was introduced in 1938: $0.25/hour.
Today, the federal minimum wage is $7.25/hour.
• Many states and cities have higher minimum wages.
Studies suggest a 10 percent increase in the minimum wage
reduces teenage employment by about 2 percent.
• Overall effect on unemployment rate is small at current levels.

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Labor unions
Labor unions are organizations of workers that bargain with
employers for higher wages and better working conditions.
Unions are probably not a significant cause of unemployment in
the United States. While they raise the wage, only about 9 percent
of private-sector workers are unionized, limiting the effect that
unions have on the wider economy.

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Efficiency wages
Efficiency wage: An above-market wage that a firm pays to
increase workers’ productivity.
Firms want to get the best performance they can out of their
workers.
• Sometimes monitoring workers is difficult or costly; an
alternative is to pay them a relatively high wage, making them
motivated to perform well in order to keep their job.
• These above-market wages are probably another reason why
unemployment exists even when cyclical unemployment is
zero.

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9.4 Measuring Inflation

Define the price level and the inflation rate and understand how they are computed

In the previous chapter we introduced the idea of the price level:

a measure of the average prices of goods and services in the
economy.
We refer to the percentage increase in the price level from one
year to the next as the inflation rate.
Last chapter, we used the GDP deflator to measure changes in
the price level. By measuring changes in the prices of different
baskets of goods, we would come up with different measures.
Two commonly-used measures are:
• The consumer price index (CPI)
• The producer price index (PPI)
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Figure 9.7 The CPI market basket, December 2014

The consumer price

index is a measure of
the average change
over time in the prices a
typical urban family of
four pays for the goods
and services they
purchase.
The chart shows the
composition of the
basket of goods used to
create the CPI. This
basket of goods derives
from a survey of 14,000
households by the BLS.
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Calculating the CPI

To calculate the CPI in a given year, we need:
• A basket of goods
• The cost to purchase the basket of goods in a base year
• The prices in the current year
The CPI in the current year is the cost to purchase the basket of
goods this year, divided by the cost in the base year. By
convention, we multiply this by 100, so that the CPI in the base
year is 100.

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A simple CPI calculation (1 of 2)

The table above gives the information we need to create the CPI
in 2016 and 2017, using the basket of goods from 1999.

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A simple CPI calculation (2 of 2)

Based on these data, the inflation ate from 2016 to 2017 is the
percentage change in the CPI:
122 − 120
× 100 = 1.7%
120
Since the CPI measures consumer prices, it is often referred to as
the cost of living index. CPI-inflation is sometimes used to
generate “fair” increases in wages for workers, and government
benefits.

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Is the CPI an accurate measure of

inflation?
Some potential problems with the CPI include:
• Substitution bias: Consumers may change their purchasing
habits away from goods that have increased in price.
• Increase in quality bias: Difficult to separate improvement in
quality from increase in price, say in cars or computers.
• New product bias: The basket of goods changes only every 10
years. There is a delay to including new goods like cell phones.
• Outlet bias: CPI uses full-retail price, but many people now buy
from discount stores or online.
For these reasons, economists believe the CPI overstates true
inflation by 0.5 to 1 percentage point.

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Producer price index

The producer price index (PPI) is an average of the prices
received by producers of goods and services at all stages of the
production process.
• It is conceptually similar to the CPI, in that it uses a basket of
goods, but the goods are those used by producers.
The PPI can give early warning of future movements in consumer
prices.
• Can you suggest why this is true?

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9.5 Using Price Indexes to Adjust for the

Effects of Inflation
Use price indexes to adjust for the effects of inflation

Suppose your mother received a salary of $25,000 in 1989. This

would have bought much more than a salary of $25,000 in 2014.
We can use the CPI to estimate the purchasing power of that
$25,000 in 2014 dollars:
CPI in 2014
Value in 2014 dollars = Value in 1989 dollars ×
CPI in 1989
237
Value in 2014 dollars = $25,000 × = $47,782
124
So $25,000 in 1989 would have bought about as much as $48,000
in 2014.

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Nominal and real variables

The current standard base “year” for the CPI is an average of
1982-1984 prices.
Values like wages in current-year dollars are called nominal
variables. When we adjust them for inflation, by dividing by the
current year’s price index and multiplying by 100, we convert them
to real variables.
• This is useful for comparing variables across time.

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9.6 Nominal Interest Rates versus Real

Interest Rates
Distinguish between the nominal interest rate and the real interest rate

When you lend money to someone, they typically agree to pay you back
with interest. If the interest rate is 6 percent, for example, then a $1,000
loan paid back in a year will be paid back with $1,060.
6 percent is the nominal interest rate: the stated interest rate on a loan.
We can adjust for inflation by calculating the real interest rate, equal to
the nominal interest rate minus the inflation rate.
• This is an approximation, but it is quite accurate for low interest and
inflation rates.
If prices rise by 2 percent from this year to next, then your real interest
rate on the loan is only 4 percent. This more accurately reflects the cost
of borrowing and lending money.

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Figure 9.8 Nominal and real interest rates, 1970-2015

The chart shows the interest rate on three-month treasury-bills, a

good measure of the nominal interest rate.
• The real interest rate adjusts them for changes in the CPI.
In 2009, the real interest rate was above the nominal interest rate.
The change in the CPI was negative then, indicating a rare
deflation, or decrease in the price level.
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9.7 Does Inflation Impose Costs on the

Economy?
Discuss the problems that inflation causes

Sometimes inflation seems unimportant.

• If all prices doubled overnight, it seems like nothing much
would change: the prices of goods and services would have
doubled, but so would your wage.
• So you could afford exactly as much as before.
But not all prices/wages rise at the same rate.
• So some people will see their real wage increase due to
inflation, while others will see it decrease.
• Particularly for people on fixed incomes (e.g. retirees), inflation
can seem unfair, as the purchasing power of their income falls.

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The problem with anticipated inflation

Even if inflation is anticipated, it still causes problems:
• People and firms have increased real costs of holding cash.
• Firms have menu costs: the cost to firms of changing prices.
Frequently changing prices cause are inconvenient for firms
(and consumers too!) to deal with.
• Investors are taxed on nominal returns, rather than real returns;
so this can increase the tax due.

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The problem with unanticipated inflation

When people cannot predict the rate of inflation, they find it hard
to make good borrowing and lending decisions.
• For example, in 1980 banks were charging 18 percent or more
on home loans because the rate of inflation was very high.
People who bought homes were locked into high rates even
when inflation subsided.
On the other hand, if banks lend money at a low rate and then
high inflation takes place, the real interest rate they receive may
be zero or negative; thus the risk of inflation makes banks wary of
lending.
Unpredictable inflation makes borrowing and lending risky.

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Making the Connection: What’s so bad

about falling prices? (1 of 2)

Deflation is much more dangerous for an economy than inflation.

Why? Suppose you are considering buying a car. You know the
car will be cheaper next year, so you delay purchasing. But if
everyone does the same, then many purchases are postponed,
firms stop producing, people become unemployed, etc.
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Making the Connection: What’s so bad

about falling prices? (2 of 2)

This can create a dangerous downward-spiral, delaying economic

recovery. Economists believe this occurred after the Great
Depression of the 1930s, and also in Japan in the 1990s.
There were concerns that significant periods of deflation might
have followed the recession of 2007-2009. but fortunately that did
not occur.
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