WEEK 3:

Jobs and Inflation

Why Unemployment Is a Problem

- Unemployment results in
o Lost incomes and production
o Lost human capital
- The loss of income is devastating for those who bear it.
Unemployment benefits create a safety net but don’t fully
replace lost wages, and not everyone receives benefits.
- Prolonged unemployment permanently damages a person’s job
prospects by destroying human capital.

The population is divided into two groups:

- The working-age population—the total number of people aged 15
years and over

o People in the labour force: includes all employed and

unemployed workers

 Unemployed person must satisfy one of these categories:

 On temporary layoff with an expectation of recall

 Without work but has made specific efforts to find a

job within the previous four weeks

 Has a new job to start within 4 weeks

o People not in the labour force

- People too young to work (under 15 years of age)

The Unemployment Rate:

 - The unemployment rate is the % of the labour force that is
unemployed

 ( Number of people unemployed : labour force ) x

100

o Eg: In 2017, the labour force was 19.68 million and 1.27 million
were unemployed, so the unemployment rate was 6.5 percent.

- The unemployment rate increases in a recession and reaches its peak

value after the recession ends.

The Involuntary Part-Time Rate

- The Involuntary Part-Time Rate is the % of the labour force who work
part time but want full-time jobs

 (Number of involuntary part-time workers : Labour

force) x 100

- Eg: In 2017 the 865,400 involuntary part-time workers and the labour
force was 19.68 million. The involuntary part-time rate is ( 865,400 :
19,680,000 ) x 100 = 4.4%

The labour force participation rate

- This is the % of the working-age population who are members of the
labour force.
  (Labour force : Working-age population) x 100
- E.g: In 2017, the labour force was 19.68 million and the working-age
population was 29.88 million. The labour force participation rate was
65.9%

The employment rate

- The employment rate is the % of the working-age population who have
jobs.
 (Employment : working-age population) x 100
- Eg: In 2017, the number of people employed was 18.41 million and the
working-age population was 29.88 million. The employment rate was
61.6 percent.

Other definitions of unemployment

- The purpose of the unemployment rate is to measure the
underutilization of labour resources
- Statistics Canada believes that unemployment rate gives a correct
measure
- But the official measure is an imperfect measure because it
excludes:
o Discouraged searchers: is a person who currently is neither
working nor looking for work but has indicated that he or she
wants and is available for a job and has looked for work
sometime in the recent past but has stopped looking because
of repeated failure.
o Long-term future starts: A person with a job to start in more
than four weeks is not counted as unemployed.
o Involuntary part-timers: Part-time workers who want full-time
jobs and can’t find them are not counted as unemployed.

- Most Costly Unemployment: All unemployment is costly, but the

most costly is long-term unemployment that results from job loss.
Alternative Measures of Unemployment:
- Statistics Canada reports 8 alternative measures of the
unemployment rate: three narrower than the official measure and
four broader ones.
- The narrower measures, R-1 and R-2, focus on the personal cost
of unemployment.
- R-4 is the official unemployment rate; R-3 is comparable to the
U.S. rate.
- The broader measures, R-4, R-5, and R-6, focus on assessing the
full amount of underemployed labour resources
 Unemployment can be classified into 3 types:

o Frictional unemployment: short-term unemployment caused

by normal job transitions, such as people leaving jobs to find
better ones or new graduates entering the job market.

o Structural unemployment: changes in the economy, such as

new technologies or industries replacing old ones. Workers may
need to learn new skills or move to different locations to find
jobs. It lasts longer than frictional one.

o Cyclical unemployment: Happens during economic downturns

when businesses cut jobs because of reduced demand for goods
and services.

“Natural” Unemployment

o Happens when the unemployment that arises from frictions

and structural change when there is no cyclical
unemployment.
 o The natural unemployment rate is natural unemployment as
a percentage of labour force.
- Full employment is defined as the situation in which the
unemployment rate equals the natural unemployment rate.
- When the economy is at full employment, there is no cyclical
unemployment or, equivalently, all unemployment is frictional
and structural.
- The natural unemployment rate changes over time and is influenced
by many factors. Key factors are
o The age distribution of the population: Younger people tend
to change job more -> engage in frictional unemployment
o The scale of structural change: it impacts natural
unemployment (=structural + frictional)
o The real wage rate: incentives to work (how high is that),
affect the decision to work, choose the job
o Unemployment benefits: if it’s high, your pressure to look for
the job, go back to the labour force decreases; otherwise, you
just take your time to find your job

Real GDP and Unemployment Over the Cycle

- Potential GDP is the quantity of real GDP produced at full
employment.
- Potential GDP corresponds to the capacity of the economy to produce
output on a sustained basis.
- Real GDP minus potential GDP is the output gap.
- Over the business cycle, the output gap fluctuates and the
unemployment rate fluctuates around the natural unemployment rate.

- Real GDP in 2024 = x

- Potential GDP = y
- Output gap = Real GDP – Potential GDP (x- y)
- X > Y = + Unemployment -> expansion/boom -> less than natural rate
of unemployment (the companies will willing to pay more to attract
workers than before -> more people gonna enter the workforce)
- X < Y = - unemployment -> Contraction ->

Price Level, Inflation, and Deflation

- The price level is the average level of prices and the value of money.
o A persistently rising price level is called inflation.
o A persistently falling price level is called deflation.
- We are interested in the price level because we want to
 o Measure the inflation rate or the deflation rate
o Distinguish between money values and real values of economic
variables.

Why Inflation and Deflation Are Problems

- Low, steady, and anticipated inflation or deflation is not a problem.
- Unpredictable inflation or deflation is a problem because it
o Redistributes income and wealth
o Lowers real GDP and employment
o Diverts resources from production
- Unpredictable changes in the inflation rate redistribute income in
arbitrary ways between employers and workers and between
borrowers and lenders.
- A high inflation rate is a problem because it diverts resources from
productive activities to inflation forecasting.
- From a social perspective, this waste of resources is a cost of inflation.
- At its worse, inflation becomes hyperinflation—an inflation rate that
is so rapid that workers are paid twice a day because money loses its
value so quickly

The Consumer Price Index

- The Consumer Price Index, or CPI, measures the average of the
prices paid by urban consumers for a “fixed” basket of consumer
goods and services.
- CPI measures the inflation

Reading the CPI Numbers

- The CPI is defined to equal 100 for the reference base period.
o Below 100, prices went down
o Above 100, prices went up
- Currently, the reference base period is 2002. That is, for the average
CPI of the 12 months of 2002 equals 100.
- In June 2017, the CPI was 130.4.
- This number tells us that the average of the prices paid by urban
consumers for a fixed basket of goods was 30.4 percent higher in June
2017 than it was during 2002.

Constructing the CPI

- Constructing the CPI involves three stages:
o Selecting the CPI basket (goods or services – fixed thing that we
will spend money on)
 The CPI basket is based on a survey of consumer
expenditure conducted by Statistics Canada, which is
undertaken about every two years.
o Conducting a monthly price survey
  Every month, Statistics Canada employees check the
prices of the goods and services in the CPI basket in the
major cities.
o Calculating the CPI
 1. Find the cost of the CPI basket at base-period prices.
 2. Find the cost of the CPI basket at current-period prices.
 3. Calculate the CPI for the current period.

- If there is no base year given, the first year will be the base
year, next one is the current year. Base year always 100.
- The basket of goods remains unchanged, remain constant,
remain fixed.
The CPI is calculated using the formula:
o CPI = (Cost of basket at current-period prices ÷ Cost of
basket at base-period prices)  100.
 - Using the numbers for the simple example, CPI = ($70 ÷ $50)  100
= 140.
- The CPI is 40 percent higher in the current period than it was in the
base period.

Measuring the Inflation Rate

- The major 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.
- The inflation rate equals:
[(CPI this year – CPI last year) ÷ CPI last year]  100.

The Biased CPI

- The CPI might overstate the true inflation for four reasons:
o New goods bias: does not account for new goods, if a good is in
the market for the first time, we won’t have CPI for that (no prior
year to calculate). New goods that were not available in the base
year appear and, if they are more expensive than the goods they
replace, they put an upward bias into the CPI.
o Quality change bias: might be the quality goes up that’s why
the price goes up, CPI doesn’t count for that. Quality
improvements occur every year. Part of the rise in the price is
payment for improved quality and is not inflation. The CPI counts
all the price rise as inflation.
o Commodity substitution bias: the substitution effects might
make one demand curve for a good shift. The market basket of
goods used in calculating the CPI is fixed and does not take into
account consumers’ substitutions away from goods whose
relative prices increase.
o Outlet substitution bias: didn’t count for the fact that we can
change store, buy cheaper one. As the structure of retailing
 changes, people switch to buying from cheaper sources, but the
CPI, as measured, does not take account of this outlet
substitution

- The Magnitude of the Bias

- Estimates say that the CPI overstates inflation by 0.6 percentage
points a year.
- Some Consequences of the Bias
- Distorts private contracts.
- Increases government outlays (close to a third of federal government
outlays are linked to the CPI).
- A bias of 0.6 percent is small, but over a decade adds up to billions of
dollars of additional expenditure.
- Alternative Price Indexes
- Alternative measures of the price level are
o GDP deflator
 GDP deflator = (Nominal GDP ÷ Real GDP)  100
 GDP deflator is a broader measure of the price level than
the CPI because it includes all final expenditure on
Canadian produced goods and services. But as a cost of
living, the GDP deflator is too broad.
 Over the period 2000 to 2016, the GDP deflator increased
at an average rate of 1.9 percent a year, which is 0.3
percentage points below the CPI inflation rate.
o Chained price index for consumption (CPIP)
o CPIC = (Nominal consumption expenditure ÷ Real
consumption expenditure)  100

 Because the GDP deflator and CPIC use current-period

and previous-period quantities, they incorporate
 substitution effects and new goods and overcome
the sources of bias in the CPI.
 From 2000 to 2016, CPIC increased at an average rate of
1.8 percent a year, which is 0.4 percentage points below
the CPI inflation rate.

- Core Inflation Rate

- The core inflation rate excludes the volatile prices of the CPI basket
in an attempt to reveal the inflation trend.
- The Bank of Canada monitors three measures:
o The CPI-trim is the CPI excluding the top and bottom 20 percent
most extreme price changes.
o The CPI-median measures inflation as the percentage change in
the middle items in the CPI basket.
o The CPI-common uses a statistical method to reveal the most
common price changes.

The Real Variables in Macroeconomics

- We can use the GPD deflator to deflate nominal variables to find their
real values.
- For example, Real wage rate = (Nominal wage rate ÷ GDP
deflator) 100
- But not the real interest rate! It is different.