Chapter 6: Measuring Inflation and Unemployment

Lecture 6

Chapter 6: Measuring Inflation and Unemployment

I.Aggregate price level

The price of all the goods and services produced in the economy. One of the macro goals is to keep the aggregate price level at a constant level. That is, we don’t want inflation, deflation, disinflation, or hyperinflation.

Inflation

A general rise in prices throughout the economy.

Disinflation

Inflation at a declining rate.

Deflation

A general decline in overall prices throughout the economy.

Hyperinflation

An extremely high rate of inflation of at least 50% per month.

II.It’s hard to measure the aggregate price level

It’s hard to measure the aggregate price level, so policymakers spend taxpayer dollars to estimate it. The Bureau of Labor Statistics is in charge of constructing various price indexes with which to estimate the aggregate price level.

III.Price index

A measure of prices that is used to measure inflation (that is, to estimate changes in the aggregate price level). Important price indexes include the CPI, the PCE, the PPI, and the GDP deflator.

Consumer Price Index (CPI)

A measure of the average prices paid by urban consumers for a typical market basket of consumer goods and services.

Personal Consumption Expenditure Index (PCE)

A measure of consumer prices that focuses on consumer expenditures in the GDP accounts.

Producer Price Index (PPI)

A measure of the prices received by domestic producers for their output.

GDP deflator

A measure of the prices of the components of GDP (includes prices of the goods and services bought by consumers, firms, the government, and foreigners).

IV.Important Stuff about the CPI

The CPI measures the prices of 80,000 consumer goods and services each month out of the 10s of millions of consumer goods and services that are actually available.

The CPI is a cost-of-goods index: it always measures the price of a fixed market basket of goods.

Problem: The fixed market basket of goods actually changes over time, as new goods become widespread and as old goods are discontinued.

The CPI = (cost of the market basket in the current period ÷ cost of the market basket of goods in the base period)x100

The base year of a price index gives a price level against which prices in other years can be compared. The price index in the base year is 100. This is because it is found using the formula cost of the market basket in the current period ÷ cost of the market basket of goods in the base period)x100, where the current year is the base year. Therefore the numerator and the denominator have the same value.

To find actual CPI numbers, go to click on “CPI Tables” and then click on “Table Containing History of CPI . . .” Look at the numbers under the column titled “Avg.” to find the annual average CPI index number.

Year / CPI / Inflation Rate
2006 / 201.6 / ----
2007 / 207.342
2008
2009

V.Threeuseful things that you can do with the CPI or GDP deflator

1.Use the CPI to measure the inflation rate:

The inflation rate = ((current year index–original year index) ÷ original year index) x 100

Exercise 1: Find the inflation rate from 2006 to 2007.

Answer: ((207.342 – 201.6) ÷ 201.6) x 100 = 2.8%

Exercise 2: Complete column 3 in the table above.

Exercise 3: Complete this table.

Year / GDP Deflator / Inflation Rate Since Previous Year / Is this economy experiencing inflation, disinflation, deflation, or price level stability?
1 / 212 / Not available / We can’t tell since we don’t have information for Year 0
2 / 215 / ((215 – 212)/212)x100 = 1.415% / Inflation
3 / 222
4 / 212
5 / 215
6 / 216
7 / 216
8 / 213
9 / 204

2.Use the CPI to adjust your salary for inflation:

New salary = Original salary x (current year index ÷ original year index)

Exercise 1: If you earned $32,000 in 2007 when the CPI equaled 207.342 how much did you need to earn in 2008 when the CPI equaled 215.303 in order to keep up with inflation?

Answer: $32,000 x (215.303 ÷ 207.342) = $33,228.66

Exercise 2: Use the table on the previous page to find how much you need to earn now to maintain your purchasing power if you earned $33,000 in 2008.

Answer:

3.Use the CPI to compare wages or income or prices or the GDP deflator to compare output across time:

Comparing wages/income/prices across time

To do this you must calculate real (or constant dollar) income and real (or constant dollar) prices for the two periods in question:

Real income in Year X = (Nominal income in Year X ÷ CPI in Year X) x 100

Inflation erodes the purchasing power of our incomes. Real (constant) income is nominal income adjusted for price level changes. It allows us to see how our purchasing power compares with the purchasing power we had in the past.

Exercise 1: If someone earned $100,000 in 1998 and their boss offers them $125,000 in 2008, will their purchasing power rise? To find out, calculate their real income for each period, and then compare those figures to see if real income rose:

Real income in 1998 =

Real income in 2008 =

Exercise 2: How big a raise does this person need to get the same purchasing power they had back in 1998? Use the escalation formula:

New income = original income x (current year index ÷ original year index)

Raise necessary to maintain standard of living = new income – actual income

Exercise 3: Go to use the CPI to calculate the real (constant) value of the minimum wage rate in July 2008 and July 2009. Did people earning the minimum wage rate see their purchasing power rise?

Real minimum wage in July 2008 =

Real minimum wage in July 2009 =

You use real figures for comparison purposes across time periods. Nominal figures do not allow for comparison across time periods. Here is a chart to help you see this.

If

Then we know

A person’s real income rose over time

The person has more purchasing power now than they had in the past

A person’s real income stayed the same over time

The person has the same amount of purchasing power now than they had in the past

A person’s real income fell over time

The person has less purchasing power now than they had in the past

An item’s real price rose over time

The item is relatively more expensive than it was in the past

An item’s real price stayed the same over time

The item costs relatively the same as it cost in the past

An item’s real price fell over time

The item is relatively less expensive than it was in the past

Then we

A person’s income(also called nominal income) rose over time

Cannot tell from the information given whether their purchasing power rose, fell, or stayed the same

A person’s income (also called nominal income) stayed the same over time

Cannot tell from the information given whether their purchasing power rose, fell, or stayed the same

A person’s income (also called nominal income) fell over time

Cannot tell from the information given whether their purchasing power rose, fell, or stayed the same

An item’s price (also called nominal price) rose over time

Cannot tell from the information given whether cost more, less, or the same as it did in the past

An item’s price (also called nominal price) stayed the same over time

Cannot tell from the information given whether cost more, less, or the same as it did in the past

An item’s price (also called nominal price) fell over time

Cannot tell from the information given whether cost more, less, or the same as it did in the past

VI.Real GDP

Formula: Real GDP = (Nominal GDP ÷ the GDP deflator) x 100

Go to and choose “List of Selected NIPA tables” then table 1.1.6 to review the most recent real GDP figures. Real GDP figures can be compared to see whether an economy has grown because they have been adjusted to take price changes into account.

Here is an example where we can see that the US economy grew from 2007 to 2008 but shrank in 2009 (note: these figures are subject to revision so they may be slightly different in the future). I pulled them on 2/5/2010.

Line / 2007 / 2008 / 2009
1 / Grossdomesticproduct / 13,254.1 / 13,312.2 / 12,988.7
2 / Personalconsumptionexpenditures / 9,313.9 / 9,290.9 / 9,237.3
3 / Goods / 3,273.7 / 3,206.0 / 3,143.7
4 / Durablegoods / 1,199.9 / 1,146.3 / 1,100.5
5 / Nondurablegoods / 2,074.8 / 2,057.3 / 2,037.3
6 / Services / 6,040.8 / 6,083.1 / 6,090.5
7 / Grossprivatedomesticinvestment / 2,146.2 / 1,989.4 / 1,522.8
8 / Fixedinvestment / 2,126.3 / 2,018.4 / 1,646.7
9 / Nonresidential / 1,544.3 / 1,569.7 / 1,289.1
10 / Structures / 441.4 / 486.8 / 391.0
11 / Equipmentandsoftware / 1,097.0 / 1,068.6 / 887.9
12 / Residential / 585.0 / 451.1 / 359.1
13 / Changeinprivateinventories / 19.5 / -25.9 / -111.7
14 / Netexportsofgoodsandservices / -647.7 / -494.3 / -353.8
15 / Exports / 1,546.1 / 1,629.3 / 1,468.6
16 / Goods / 1,064.8 / 1,127.5 / 987.0
17 / Services / 481.3 / 501.7 / 480.6
18 / Imports / 2,193.8 / 2,123.5 / 1,822.5
19 / Goods / 1,839.6 / 1,767.3 / 1,479.1
20 / Services / 354.2 / 356.5 / 342.9
21 / Governmentconsumptionexpenditures
andgrossinvestment / 2,443.1 / 2,518.1 / 2,566.4
22 / Federal / 906.4 / 975.9 / 1,026.7
23 / Nationaldefense / 611.5 / 659.4 / 695.1
24 / Nondefense / 294.9 / 316.4 / 331.4
25 / Stateandlocal / 1,536.7 / 1,543.7 / 1,542.8
26 / Residual / 0.3 / 20.0 / 19.2

VII.Calculating Economic Growth Rates

Economic growth rate = ((Real GDPlatest period – Real GDPearlier period )/Real GDP earlier period) x 100

Economic growth has occurred if real GDP is higher in one year than it was in the previous year. Later on we will address the issue of whether a particular growth rate is good “enough.”

VIII.Problems with inflation and deflation, or, why we want price stability

A. Problems with inflation

Inflation hurts people on fixed incomes, savers, and lenders

Web Activity:

According to the Associated Press, 3/31/2001, New York firefighters tearing down a fire-damaged ceiling found nearly $30,000 in cash believed to have been stored in a Brooklyn apartment for at least 20 years. They found the money wrapped in foil inside six envelopes marked with handwritten dates from the 1970s and 1980s.

Go to and click on inflation calculator to find what goods worth $30,000 in 1980 would cost today.

How can savers protect themselves from inflation? By demanding an inflation premium on the money they save.

Nominal interest rate = real interest rate+ expected inflation rate

Inflation hurts economic growth

Inflation makes it harder for businesses to plan, because it is hard to predict how much demand there will be at higher prices.

Inflation and international competitiveness

Inflation reduces a country’s ability to sell its products abroad.

B.Problems with Deflation

Deflation hurts borrowers

They have to pay back dollars that are “more dear” than when they got them. (Example: farmers during the Great Depression, mortgage holders these days.)

Deflation makes it harder for the Fed to help our economy

Ongoing, expected deflation creates difficulties for monetary policy. The Fed can lower its Federal Funds rate target all the way to 0%--but it can't use open market operations or any of its other tools to make the Federal Funds rate fall BELOW 0%.

(As we will see in later chapters, the Fed will want to use open market operations to reduce interest rates so that consumers and firms will spend more money, in order to help the economy grow. If the Federal Funds rate is 0%, the Fed won't be able to stimulate spending.) Therefore, ongoing, expected deflation potentially limits the Fed’s ability to affect our economy with monetary policy.

Notes: "ongoing" means more than a one-time occurrence, "expected" means that the public expects deflation to occur--that it isn't a surprise.

IX. Unemployment

A.Some Basic Definitions

The government puts all of us into one of three categories: “employed,” “unemployed,” or “not in the labor force.”

Who is “employed”?

1. Everyone who is at least 16 years old, not institutionalized or on active duty in the armed forces, and who did any work for pay or profit during the survey week

2. Everyone who is at least 16 years old, not institutionalized or on active duty in the armed forces, and who did at least 15 hours of unpaid work in a family-operated enterprise

3. Everyone who is at least 16 years old, not institutionalized or on active duty in the armed forces, and who was temporarily absent from their regular jobs because of illness, vacation, bad weather, strike, or various personal reasons

Who is “unemployed”?

1. Everyone who is at least 16 years old, not institutionalized or on active duty in the armed forces, and who did not have a job at all during the survey week but made specific active efforts to find a job during the prior 4 weeks, and was available for work (unless temporarily ill)

2. Everyone who is at least 16 years old, not institutionalized or on active duty in the armed forces, and who was waiting to be called back to a job from which they had been temporarily laid off

Who is “not in the labor force”?

1.Everyone who is under 16

2.Everyone who is institutionalized

3.Everyone who is a member of the armed forces on active duty

4.Everyone else who is not employed or unemployed

B.How the Government Tracks theUnemployment Rate

See for How the Government Measures Unemployment and the BLS Handbook of Methods

The government conducts a monthly survey called the Current Population Survey (CPS) to measure unemployment. There are about 60,000 households in the sample for this survey. Interviewers collect information only about household members who are at least 16 years old who are not in an institution such as a prison or mental hospital or on active duty in the armed forces.

A CPS surveyor asks the following questions for each household member who is at least 16 years old and who is not institutionalized or on active duty in the armed forces.

1.Did you do any work for pay or profit during the survey week?

If the answer is yes the person is employed.

If the answer is no the surveyor asks the next question.

2.Did you do at least 15 hours of unpaid work in a family-operated enterprise?

If the answer is yes the person is employed. (People who work 15 hours or more per week without pay in a family-operated business are considered employed, and fall into a group called “unpaid family workers”.)

If the answer is no the researcher asks the next question.

3.Do you have a regular job that you were temporarily absent from due to illness, vacation, bad weather, strike, or various personal reasons?

If the answer is yes the person is employed.

If the answer is no, the person is NOT counted as employed, because they did not have a job at all during the survey week. The researcher asks the next question.

4.Did you make specific active efforts to find a job during the prior 4 weeks, and were you available for work (unless temporarily ill)?

If the answer is yes the person is unemployed.

If the answer is no the researcher asks the next question.

5.Were you waiting to be called back to a job from which you had been temporarily laid off?

If the answer is yes the person is unemployed.

If the answer is no then the person is not in the labor force.

For 2007:

2007
Total U.S. Population / 301,627,157
- Under 16, on active duty in the armed forces, or institutionalized / 69,754,157
= Civilian noninstitutional population / 231,867,000
- employed / 146,047,000
- unemployed / 7,078,000
= everyone else who is not in the labor force (retirees, college students who don’t work, housewives and househusbands, etc.) / 78,743,000

Sources:

The unemployment rate= unemployed/civilian labor force = 7,078,000/(146,047,000 + 7,078,000) = 4.6% for 2007

C.Problems with Unemployment Statistics

The presence of discouraged workers and underemployment mask weaknesses in the economy.

Discouraged workers

Discouraged workers are people who aren’t actively seeking work but would take a job if one were offered. They are “not in the labor force”, but their existence is an indicator of the strength or weakness of the economy. See

Underemployment

Underemployment occurs when people take jobs that do not fully exploit their education, background, or skills.

D.The Types of Unemployment

1.Frictional Unemployment

This type of unemployment occurs when qualified people with transferable skills change jobs or enter the labor force, due to “frictions” in the economy.

2.Structural Unemployment

This type of unemployment occurs when people do not have the skills necessary to qualify for the jobs that exist, due to “structural changes” in the economy.

3.Cyclical Unemployment

= Total Unemployment – Frictional Unemployment – Structural Unemployment. This type of unemployment occurs when there is insufficient spending in the economy.

E.The Natural Unemployment Rate = Frictional Unemployment Rate + Structural Unemployment Rate

F.Full Employment occurs when there is no cyclical unemployment. This is when our economy is at the natural unemployment rate. Full employment is a useful concept for macroeconomic policy-makers. In terms of achieving the three macroeconomic goals, they worry only about eliminating cyclical unemployment, but they do not worry about eliminating frictional and structural unemployment. Therefore, as soon as they eliminate cyclical unemployment, they declare that the economy has achieved "full employment," then they shake hands, exchange "high fives," and go home happy.

Question: Is the unemployment rate 0 when our economy is at full employment?

Answer:_____. Explanation:______.

Go to to see total unemployment rates.