Chapter 5
Unemployment, Inflation, and National Income
Chapter Summary
I.Individuals may be unemployed because of frictional, structural, or cyclical causes. A frictionally unemployed person is one who is temporarily laid off or has resigned, while a structurally unemployed person is one who has lost a job because of a change in the structure of demand or because of technological advance. Cyclical unemployment is caused by the business cycle and is due to insufficient aggregate spending.
2.Cyclical unemployment imposes a cost upon both society and the individual. Society's cost is the output lost in the current production period. Okun's law specifies that 1% of the labor force is cyclically unemployed for each 2% that real GDP falls below potential GDP. Personal losses resulting from cyclical unemployment include loss of income, loss of skills, and loss of self-esteem.
3.A price index relates the average price of a basket of goods in a specific period to the average price of the same goods during a reference period. The consumer price index (CPI), producer price index (PPI), and GDP deflator are three price indexes that measure the price level. The CPI measures the price level for urban consumers; the PPI measures the price level at wholesale for intermediate and crude materials and finished goods; the GDP deflator is a price index for all the components of GDP.
4.Inflation is the annual rate of increase in a price index. Disinflation exists when there is a decrease in the annual rate of inflation; deflation occurs when there is an annual rate of decrease in a price index. Inflation can be demand or supply induced. An excessive increase in aggregate spending is the cause of demand-pull inflation and is generally characterized by increases in both the price level and real output. Cost-push inflation is supply induced; excessive increases in production costs occur and result in increases in the price level and decreases in real output.
5.Unanticipated inflation has an uneven impact on individuals, causes a decrease in economic activity, and discourages capital formation. The cost of unanticipated inflation to an individual consists of decreases in real compensation, in real wealth, and in the purchasing power of retirement income. Economic activity declines as a result of reduced aggregate spending, and there is a slowdown in the rate of economic growth as a result of a low level of net investment.
6.Gross national product (GNP), net national product (NNP), gross domestic product (GDP), and national income (NI) are various measures of national output. NNP equals GNP less the allowance made for capital which has worn out during the year. NI consists of payments made to the factors of production owned by residents of that economy; NI plus indirect business taxes equals NNP. GDP includes only that output which is produced within an economy's geographical borders; in contrast, GNP consists of the output produced either inside or outside the country by economic resources owned by residents of that country.
7.Personal income and personal disposable income are measures of income received by individuals. Personal disposable income is the amount of income individuals have to spend, whereas personal income is the income received, some of which is paid to the government as taxes. Personal disposable income equals personal income less personal income taxes.
72
CHAP. 5]UNEMPLOYMENT, INFLATION, AND NATIONAL INCOME73
Important Terms
Consumer price index (CPI). A price index for goods and services purchased by urban consumers. Cost-push inflation. Inflation caused by large increases in the cost of producing output.
Cyclical unemployment. Unemployment that exists when real output is below an economy's potential output due to an inadequate level of aggregate spending.
Deflation. The annual rate of decrease in the price level.
Demand-pull inflation. Inflation caused by excessive aggregate spending.
Depreciation. The amount of capital used up in producing current GDP.
Disinflation. A decrease in the annual rate of inflation.
Frictional unemployment. Temporary unemployment of members of the labor force who are between jobs because of temporary layoffs or because they quit previous jobs and are looking for new ones.
GDP deflator. The price index for the output included in GDP.
Inflation. The annual rate of increase in a price index.
Labor force. As measured in the United States, the number of persons 16 years of age or older who are employed (working for pay) or are unemployed and looking for paid work.
National income (NI). Income earned by the factors of production.
Natural rate of unemployment. The unemployment rate that exists when real GDP equals potential GDP and the GDP gap is zero.
Net national product (NNP). GNP less allowance for the depreciation of the economy's stock of capital.
Okun's law. A 1% unemployment rate exists for each 2% that real GDP falls below the economy's potential GDP.
Personal disposable income. Personal income less income taxes; the income which individuals have available for spending.
Price index. An index that relates the average price of a bundle of commodities in a specific period to the average price of these commodities during a reference period.
Producer price index (PPI). A price index for goods at the wholesale level, specifically finished goods, intermediate goods, and crude materials.
Replacement investment. The amount of capital needed to replace capital that depreciated (was used up) in producing current GDP.
Structural unemployment. Unemployment in which members of the labor force are out of work because their skills are no longer demanded due to a change in the structure of demand or technological improvements.
Unemployment rate. The percent of the total labor force which is unemployed.
Outline of Chapter 5: Unemployment, Inflation, and National Income
5.1Unemployment and the Labor Force
5.2Cost of Unemployment
5.3 The Price Level
5.4 Inflation
5.5Cost of Inflation
5.6 Measuring Domestic Output
5.7 Measuring Personal Disposable Income
74UNEMPLOYMENT. INFLATION, AND NATIONAL INCOME[CHAP. 5
5.1 UNEMPLOYMENT AND THE LABOR FORCE
The U.S. labor force does not include the entire population but only those who are 16 years of age or older, employed, or unemployed and looking for work. In 1990, 49.6% of the U.S. population was in the labor force; 23.0% of the U.S. population was under 16 years of age, while 27.4% of the U.S. population was retired, in school, homemakers, in the armed services, or institutionalized. Note that a working-age person who is not looking for work is considered voluntarily unemployed and is not included in the labor force. It therefore follows that the size of the labor force and the number of people unemployed can be understated when a significant number of workers, after a prolonged search, become discouraged and stop looking for work.
The unemployment rate is the percent of the total labor force which is unemployed. Individuals can become unemployed due to frictional, structural, or cyclical causes. Frictional unemployment is temporary and occurs when a person (1) quits a current job before securing a new one, (2) is not immediately hired when first entering the labor force, or (3) is let go by a dissatisfied employer. Workers who lose their jobs because of a change in the demand for a particular commodity or because of technological advance are structurally unemployed; their unemployment normally lasts for a longer period since they usually possess specialized skills which are not demanded by other employers. Cyclical unemployment is the result of insufficient aggregate demand. Workers have the necessary skills and are available to work, but there are insufficient jobs because of inadequate aggregate spending. Cyclical unemployment occurs when real GDP falls below potential GDP, i.e., there is a positive GDP gap. Full employment exists when there is no cyclical unemployment but normal amounts of frictional and structural unemployment; thus, full employment exists at an unemployment rate greater than zero. Economists refer to the full-employment rate of unemployment as the natural rate of unemployment. The natural rate of unemployment may change when there is a change in the normal amount of frictional and structural unemployment.
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Actual unemployment rate
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1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 Year
Fig. 5-1
EXAMPLE 5.1. Figure 5-I presents the U.S. unemployment rate and its natural rate of unemployment from 1965 through 1988. Note that the natural rate of unemployment, while relatively constant during this period, increases from 5.6% in 1965 to 6.0% in 1980. The difference between the natural rate of unemployment and the actual unemployment rate reflects cyclical unemployment. Cyclical unemployment is positive when potential GDP exceeds real GDP and negative when real GDP is greater than potential GDP. The cyclical unemployment rate increases when economic activity contracts and the economy enters a recession (1970, 1974, 1980, 1982, 1990). Note that cyclical unemployment is negative between 1965 and 1970 (the Vietnam War period) when real GDP exceeds potential GDP and the U.S. economy is producing beyond its normal full-employment level. A negative cyclical unemployment rate indicates that the normal job search period for those who are frictionally and structurally unemployed is shortened because of an abnormally large number of job openings.
CHAP. 51UNEMPLOYMENT, INFLATION, AND NATIONAL INCOME75
5.2 COST OF UNEMPLOYMENT
Cyclical unemployment imposes costs upon both society and the person unemployed. Society's cost is an opportunity cost—the amount of output which is not produced and therefore is lost forever. Okun's law, formulated by the late Yale economist Arthur Okun, states that the unemployment rate is I% above the natural rate for each 2% that real GDP falls below potential GDP. For example, an economy that has a potential output of $100 billion but actually produces only $98 billion has an unemployment rate 1% above the natural rate: the opportunity cost of this I% cyclical unemployment rate is the $2 billion output that is not produced. In addition to this macroeconomic cost, unemployed workers bear a personal cost: loss of income, loss of skills when unemployed over an extended period of time, and loss of self-esteem. These personal costs that occur during an economic downturn are unevenly distributed between white-collar and blue-collar workers, men and women, blacks and whites, and young and middle-aged workers.
EXAMPLE 5.2. Table 5-1 presents the unemployment rate by sex, age. and race in 1992, when U.S. real output was considerably below potential output, and in 1987, when U.S. real GDP equaled potential GDP. Note that the unemployment rate is always higher for 16- to 19-year-olds than for those 20 and older, and higher for blacks and others than for whites. Also note that when the economy is below its potential, the incidence of unemployment is dramatically higher for 16- to 19-year-olds than for those 20 and older, and dramatically higher for blacks and others than for whites.
Table 5-1 U.S. Unemployment Rates, 1992
and 1987
All civilian workers / 7.4 / 6.2
By age:
16-19 / 20.0 / 16.9
All males 16-19 / 21.5 / 17.8
All females 16-19 / 18.5 / 15.9
Males 20 and older / 6.9 / 5.4
Females 20 and older / 6.3 / 5.4
By race:
White / 6.5 / 5.3
Black and other / 12.7 / 11.6
By sex:
Female / 6.9 / 6.2
Male / 7.8 / 6.2
SOURCE Economic Report of the President, 1994
5.3 THE PRICE LEVEL
A price index relates prices in a specific year (month or quarter) to prices during a reference period. For example, the consumer price index (CPI), the most frequently quoted price index, relates the prices that urban consumers paid for a fixed basket of approximately 400 goods and services in a given month to the prices that existed during a reference period. Column 2 in Table 5-2 presents the annual CPI for 1975 through 1993. The reference period for all consumer prices in Table 5-2 is 1982-1984. The 109.6 index for consumer prices in 1986 relative to the 100 index for 1982-1984 indicates that prices in 1986 are 9.6% higher in 1986 than they were during the 1982-1984 reference period. [The difference in the index (9.6) relative to the base year index (100) is 9.6/100 = 0.096 = 9.6%.1
The producer price index (PPI) and GDP deflator are the other two major price indexes, The PPI measures the prices for finished goods, intermediate materials, and crude materials at the wholesale level. Because wholesale prices are eventually translated into retail prices, changes in the PPI for consumer goods are usually a good predictor of changes in the CPI. The GDP deflator is the most comprehensive measure
76UNEMPLOYMENT, INFLATION, AND NATIONAL INCOME[CHAP. 5
of the price level since it measures prices for net exports, investment, and government expenditures, as well as for consumer spending. Because GDP dates are only available quarterly, the CPI, which is published monthly, is used more frequently than the GDP deflator to measure inflation in the United States.
Table 5-2 CPI and Inflation, U.S. 1975-1993
SOURCE: Economic Report of the President, 1994
EXAMPLE 5.3. The CPI for 1975 through 1993 is presented in column 2 of Table 5-2. The reference period, 19821984, has a value of 100. [The average of the indexes for 1982, 1983, and 1984 is 100: (96.5 + 99.6 + 103.9)/3 = 100.1 Prices in earlier and later years can be related to prices in the base period to establish the relative change in prices. For example, the CPI for 1987 is 113.6, indicating that prices in 1987 are 113.6% of what existed in the 1982-1984 period, i.e., prices increased 13.6% between 1982-1984 and 1987. The CPI in 1979 is 72.6. indicating that consumer prices in 1979 are 72.6% of their 1982-1984 level.
5.4 INFLATION
Inflation is the annual rate of increase in the price level. Disinflation is a term used by economists to denote a slowdown in the rate of inflation; deflation exists when there is an annual rate of decrease in the price level. U.S. inflation rates, measured by changes in the CPI, are presented in column 3 of Table 5-2. The U.S. inflation rate has varied from 13.5% in 1980 to 1.9% in 1986. Disinflation existed in the United States from 1980 through 1983 as the rate of inflation declined from 13.5% in 1980 to 3.2% in 1983. While there have been some monthly decreases in the price level, the U.S. economy has not experienced deflation, an annual rate of decrease in the price level, since the 1930s.
EXAMPLE 5.4. Column 3 of Table 5-2 presents annual rates of change in the CPI. The annual rate of change in the CPI is the change in an index between two years relative to the value of the index in the first of these two years. For example, the rate of inflation in 1990 is 5.4% which is the change in the CPI between 1990 and 1989 (6.7 = 130.7 - 124.0) divided by the 1989 index (124.0) and then stated as a percent (6.7/124.0 = 0.0540 = 5.40%). Consumer prices increased 5.4% between 1989 and 1990 and are 30.7% higher in 1990 than they were during the 1982-1984 base period.
CHAP. 51UNEMPLOYMENT. INFLATION, AND NATIONAL INCOME77
Economists identify two distinct causes of inflation: demand-induced inflation and supply-induced inflation. Demand-pull (demand-induced) inflation is inflation that occurs when aggregate spending exceeds the economy's normal full-employment level of output. Demand-pull inflation is normally characterized by both a rising price and rising output level. It generally results in a negative GDP gap and therefore an unemployment rate lower than the natural rate. Cost-push (supply-push) inflation originates from increases in the cost of producing goods and services. It is usually associated with increases in the price level, decreases in aggregate output. and an increase in unemployment. When inflation is caused by supply forces. the real GDP gap is positive and the unemployment rate rises above the natural rate.
,11
ctEXAMPLE 5.5. Aggregate output is yo and the price level is po for aggregate supply and aggregate demand curves AS' and AD' in Fig. 5-2. We shall assume that output y,, is the economy's full-employment level of output. i.e.. the
0
mica actual unemployment rate equals the economy's natural rate of unemployment. An increase in aggregate demand shifts the aggregate demand curve outward from AD' to AD". which moves the equilibrium point from E., to El : the price level increases from po to pi. and real output increases from sn to yi. The AD' to AD" increase in aggregate spending is an example of demand-pull inflation: increased aggregate spending has "pulled up" the price level.
Fig. 5-2
EXAMPLE 5.6, Aggregate output is yo and the price level is po for aggregate supply and aggregate demand curves AS' and AD' in Fig. 5-3. We shall assume that output yo is the economy's full-employment level of output. A substantial
MW increase in the price of a basic raw material, such as oil, shifts the aggregate supply curve inward from AS' to AS" and changes the equilibrium point from En to Et; the price level increases from po to Pt. and aggregate output falls from yo to yi. The substantial increase in production costs. corns paribus, pushes up the price level: inflation is induced by a decrease in aggregate supply.
5.5 COST OF INFLATION
Inflation can slow economic growth, redistribute income and wealth, and cause economic activity to contract. Inflation impairs decision making since it creates uncertainty about future prices and/or costs and distorts economic values. For example, an individual may postpone the purchase of a condominium or a business may postpone the purchase of equipment because of increasing uncertainty about the purchasing power of future monetary streams (Example 5.7). Such postponed capital outlays slow capital formation and economic growth. Incorrectly anticipated inflation will lower the real income and wealth of individuals and result in less consumer spending and a lower level of real GDP (Example 5.8).