Macroeconomic Goals 17.1
17 c h a p t e r
THREE MAJOR MACROECONOMIC GOALS
Recall from Chapter 1 that macroeconomics is the study of the whole economy—the study of the forest, not the trees. Nearly every society has been interested in three major macroeconomic goals: (1) maintaining employment of human resources at relatively high levels, meaning that jobs are relatively plentiful and financial suffering from lack of work and income is relatively uncommon; (2) maintaining prices at a relatively stable level so that consumers and producers can make better decisions; and (3) achieving a high rate of economic growth, meaning a growth in output per person over time. We use the term real gross domestic product (RGDP) to measure output or production. The term real is used to indicate that the output is adjusted for the general increase in prices over time. Technically, gross domestic product (GDP) is defined as the total value of all final goods and services produced in a given period, such as a year or a quarter.
WHAT OTHER GOALS ARE IMPORTANT?
In addition to these primary goals, most societies are concerned, at various times, about other economic issues, some of which are essentially microeconomic in character. For example, “quality of life” issues have prompted some societies to try to reduce “bads,” such as pollution and crime, and increase goods and services, such as education and health services. Another goal has been “fairness” in the distribution of income or wealth. Still another goal pursued in many nations at one time or another has been self-sufficiency in the production of certain goods and services. For example, in the 1970s, the United States implemented policies that reduced U.S. reliance on other nations for supplies of oil, partly for reasons of national security.
HOW DO VALUE JUDGMENTS AFFECT ECONOMIC GOALS?
In stating that nations have economic goals, we must acknowledge that nations are made up of individuals.
Individuals within a society may differ considerably in how they evaluate the relative importance of certain issues, or even in whether they consider certain “problems” really to be problems after all. For example, most people view economic growth positively, but there are those who consider it less favorably. While some citizens may think the income distribution is just about right, others might think it provides insufficient incomes to the poorer members of society; still others think it involves taking too much income from the relatively well-todo and thereby reduces incentives to carry out productive, income-producing activities.
ACKNOWLEDGING OUR GOALS: THE EMPLOYMENT ACT OF 1946
Many economic problems—particularly those involving unemployment, price instability, and economic stagnation—are pressing concerns for the U.S. government. In fact, it was the concern over both unemployment and price instability that led to the passage of the Employment Act of 1946, which requires the U.S. government to pursue unemployment policies that are also consistent with price stability.
This was the first formal acknowledgment of these primary macroeconomic goals.
356 CHAPTER SEVENTEEN | Macroeconomic Goals
Macroeconomic Goals
s e c t i o n
17.1
_ What are the most important macroeconomic goals in the United States?
_ Are these goals universal?
_ How has the United States shown its commitment to these goals?
THE CONSEQUENCES OF HIGH UNEMPLOYMENT
Nearly everyone agrees that it is unfortunate when a person who wants a job cannot find one. A loss of a job can mean financial insecurity and a great deal of anxiety. High rates of unemployment in a society can increase tensions and despair. A family without income from work undergoes great suffering; as a family's savings fade, family members wonder where they are going to obtain the means to survive.
Society loses some potential output of goods when some of its productive resources—human or nonhuman—remain idle, and potential consumption is reduced. Clearly, then, there is a loss in efficiency when people willing to work and equipment able to produce remain idle. That is, other things equal, relatively high rates of unemployment are viewed almost universally as undesirable.
WHAT IS THE UNEMPLOYMENT RATE?
When discussing unemployment, economists and politicians refer to the unemployment rate. To calculate the unemployment rate, you must first understand another important concept—the labor force. The labor force is the number of people over the age of 16 who are available for employment, whether or not they are currently employed, as seen in Exhibit 1. The civilian labor force figure excludes people in the armed services and those in prisons or mental hospitals. Other people regarded as outside the labor force include homemakers, retirees, and full-time students. These groups are excluded from the labor force because they are not considered currently available for employment.
When we say that the unemployment rate is 5 percent, we mean that 5 percent of the population over the age of 16 who are willing and able to work are unable to get jobs. That 5 percent means 5 out of 100 people in the total labor force are unemployed.
To calculate the unemployment rate, we simply divide the number of unemployed by the number in the civilian labor force.
Unemployment rate 5 Number of unemployed/ Civilian labor force In September 2003, the number of civilians unemployed in the United States was 9 million and the civilian labor force totaled 147 million. Using this data, we can calculate that the unemployment rate in September 2003 was 6.1 percent.
Unemployment rate 5 9 million/147 million 5
.061 3 100 5 6.1 percent
THE WORST CASE OF U.S. UNEMPLOYMENT
By far the worst employment downturn in U.S. history occurred during the Great Depression, which
Employment and Unemployment 357
1. The most important U.S. macroeconomic goals are full employment, price stability, and economic growth.
2. Individuals each have their own reasons for valuing certain goals more than others.
3. The United States showed its commitment to the major macroeconomic goals with the Employment Act of 1946.
1. What are the three major economic goals of most societies?
2. What is the Employment Act of 1946? Why was it significant?
s e c t i o n c h e c k
Employment and Unemployment
s e c t i o n
17.2
_ What are the consequences of unemployment?
_ What is the unemployment rate?
_ Does unemployment affect everyone equally?
_ What causes unemployment?
_ How long are people typically unemployed?
began in late 1929 and continued until 1941. Unemployment rose from only 3.2 percent of the labor force in 1929 to more than 20 percent in the early 1930s, and double-digit unemployment persisted through 1941. The debilitating impact of having millions of productive people out of work led Americans (and people in other countries as well) to say, “Never again.” Some economists would argue that modern macroeconomics, with its emphasis on the determinants of unemployment and its elimination, truly began in the 1930s.
VARIATIONS IN THE UNEMPLOYMENT RATE
Exhibit 2 shows the unemployment rates over the last 40 years. Unemployment since 1960 has ranged from a low of 3.5 percent in 1969 to a high of 9.7 percent in 1982. Unemployment in the worst years is two or more times what it is in good years. Before 1960, variations in unemployment were more pronounced.
358 CHAPTER SEVENTEEN | Macroeconomic Goals
Civilians Employed
(137.6 million)
Unemployed
(9 million)
Out of Labor Force
(75.2 million) (221.8 million)
Total Adult Population
(147 million)
Labor Force (Employed + Unemployed)
The U.S. Labor Force, 2003 SECTION 17.2
EXHIBIT 1
10% 9 8 7 6 5 4 3 2 1 0 1960 1965 1970 1975 1980
Year
1990 1985 1995 2000 2003
U.S. Unemployment Rate Percent
Unemployment Rates SECTION 17.2
EXHIBIT 2
SOURCE: Bureau of Labor Statistics, September 2003.
SOURCE: Bureau of Labor Statistics, September 2003.
ARE UNEMPLOYMENT STATISTICS ACCURATE REFLECTIONS OF THE LABOR MARKET?
In periods of prolonged recession, some individuals think that the chances of landing a job are so bleak that they quit looking. These people are called discouraged workers. Individuals who have not actively sought work for four weeks are not counted as unemployed; instead, they fall out of the labor force. Also, people looking for full-time work who grudgingly settle for part-time jobs are counted as “fully” employed, even though they are only “partly” employed. However, at least partially balancing these two biases in government employment statistics is the number of people who are overemployed—that is, working overtime or more than one job. Also, a number of jobs in the underground economy (e.g., drug dealing, prostitution, gambling, and so on) are not reported. In addition, many people may claim they are seeking work when, in fact, they may just be going through the motions so they can continue to collect unemployment compensation or receive other government benefits.
WHO ARE THE UNEMPLOYED?
Unemployment usually varies greatly between different segments of the population and over time.
Education as a Factor in Unemployment
According to the Bureau of Labor Statistics, the unemployment rate across the sexes and races among college graduates is significantly lower than for those who do not complete high school. In April 2002, the unemployment rate for individuals without high school diplomas was 9.0 percent compared with 4.7 percent for those with college degrees.
Further, college graduates have lower unemployment rates than people who have some college education but did not complete their bachelor's degrees (5.7 percent).
Age, Sex, and Race as Factors in Unemployment
The incidence of unemployment varies widely among the population. Unemployment tends to be greater among the very young, among blacks and other minorities, and among workers with few skills. The unemployment rate for adult females tends to be higher than that for adult males.
Considering the great variations in unemployment for different groups in the population, we calculate separate unemployment rates for groups classified by sex, age, race, family status, and type of occupation. Exhibit 3 shows unemployment rates for various groups. Note that the variation around the average unemployment rate for the total population of 5.7 percent was considerable. The unemployment rate for blacks and Hispanics was much higher than the rate for whites, a phenomenon that has persisted throughout the post-World War II period. Unemployment among teenagers was much higher than adult unemployment, at 16.4 percent. Some would regard teenage unemployment a lesser evil than unemployment among adults, because most teenagers have parents or guardians on whom they can rely for subsistence.
CATEGORIES FOR UNEMPLOYED WORKERS
According to the Bureau of Labor Statistics, there are four main categories of unemployed workers:
job losers (those who were temporarily laid off or fired), job leavers (those who quit their jobs), reentrants
(those who worked before and are reentering the labor force), and new entrants (those entering the labor force for first time—primarily, teenagers).
It is a common misconception that most workers are unemployed because they have lost their jobs.
While job losers may typically account for 50 percent to 60 percent of the unemployed, a sizable fraction is due to job leavers, new entrants, and reentrants, as seen in Exhibit 4.
Employment and Unemployment 359 Teenagers have the highest rates of unemployment. Do you think it would be easier for them to find jobs if they had more experience and higher skill levels?
© SW Productions/Photodisc/Getty One Image
HOW MUCH UNEMPLOYMENT?
While unemployment is painful to those who have no source of income, reducing unemployment is not costless. In the short run, a reduction in unemployment may come at the expense of a higher rate of inflation, especially if the economy is close to full capacity, where resources are almost fully employed.
Moreover, trying to match employees with jobs quickly can lead to significant inefficiencies because of mismatches between a worker's skill level and the level of skill required for a job. For example, the economy would be wasting resources subsidizing education if people with Ph.D.'s in biochemistry were driving taxis or tending bar.
That is, the skills of the employee may be higher than that necessary for the job, resulting in what economists call underemployment. Another cause of inefficiencies is placing employees in jobs beyond their abilities.
THE AVERAGE DURATION OF UNEMPLOYMENT
The duration of unemployment is equally as important as the amount of unemployment. The financial consequences of a head of household being unemployed 4 or 5 weeks are usually not extremely serious, particularly if the individual is covered by an unemployment compensation system. The impact becomes much more serious if a person is unemployed for several months. Therefore, it is useful to look at the average duration of unemployment to discover what percentage of the labor force is unemployed longer than a certain period, say 15 weeks. Exhibit 5 presents data on the duration of unemployment. As you can see in this table, roughly 30 percent of the unemployed were out of work less than 5 weeks, and 23 percent of the total
360 CHAPTER SEVENTEEN | Macroeconomic Goals
a. U.S. Unemployment, by Sex and Age b. U.S. Unemployment, by Race or Ethnic Group
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0%
Total Population Men Women Teenagers (16-19 years)
Total Population White Black Hispanic Unemployment Rate Unemployment Rate
Unemployment in the United States by Age, Sex, and Race SECTION 17.2
EXHIBIT 3
Job losers
55.9%
Reentrants
26.9%
Job leavers
9.4%
New entrants
7.8%
Reasons for Unemployment
SECTION 17.2
EXHIBIT 4
SOURCE: Bureau of Labor Statistics.
SOURCE: Bureau of Labor Statistics, September 2003.
unemployed were out of work for more than six months. The duration of unemployment tends to be greater when the amount of unemployment is high and smaller when the amount of unemployment is low. Unemployment of any duration, of course, means a potential loss of output. This loss of current output is permanent; it is not made up when unemployment starts falling again.
LABOR FORCE PARTICIPATION RATE
The percentage of the population that is in the labor force is what economists call the labor force participation rate. Since 1950, the labor force participation rate has increased from 59.2 percent to 67.1 percent. Most of that change occurred between 1970 and 1990. The increase in the labor force participation rate can be attributed in large part to the entry of the baby boomers into the labor force and a 14.2 percentage point increase in the women's labor force participation rate.
Over the last 50 years, the number of women working has shifted dramatically, reflecting the changing role of women in the workforce. In Exhibit 6, we see that in 1950 less than 34 percent of women were working or looking for work. Today that figure is roughly 60 percent. In 1950, more than 85 percent of men were working or looking for work. Today the labor force participation rate for men has fallen to roughly 74 percent, as many men stay in school longer and opt to retire earlier.
Employment and Unemployment 361
Duration of Unemployment
SECTION 17.2
EXHIBIT 5
Duration Percent Unemployed
Less than 5 weeks 30.3% 5 to 14 weeks 30.8 15 to 26 weeks 15.7 27 weeks and over 23.2
SOURCE: Bureau of Labor Statistics, September 2003.
1950 1960 1970 1980 1990 2002 Total 59.2% 59.4% 60.4% 63.8% 66.4% 66.6%
Men 86.4 83.3 79.7 77.4 76.1 73.8
Women 33.9 37.7 43.3 51.5 57.5 59.8
SOURCE: Bureau of Labor Statistics.
Labor Force Participation Rates for Men and Women SECTION 17.2
EXHIBIT 6
1. The consequences of unemployment to society include a reduction in potential output and consumption—a decrease in efficiency.
2. The unemployment rate is found by taking the number of people officially unemployed and dividing by the number in the civilian labor force.
3. Unemployment rates are the highest for minorities, the young, and less-skilled workers.
4. There are four main categories of unemployed workers: job losers, job leavers, reentrants, and new entrants.
5. The duration of unemployment tends to be greater (smaller) when the amount of unemployment is high (low).
1. What happens to the unemployment rate when the number of unemployed people increase, ceteris paribus? When the labor force grows, ceteris paribus?
2. How might the official unemployment rate understate the “true” degree of unemployment? How might it overstate it?
3. Why might the fraction of the unemployed who are job leavers be higher in a period of strong labor demand?
4. Suppose you live in a community of 100 people. If 80 people are over 16 years old and 72 people are willing and able to work, what is the unemployment rate in that community?
5. What would happen to the unemployment rate if a substantial group of unemployed people started going to school full time? What would happen to the size of the labor force?
6. What happens to the unemployment rate when officially unemployed people become discouraged workers? Does anything happen to employment in this case?
s e c t i o n c h e c k
In examining the status of and changes in the unemployment rate, it is important to recognize that there is not just one kind of unemployment. In this section, we will examine the three types of unemployment —frictional, structural, and cyclical—and evaluate the relative effects of each on the overall unemployment rate.
FRICTIONAL UNEMPLOYMENT
Some unemployment results from people being temporarily between jobs. For example, consider an advertising executive who was fired in Chicago on March 1 and is now actively looking for similar work in San Francisco. This is an example of
frictional unemployment. Of course, not all unemployed workers were fired; some may have voluntarily quit their jobs. In either case, frictional unemployment is short term and results from the normal turnover in the labor market, such as when people change from one job to another.
SHOULD WE WORRY ABOUT FRICTIONAL UNEMPLOYMENT?
Geographic and occupational mobility are considered good for the economy because they generally lead human resources to go from activities of relatively low productivity or value to areas of higher productivity, increasing output in society as well as the wage income of the mover. Hence, frictional unemployment, while not good in itself, is a byproduct of a healthy phenomenon, and because it is often short lived, it is generally not viewed as a serious problem. While the amount of frictional unemployment varies somewhat over time, it is unusual for it to be much less than 2 percent of the labor force. Actually, frictional unemployment tends to be somewhat greater in periods of low unemployment, when job opportunities are plentiful.
This high level of job opportunity stimulates mobility, which, in turn, creates some frictional unemployment.
STRUCTURAL UNEMPLOYMENT
A second type of unemployment is structural unemployment.
Like frictional unemployment, structural unemployment is related to occupational movement or mobility, or in this case, to a lack of mobility.
Structural unemployment occurs when workers lack the necessary skills for jobs that are available or have particular skills that are no longer in demand.
For example, if a machine operator in a manufacturing plant loses his job, he could still remain unemployed despite the openings for computer programmers in his community. The quantity of unemployed workers conceivably could equal the number of job vacancies, but the unemployment persists because the unemployed lack the appropriate skills. Given the existence of structural unemployment, it is wise to look at both unemployment and job vacancy statistics in assessing labor market conditions. Structural unemployment, like frictional unemployment, reflects the dynamic dimension of a changing economy. Over time, new
362 CHAPTER SEVENTEEN | Macroeconomic Goals
Types of Unemployment
s e c t i o n
17.3
_ What are the three types of unemployment?
_ What is frictional unemployment?
_ What is structural unemployment?
_ What is cyclical unemployment?
_ What is the natural rate of unemployment?
What type of unemployment would occur if these coal miners lost their jobs as a result of a reduction in demand for coal and needed retraining to find other employment?
Usually, structural unemployment occurs because of workers' poor skills or long-term changes in demand. Consequently, it generally lasts for a longer period than does frictional unemployment.
© Barry Lewis/CORBIS
jobs open up that require new skills, while old jobs that required different skills disappear. It is not surprising, then, that many people advocate government- subsidized retraining programs as a means of reducing structural unemployment.
The dimensions of structural unemployment are debatable, in part because of the difficulty in precisely defining the term in an operational sense.
Structural unemployment varies considerably— sometimes it is very low and at other times, as in the 1970s and early 1980s, it is high. To some extent, in this latter period, jobs in the traditional sectors like automobile manufacturing and oil production gave way to jobs in the computer and biotechnology sectors. Consequently, structural unemployment was higher.
LABOR MARKET IMPERFECTIONS AND UNEMPLOYMENT
Some unemployment is actually normal and important to the economy. Frictional and structural unemployment is simply unavoidable in a vibrant economy. To a considerable extent, we can view both frictional and structural unemployment as phenomena resulting from imperfections in the labor market. For example, if individuals seeking jobs and employers seeking workers had better information about each other, the amount of frictional unemployment would be considerably lower.
It takes time for suppliers of labor to find the demanders of labor services, and it takes time and money for labor resources to acquire the necessary skills. But because information and job search are costly, bringing together demanders and suppliers of labor services does not occur instantaneously.
CYCLICAL UNEMPLOYMENT
Often, unemployment is composed of more than just frictional and structural unemployment. In years of relatively high unemployment, some joblessness may result from short-term cyclical fluctuations in the economy. We call this cyclical unemployment.
Whenever the unemployment rate is greater than normal, as during a recession, there is cyclical unemployment. Most attempts to solve the cyclical unemployment problem have emphasized increasing aggregate demand to counter recession.
THE NATURAL RATE OF UNEMPLOYMENT
It is interesting to observe that over the period in which annual unemployment data are available, the median, or “typical,” annual unemployment rate has been at or slightly above 5 percent. Some economists call this typical unemployment rate the natural rate of unemployment. When unemployment rises well above 5 percent, we have abnormally high unemployment; when it falls below 5 percent, we have abnormally low unemployment. The natural rate of unemployment of approximately 5 percent roughly equals the sum of frictional and structural unemployment when they are at their maximums. Thus, we can view unemployment rates below the natural rate as reflecting the existence of below-average levels of frictional and structural unemployment.
When unemployment rises above the natural rate, however, it reflects the existence of cyclical unemployment. In short, the natural rate of unemployment is the unemployment rate when there is neither a recession nor a boom.
For the most part, economists have come to accept a current range between 5 percent and 5.5 percent for the natural rate of unemployment. The natural rate of unemployment can change over time as technological, demographic, institutional, and other conditions vary. For example, as baby boomers have aged, the natural rate has fallen because middle-aged workers generally have lower unemployment rates than do younger workers. In addition, the internet and job placement agencies
Types of Unemployment 363
Are layoffs more prevalent during a recession than a recovery? Do most resignations occur during a recovery?
Layoffs are more likely to occur during a recession.
When times are bad, employers are often forced to let workers go. Resignations are relatively more prevalent during good economic times because there are more job opportunities for those seeking new jobs.
CYCLICAL UNEMPLOYMENT
USING WHAT YOU'VE LEARNED
A Q
have improved access to employment information and allowed workers to find jobs more quickly.
Also, the new work requirements of the welfare laws have increased the number of people with jobs. Thus, the natural rate is not fixed because it can change with demographic changes over time.
Full Employment and Potential Output
When all the resources of an economy— labor, land, and capital—are fully employed, the economy is said to be producing its potential output—the amount these resources could produce if they were fully employed.
Literally, full employment of labor means that the economy is providing employment for all who are willing and able to work with no cyclical unemployment. It also means that capital and land are fully employed. That is, at the natural rate of unemployment, all resources are fully employed, the economy is producing its potential output, and there is no cyclical unemployment. This does not mean the economy will always be producing at its potential output of resources. For example, when the economy is experiencing cyclical unemployment, the unemployment rate is greater than the natural rate. It is also possible that the economy can temporarily exceed the natural rate as workers take on overtime or moonlight by taking on extra employment.
364 CHAPTER SEVENTEEN | Macroeconomic Goals
UNEMPLOYMENT AROUND THE GLOBE, 2002
14% 12 10 8 6 4 2 0 Australia
6.3%
Canada
7.6%
Germany
9.8%
Italy
9.1%
France
9.1%
United Kingdom
5.2%
U.S.
5.8%
Japan
5.4%
Sweden
4.0%
GLOBAL WATCH
CONSIDER THIS:
Many developed countries had higher unemployment rates than the United States did in 2002. Generous unemployment benefits and sluggish economic growth in European countries helped cause the higher unemployment rates.
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SOURCE: CIA—The World Factbook, 2003. http://www.cia.gov.
Types of Unemployment 365
(CNN)—Lighthouses have been called the most altruistic structures ever built. After almost 300 years of guiding ships along the U.S. coasts and Great Lakes, their usefulness is waning. But they have never lost their power to ignite poetry in those who visit them.
“Lighthouses are to America what castles are to Europe.
They're among the oldest standing structures in (the U.S.),” says Tim Harrison, editor of the Maine-based Lighthouse Digest.
When the United States became a country, 12 lighthouses kept vigil over settled shores, according to Wayne Wheeler, founder of the U.S. Lighthouse Society. Over the years, he says more than 2,000 light stations were built. Today, the National Park Service estimates about 634 lighthouses remain, 405 of which are in service.
Automation has virtually eliminated the romantic tradition of lighthouse keepers—salty, solitary souls guiding ships safely through treacherous storms. And electronic pings are replacing the mournful drone of the foghorn calling sailors home.
SOURCE: CNN Interactive, Destinations, April 19, 1997.© 1997 Cable News Network, LP, LLLP. An AOL Time Warner Company. All rights reserved.
A LIGHT THAT NEVER GOES OUT
In The NEWS
CONSIDER THIS:
Like elevator operators and service station attendants, lighthouse keepers have given way to automation. In a world of scarcity, lighthouse keepers can now be employed producing something that is more valuable from society's perspective.
1. The three types of unemployment are frictional unemployment, structural unemployment, and cyclical unemployment.
2. Frictional unemployment results when a person moves from one job to another as a result of normal turnovers in the economy.
3. Structural unemployment results when people who are looking for jobs lack the required skills for the jobs that are available or a long-term change in demand occurs.
4. Cyclical unemployment is caused by a recession.
5. Imperfections in the labor market and institutional factors result in higher rates of unemployment.
6. When cyclical unemployment is almost completely eliminated, our economy is said to be operating at full employment, or at a natural rate of unemployment.
1. Why do we want some frictional unemployment?
2. Why might a job retraining program be a more useful policy to address structural unemployment than to address frictional unemployment?
3. What is the traditional government policy “cure” for cyclical unemployment?
4. What types of unemployment are present at full employment (at the natural rate of unemployment)?
5. Why might frictional unemployment be higher in a period of plentiful jobs (low unemployment)?
6. If the widespread introduction of the automobile caused a productive buggy whip maker to lose his job, would he be structurally or frictionally unemployed?
7. If a fall in demand for domestic cars causes auto workers to lose their jobs in Michigan, while there are plenty of jobs for lumberjacks in Montana, what kind of unemployment results?
s e c t i o n c h e c k
©Jeremy Woodhouse/PhotoDisc/GettyOneImages
WHY DOES UNEMPLOYMENT EXIST?
In many markets, prices adjust to the market equilibrium price and quantity, and no prolonged periods of shortage or surplus occur. However, in labor markets, obstacles prevent wages from adjusting and balancing the quantity of labor supplied and the quantity of labor demanded. In Exhibit 1, we see that W1 is higher than the market equilibrium wage that equates the quantity demanded of labor with the quantity supplied of labor. At W1, the quantity of labor supplied is greater than quantity of labor demanded, resulting in an excess quantity supplied of labor—unemployment. That is, more people want to work at the going (nonequilibrium) wage than employers want to hire, and those who are not able to find work are “unemployed.” Why is this so? Economists have cited three reasons for the failure of wages to balance the labor demand and labor supply equilibrium—minimum wages, unions, and the efficiency wage theory.
MINIMUM WAGES AND UNEMPLOYMENT
Many different types of labor markets exist for different types of workers. The labor market for workers with little experience and job skills is called the unskilled labor market. Suppose the government decided to establish a minimum wage rate (an hourly wage floor) for unskilled workers above the equilibrium wage, WE. At the minimum wage, the quantity of labor supplied grows because more people are willing to work at a higher wage. However, the quantity of labor demanded falls because some employers would find it unprofitable to hire low-skilled workers at the higher wage. At W1, a gap exists between the quantity of labor demanded and the quantity supplied, representing a surplus of unskilled workers—unemployment, as seen in Exhibit 1.
THE IMPACT OF UNIONS ON THE UNEMPLOYMENT RATE
Unions negotiate their wages and benefits collectively through their union officials, a process called collective bargaining. If, through this process of collective bargaining, union officials are able to increase wages, then unemployment will rise in the union sector. If the bargaining raises the union wage above the equilibrium level, the quantity of union labor demanded will decrease, and the quantity of union labor supplied will increase —that is, union workers will be unemployed. The union workers that still have their jobs will be better off,
366 CHAPTER SEVENTEEN | Macroeconomic Goals
Reasons for Unemployment
s e c t i o n
17.4
_ How does a higher minimum wage lead to greater unemployment among the young and unskilled?
_ Can unions cause higher rates of unemployment?
_ How does an efficiency wage cause a higher rate of unemployment?
_ How do changes in job search costs affect the unemployment rate?
_ Does unemployment insurance increase the unemployment rate?
0 W1
WE
QE QD QS
Labor Supply Surplus of Labor (Unemployment) Labor Demand
Quantity of Labor Real Wage
Wages Above Equilibrium Lead to Greater Unemployment
SECTION 17.4
EXHIBIT 1
The labor market is in equilibrium where the quantity demanded of labor is equal to the quantity supplied of labor, at
WE and QE. If the wage persists above the equilibrium wage, a surplus of labor or unemployment of QS 3 QD exists. That is, at
W1, the quantity of labor supplied is greater than the quantity of labor demanded; this surplus of labor we can think of as unemployment.
but some who are equally skilled will be unemployed and will either seek nonunion work or wait to be recalled in the union sector. Many economists believe that is why wages are approximately 15 percent higher in union jobs, even when nonunion workers have comparable skills.
This has the potential to lead to a problem called the insider-outsider hypothesis. Insiders are the union members who have little or no concern for outsiders—nonmembers or previous members who would like to be insiders. Because insiders have some control over wages and hiring through their union officials, they may be effective in keeping the union wage above the equilibrium wage even in a recession. During a recession, the unemployed outsiders might be willing to work for lower wages, but employers and insiders might view this as undercutting their efforts to keep wages up. That is, the disruption and morale problem associated with hiring outsiders at a lower wage might lead to prolonged periods of unemployment.
EFFICIENCY WAGE
In economics, it is generally assumed that as productivity rises, wages rise, and workers can raise their productivity through investments in human capital like education and on-the-job training.
However, some economists follow the efficiency wage model, which is based on the belief that
higher wages lead to greater productivity.
In the efficiency wage model, employers pay their employees more than the equilibrium wage to be more efficient. Proponents of this theory suggest that it may lead to attracting the most productive workers, fewer job turnovers, and higher morale, which in turn can lead to lower hiring and training costs. Because the efficiency wage rate is greater than the equilibrium wage rate, the quantity of labor supplied is greater than the quantity of labor demanded, resulting in greater amounts of unemployment.
In 1914, Henry Ford increased his workers' wages from $3 to $5 per day—roughly twice the going wage rate for unskilled workers. This wage rate led to long lines of workers seeking jobs at the Ford plant—that is, quantity supplied greatly exceeded quantity demanded at the efficiency wage rate. Ford knew that assembly line work was boring, and to overcome the problem he was having with morale and absenteeism, he decided to increase daily wages to $5 a day. At the time, many business leaders were skeptical because this put Ford's labor costs at nearly twice that of his rivals.
However, Ford profits continued to mount. How did this happen? Historical records suggest that the efficiency wage led to lower turnovers, less absenteeism, better hires, and less shirking—in short, greater worker productivity. Even though the higher wages led to higher labor costs, overall production costs fell with the gains in labor productivity.
Some scholars have argued that the positive effects of the efficiency wage are unique to assembly line production, where there is a high degree of worker interdependence.
JOB SEARCH
Another reason for unemployment has to do with the nature of labor markets. Because of frictional unemployment, some unemployment would exist even if labor supply and labor demand were balanced.
Different firms offer different compensation packages (salary, fringe benefits, working conditions), and workers are sometimes unaware of these packages when they seek the “best” job available.
It takes time and money to locate the best available opportunities. Also, not all job seekers are the same: They have different tastes and preferences about types of jobs and job locations. Sometimes it is difficult to get the information about particular jobs to the right job candidate. These search activities prolong the duration of unemployment. However, the search goes on because the job seeker hopes to find a better offer.
The labor demand and supply curves are constantly shifting. That is, labor markets are constantly in flux—people losing jobs, leaving jobs, reentering jobs. In a growing and dynamic economy, jobs are constantly being destroyed and created.
This leads to temporary unemployment as workers search for the best jobs for their skills.
UNEMPLOYMENT INSURANCE
Losing a job can lead to considerable hardships, and unemployment insurance is designed to partially offset the severity of the unemployment problem.
The program does not cover those that were fired or quit their jobs. To qualify, recipients must have worked a certain length of time and lost their jobs because the employer no longer needed their skills. The typical compensation is half salary for 26 weeks. While the program is intended to ease
Reasons for Unemployment 367
the pain of unemployment, it also leads to prolonged periods of unemployment, as job seekers stay unemployed for longer periods searching for new jobs.
For example, some unemployed people may show little drive in seeking new employment, because unemployment insurance lowers the opportunity cost of being unemployed. Say a worker making $400 a week when employed receives $220 in compensation when unemployed; as a result, the cost of losing the job is not $400 a week in forgone income but only $180. It has been estimated that the existence of unemployment compensation programs may raise overall unemployment rates by as much as 1 percent.
Without unemployment insurance, a job seeker would be more likely to take the first job offered, even if the job did not match the job seeker's preferences or skill levels. A longer job search might mean a better match, but it comes at the expense of lost production and greater amounts of tax dollars.
DOES NEW TECHNOLOGY LEAD TO GREATER UNEMPLOYMENT?
Although many believe that technological advances inevitably result in the displacement of workers, this is not necessarily the case. Generally, new inventions are cost saving, and these cost savings usually generate higher incomes for producers and lower prices and better products for consumers— benefits that ultimately result in the growth of other industries. If the new equipment is a substitute for labor, it might displace workers. For example, many fast-food restaurants have installed selfservice beverage bars to replace workers. However, new capital equipment requires new workers to manufacture and repair the new equipment. The most famous example of this is the computer, which was supposed to displace thousands of workers. Instead, the computer generated a whole new growth industry that created jobs. The problem is that it is easy to see only the initial effect of technological advances (displaced workers) but difficult to recognize the implications of that invention throughout the whole economy over time.
368 CHAPTER SEVENTEEN | Macroeconomic Goals
Will new technology in one industry displace workers in the whole economy? No. Some job loss may occur for specific jobs or within specific industries. However, the overall effect of technological improvement is the release of scarce resources, which expands output and employment in other areas, and ultimately greater economic growth and a higher standard of living.
If unemployment insurance (compensation) benefits increased, would this line be even longer? While unemployment insurance reduces the hardships involved with unemployment, it also increases the rate of unemployment.
Studies indicate that unemployment insurance reduces the search efforts of the unemployed.
© Lisa Quinones/Black Star/PictureQuest © Bob Sacha/Aurora/PictureQuest
STABLE PRICE LEVEL AS A DESIRABLE GOAL
Just as full employment brings about one kind of economic security, an overall stable price level increases another form of economic security. Most prices in the U.S. economy tend to rise over time.
The continuing rise in the overall price level is called
inflation. Even when the level of prices is stable, some prices will be rising while others are falling.
However, when inflation is present, the goods and services with rising prices will outweigh the goods and services with lower prices. Without stability in the price level, consumers and producers will experience more difficulty in coordinating their plans and decisions. When the overall price level is falling, there is deflation. The average price level in the U.S.
economy fell throughout the late 19th century.
In general, the only thing that can cause a sustained
increase in the rate of inflation is a high rate of growth in money, a topic we will discuss thoroughly in upcoming chapters.
THE PRICE LEVEL OVER THE YEARS
Unanticipated and sharp changes in the price level are almost universally considered to be “bad” and to require a policy remedy. What is the historical record of changes in the overall U.S. price level? Exhibit 1 shows changes in the consumer price index (CPI), the standard measure of inflation, from 1914 to 2003. Can you believe that in 1940, stamps were three cents per letter, postcards were a penny, the median price of a house was $2,900, and the price of a new car was $650? However, the problem with
Inflation 369
1. Economists have cited three reasons why wages have failed to bring the quantity of labor demanded into balance with the quantity of labor supplied—minimum wage, unions, and the efficiency wage theory.
2. At the minimum wage, the quantity of labor supplied grows because more people are willing to work at a higher wage.
However, the quantity of labor demanded falls because some employers would find it unprofitable to hire low skilled workers at the higher wage. That is, a higher minimum wage can lead to higher rates of unemployment—particularly among unskilled teenagers.
3. According to the insider-outsider hypothesis, insiders are the union members who have little or no concern for outsiders —non-members or previous members who would like to be insiders. Because insiders have some control over wages and hiring, through their union officials, they may be effective in keeping the union wage above the equilibrium wage even in a recession.
4. If the efficiency wage rate is greater than the equilibrium wage rate, the quantity of labor supplied is greater than the quantity of labor demanded, resulting in greater amounts of unemployment.
5. Sometimes it is difficult to get the information about particular jobs to the right job candidate. These search activities prolong the duration of unemployment.
6. Some unemployed persons may show little drive in seeking new employment, given the existence of unemployment compensation. Unemployment compensation lowers the opportunity cost of being unemployed.
1. What are the three reasons for wages to fail to balance labor supply and labor demand?
2. What is the insider-outsider hypothesis?
3. What is an efficiency wage?
4. How do search costs lead to prolonged periods of unemployment?
5. Why would higher unemployment compensation in a country like France lead to higher rates of unemployment?
6. Does new technology increase unemployment?
s e c t i o n c h e c k
Inflation
s e c t i o n
17.5
¡ Why is the overall price level important?
¡ How has the price level behaved this century?
¡ Who are the winners and losers during inflation?
¡ Can wage earners avoid the consequences of inflation?
comparing prices today with prices in the past is that it focuses on the number of dollars it takes to buy something rather than the purchasing power of the dollar. For example, if prices and wages both doubled overnight, raising the price of a quart of milk from $1 to $2, you would be no worse off because you would still work the same number of minutes to buy a quart of milk.
WHO LOSES WITH INFLATION?
Inflation brings about changes in peoples' real incomes, and these changes may be either desirable or undesirable. Suppose you retire on a fixed pension of $2,000 per month. Over time, that $2,000 will buy less and less if prices generally rise. Your real income—your income adjusted to reflect changes in purchasing power—falls. Inflation lowers income in real terms for people on fixed-dollar incomes.
Likewise, inflation can hurt creditors. Suppose you loaned someone $1,000 in 1985 and were paid back $1,000 plus interest in 2003. The $1,000 in principal you were paid back actually is worth less in 2003 than it was in 1985 because inflation has eroded the purchasing power of the dollar. Thus, inflation erodes the real wealth of the creditor. Another group that sometimes loses from inflation, at least temporarily, comprises people whose incomes are tied to long-term contracts. If inflation begins shortly after a labor union signs a three-year wage agreement, it may completely eat up the wage gains provided by the contract. The same applies to businesses that agree to sell quantities of one thing, say coal, for a fixed price for a given number of years.
If some people lose because of changing prices, others must gain. Debtors pay back dollars worth less in purchasing power than those borrowed.
Corporations that can quickly raise the prices on their goods may have revenue gains greater than their increases in costs, providing additional profits.
Wage earners sometimes lose from inflation because wages may rise at a slower rate than the price level. The redistributional impact of inflation is not the result of conscious public policy; it just happens.
The uncertainty that inflation creates can also discourage investment and economic growth. When inflation rates are high, they also tend to vary considerably and that creates a lot of uncertainty. This uncertainty complicates planning for businesses and households, which is vital to capital formation.
Moreover, inflation can raise one nation's price level relative to that in other countries. In turn, this can make financing the purchase of foreign goods difficult, or it can decrease the value of the national currency relative to that of other countries. In its extreme form, inflation can lead to a complete erosion in faith in the value of the pieces of paper we commonly call money. In Germany after both world wars, prices rose so fast that people in some cases finally refused to take paper money, insisting instead on payment in goods or metals whose prices
370 CHAPTER SEVENTEEN | Macroeconomic Goals
30% 20% 10% 0%
-10%
-20%
-30% 1910 1920 1930 1940 1950
Year Percent
1970 1980 1960 1990 2000
Consumer Price Index
All Urban Consumers (CPI-U), Annual Percentage Change
The Price Level in the United States, 1914-2003 SECTION 17.5
EXHIBIT 1
SOURCE: Bureau of Labor Statistics, 2003.
tend to move predictably with inflation. Unchecked inflation can feed on itself and ultimately lead to hyperinflation of 300 percent or more per year. We saw these rapid rates of inflation in Argentina in the 1980s and Brazil in the 1990s. Most economists believe we can live quite well in an environment of low, steady inflation, while no economist believes we can prosper with high, variable inflation.
UNANTICIPATED INFLATION DISTORTS PRICE SIGNALS
High inflation also distorts economic decisions by affecting after-tax income because many aspects of the tax system are not indexed for inflation, such as the capital gains tax. (A capital gain is the difference between the price at which an asset—for
Inflation 371
By Peter G. Gosselin
Washington—For half a century, Americans have assumed that when it comes to prices, there is only one direction—up.
We railed against this apparent fact when the inflation of the 1970s eroded the value of our money. We reveled in it when the boom of the `90s sent our stock values through the roof. But one way or another, we've always taken it for granted that prices only rise.
Now comes word from the folks at the Federal Reserve that up may not be the only direction after all, and that we may be on the verge of a deflation—a broad price decline.
If they're right, hold on to your hats. We could be headed for a looking-glass world in which all the familiar rules of work, money, investment, even daily life get turned on their heads.
“Alice in Wonderland has nothing up on deflation. It would upset almost every settled notion we have about our economic lives,” said Roger M. Kubarych, a former senior Fed official who now is an executive with HVB Americas Inc., the U.S. subsidiary of a major German bank.
To fully appreciate how different an era of down could be from the now possibly passing age of up, it's important to make a distinction.
People generally associate deflation with cataclysms such as the Great Depression, when prices plunged along with almost everything else in the economy.
But it doesn't have to be this way. Prices can fall gently while the economy rises, and they have for substantial chunks of American history; for instance, for much of the period from the end of the Civil War through the start of the 20th century.
Of course, that wouldn't make the experience of deflation any the less strange—or unsettling—for modern Americans.
NEW STRATEGY: AVOIDING PAY CUTS
Take raises. Most people assume that sooner or later they will get one. It may not be as big as they want. It may not cover their growing appetite for wide-screen TVs and DVD players.
But it's still a raise.
However, if deflation were to set in, raises would almost certainly vanish, and pay cuts would become the order of the day.
That's because as prices across the economy fall at, say, 3% a year, each dollar you receive in wages would be able to buy that much more and so would be that much more valuable to you—and to your employer.
A good strategy under such circumstances: “You should march into your boss and announce that you will not accept a penny more than you make right now as long as he agrees not to pay you a cent less,” said Marc Weidenmier, an economist at Claremont McKenna college in California.
Or consider debt: Americans were happy to load up on it during the inflation-wracked 1970s and early 1980s, when rising prices ensured that the dollars with which they repaid their loans were less valuable than those they had borrowed. And they have been happy to load up again in the early 2000s, when extremely low interest rates seem to be erasing the cost of borrowing.
But matters would look considerably different if prices went into a general decline, causing repayment dollars to become more, not less, valuable. Consumers and companies probably would react by throwing their finances into reverse and paying off loans as fast as they possibly could.
THE UPSIDE OF FALLING PRICES
Mild deflation would assure working people (at least those who fend off pay cuts) of steadily rising real wages.
A 3%-a-year decline in overall prices translates directly into a 3% boost in people's buying power.
It would offer Americans an appealing alternative to the maddening task of trying to pick investments, and a tax-exempt one at that. Just sew your money in a mattress and watch its value rise.
Finally, it might help slow the frantic pace of American life.
Alice in Wonderland-like, “deflation elongates time,” said Kubarych, the former Fed official. “It means that you don't have to hurry out and buy something for fear the price will rise.
“It feeds a certain relaxation of attitude because the longer you wait, the lower the price.” That doesn't sound half bad.
SOURCE: Los Angeles Times, May 12, 2003, p. C1.
PRICE OF DEFLATION: AN UPSIDE-DOWN WORLD
In The NEWS
instance, a stock—is sold and the price at which it is bought.) Also, high inflation leads to people spending their time and financial resources trying to find hedges against inflation rather than engaging in productive activities.
In periods of high and variable inflation, households and firms have a difficult time distinguishing between changes in the relative price of individual goods and services (the price of a specific good compared to the prices of other goods) and changes in the general price level of all goods and services.
Suppose the price of oil rises by 5 percent between 2003 and 2004, but the overall price level (inflation rate) increases by only 2 percent during that period.
Then we could say that between 2003 and 2004, the relative price of oil rose only 3 percent (5 percent - 2 percent). The next year, the price of oil might increase 5 percent again, but the general inflation rate might be 6 percent. That is, between 2004 and 2005, the relative price of oil might actually fall by 1 percent (5 percent - 6 percent). Remember, the relative price is the price of a good relative to all other goods and services. Because of this difficulty in establishing relative prices, inflation distorts the information that flows from price signals.
Does the good have a higher price because it has become relatively more scarce and therefore more valuable relative to other goods, or did the price rise along with all other prices because of inflation?
This muddying of price information undermines good decision making.
MENU AND SHOE-LEATHER COSTS
Another cost of inflation is that incurred by firms as a result of being forced to change prices more frequently. For example, a restaurant might have to print new menus, or a department or mail-order store may have to print new catalogs to reflect changing prices. These costs are called menu costs, and they are the costs of changing posted prices. In some South American economies in the 1980s, inflation increased at over 300 percent per year, with prices changing on a daily, or even hourly, basis in some cases. Imagine how large the menu costs could be in an economy such as that!
There is also the shoe-leather cost of inflation— the cost of going to and from the bank to check on your assets (so often that you wear out the leather on your shoes). Specifically, high rates of inflation erode the value of a currency; this means that people will want to hold less currency—perhaps going to the ATM once a week rather than twice a month.
That is, the higher inflation rates lead to higher nominal interest rates, and this may induce more individuals to put money in the bank rather than allowing it to depreciate in their pockets. The effects of shoe-leather costs of inflation, like those of menu costs, are very modest in countries with low inflation rates but can be quite large in countries where inflation is substantial.
INFLATION AND INTEREST RATES
The interest rate is usually reported as the nominal interest rate, which means it is not adjusted for inflation.
We determine the real interest rate by taking the nominal rate of interest and subtracting the inflation rate.
Real interest rate 5 Nominal interest rate
2 Inflation rate
372 CHAPTER SEVENTEEN | Macroeconomic Goals
What if JCPenney was selling its clothes through its catalogs in a country with very high and unexpected changes in the inflation rate? How often would JCPenney have to print new catalogs? Would this be costlier than selling in an environment with low and anticipated inflation rates?
Reprinted with permission from JCPenney, Inc.
For example, if the nominal interest rate was 5 percent and the inflation rate was 3 percent, the real interest rate would be 2 percent.
If people can correctly anticipate inflation, they will behave in a manner that will largely protect them against loss. Consider the creditor who believes that the overall price level will rise 6 percent a year, based on experience in the immediate past.
Would that creditor lend money to someone at a 5 percent rate of interest? No. A 5 percent rate of interest means that a person borrowing $1,000 now will pay back $1,050 ($1,000 plus 5 percent of $1,000) one year from now. But if prices go up 6 percent, it will take $1,060 to buy what $1,000 does today ($1,060 is 6 percent more than $1,000).
Thus, the creditor lending at 5 percent will get paid back an amount ($1,050) that is less than the purchasing power of the original loan ($1,060) at the time it was paid back. The real interest rate, then, would actually be negative. Hence, to protect themselves, creditors will demand a rate of interest large enough to compensate for the deteriorating value of money.
Failure to understand the difference between nominal and real interest rates is critical. In most economic decisions, it is the real rate of interest that matters because it is this rate that shows how much borrowers pay and lenders receive in terms of purchasing power—goods and services money can buy.
Investors and lenders will do best when the real interest rates are high. For example, investors that bought a bond in 1985 did very well, even though
Inflation 373
AVERAGE ANNUAL INFLATION RATES, SELECTED COUNTRIES, 2002
250% 140% 120% 100% 80% 60% 40% 20% 0%
Turkey
45.2%
Brazil
8.3%
Romania
22.5%
Indonesia
11.9%
Mexico
6.4%
U.K.
2.1%
U.S.
1.6%
Canada
2.2%
Argentina
41%
Angola
106%
Inflation Rate (Annual Percent Change)
GLOBAL WATCH
Evaluate the following three statements regarding what happens during inflation: (1) People have less money to spend, (2) fewer goods are available, and (3) people must pay more money for goods purchased.
Of the three statements, only one is correct: With inflation, we must, on average, pay more money for the goods we purchase. Inflation does not necessarily mean we have fewer goods but rather that, on net, these goods have higher price tags. Inflation does not necessarily mean that people have less money to spend. Employees and unions will bargain for higher wages when there is inflation.
INFLATION
USING WHAT YOU'VE LEARNED
A Q
SOURCE: CIA—The World Factbook, 2003. http://www.cia.gov.
the nominal interest rate was not that high, as we can see in the table in Exhibit 2. Exhibit 3 shows the real interest rates since 1970. We see that the real interest rate was actually negative from the early 1970s to the early 1980s. When the real interest rate is negative, the lender pays the borrower rather than the borrower paying the lender!
In Exhibit 4, notice that when the nominal interest rate is high, the inflation rate is high; and when the nominal interest rate is low, the inflation rate is low. Why? The reason is that when inflation is high, borrowers offer and lenders demand higher nominal interest rates to compensate for the falling value of money in the future. When the inflation rate is low, borrowers offer and lenders demand lower nominal interest rates because the value of money (purchasing power) is falling less quickly.
Therefore, there is a tendency for nominal interest rates and inflation rates to move together—high inflation rates mean high nominal interest rates, and low inflation rates mean low nominal interest rates.
ANTICIPATED INFLATION AND THE NOMINAL INTEREST RATE
The economic theory behind the behavioral responses of creditors and debtors to anticipated inflation is straightforward and can be expressed in the simple diagram in Exhibit 5. An interest rate is, in effect, the price that one pays for the use of funds. Like other prices, interest rates are determined by the interaction of demand and supply forces. The lower the interest rate (price), the greater the quantity of loanable funds demanded,
ceteris paribus; the higher the interest rate (price), the greater the quantity of loanable funds supplied by individuals and institutions like banks, ceteris paribus. Suppose that in an environment where prices in general are expected to remain stable in the near future, the demand for loanable funds is depicted by D1 and the supply of such funds is indi-
374 CHAPTER SEVENTEEN | Macroeconomic Goals
15 10 5 0 -5 1965 1970 1975 1980 1985
Year Interest Rates (percent per year)
1995 2000 1990
Nominal interest rate Real interest rate
Real and Nominal Interest Rates
SECTION 17.5
EXHIBIT 3
The real interest rate is the nominal interest rate (the rate on a three-month treasury bill) minus the inflation rate (measured by the consumer price index).
SOURCE: Economic Report of the President 2003.
Nominal Real Interest 2 Inflation 5 Interest Year Rate* Rate** Rate
1965 4.0% 1.6% 2.4% 1970 6.5% 5.7% .8% 1975 5.8% 9.1% 23.3% 1980 11.5% 13.5% 22.0% 1985 7.5% 3.6% 4.0% 1990 7.5% 5.4% 2.1% 1995 5.5% 2.8% 2.7% 2000 5.9% 3.4% 2.5% 2002 1.6% 1.6% 0%
SOURCE: Economic Report of the President 2003 * three month Treasury Securities ** year to year inflation rate
Nominal Interest Rates, Inflation Rates, and Real Interest Rates, 1965-2002
SECTION 17.5
EXHIBIT 2
cated by S1. In this scenario, the equilibrium price, or interest rate, will be i1, where the quantity demanded equals the quantity supplied.
When people start expecting future inflation, creditors like banks will become less willing to lend funds at any given interest rate, because they fear they will be repaid in dollars of lesser value than those they loaned. This is depicted by a leftward shift in the supply curve of loanable funds (a decrease in supply) to S2. Likewise, demanders of funds (borrowers) are more anxious to borrow because they think they will pay their loans back in dollars of lesser purchasing power than the dollars they borrowed.
Thus, the demand for funds increases from
D1 to D2. Both the decrease in supply and the increase in demand push up the interest rate to a new equilibrium, i2. Whether the equilibrium quantity of loanable funds will increase or decrease depends on the relative sizes of the shifts in the respective curves.
DO CREDITORS ALWAYS LOSE DURING INFLATION?
Usually, lenders are able to anticipate inflation with reasonable accuracy. For example, in the late 1970s, when the inflation rate was more than 10 percent a year, nominal interest rates on a 90-day
Inflation 375
16 14 12 10 8 6 4 2 0 1960 1965 1970 1975 1980
Year Inflation and Nominal Interest Rates
1990 1995 1985 2000 2002
Nominal interest rate Inflation rate
Inflation and Nominal Interest Rates in the United States, 1960-2002
SECTION 17.5
EXHIBIT 4
Nominal interest rates tend to be high when inflation is high and low when inflation is low.
SOURCE: Economic Report of the President 2003.
i2
i1
D1
D2
S1
S2
Nominal Interest Rate Quantity of Loanable Funds
0
Nominal Interest Rates SECTION 17.5
EXHIBIT 5
Nominal interest rates are determined by the intersection of the demand and supply curves for loanable funds. The lower the interest rate (price), the greater the quantity of loanable funds demanded,
ceteris paribus; the higher the interest rate, the greater the quantity of loanable funds supplied by individuals and institutions like banks, ceteris paribus. Expected inflation shifts the supply curve left and the demand curve right, both of which tend to increase nominal (money) interest rates.
Treasury bill were relatively high. In 2002, with low inflation rates, the nominal interest rate was relatively low. If the inflation rate is anticipated accurately, new creditors will not lose nor will debtors gain from a change in the inflation rate.
However, nominal interest rates and real interest rates do not always run together. For example, in periods of high unexpected inflation, the nominal interest rates can be very high when the real interest rates are very low or even negative.
PROTECTING OURSELVES FROM INFLATION
Increasingly, groups try to protect themselves from inflation by using cost-of-living clauses in contracts.
With these clauses, laborers automatically get wage increases that reflect rising prices. The same is true of many pensioners, including those on Social Security.
Personal income taxes also are now indexed (adjusted) for inflation. However, some of the tax code is still not indexed for inflation. This can affect the incentives to work, save, and invest.
Some economists have argued that we should go one step further and index everything, meaning that all contractual arrangements would be adjusted frequently to take account of changing prices. Such an arrangement might reduce the impact of inflation, but it would also entail additional contracting costs (and not every good—most notably, currency—can be indexed). An alternative approach has been to try to stop inflation through various policies relating to the amount of government spending, tax rates, or the amount of money created. Wage and price controls—legislation limiting wage and price increases—offer still another approach to the inflation problem.
376 CHAPTER SEVENTEEN | Macroeconomic Goals
Suppose you had a 30-year fixed-interest mortgage on a home you purchased six years ago. In the meantime, the inflation rate has fallen considerably and probably will not reach that higher level again. Did you get a good interest rate on your loan?
No. You will be paying a higher interest rate to borrow money than others who have borrowed money more recently. Of course, you could refinance to get a lower interest rate, but you would need to calculate how much you would save on your loan and compare it to the cost of refinancing to determine whether that would be worth doing.
ANTICIPATED INFLATION AND INTERST RATES
USING WHAT YOU'VE LEARNED
A Q
1. Unanticipated inflation causes unpredictable transfers of wealth and reduces the efficiency of the market system by distorting price signals.
2. Inflation generally hurts creditors and those on fixed incomes and pensions; debtors generally benefit from inflation.
3. The nominal interest rate is the actual amount of interest you pay. The real interest rate is the nominal rate minus the inflation rate.
4. Wage earners attempt to keep pace with inflation by demanding higher wages each year or by indexing their annual wage to inflation.
1. How does price level stability reduce the difficulties buyers and sellers have in coordinating their plans?
2. What will happen to the nominal interest rate if the real interest rate rises, ceteris paribus? What if inflation increases,
ceteris paribus?
3. Say you owe money to Big River Bank. Will you gain or lose from an unanticipated decrease in inflation?
4. How does a variable interest rate loan “insure” the lender against unanticipated increases in inflation?
5. Why will neither creditors nor debtors lose from inflation if it is correctly anticipated?
6. How could inflation make people turn to exchange by barter?
7. What would happen in the loanable funds market if suppliers of loanable funds expect a substantial fall in inflation, while demanders of funds expect a substantial rise in inflation?
s e c t i o n c h e c k
SHORT-TERM FLUCTUATIONS IN ECONOMIC GROWTH
The aggregate amount of economic activity in the United States and most other nations has increased markedly over time, even on a per capita basis, indicating economic growth. Short-term fluctuations in the level of economic activity also occur. We sometimes call these short-term fluctuations business cycles. Exhibit 1 illustrates the distinction between long-term economic growth and short-term economic fluctuations. Over a long period, the line representing economic activity slopes upward, indicating increasing real output. Over short periods, however, there are downward, as well as upward, output changes. Business cycles refer to the shortterm ups and downs in economic activity, not to the long-term trend in output, which in modern times has been upward.
THE PHASES OF A BUSINESS CYCLE
A business cycle has four phases—expansion, peak, contraction, and trough—as illustrated in Exhibit 2.
The period of expansion is when output (real GDP) is rising significantly. Usually during the expansion phase, unemployment is falling and both consumer and business confidence is high. Thus, investment is rising, as are expenditures for expensive durable consumer goods, such as automobiles and household appliances. The peak is the point in time when the expansion comes to an end, when output is at the highest point in the cycle. The contraction is a period of falling real output and is usually accompanied by rising unemployment and declining business and consumer confidence. The contraction phase is measured from the peak to the trough—the point in time when output stops declining and business activity is at its lowest point in the cycle. Investment spending and expenditures on consumer durable goods fall sharply in a typical contraction.
The contraction phase is also called recession, a period of significant decline in output and employment (lasting more than a few months). Unemployment is relatively high at the trough, although the actual maximum amount of unemployment may
Economic Fluctuations 377
Economic Fluctuations
s e c t i o n
17.6
_ What are short-term economic fluctuations?
_ What are the four stages of a business cycle?
_ Is there a difference between a recession and a depression?
_ Can an economy be in a recession while still growing?
Real GDP per Year Time
0
Growth Trend
Business Cycles and Economic Growth
SECTION 17.6
EXHIBIT 1
In a growing economy, business downturns are temporary reversals from a long-term trend of economic growth.
Real GDP per Year Time
0
Trough Growth Trend Contraction Expansion Peak Peak Recession Recovery
Four Phases of a Business Cycle
SECTION 17.6
EXHIBIT 2
Business cycles have four phases: expansion, peak, contraction, and trough. The expansion phase usually is longer than the contraction, and in a growing economy, output (real GDP) will rise from one business cycle peak to the next.
not occur exactly at the trough. Often, unemployment remains fairly high well into the expansion phase. The expansion phase is measured from the trough to the peak.
HOW LONG DOES A BUSINESS CYCLE LAST?
There is no uniformity to the length of a business cycle.
Because it does not have the regularity that the term cycle implies, economists often use the term
economic fluctuation rather than business cycle. In both the 1980s and the 1990s, expansions were quite long by historical standards. The contraction phase is one of recession, a decline in business activity.
A severe recession is called a depression. Likewise, a prolonged expansion in economic activity is sometimes called a boom. Exhibit 3 shows the record of U.S. business cycles since 1854. Notice that contractions seem to be getting shorter over time.
The National Bureau of Economic Research (NBER) Business Cycle Dating Committee determined that a recession began in March 2001, ending an expansion that lasted from March 1991 to March 2001.
The attacks of September 11, 2001, clearly deepened the contraction and may have been instrumental in turning a contraction into a recession.
378 CHAPTER SEVENTEEN | Macroeconomic Goals
Expansion Contraction Trough (Months) Peak (Months)
December 1854 30 June 1857 18 December 1858 22 October 1860 8 June 1861 46 (Civil War) April 1865 32 December 1867 18 June 1869 18 December 1870 34 October 1873 65 March 1879 36 March 1882 38 May 1885 22 March 1887 13 April 1888 27 July 1890 10 May 1891 20 January 1893 17 June 1894 18 December 1895 18 June 1897 24 June 1899 18 December 1900 21 September 1902 23 August 1904 33 May 1907 13 June 1908 19 January 1910 24 January 1912 12 January 1913 23 December 1914 44 (World War I) August 1918 7 March 1919 10 January 1920 18 July 1921 22 May 1923 14 July 1924 7 October 1926 13 November 1927 21 August 1929 43 (Depression) March 1933 50 May 1937 13 (Depression) June 1938 80 (World War II) February 1945 8 October 1945 37 November 1948 11 October 1949 45 (Korean War) July 1953 10 May 1954 39 August 1957 8 April 1958 24 April 1960 10 February 1961 106 (Vietnam War) December 1969 11 November 1970 36 November 1973 16 March 1975 58 January 1980 6 July 1980 12 July 1981 16 November 1982 92 July 1990 8 March 1991 120 March 2001 8 November 2001 —
SOURCE: http://www.nber.org/cycles.html; U.S. Department of Commerce, Survey of Current Business, September 2003, Table C-51.
A Historical Record of U.S. Business Cycles, 1854-2001 SECTION 17.6
EXHIBIT 3
Between 1982 and 2000, the economy has experienced a very long boom with only a brief eight-month recession in 1990-1991. The expansion of the 1990s was the longest in history. According to Nobel laureate Paul Samuelson, “the old-fashioned business cycle, in its virulence, should be as gone as the old-fashioned diptheria and pre-penicillin diseases.”
SEASONAL FLUCTUATIONS AFFECT ECONOMIC ACTIVITY
While the determinants of cyclical fluctuations in the economy are the major thrust of the next several chapters, it should be mentioned that some fluctuation in economic activity reflects seasonal patterns. Business activity, whether measured by production or by the sale of goods, tends to be high in the two months before the winter holidays and somewhat lower in summertime, when many families are on vacation. Within individual industries, of course, seasonal fluctuations in output often are extremely pronounced, agriculture being the best example.
Often, key economic statistics, like unemployment rates, are seasonally adjusted, meaning the numbers are modified to account for normal seasonal fluctuations. Thus, seasonally adjusted unemployment rates in summer months are below actual unemployment rates, because employment is normally high in summertime due to the inflow of school-age workers into the labor force.
POLITICAL BUSINESS CYCLES
Studies have shown there is a strong correlation between the performance of the economy and the fate of an incumbent president's (or an incumbent president's party) bid for reelection. In fact, the 1992 presidential election sheds light on this hypothesis.
President George H. W. Bush lost his reelection bid shortly after the economy had struggled through the 1990-1991 recession. Some scholars have speculated that if the election had taken place a few months later when the economic data looked a lot stronger, President Bush would have been reelected.
If this correlation between the strength of the economy and a successful reelection bid does exist, it would be in the best interest of the incumbent to do everything in his or her power to stimulate the economy in the period leading up to the election.
This might take the form of trying to pressure the Federal Reserve System into using monetary policy to lower the interest rate or pressing Congress to cut taxes or increase government spending—anything that might generate more spending and thus greater employment. Of course, the negative side to all of this is that although the incumbent may get reelected, the economy may have been overstimulated, causing inflationary problems.
However, the evidence of a political business cycle is mixed. It is possible that the 1972 presidential election might have been a political business cycle because the economy was pushed beyond potential GDP with expansionary monetary policy. However, the elections of 1980 and 1992 occurred during recessions, indicating that no one successfully tried to overstimulate the economy before either of those elections. In 1980, Ronald Reagan defeated Jimmy Carter at least partly because Carter's appointee to the Fed, Paul Volker, pursued a contractionary monetary policy to fight the high inflation rates of the late 1970s. The expected result was a recession that most likely lost the 1980 election for Carter.
FORECASTING CYCLICAL CHANGES
The farmer and the aviator rely heavily on weather forecasters for information on climatic conditions in planning their activities. Similarly, businesses, government agencies, and to a lesser extent, consumers, rely on economic forecasts to learn of forthcoming developments in the business cycle. If it looks like the economy will continue in an expansionary phase, businesses might expand production to meet a perceived forthcoming need; if it looks like contraction is coming, business may decide to be more cautious.
Forecasting Models
Using theoretical models, which will be discussed in later chapters, economists gather statistics on economic activity in the immediate past, including, for example, consumer expenditures, business inventories, the supply of money, governmental expenditures, tax revenues, and so on. Using past historical relationships between these factors and the overall level of economic activity (which form the basis of the economic theories), they formulate econometric models. Statistics from the immediate past are plugged into the model, and forecasts are made. Because human behavior changes and we cannot correctly make assumptions about certain future developments, our numbers are imperfect and our econometric models are not always accurate. Like the weather forecasts, although the econometric models are not perfect, they are helpful.
Leading Economic Indicators
One less sophisticated but very useful forecasting tool is watching trends in leading economic indicators.
Some types of economic activity change before the economy as a whole changes. If in March these activities show an increase after having declined for
Economic Fluctuations 379
several months, past experience suggests the entire output will start rising after a few months, perhaps in July or August. About a dozen such leading indicators exist, including the lengths of the average workweek, the magnitude of the nation's money supply, prices of common stocks, the number of new businesses formed, and new orders for plants and equipment. The Department of Commerce combines all these into an index of leading indicators.
If the index rises sharply for two or three months, it is likely (but not certain) that increases in the overall level of activity will follow.
Since the development of the leading economic indicators some 60 years ago, the composite index of leading economic indicators has never failed to give some warning of an economic downturn. Unfortunately, the lead time has varied widely. The composite index turned down 23 months prior to the 1957-1958 recession but gave only a threemonth warning before the 1981-1982 slump. This variance in lead time can cause particular policy problems. Specifically, the use of leading economic indicators to predict future trends can make policy decisions less accurate. For example, if the federal government responds with policies to combat the recession as soon as the leading economic indicators begin predicting a recession, then the recession that would have occurred may fail to materialize.
On the other hand, a self-fulfilling prophecy may result if businesses respond with cutbacks in orders for plant and equipment as soon as the leading economic indicators begin predicting a recession.
While the economic indicators do provide a warning of a likely downturn, they do not provide accurate information on the depth or duration of the downturn.
380 CHAPTER SEVENTEEN | Macroeconomic Goals
1. Business cycles (or economic fluctuations) are short-term fluctuations in the amount of economic activity, relative to the long-term growth trend in output.
2. The four phases of a business cycle are expansion, peak, contraction, and trough.
3. Recessions occur during the contraction phase of a business cycle. Severe, long-term recessions are called depressions.
4. The economy often goes through short-term contraction even during a long-term growth trend.
1. Why would you expect unemployment to fall during an economy's expansionary phase and to rise during a contractionary phase?
2. Why might a politician want to stimulate the economy prior to a reelection bid?
3. Why is the output of investment goods and durable consumer goods more sensitive to the business cycle than that of most goods?
4. Why might the unemployment rate fall after output starts recovering during the expansion phase of the business cycle?
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Key Terms and Concepts 381
The most important macroeconomic goals are full employment, price stability, and economic growth.
The United States showed its commitment to the major macroeconomic goals with the Employment Act of 1946. The consequences of unemployment to society include a reduction in potential output and consumption—a decrease in efficiency. The unemployment rate is found by taking the number of people officially unemployed and dividing by the number in the labor force. Unemployment rates are the highest for minorities, the young, and less skilled workers.
There are four main categories of unemployed workers: job losers, job leavers, reentrants, and new entrants. The duration of unemployment tends to be greater (smaller) when the amount of unemployment is high (low). The three types of unemployment are frictional unemployment, structural unemployment, and cyclical unemployment. Frictional unemployment results from people moving from one job to another. Structural unemployment results when people who are looking for jobs lack the required skills for the available jobs. Cyclical unemployment is caused by a recession. The natural rate of unemployment is attributable to structural and frictional unemployment only; no cyclical unemployment is thought to be present.
Price stability provides security in the marketplace by ensuring constant purchasing power of a nation's currency. Inflation generally hurts creditors and those on fixed incomes and pensions; debtors generally benefit from unexpected inflation while creditors generally are hurt. Inflation distorts price signals, leads to shoe-leather costs and menu costs, arbitrarily redistributes wealth, and discourages long-term planning and investment. The nominal interest rate is the actual amount of interest you pay. The real interest rate is the nominal rate minus the inflation rate.
Business cycles are short-term fluctuations in economic activity, relative to the long-term trend in output. The four phases of a business cycle are expansion, peak, contraction, and trough. Recessions occur during the contraction phase of a business cycle.
Severe, long-term recessions are called depressions.
Summar y
real gross domestic product (RGDP) 356 Employment Act of 1946 356 unemployment rate 357 labor force 357 discouraged worker 359 job loser 359 job leaver 359 reentrant 359 new entrant 359 underemployment 360 labor force participation rate 361 frictional unemployment 362 structural unemployment 362 cyclical unemployment 363 natural rate of unemployment 363 potential output 364 minimum wage rate 366 insider-outsider hypothesis 367 efficiency wage model 367 price level 369 inflation 369 deflation 369 consumer price index (CPI) 369 relative price 372 menu costs 372 shoe-leather cost 372 nominal interest rate 372 real interest rate 372 wage and price controls 376 business cycles 377 expansion 377 peak 377 contraction 377 trough 377 recession 377 depression 378 boom 378 leading economic indicators 379
K e y Ter m s a n d C o n c e p t s
382 CHAPTER SEVENTEEN | Macroeconomic Goals
1. Which of the following individuals would economists consider unemployed?
a. Sam looked for work for several weeks but has now given up his search and is going back to college.
b. A 14-year-old wants to mow lawns for extra cash but is unable to find neighbors willing to hire her.
c. A factory worker is temporarily laid off but expects to be called back to work soon.
d. A receptionist, who works only 20 hours per week, would like to work 40 hours per week.
e. A high school graduate is spending the summer backpacking across the country rather than seeking work.
2. Identify whether each of the following reflects seasonal, structural, frictional, or cyclical unemployment.
a. A sales employee is laid off due to slow business after consumer spending falls.
b. An automotive worker is replaced by robotic equipment on the assembly line.
c. A salesperson quits a job in California and seeks a new sales position after moving to New York.
d. An employee is fired due to poor job performance and searches the want ads each day for work.
3. Calculate the unemployment rate for an economy using the following data: Number of employed: 80 million Number of unemployed: 15 million Number of discouraged workers: 5 million Total adult population: 160 million
4. Unemployment benefits in many European countries tend to be both more generous and available for longer periods than those in the United States. What impact do you think this is likely to have on the unemployment rate in a European country? Why?
5. How can unions result in higher unemployment rates? How would the results differ for someone who wants to be employed in the union sector compared with someone who currently has a job in the union sector?
6. You borrow $10,000 at a nominal interest rate of 6 percent. What is the real rate of interest at each of the following inflation rates?
a. 2 percent
b. 6 percent
c. 8 percent
7. You borrow money at a fixed rate of interest to finance your college education. If the rate of inflation unexpectedly slows down between the time you take out the loan and the time you begin paying it back, is there a redistribution of income? Do you gain or lose? What if you already expected the inflation rate to slow at the time you took out the loan? Explain.
8. How does an adjustable rate mortgage agreement protect lenders against inflation? Who bears the inflation risk?
9. In 2000, a proposal was made in Santa Monica, California, to raise the minimum wage in the hotel and shopping district to a “living” wage of $10.69 per hour. Predict the effect of such legislation on unemployment in the hotel and shopping industry in Santa Monica. What would you expect to happen to the unemployment rate in neighboring areas?
10. Go to the Sexton Web site for this chapter at
http://sexton.swlearning.com, and click on the Interactive Study Center button. Under Internet Review Questions, click on the Conference Board link to find out the latest information about leading economic indicators. Based on the latest trend in the data, what can you predict about the outlook for employment in the economy?
REVIEW QUESTIONS
CHAPTER 17: MACROECONOMIC GOALS
17.1 Macroeconomic Goals
1. What are the three major economic goals of most societies?
The three major economic goals of most societies are maintaining employment at high levels, so that jobs are relatively plentiful and financial suffering from lack of income is relatively uncommon, price stability, so consumers and producers can make better decisions, and achieving a high rate of economic growth, so output, and therefore income and consumption, increases over time.
2. What is the Employment Act of 1946? Why was it significant?
The Employment Act of 1946 was a law that committed the federal government to policies designed to reduce unemployment in a manner consistent with price stability. It was significant as the first formal government acknowledgment of these primary macroeconomic goals.
17.2: Employment and Unemployment 1. What happens to the unemployment rate when the number of unemployed people increases, ceteris paribus? When the labor force grows, ceteris paribus?
The unemployment rate is defined as the number of people officially unemployed divided by the labor force. Therefore, the unemployment rate rises as the number of unemployed people increases and it falls when the labor force grows, ceteris paribus.
2. How might the official unemployment rate understate the “true” degree of unemployment? How might it overstate it?
The official unemployment rate understates the “true” degree of unemployment by not including discouraged workers as unemployed, by counting part time workers who cannot find full time jobs as “fully” employed, and by counting those employed in jobs that underutilize worker skills as “fully” employed.
It overstates the “true” degree of unemployment by not counting those working overtime or multiple jobs as “overemployed,” by counting those employed in the underground economy as unemployed and by including those just “going through the motions” of job search to maintain unemployment benefits or other government benefits as unemployed.
3. Why might the fraction of the unemployed who are job leavers be higher in a period of strong labor demand?
In a period of strong labor demand, people would be more confident of their ability to find other jobs, and therefore they would be more likely to leave (quit) their current jobs.
4. Suppose you live in a community of 100 people. If 80 people are over 16 years old and 72 people are willing and able to work, what is the unemployment rate in that community?
The unemployment rate in this community is the number unemployed (8) divided by the labor force (80), or 10 percent.
5. What would happen to the unemployment rate if a substantial group of unemployed people started going to school full time? What would happen to the size of the labor force?
Full time students are not considered part of the labor force, so the labor force, the number officially unemployed, and the unemployment rate would all fall if a substantial group of unemployed people became full time students.
6. What happens to the unemployment rate when officially unemployed people become discouraged workers? Does anything happen to employment in this case?
When officially unemployed workers become discouraged workers, they stop seeking jobs and are no longer counted as either part of the labor force or as unemployed, reducing the unemployment rate. However, since they do not find jobs, there is no effect on employment as a result.
17.3: Types of Unemployment 1. Why do we want some frictional unemployment?
We want some frictional unemployment because we want human resources employed in areas of higher productivity, and some period of job search (frictional unemployment), rather than taking the first job offered, can allow workers to find more productive employment.
2. Why might a job retraining program be a more useful policy to address structural unemployment than to address frictional unemployment?
Structural unemployment reflects people who lack the necessary skills for the jobs available, rather than a temporary period of search between jobs. A job retraining program to develop skills to match the jobs available addresses such structural unemployment, not frictional unemployment.
3. What is the traditional government policy “cure” for cyclical unemployment?
The traditional government policy “cure” for cyclical unemployment is to adopt policies designed to increase aggregate demand for goods and services.
4. What types of unemployment are present at full employment (at the natural rate of unemployment)?
At full employment (at the natural rate of unemployment), both frictional and structural unemployment, but not cyclical unemployment, are present.
5. Why might frictional unemployment be higher in a period of plentiful jobs (low unemployment)?
In a period of plentiful jobs, frictional unemployment can be higher because job opportunities are plentiful, which stimulates mobility between jobs, which, in turn, increases frictional unemployment.
6. If the widespread introduction of the automobile caused a productive buggy whip maker to lose his job, would he be structurally or frictionally unemployed?
If the buggy whip maker's skills were demand in other industries, this would result in frictional unemployment, but if his skills were not in demand in other industries, this would result in structural unemployment.
7. If a fall in demand for domestic cars causes auto workers to lose their jobs in Michigan, while there are plenty of jobs for lumberjacks in Montana, what kind of unemployment results?
This would be an example of structural unemployment, resulting from skills mismatched to the jobs available.
Section Check Answers SC-29 17.4: Reasons for Unemployment 1. What are the three reasons for wages to fail to balance labor supply and labor demand?
Minimum wages, unions, and efficiency wage can each lead to a failure to balance labor supply and demand, by leading to wages for some workers that are above their opportunity costs, and increasing unemployment.
2. What is the insider-outsider hypothesis?
The insider-outsider hypothesis is that insiders are union members who have little or no concern for outsiders, such as non-members. But they have some control over wages and hiring, allowing them to keep wages above the equilibrium wage, even in a recession.
3. What is an efficiency wage?
An efficiency wage is a wage that is greater than the equilibrium wage. Its intent is to reduce the costs of turnover, absenteeism and shirking, and increase worker quality and morale, thereby increasing productivity and reducing costs. If the increased productivity and reduced costs that results outweigh the higher wage costs, producers' profits will rise.
4. How do search costs lead to prolonged periods of unemployment?
Because employers offer different jobs, compensation packages and working conditions, and workers differ in skills and preferences, matching up workers to appropriate jobs requires a great deal of information. The search for this information entails frictional unemployment, which can also be thought of as employment in gathering information, which, in some cases, can lead to prolonged periods of unemployment.
5. Why would higher unemployment compensation in a country like France lead to higher rates of unemployment?
Unemployment insurance lowers the opportunity cost to a worker from being unemployed, increasing the duration of unemployment and the unemployment rate. Higher unemployment insurance payments will decrease the opportunity cost of remaining unemployed, tending to induce the duration of unemployment and raise the unemployment rate.
6. Does new technology increase unemployment?
New technology can increase unemployment among those whose skills are replaced by that technology. However, it also creates new jobs manufacturing, servicing and repairing the new equipment, and, by lowering costs, new technology frees up more income to demand other goods and services, creating jobs in those industries.
17.5: Inflation 1. How does price level stability reduce the difficulties buyers and sellers have in coordinating their plans?
Price level instability increases the difficulties buyers and sellers have in coordinating their plans by reducing their certainty about what price changes mean-do they reflect changes in relative prices or changes in inflation? Eliminating this uncertainty makes the meaning of price changes clearer, allowing buyers and sellers to better co-ordinate their plans through the price system. High and variable rates of inflation also interacts with the tax code in ways which distort incentives and leads people to invest resources trying to protect themselves against inflation rather than in socially productive activities.
2. What will happen to the nominal interest rate if the real interest rate rises, ceteris paribus? What if inflation increases, ceteris paribus?
The real interest rate is the nominal interest rate minus the inflation rate. Alternatively, the nominal interest rate is the sum of the desired real interest rate and the expected inflation rate. If either the real interest rate or the rate of inflation increases, nominal interest rates will also increase.
3. Say you owe money to Big River Bank. Will you gain or lose from an unanticipated decrease in inflation?
An unanticipated decrease in inflation will mean that the dollars you must pay back on your loan will be worth more than you expected, raising the real interest rate you must pay on that loan, which makes you worse off.
4. How does a variable interest rate loan “insure” the lender against unanticipated increases in inflation?
With a variable interest rate loan, an unanticipated increase in inflation does not reduce the real interest rate received by the lender, but instead increases the nominal interest rate on the loan to compensate for the increased inflation.
5. Why will neither creditors nor debtors lose from inflation if it is correctly anticipated?
Correctly anticipated inflation will be accurately reflected in the terms creditors and debtors agree to, so that neither will lose from inflation. Only unexpected rates of inflation can redistribute wealth between debtors and creditors.
6. How could inflation make people turn to exchange by barter?
If inflation is very rapid, people lose faith in the value of their monetary unit, and this can lead to exchange by barter, because goods can then have a more predictable value than their country's money.
7. What would happen in the loanable funds market if suppliers of loanable funds expect a substantial fall in inflation, while demanders of funds expect a substantial rise in inflation?
If suppliers of loanable funds expect a substantial fall in inflation, they would demand a smaller “inflation premium” to loan money, increasing the supply of loanable funds. If demanders of funds expect a substantial rise in inflation, they will be willing to offer a greater “inflation premium” to borrow, increasing the demand for loanable funds. The increased supply of loanable funds pushes down interest rates, while the increased demand for loanable funds pushes up interest rates, so the net effect on interest rates is unknown, without further information about the relative sizes of the shifts in the curves.
17.6: Economic Fluctuations 1. Why would you expect unemployment to fall during an economy's expansionary phase and to rise during a contractionary phase?
Output increases during an economy's expansion phase. To produce that increased output in the short term requires more workers, which increases employment and reduces the unemployment rate, other things equal.
SC-30 Section Check Answers 2. Why might a politician want to stimulate the economy prior to a reelection bid?
A politician may want to stimulate the economy prior to a reelection bid because there is a strong correlation between the performance of the economy and the fate of an incumbent's bid for reelection.
3. Why is the output of investment goods and durable consumer goods more sensitive to the business cycle than that of most goods?
When output is growing and business confidence is high, investment rises sharply because it appears highly profitable; when incomes and consumer confidence are high, durable goods, whose purchases are often delayed in less prosperous times, rise sharply in demand. In recessions, investment and consumer durables purchases fall sharply, as such projects no longer appear profitable, and plans are put on hold until better times.
4. Why might the unemployment rate fall after output starts recovering during the expansion phase of the business cycle?
Often unemployment remains fairly high well into the expansion phase, because it takes a period of recovery before businesses become convinced that the increasing demand for their output is going to continue, making it profitable to hire added workers.
CHAPTER 17: MACROECONOMIC GOALS
17.1 Macroeconomic Goals
1. What are the three major economic goals of most societies?
The three major economic goals of most societies are maintaining employment at high levels, so that jobs are relatively plentiful and financial suffering from lack of income is relatively uncommon, price stability, so consumers and producers can make better decisions, and achieving a high rate of economic growth, so output, and therefore income and consumption, increases over time.
2. What is the Employment Act of 1946? Why was it significant?
The Employment Act of 1946 was a law that committed the federal government to policies designed to reduce unemployment in a manner consistent with price stability. It was significant as the first formal government acknowledgment of these primary macroeconomic goals.
17.2: Employment and Unemployment 1. What happens to the unemployment rate when the number of unemployed people increases, ceteris paribus? When the labor force grows, ceteris paribus?
The unemployment rate is defined as the number of people officially unemployed divided by the labor force. Therefore, the unemployment rate rises as the number of unemployed people increases and it falls when the labor force grows, ceteris paribus.
2. How might the official unemployment rate understate the “true” degree of unemployment? How might it overstate it?
The official unemployment rate understates the “true” degree of unemployment by not including discouraged workers as unemployed, by counting part time workers who cannot find full time jobs as “fully” employed, and by counting those employed in jobs that underutilize worker skills as “fully” employed.
It overstates the “true” degree of unemployment by not counting those working overtime or multiple jobs as “overemployed,” by counting those employed in the underground economy as unemployed and by including those just “going through the motions” of job search to maintain unemployment benefits or other government benefits as unemployed.
3. Why might the fraction of the unemployed who are job leavers be higher in a period of strong labor demand?
In a period of strong labor demand, people would be more confident of their ability to find other jobs, and therefore they would be more likely to leave (quit) their current jobs.
4. Suppose you live in a community of 100 people. If 80 people are over 16 years old and 72 people are willing and able to work, what is the unemployment rate in that community?
The unemployment rate in this community is the number unemployed (8) divided by the labor force (80), or 10 percent.
5. What would happen to the unemployment rate if a substantial group of unemployed people started going to school full time? What would happen to the size of the labor force?
Full time students are not considered part of the labor force, so the labor force, the number officially unemployed, and the unemployment rate would all fall if a substantial group of unemployed people became full time students.
6. What happens to the unemployment rate when officially unemployed people become discouraged workers? Does anything happen to employment in this case?
When officially unemployed workers become discouraged workers, they stop seeking jobs and are no longer counted as either part of the labor force or as unemployed, reducing the unemployment rate. However, since they do not find jobs, there is no effect on employment as a result.
17.3: Types of Unemployment 1. Why do we want some frictional unemployment?
We want some frictional unemployment because we want human resources employed in areas of higher productivity, and some period of job search (frictional unemployment), rather than taking the first job offered, can allow workers to find more productive employment.
2. Why might a job retraining program be a more useful policy to address structural unemployment than to address frictional unemployment?
Structural unemployment reflects people who lack the necessary skills for the jobs available, rather than a temporary period of search between jobs. A job retraining program to develop skills to match the jobs available addresses such structural unemployment, not frictional unemployment.
3. What is the traditional government policy “cure” for cyclical unemployment?
The traditional government policy “cure” for cyclical unemployment is to adopt policies designed to increase aggregate demand for goods and services.
4. What types of unemployment are present at full employment (at the natural rate of unemployment)?
At full employment (at the natural rate of unemployment), both frictional and structural unemployment, but not cyclical unemployment, are present.
5. Why might frictional unemployment be higher in a period of plentiful jobs (low unemployment)?
In a period of plentiful jobs, frictional unemployment can be higher because job opportunities are plentiful, which stimulates mobility between jobs, which, in turn, increases frictional unemployment.
6. If the widespread introduction of the automobile caused a productive buggy whip maker to lose his job, would he be structurally or frictionally unemployed?
If the buggy whip maker's skills were demand in other industries, this would result in frictional unemployment, but if his skills were not in demand in other industries, this would result in structural unemployment.
7. If a fall in demand for domestic cars causes auto workers to lose their jobs in Michigan, while there are plenty of jobs for lumberjacks in Montana, what kind of unemployment results?
This would be an example of structural unemployment, resulting from skills mismatched to the jobs available.
Section Check Answers SC-29 17.4: Reasons for Unemployment 1. What are the three reasons for wages to fail to balance labor supply and labor demand?
Minimum wages, unions, and efficiency wage can each lead to a failure to balance labor supply and demand, by leading to wages for some workers that are above their opportunity costs, and increasing unemployment.
2. What is the insider-outsider hypothesis?
The insider-outsider hypothesis is that insiders are union members who have little or no concern for outsiders, such as non-members. But they have some control over wages and hiring, allowing them to keep wages above the equilibrium wage, even in a recession.
3. What is an efficiency wage?
An efficiency wage is a wage that is greater than the equilibrium wage. Its intent is to reduce the costs of turnover, absenteeism and shirking, and increase worker quality and morale, thereby increasing productivity and reducing costs. If the increased productivity and reduced costs that results outweigh the higher wage costs, producers' profits will rise.
4. How do search costs lead to prolonged periods of unemployment?
Because employers offer different jobs, compensation packages and working conditions, and workers differ in skills and preferences, matching up workers to appropriate jobs requires a great deal of information. The search for this information entails frictional unemployment, which can also be thought of as employment in gathering information, which, in some cases, can lead to prolonged periods of unemployment.
5. Why would higher unemployment compensation in a country like France lead to higher rates of unemployment?
Unemployment insurance lowers the opportunity cost to a worker from being unemployed, increasing the duration of unemployment and the unemployment rate. Higher unemployment insurance payments will decrease the opportunity cost of remaining unemployed, tending to induce the duration of unemployment and raise the unemployment rate.
6. Does new technology increase unemployment?
New technology can increase unemployment among those whose skills are replaced by that technology. However, it also creates new jobs manufacturing, servicing and repairing the new equipment, and, by lowering costs, new technology frees up more income to demand other goods and services, creating jobs in those industries.
17.5: Inflation 1. How does price level stability reduce the difficulties buyers and sellers have in coordinating their plans?
Price level instability increases the difficulties buyers and sellers have in coordinating their plans by reducing their certainty about what price changes mean-do they reflect changes in relative prices or changes in inflation? Eliminating this uncertainty makes the meaning of price changes clearer, allowing buyers and sellers to better co-ordinate their plans through the price system. High and variable rates of inflation also interacts with the tax code in ways which distort incentives and leads people to invest resources trying to protect themselves against inflation rather than in socially productive activities.
2. What will happen to the nominal interest rate if the real interest rate rises, ceteris paribus? What if inflation increases, ceteris paribus?
The real interest rate is the nominal interest rate minus the inflation rate. Alternatively, the nominal interest rate is the sum of the desired real interest rate and the expected inflation rate. If either the real interest rate or the rate of inflation increases, nominal interest rates will also increase.
3. Say you owe money to Big River Bank. Will you gain or lose from an unanticipated decrease in inflation?
An unanticipated decrease in inflation will mean that the dollars you must pay back on your loan will be worth more than you expected, raising the real interest rate you must pay on that loan, which makes you worse off.
4. How does a variable interest rate loan “insure” the lender against unanticipated increases in inflation?
With a variable interest rate loan, an unanticipated increase in inflation does not reduce the real interest rate received by the lender, but instead increases the nominal interest rate on the loan to compensate for the increased inflation.
5. Why will neither creditors nor debtors lose from inflation if it is correctly anticipated?
Correctly anticipated inflation will be accurately reflected in the terms creditors and debtors agree to, so that neither will lose from inflation. Only unexpected rates of inflation can redistribute wealth between debtors and creditors.
6. How could inflation make people turn to exchange by barter?
If inflation is very rapid, people lose faith in the value of their monetary unit, and this can lead to exchange by barter, because goods can then have a more predictable value than their country's money.
7. What would happen in the loanable funds market if suppliers of loanable funds expect a substantial fall in inflation, while demanders of funds expect a substantial rise in inflation?
If suppliers of loanable funds expect a substantial fall in inflation, they would demand a smaller “inflation premium” to loan money, increasing the supply of loanable funds. If demanders of funds expect a substantial rise in inflation, they will be willing to offer a greater “inflation premium” to borrow, increasing the demand for loanable funds. The increased supply of loanable funds pushes down interest rates, while the increased demand for loanable funds pushes up interest rates, so the net effect on interest rates is unknown, without further information about the relative sizes of the shifts in the curves.
17.6: Economic Fluctuations 1. Why would you expect unemployment to fall during an economy's expansionary phase and to rise during a contractionary phase?
Output increases during an economy's expansion phase. To produce that increased output in the short term requires more workers, which increases employment and reduces the unemployment rate, other things equal.
SC-30 Section Check Answers 2. Why might a politician want to stimulate the economy prior to a reelection bid?
A politician may want to stimulate the economy prior to a reelection bid because there is a strong correlation between the performance of the economy and the fate of an incumbent's bid for reelection.
3. Why is the output of investment goods and durable consumer goods more sensitive to the business cycle than that of most goods?
When output is growing and business confidence is high, investment rises sharply because it appears highly profitable; when incomes and consumer confidence are high, durable goods, whose purchases are often delayed in less prosperous times, rise sharply in demand. In recessions, investment and consumer durables purchases fall sharply, as such projects no longer appear profitable, and plans are put on hold until better times.
4. Why might the unemployment rate fall after output starts recovering during the expansion phase of the business cycle?
Often unemployment remains fairly high well into the expansion phase, because it takes a period of recovery before businesses become convinced that the increasing demand for their output is going to continue, making it profitable to hire added workers.