Chapter 7 - Economic Fluctuations, Unemployment and Inflation

Example: misery index = Un rate + inf rate. Lower the better. Right now it would be about 8%. 70s and 80s it was 20-25%.

BUSINESS CYCLES -
Real growth in GDP has averaged 3%/year over this century. Some periods it was 6% and other periods it was negative. The fluctuations in real GDP growth is what we call the business cycle. We are in the expansionary phase of the ninth business cycle since WWII. Last recession was 91-92. Alternate periods of econ expansion and contraction. See page 168-169.

Expansion - low unemployment, strong retail sales, rising stock market, pos growth in real output, etc.

Contraction/recession - high unemployment, weak retail sales, declining stock market, low or neg growth in real output.

Recession - two or more consecutive quarters of neg real GDP growth.

Depression - prolonged and severe recession lasting years. un=25% in 1930s.

The business cycle does NOT mean that there is anything regular about the bus cycle. Fluctuations are random and unpredictable. Periods of expansion and contraction vary quite a bit. Expansions have lasted from two years to eight years.


ECONOMIC FLUCTUATIONS AND THE LABOR MARKET

Swings in the business cycle influence the demand for labor and the un rate. Some definitions:

Labor Force = those over 16 who are either employed or looking for a job (unemployed).

RATE OF LABOR FORCE PARTICIPATION = Labor Force/Total population. See page 171.

Not in the labor force = household workers, students, retirees, and disabled.

In 1995, the rate of labor-force participation was 66.6%. 132.3m/198.6m. Men - 75.4% Women - 59.2%. Average = 66.6%. See page 172 for an analysis of how the labor-force participation of men and women varies over time.

The LFP (labor force participation) for women has been increasing, and for men has been decreasing. Shows how the workforce and labor market have been changing. LFP is about the same in Canada vs US (67 vs 66%) In Germany, it is 55% and in Italy it is 47%.

UN RATE= No of persons unemployed/Labor force x 100. Percentage of persons in the labor force who are:

1) actively looking for a job or
2) waiting to begin or return to a job.

Avg un rate over the last 25 years has been 6.7% vs. 4.5% right now in U.S. vs. 12% in Germany, France, Belgium and 20% in Spain. Un rate is calculated by survey of about 60,000 households every month, representing about 100,000 adults in 729 locations around the country. See page 173.


REASONS FOR UNEMPLOYMENT

In a dynamic economy, there will periods of labor mobility as workers move:
1) from contracting industries into expanding industries and
2) into and out of labor force.

Firms and entire industries are constantly changing.  Some are expanding and hiring people and others are contracting and laying people off.  There are new industries that didn't even exist 20 years ago - computer technology, VCRs, CDs, cellular phones, cable TV, fuel injection, fiber optics, web page design, etc. that have provided millions of new jobs.  Other industries have contracted or gone out of business - carburetors, vinyl records, typewriters, copper wire, etc.

Thousands of new products are introduced every year, many fail. Thousands of new companies start every year and many fail. An economy is a very dynamic system characterized by constant change. As the economy changes, new opportunities are constantly emerging, and others are disappearing. Market is a net job creator, but it is also a job destroyer. "creative destruction."

Point: in a dynamic economy, un is natural and in some ways even very healthy. Change makes us uncomfortable, but in most cases makes us better off in the long run.

See page 174 for a breakdown of the main five reasons that people are temporarily unemployed.

1. 7.8% - new entrants. Graduates from high school, college, vo-tech school, grad school, etc. People looking for a job for the first time.

2. 34% - re-entrants. People going back to school for further education/grad school, etc. Over 40% of unemployed are people entering the labor market after getting training, investing in human capital.

3. 11% - people left jobs voluntarily to find something better, or become a housewife or househusband, etc.

4. 33% - people who got fired or terminated. Company went bankrupt.

5. 14% - people who got laid off.

Demographics, age and sex, affect unemployment. See page 175.

Un rate is higher for young people compared to older people, as they try to figure out what career is best suited to their talents and abilities.

Unemployment has a pos side - people are trying to find a better job, or a more pleasant work environment, or move to a better area, or find a job that better suits them. People can expect 4 or 5 careers now in their lifetime.


THREE TYPES OF UNEMPLOYMENT - Economists classify un into three categories:

1) Frictional un - a result of the "friction" in the economy created by incomplete, imperfect information. Workers may not be aware of all of the jobs available and employers may not be aware of all of the qualified employees. Information is costly and imperfect. Because workers and employers don't have access to perfect information, there is some un due to the lack of complete information.

There are ways to reduce frictional un, and the lack of information. Headhunters, employment agencies specialize in trying to match up employers and employees. Trade magazines and journals advertise. Colleges have career service offices, etc. Internet may reduce the cost of obtaining information, could reduce frictional unemployment. Frictional un is natural, doesn't necessarily represent inefficiency.

WORKAVE.COM

2) Structural - in frictional un, the workers are fully qualified, it is just that they may not know where the jobs are. Structural un is a result of the dynamic changes in the economy that make someone's skills obsolete. They are faced with possible retraining and a career change.

Causes of structural un:

a. dynamic change - new products, new industries, new opportunities for some, reduced opportunities for others. Restructuring, downsizing, and outsourcing have created new opportunities, new jobs, but eliminated other jobs. Economy is changing as we move into the Information Age and as international competition intensifies. Increasing premium for education and high-skilled jobs.

b. Shifts in public sector priorities. Examples: end of Cold War, reduction on defense spending, base closings.

Example: Regulation/Deregulation may create structural unemployment.

Example: airline and trucking industries were deregulated in early 80s, industries changed.

c.Institutional factors-min wage laws reduce the amount of on the job training that employers are willing to offer and thus contribute to structural un.

3. Cyclical un - temporary un due to recession from reduced demand for labor during an econ downturn. Stabilization policies could help minimize cyclical un. Historically, un rate is linked to the bus cycle and the real growth rate of the economy. During an expansion, output growth is high and un is low. During a recession, output growth is low/neg and un is high. See page 179.


FULL EMPLOYMENT - doesn't mean zero unemployment. We could achieve zero un with forced labor, or a chain gang approach. We really don't want zero unemployment, it is a sign of a stagnant econ. Some un is natural, expected and healthy. People are trying to make their lives better.

Full employment/Full output - efficient use of labor and resources in the econ, allowing for frictional and structural un. In US, it is estimated to be 94-95%. Means that 5-6% un is natural.

Natural rate of un = frictional + structural un. Long run, sustainable condition due to imperfect information and dynamic changes. Maximum, sustainable rate of output.

Warning: Nat rate NOT a FIXED number. Can be influenced by demographics and public policy.

Examples: un is higher for young people, so as the baby boom generation entered the work force, a higher percentage of the labor force was young, which pushed up the nat rate of un by 1.5% in the 60s and 70s.

POLICY INFLUENCES ON UN- economists feel that min wage laws reduce the amount of on-the-job training, which increases the nat rate of un. Also, un benefits, or increases in un benefits, prolong periods of unemployment.

Page 179 shows the actual un rate vs. the estimated natural rate. Un rate fluctuates with the business cycle. Actual un was below the nat rate during the expansion of the late 80s and is again below the natural rate now. Much of the study in the field of Macroecon is looking at why actual un differs from the natural rate, and why the nat rate changes over time.

Final point: full production vs full employment. Full employment is not a desirable goal if it involves employment at unproductive jobs. Example: Russia may have had full employment in the sense that everyone had a "job", but it is not operating at full output or full production.


MEASUREMENT PROBLEMS FOR UN -

1. Discouraged workers, who have given up looking for a job, are not counted in the labor force, so are not counted in un rate. Only those people who are actively job-searching are counted in un rate.

The 4.9% un rate doesn't count discouraged workers, so actual rate is higher. In the 1991 recession, the DL estimate that there were 1m discouraged workers, about .8% of the workforce.

2. Part-time workers are NOT classified as unemployed, even though they may desire full-time employment. Someone working only one hour a week is still considered to be working, even though they may want 40 hour week. There could be significant UNDEREMPLOYMENT that is not calculated in un rate.

3. Some people claiming to be looking for a job, and counted as unemployed, may not be seriously seeking employment at all. People receiving assistance in the form of un insurance, welfare programs, general assistance, AFDC, food stamps, etc. may be classified as unemployed (looking for work), even though they are not serious. If there are work registration requirements for receiving assistance, some people may register to receive the benefits, not to actively seek employment.

In fact, starting work registration requirements may increase the number of people who are considered unemployed. Also, un benefits, or extending un benefits or more generous un benefits, may decrease the incentive to actively seek employment and increase the un rate.

4. Underground economy - some people counted as unemployed may actually be working in the underground economy. Because of the problems mentioned, some economist argue that the

RATE OF EMPLOYMENT is a better measure of job availability. Also called the Employment/Population ratio.

Rate of employment is equal to = # of persons employed (over 16)/population. For example, if large nos. of discouraged workers stop looking for work, the un rate drops. The rate of employment isn't affected by that kind of change.


EFFECTS OF INFLATION -

Inflation = an increase in the general price level.

Inflation erodes the purchasing power of the dollar. Even when inflation is zero, some prices are rising and some are falling, but the average is zero. Inflation is the average increase in the general price level.

3% inflation means that prices rose by 3%, on average. Some goods increased by more than 3, some less than three. Inflation is the percentage change in the price index.

Example: price index goes from 200 to 220. Inflation is 10%.

See page 184 for a historical view of inflation. See page 185 for an intl comparison of inflation. Low inflation also tends to be more stable and high inflation tends to be more volatile. We want LOW, STABLE inflation.

Anticipated vs Unanticipated Inflation/Expected vs Surprise inflation.
Unanticipated, or surprise inflation is inflation that was not expected by most people. People are caught off guard. When inflation is high and volatile, people never know what to expect, makes business planning difficult. Anticipated inflation is a change in the price level that is expected.

For example, we would expect inflation next year to be 3 percent. If it turns out to be 3%, it was expected. If it turns out to be 12%, there would be 9% of inflation that was unexpected.


COSTS OF INFLATION-

High and variable inflation makes the economy operate less efficiently for several reasons.

1. Distorts long term contracts. Example: long term labor contracts, long term contracts between companies and suppliers, mortgages, life insurance policies, pensions, bonds, tax brackets, capital gains, etc.

Example: German man who bought a life insurance for his wife and daughter, say 1m marks, when it was cashed it would only buy a loaf of bread.

If inflation is high and uncertain, people may not enter into potentially profitable long-term relationships, and trade is reduced. Or people spend more time and energy on contracts, or make shorter contracts, or more complicated contracts.

2. Resources get used up trying to avoid the negative effects of inflation. Time, attention and energy get diverted away from productive activities to trying to protect against the effects of inflation. Investment gets distorted away from productive uses toward inflation hedges.

Example: menu costs. "Shoe Leather Costs"

3. Reduces the information content of prices.  Jams the transmission of information.  Distorts prices. Prices can't co-ordinate econ activity.  Econ efficiency is reduced. People lose faith in the econ system.

STAGFLATION -

Inflation can act as an econ stimulant and temporarily lead to prosperity and econ growth, but it is artificial and temporary and leads to malinvestment. Econ will eventually experience an econ hangover, as the negative effects of inflation slowly distort the econ and lead to a stagnant economy.

Stagflation describes the condition of high inflation and high unemployment, or high inflation and sluggish output growth. High misery index.

Example: 1970s, in mid and late 70s inflation averaged about 12% and un averaged about 10%, stock market was flat for a decade. One of the challenges of modern macroeconomics is to develop policies that contribute to low stable rates of inflation and sustained, growth rates of real output.


ADJUSTING TO INFLATION - When inflation is expected and accepted as a permanent part of the economy, certain adjustments will be made:

1) Escalator clauses, COLAs, as part of collective bargaining. Wages/ salaries are automatically adjusted for inflation as part of a contract. Example: five year contract between UAW and GM, calling for wages to be adjusted for inflation. If inflation next year is 3%, wages auto go up by 3%. If inf is 10%, wages go up by 10%, etc.

2) ARMs, variable rate loans will be used more often.

3) Life and home owners policies are adjusted more frequently. Example: replacement cost of your house.

4) Long term contracts will be indexed to inflation. Example: GM has long term contracts for steel, rubber, raw materials, etc that might be indexed to inflation. Income tax brackets are now indexed.

5) States now have college tuition plans for parents to contribute now and have a guaranteed tuition for children in 18 years. Adjustments to inflation are costly and are not perfect. Should not be considered a substitute for price level stability.


WHAT CAUSES INFLATION?
"Too much money chasing too few goods."
"Inflation is always and everywhere a monetary phenomenon." We will consider inflation in detail later.

Problems: 3, 10, 13, 15, 16

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