In This Lecture….. Phases of the Business Cycle Calculating Official Unemployment Rate Problems with Measuring the Unemployment Rate Four Types of Unemployment Full Employment (Natural Rate of Unemployment) Potential Real GDP Recessionary Gap / Inflationary Gap

Business Cycle Phases Expansion: when Real GDP is rising. Peak: when Real GDP stops rising, it has hit the peak. Recession: when Real GDP is actually declining. Two consecutive quarters of decline Depression: if decline is very large Trough: when Real GDP stops falling, it has hit the trough Recovery: period while Real GDP is making up for the production that was lost during a recession.

Business Cycles Recurrent swings (up and down) in Real GDP; alternating periods of expansions and recessions. 3

Determining Labor Participation & Unemployment Rate Current Population Survey / Household Survey Conducted every month U.S. Bureau of the Census Sample of 60,000 households 16 years of age and older Labor Participation: Employed / Unemployed BLS: calculates monthly unemployment rate

Understanding the Unemployment Rate and the Labor Force Participation Rate

Labor Force & Labor Force Participation Rate Labor force – The labor force is the sum of those people who are officially employed and unemployed. Labor force participation rate - The percentage of the working-age population that is in the civilian labor force: Labor force LFPR = --------------------------------------------- x 100 Working-Age Population

Calculating the Official Unemployment Rate Unemployment Rate-The percentage of the civilian force that is unemployed: Number of unemployed persons U = -------------------------------------------- X 100 Labor force 7

Problems with Measuring the Unemployment Rate Distinguishing between the unemployed and those not in labor force. Discouraged Workers Part-time vs. Full-time jobs Inaccurate responses to survey Beware of Liars Working in the Underground Economy

Types of Unemployment Frictional Unemployment and Job Search Frictional unemployment: Short-term unemployment arising from the process of matching workers with jobs. Structural Unemployment Structural unemployment: Unemployment arising from a persistent mismatch between the skills and characteristics of workers and the requirements of jobs.

Types of Unemployment Cyclical Unemployment Cyclical unemployment: Unemployment caused by a business cycle recession. Full Employment Natural rate of unemployment: The normal rate of unemployment, consisting of structural unemployment plus frictional unemployment.

EXAMINING UNEMPLOYMENT How Is Unemployment Defined and Measured? FIGURE 6.2 Unemployment Rates in Developed Countries

Government Policies & the Unemployment Rate Unemployment Insurance & Other Payments Legislation against firing workers Minimum Wage Laws Labor Unions Efficiency Wages 12 - 5 Average Unemployment Rates in the United States, Canada, Japan, and Europe, 1995-2004

Self Test What is the major difference between a person who is frictionally unemployed and one who is structurally unemployed? The frictionally unemployed person has readily transferable skills, and the structurally unemployed person does not.

Self Test If the cyclical unemployment rate is positive, what does this imply? It implies that the (actual, measured) unemployment rate in the economy is greater than the natural unemployment rate. For example, if the unemployment rate is 8 percent and the natural unemployment rate is 6 percent, the cyclical unemployment rate is 2 percent.

Understanding Potential Real GDP Potential Real GDP – The amount of production we need to have in order to have full employment. Potential GDP is a goal – the amount an economy would like to produce in order to have full employment. Real GDP: Remember………..Real GDP is the amount we actually produce GDP Gap: The difference between the actual Real GDP and the Potential Real GDP

Understanding GDP Gaps Recessionary Gap – occurs when Real GDP falls below Potential Real GDP. Therefore, in this case, the unemployment rate is above the natural rate of unemployment. That is, the economy is not exhibiting full employment. Inflationary Gap – occurs when Real GDP falls above Potential Real GDP. Therefore, in this case, the unemployment rate is below the natural rate of unemployment. That is, the economy can provide jobs to whomever wants one and inflation is on the rise.

In This Lecture….. Defining Price Level and Inflation Calculating the Consumer Price Index (CPI) COLA Calculating Percentage Changes in the CPI Overstating the CPI GDP Deflator Nominal Interest Rate vs. Real Interest Rate The Effects of Inflation 17

Defining Price Level & Inflation Price Level - A weighted average of the prices of all good and services. Inflation – an increase in the price level Deflation – a decrease of the price level Price Index – A measure of the price level 18

The Consumer Price Index (CPI) Consumer price index (CPI): An average of the prices of the goods and services purchased by the typical urban family of four. 12 - 6 The CPI Market Basket, December 2004

The Consumer Price Index (CPI) COLA – Cost of living adjustment…….income is adjusted automatically to reflect the increases in prices, as measured by the increase in the CPI. Base Year - The year chosen as a point of reference or basis of comparison for prices in other years; a benchmark year. 20

Shortcomings of the CPI Substitution Bias Outlet Bias Increase in Quality Bias Overstated by 1%? 21

Computing the Consumer Price Index 22

Changes in Prices In 2005 the CPI was 195.3; in 2006 the index was 201.6. What was the percentage change in prices from 2005-2006? Click below for answer. 3.23 % 23

Consumer Price Index 1983-2007 Year Annual 1983 99.6 1984 103.9 1985 107.6 1986 109.6 1987 113.6 1988 118.3 1989 124.0 1990 130.7 1991 136.2 1992 140.3 1993 144.5 1994 148.2 1995 152.4 Year Annual 1996 156.9 1997 160.5 1998 163.0 1999 166.6 2000 172.2 2001 177.1 2002 179.9 2003 184.0 2004 188.9 2005 195.3 2006 201.6 2007 207.3 2008 24

Self-Test 1. What is a base year? It is a year that is used for comparison purposes with other years. 25

Self Test 2. Explain how the CPI is calculated. The CPI is calculated as follows: (1) define a market basket, (2) determine how much it would cost to purchase the market basket in the current year and in the base year (3) divide the dollar cost of purchasing the market basket in the current year by the dollar cost of purchasing the market basket in the base year, and (4) multiply the quotient by 100. 26

The GDP Deflator GDP Deflator: another measure of the price level . Evaluates changes in the prices of ALL products…….calculated as nominal GDP divided by Real GDP x 100. Real GDP = Nominal GDP x 100 Real GDP 27

The GDP Deflator: Better Measure of Inflation? No fixed Market Basket Base Year is different from CPI GDP Deflator measures changes in the prices of all goods and services, whereas the CPI measures only a basket of goods. 28

Self-Test 4. Assume there are three goods in the economy: Quantity 2000 Quantity 2008 Price 2000 Price 2008 A 10 15 $1 $3 B 5 10 $2 $6 C 20 20 $5 $15 Using this data, calculate the GDP Deflator for 2008. 29

Effects of Inflation: Winners & Losers Debtors Nominal interest rate: interest rate quoted Real interest rate: nominal interest rate minus the rate of inflation Homeowners Wage earners Government Losers Creditors Savers Wage Earners 30