1. Principles of Macroeconomics
Measuring Inflation and Unemployment

2. Measuring Inflation and Unemployment
Learning Objectives
Understand
The concept of calculating a CPI
The concept of the GDP deflator
The consequences of inflation, including hyperinflation
Understand the concept of unemployment
The (short-run) inverse relationship between inflation and unemployment (Phillips Curve).

3. Measuring Inflation and Unemployment
Measuring Inflation – The Consumption Basket
All Items
Weights
Food and Beverages
14.901
Housing
41.448
Apparel
3.437
Transportation
16.418
Medical care
7.551
Education and Communication
7.087
Recreation
5.793
Other Goods and Services
3.365
Sum
100
Source: Bureau of Labor Statistics, CPI Detailed Report
Data for December 2014
One problem of calculating consisting consumer price indices is that old products disappear, new products are invented.
There are also Producer Price Indices.

4. Measuring Inflation and Unemployment
Example: KSU Student’s Consumption Basket
Please fill out the table.
Item
Weight
2013 Prices
2014 Prices
2015 Prices
Inflation
‘13’14
‘14’15
‘13’15
Dorm
0.5 50 60 70
Food
0.4 10 20 25
School
0.1 30
Sum
1.0
CPI2014 =
CPI2015 =

5. Measuring Inflation and Unemployment
Example: KSU Student’s Consumption Basket
Too difficult? Here are some answers.
Item
Weight
2013 Prices
2014 Prices
2015 Prices
Inflation
‘13’14
‘14’15
‘13’15
Dorm
0.5 50 60 70
20%
40%
Food
0.4 10 20 25
School
0.1 30
Sum
1.0
CPI2014 = 32
CPI2015 = 48

6. Measuring Inflation and Unemployment
The GDP Deflator
The GDP deflator is a measure of the overall level of prices.
Definition:
One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next.

7. Measuring Inflation and Unemployment
Real versus Nominal GDP
Inflation can distort economic variables like GDP, so we have two versions of GDP: One is corrected for inflation, the other is not.
Nominal GDP values output using current prices. It is not corrected for inflation.
Real GDP values output using the prices of a base year. Real GDP is corrected for inflation.

8. Measuring Inflation and Unemployment
Example: Nominal GDP
Pizza
Latte
year P Q
2013
$10
400
$2.00
1,000
2014
$11
500
$2.50
1,100
2015
$12
600
$3.00
1,200
Increase:
Compute nominal GDP in each year:
2013: $10 x $2 x 1,000 = $6,000
2014: $11 x $2.50 x 1,100 = $8,250
2015: $12 x $3 x 1,200 = $10,800
37.5%
30.9%

9. Measuring Inflation and Unemployment
Example: Real GDP
Pizza
Latte
year P Q
2013
$10
400
$2.00
1,000
2014
$11
500
$2.50
1,100
2015
$12
600
$3.00
1,200
$10
$2.00
Increase:
Compute real GDP in each year, using 2013 as the base year:
2013: $10 x $2 x 1,000 = $6,000
2014: $10 x $2 x 1,100 = $7,200
2015: $10 x $2 x 1,200 = $8,400
20.0%
16.7%

10. Measuring Inflation and Unemployment
Example: GDP - Comparison
year
Nominal GDP
Real GDP
GDP Deflator (2013=100)
2013
$6,000
100
2014
$8,250
$7,200
114.58
2015
$10,800
$8,400
128.57
In each year, nominal GDP is measured using the (then) current prices.
Real GDP is measured using constant prices from the base year (2013 in this example).

11. Measuring Inflation and Unemployment
Example: GDP - Comparison
year
Nominal GDP
Real GDP
2013
$6,000
2014
$8,250
$7,200
2015
$10,800
$8,400
37.5%
20.0%
30.9%
16.7%
The change in nominal GDP reflects both prices and quantities.
The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation).
Hence, real GDP is corrected for inflation.

12. Measuring Inflation and Unemployment
Nominal vs. Real GDP
Source: World Bank Development Indicator Database.

13. Measuring Inflation and Unemployment
GDP Deflator
In 2013, nominal GDP was trillion in current US dollars. The GDP deflator in 2013 (base year=2005) was , how big was real GDP in 2013?
Source: World Bank Development Indicator Database.

14. Measuring Inflation and Unemployment
Inflation – Who wins, who loses?
Winners: debtors
Losers: creditors
In the long run everyone loses, especially when inflation becomes non-predictable and inflation spins out of control (Hyperinflation).
Similarly, under deflation borrowers lose, creditors win.

15. Measuring Inflation and Unemployment
Hyperinflation Germany 1923
Kids playing with worthless money
Workers collecting pay
The only good thing about hyperinflation was that there were no bank robberies!
Burning money in the kitchen stove

16. Measuring Inflation and Unemployment
Causes of Inflation
Cost push-inflation (like the oil-price crises of 1973, price wage spiral).
Demand pull-inflation (often when government pays its debt by printing money, example: Bolivia 1986).

17. Measuring Inflation and Unemployment
Inflation, Disinflation, and Deflation

18. Measuring Inflation and Unemployment
The Labor Force (LF)
LF=Employed + Unemployed
Employed: People age≥16 who work for pay or profit.
Unemployed: People age≥16 who are not employed, but are available for work and have been actively seeking work for the previous 4 weeks
Problem: Discouraged workers underestimate real LF)
Unemployment Rate = Unemployed/LF×100
LF Participation Rate = LF/Population

19. Measuring Inflation and Unemployment
Labor Force Participation Rate
Source: Bureau of Labor Statistics

20. Measuring Inflation and Unemployment
Unemployment Rate
Source: Bureau of Labor Statistics

21. Measuring Inflation and Unemployment
Causes of Unemployment
Frictional (transitional) unemployment, which is “between the jobs unemployment.”
Structural unemployment, which is unemployment caused by structural factors like inflation, deflation, high wage rates, taxes, and regulations.
Cyclical unemployment, which is unemployment caused by seasonal factors and general business cycles.

22. Measuring Inflation and Unemployment
Natural Rate of Unemployment
Because of frictional, structural, and cyclical factors, there will always be some unemployment, which can be thought of as “natural.”
The actual rate of unemployment, which is largely affected by short term dynamics likes booms and busts, always fluctuates around a long term average.

23. Measuring Inflation and Unemployment
Natural Rate of Unemployment
Source: Bureau of Labor Statistics

24. Measuring Inflation and Unemployment
Natural Rate of Unemployment – A Simple Model
Finding the natural rate of unemployment by solving for U/LF:
Basic idea: Those employed losing jobs (lE) must equal unemployed finding jobs (jU).
Example: If 1.5% of all employed get always unemployed (l=0.015) and 28.5% of all unemployed always find a job (j=0.285), the natural rate of unemployment is

25. Measuring Inflation and Unemployment
The relationship between inflation and unemployment – The Phillips Curve
The Phillips curve shows a short-run inverse relationship between inflation and unemployment. Why?
The basic logic goes like this: Because wages are sticky in the long run, inflation reduces the real wage, therefore encouraging companies to hire more.
The Phillips curve does not hold in the long run. Why? The basic logic goes like this: Because workers lost real income due to inflation, they will ask for hire wages in the long run, therefore triggering a price-wage- spiral.