PRINCIPLES OF MACROECONOMICS Measuring Inflation and Unemployment Measuring

PRINCIPLES OF MACROECONOMICS Measuring Inflation and Unemployment

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).

Measuring Inflation and Unemployment Measuring Inflation – The Consumption Basket All Items Food and Beverages Housing Apparel Transportation Medical care Education and Communication Recreation Other Goods and Services Sum Weights 14. 901 41. 448 3. 437 16. 418 7. 551 7. 087 5. 793 3. 365 100 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 also Producer Price Indices.

Measuring Inflation and Unemployment Example: KSU Student’s Consumption Basket Item Weight 2013 Prices 2014 Prices 2015 Prices Dorm 0. 5 50 60 70 Food 0. 4 10 20 25 School 0. 1 30 20 30 Sum 1. 0 CPI 2014 = CPI 2015 = � Please fill out the table. Inflation ‘ 13 ’ 14 Inflation ‘ 14 ’ 15 Inflation ‘ 13 ’ 15

Measuring Inflation and Unemployment Example: KSU Student’s Consumption Basket Item Weight 2013 Prices 2014 Prices 2015 Prices Inflation ‘ 13 ’ 14 Dorm 0. 5 50 60 70 20% Food 0. 4 10 20 25 School 0. 1 30 20 30 CPI 2014 = CPI 2015 = Sum 1. 0 32 � Too Inflation ‘ 14 ’ 15 48 difficult? Here are some answers. Inflation ‘ 13 ’ 15 40% 20%

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.

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.

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 400 + $2 x 1, 000 2014: $11 x 500 + $2. 50 x 1, 100 = $8, 250 2015: $12 x 600 + = $10, 800 $3 x 1, 200 = $6, 000 37. 5% 30. 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 Compute real GDP in each year, using 2013 as the base year: 2013: $10 x 400 + $2 x 1, 000 = $6, 000 2014: $10 x 500 + $2 x 1, 100 = $7, 200 2015: $10 x 600 + $2 x 1, 200 = $8, 400 Increase: 20. 0% 16. 7%

Measuring Inflation and Unemployment Example: GDP - Comparison year Nominal GDP Real 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).

Measuring Inflation and Unemployment Example: GDP - Comparison Nominal GDP Real GDP 2013 $6, 000 2014 $8, 250 2015 $10, 800 year 37. 5% 30. 9% $7, 200 $8, 400 20. 0% 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.

Measuring Inflation and Unemployment Nominal vs. Real GDP Trillions 1, 800. 0 1, 600. 0 1, 400. 0 1, 200. 0 1, 000. 0 800. 0 600. 0 400. 0 200. 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Base Year GDP Nominal GDP Real (2005 USD) Source: World Bank Development Indicator Database.

Measuring Inflation and Unemployment GDP Deflator 140 In 2013, nominal GDP was 16. 77 trillion in current US dollars. The GDP deflator in 2013 (base year=2005) was 116. 04, how big was real GDP in 2013? 120 100 80 60 40 20 05 20 10 20 95 19 90 19 85 19 80 19 75 19 70 19 65 19 19 60 0 GDP Deflator Source: World Bank Development Indicator Database.

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.

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

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).

Measuring Inflation and Unemployment Inflation, Disinflation, and Deflation

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

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

Measuring Inflation and Unemployment Rate Source: Bureau of Labor Statistics

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.

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.

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

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 (l. E) must equal unemployed finding jobs (j. U). 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

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.