Week 11, Unemployment and Inflation

Monday 13 May 2024

11:03 AM

Measuring the Unemployment Rate and the Labour Force Participation Rate

The labor force survey:

Unemployment rate:
The percentage of the labor force that is unemployed.

Labor force:
The sum of employed and unemployed workers in the economy.

Discouraged workers:
People who are available for work but have not looked for a job during the previous four
weeks because they believe no jobs are available for them.

The Australian Bureau of Statistics (ABS) labor force survey:

 Monthly sample of around 0.32% of the population aged 15 and over.

 To be classified as employed, a person must have worked in paid employment only 1 hour or
more in the week before the survey.

 To be classified as unemployed, a person must not have worked at all in the week before the
survey, must have been actively looking for work in the past 4 weeks, and must be ready to
start work immediately.
 Measuring the unemployment rate and the labor force participation rate

The unemployment rate measures the percentage of the labour force that is unemployed.

The labour force survey, cont.

Labour force participation rate:

The percentage of the working age population that is in the labour force.

Problems with measuring the unemployment rate

1. The number of discouraged workers increases during a recession, therefore the official
unemployment rate appears lower than it would otherwise be.

2. Under-employed workers – people who work part-time but would like to work more hours
are counted as “employed” which tend to make the employment situation appear better
than it is.

3. People who claim to be unemployed (but are not) can lead to the unemployment rate being
overstated and vice versa.

Measuring the unemployment rate and the labour force participation rate

Trends in labour force participation

The higher the participation rate, the more labour is available and the higher the level of
potential GDP.

1978 – 2014: Male participation rate fell from 79% to 71% in Australia.

1978 – 2014: Female participation rate rose from 44% to 58.6% in Australia.

The decline in labour force participation among adult men has been more than offset by a
sharp increase in the labour force participation rate for adult women.
 As a result, the overall labour force participation rate rose from 61 per cent in 1978 to 64.5 per
cent by late 2014.

How long are people usually unemployed?

2014, Australia:
Around 44% of unemployed people found a job within 3 months, and almost 60% within 6
months.

Long-term unemployed:
Those in the labour force who have been continuously unemployed for a year or longer.

2014, Australia:
20% of the unemployed were long-term unemployed.

Job creation and job destruction

The Australian economy creates and destroys hundreds of thousands of jobs every year:

o New firms begin; existing firms expand.

o Some firms contract; some firms go out of business.

Job creation and destruction is a normal part of an economy and is due to changes in:

o Consumer tastes, technological change, and entrepreneurial success and failure.

The Costs of Unemployment

Costs to the economy:

 Loss of gross domestic product

 Loss or deterioration of human capital
 o unemployment, particularly for lengthy periods of time, can lead to a loss of human
capital because a person’s skills may deteriorate when they are not using them.

 Retraining costs
o The unemployed may have to be retrained due to their skills deteriorating during
their period of unemployment, or because their pre-existing skills are no longer
required by the economy.

 Costs to the government

o Unemployment benefit payments are a net drain on the federal budget.
o The opportunity cost of funds directed towards unemployment benefits.
o Loss of tax revenue – individual income tax, company tax and GST.

The Costs of Unemployment

Costs to the individual:

 Loss of income
o When a previously employed person becomes unemployed they experience a
significant reduction in income, equal to the difference between their previous wage
level and the unemployment benefit. Unemployment is one of the main causes of
poverty.

 Social costs
o As we discussed earlier, the individual may also experience loss of skills during their
period of unemployment, and retraining costs. However, becoming unemployed can
also lead to despair and loss of self-esteem.

o Unemployment may contribute to family break-ups, health problems, mental illness, crime
and political unrest.

Note the burden of unemployment, which is an economic problem experienced by the

whole economy, falls unequally. Those actually unemployed shoulder the brunt of the
burden.
 Figure 13.3: Unemployment rate by age, 2014.
The rate of unemployment is significantly higher among 15 – 19 year olds - 18.5% -
than for any other group. In most societies, some demographic groups will be more
vulnerable to unemployment than others. The graph shows young, unskilled people in
Australia fall into this category.

Types of Unemployment

 The unemployment rate follows the business cycle (will be explained in detail next week).

 Rises during and soon after economic contractions and recessions.

 Falls during economic expansions and booms.

 Types of Unemployment

Cyclical unemployment:
Unemployment caused by a business cycle contraction.
 Also known as ‘demand deficient’ unemployment.

Falling sales lead to cut-backs on production and the sacking of workers.

When the economy begins to recover, the unemployment rate usually continues to rise for
some time because:
 Discouraged workers re-enter the workforce, believing that economic growth will provide
jobs. However, until they find work they are unemployed, increasing the unemployment
rate.

 Some firms have excess capacity, and also want to wait to see if the recovery lasts before
hiring new workers.

Frictional unemployment:
Short-term unemployment arising from the process of matching workers with jobs.

 For example; university graduates looking for their first job, people re-entering the
workforce after an absence or people who have lost or quit their job and are looking for
their new job.

 Some frictional unemployment is good for the economy because:

o It means that workers and employers are taking the time necessary to match worker
attributes with job characteristics.

o New workers with skills (graduates) are entering the labour force.

Seasonal unemployment:
Unemployment due to factors such as weather, variations in tourism and other calendar-
related events.

Structural unemployment:
Unemployment arising from a persistent mismatch between the skills and characteristics of
workers and the requirements of jobs.
e.g. New technology may make some workers redundant.

While frictional unemployment is short term, structural unemployment can last for longer
periods because workers need time to learn new skills and some may never acquire these.

Full employment

As the economy moves through the expansion phase of the business cycle, cyclical
unemployment will eventually drop to zero. The unemployment rate will not be zero,
however, because of frictional and structural unemployment.
When the only remaining unemployment is structural and frictional unemployment, the
economy is said to be at full employment.

Economists often think of frictional and structural unemployment as being the normal
underlying level of unemployment in the economy. The fluctuations around this normal level
of unemployment, which we see in Figure 11.4, are mainly due to the changes in the level of
cyclical unemployment.

The normal level of unemployment, which is the sum of frictional and structural
unemployment, is referred to as the natural rate of unemployment, and occurs when the
economy is operating at potential GDP; there is no cyclical unemployment.

The natural rate of unemployment is also sometimes called the full-employment rate of
unemployment.

Measuring Inflation

Inflation:
The sustained increase in the general level of prices in the economy.
Inflation affects the purchasing power of money

Inflation hurts people on fixed incomes, such as retired persons who may be receiving a
pension of a fixed number of dollars each year.

Price level:
A measure of the average prices of goods and services in the economy.

Inflation rate:
The percentage increase in the general price level in the economy from one year to the next.

Last week, we introduced the GDP deflator as a measure of the price level. The GDP deflator is
a very broad measure of the price level because it includes the price of every final good and
service produced in the economy. But, for some purposes, it is too broad. For example, if we
want to know the impact of inflation on the typical household, the GDP deflator may be
 misleading because it includes the prices of products such as large electric generators and
machines that are included in the investment component of GDP but are not purchased by the
typical household.

Further, the GDP deflator measures the prices of only those goods and services produced in
Australia. However, as we know, consumers purchase many goods and services produced
overseas.

Our focus now is on measuring changes in the cost of living as experienced by the typical
household. This can be achieved by measuring the inflation rate by changes in the consumer
price index and the producer price index.

The consumer price index (CPI)

Consumer price index (CPI):

A measure of changes in retail prices of a basket of goods and services representative of
consumption expenditure by typical Australian households in capital cities.

The Australian Bureau of Statistics (ABS) surveys households on their spending habits.

 The goods and services typically purchased by households is the ‘market basket’.

 The prices of goods and services in the market basket are given a weight according to their
fraction of a ‘typical’ family budget.

The CPI measures the rate of change in the prices of the goods and services in the market
basket.

Figure 13.5 : The CPI market basket.

Goods and services in the CPI market basket are grouped into 11 broad categories. Over half
of the market basket falls into the categories of housing, transportation and food.
 The following is a simplified example of the market basket to show how the CPI is constructed.

The table on the previous slide shows that statisticians use base year quantities to measure
the cost of the basket for the base year and the years that follow.

The inflation rate in 2016 would be the percentage change in the CPI from 2015 to 2016:

Because the CPI is designed to measure the cost of living, we can also say that the cost of living
in our simple example increased by 1.7 per cent during 2016.

Is the CPI accurate?

The CPI is the most widely used measure of inflation.

Four sources of bias in the CPI may lead to it overstating the inflation rate.

 Substitution bias:
In constructing the CPI the ABS assumes that each month consumers purchase the
same amount of each product in the market basket.

 Increase in quality bias:

Increases in the prices of products such as cars partly reflect their improved
quality and partly are pure inflation.

 New product bias:

 The ABS updates the market basket of goods used in calculating the CPI only
approximately every five to six years. This means that new products introduced
between updates are not included in the market basket.

 Outlet bias:
The acquisition of goods by mail order or over the phone or Internet from outlets
within and outside the capital city of residence is considered by the ABS to be
relatively small which might not be true sometimes. If the ABS continued to collect
price statistics from traditional full-price retail stores, the CPI would not reflect the
prices some consumers actually paid.

Measuring inflation

The producer price index (PPI)

In addition to the GDP deflator and the CPI, the ABS also calculates the producer price index
(PPI). Like the CPI, the PPI tracks the prices of a market basket of goods. But, whereas the CPI
tracks the prices of goods and services purchased by the typical household, the PPI tracks the
prices firms in Australia receive for goods and services at all stages of production.

The PPI includes the prices of intermediate goods, such as flour, cotton, steel and timber, and
raw materials, such as raw wool, coal and crude oil. If the prices of these goods rise, the cost
to firms of producing final goods and services will rise, which may lead firms to increase the
prices of goods and services purchased by consumers.

Changes in the PPI therefore can give an early warning of future movements in the CPI.

Using Price Indexes to Adjust for the Effects of Inflation

The purchasing power of the dollar falls over time as prices rise.

Price indexes, such as the CPI, enable the adjustment to be made for the effects of inflation, so
dollar values can be compared over time.

The 2014 purchasing power equivalent of a $20 000 salary in 1980 can be found using the CPI.
For example:

Does inflation impose costs on the economy?

Inflation affects the distribution of income

 People on fixed incomes ( e.g. retired worker) are likely to experience reduced purchasing
power due to inflation.
 The extent of redistribution depends, in part, on the degree to which inflation is anticipated
or unanticipated.

Does inflation impose costs on the economy?

The problems with anticipated inflation

Income redistribution, as some people’s income will fall behind anticipated inflation.

Those holding wealth in paper money.

Menu costs:
The costs to firms of changing prices.

Increases taxes paid by those who own income-generating assets, such as bonds, shares and
deposits, and also increases individual income taxes paid due to ‘bracket creep’.

Does inflation impose costs on the economy?

The problems with unanticipated inflation

There are winners and losers, depending on whether inflation is higher than or lower than
anticipated.

For example: People on fixed-payment contracts will lose if inflation is higher than
anticipated.

Borrowers on fixed-rate contracts may gain and lenders may lose when inflation is
higher than anticipated.

Does inflation impose costs on the economy?

The problems with unanticipated inflation, cont.

Nominal interest rate:

The stated interest rate on a loan.

Real interest rate:

The nominal interest rate minus the inflation rate.

If the inflation rate is higher than expected, borrowers may gain and lenders receive a lower
real interest rate (on a fixed interest rate loan).

The real interest rate provides a better measure of the true cost of borrowing and the true
return to lending than does the nominal interest rate.

It is possible for the nominal interest rate to be less than the real interest rate during times of
deflation (very rare in Australia).
 Does inflation impose costs on the economy?

Hyperinflation

Hyperinflation:
Extremely rapid increases in the general price level.

 In periods of hyperinflation money loses value so rapidly that firms and households try to
avoid holding it.
 Hyperinflation is often associated with political instability and is usually accompanied by a
severe recession and economic and political turmoil

Deflation

Deflation:
A decline in the general price level in the economy, which does not occur very often.

Problems with deflation include:

 Increases debt burdens

 Reduces asset values and wealth

 Gains to consumers from falling prices may be negated by falling wages

 The real interest rate rises above the nominal interest rate, discouraging business borrowing

 Long-term deflation can severely erode economic growth

What Causes Inflation?

Demand-pull inflation:
Inflation that is caused by an increase in the aggregate demand for goods and services and
production levels are unable to meet this demand immediately.

 Aggregate demand: The quantity of goods and services demanded by households, firms and
government, plus net exports.
 Production may be unable to meet demand, particularly when the economy is close to, or at,
full employment.

Cost-push inflation:
Inflation that arises as a result of a negative supply shock - that is, anything that causes a
decrease in the aggregate supply of goods and services.

Aggregate supply:
The quantity of goods and services supplied by firms.

Sources of a supply shock can include:

 Increases in import prices, wages, taxation, monopoly power in product markets
 Natural disasters, such as droughts, floods, earthquakes

Is There a Short-run Trade-off between Unemployment and Inflation?

The Phillips curve:

Phillips curve:
A curve showing the short-run relationship between the unemployment rate and the inflation
rate.