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					        Chapter 7
The Anatomy of Inflation
  and Unemployment
•    So far have focused on how various economic factors
     determine output, prices, unemployment, and inflation
      now examine the consequences of inflation and
     unemployment and the tradeoff between them
•    Two major costs of unemployment:
    1.   Lost production
    2.   Undesirable effects on the distribution of income
•    The costs of inflation depend on the type:
        Unanticipated inflation creates significant redistribution of
        Impact of anticipated inflation, especially of moderate levels, is

•   The greatest single cost of               [Insert Figure 7-1 here]
    unemployment is lost
    production  people who
    don’t work don’t produce
    •   This cost is large: a recession can
        imply drop in GDP by 3-5%
    •   Okun’s law states that 1 extra
        point of unemployment costs 2%
        of GDP [See Figure 7-1]
•   Costs are borne unevenly, and
    mainly by those who lose their
•   Workers just entering the labor
    force and teenagers are
    amongst the hardest hit
•   Costs of extremely high inflation are easy to see
    •   M lubricates the economy  if P increase dramatically:
        •   money is no longer a useful medium of exchange
        •   output can drop substantially
•   Costs of low, single-digit inflation are more difficult to
•   Unanticipated inflation has distributional implications:
    •   debtors benefit by repaying in cheaper dollars
    •   creditors suffer by being repaid in cheaper dollars

           The Anatomy of Unemployment
•        Research has revealed five key characteristics of
         unemployment in the U.S.
    1.    There are large variations in unemployment rates across
          groups defined by age, race, or experience.
    2.    There is high turnover in the labor market. Flows into and out
          of employment and unemployment are high relative to the
          numbers of employed or unemployed.
    3.    A significant part of this turnover is cyclical: Layoffs and
          separations are high during recessions, and voluntary quits are
          high during booms.
    4.    Most people who become unemployed in any given month
          remain unemployed for only a short time.
    5.    Much of the U.S. unemployment consists of people who will
          be unemployed for quite a long time.
            The Anatomy of Unemployment
•        The size of the labor force is         [Insert Table 7-2 here]
         determined by surveys
    •      Labor force = unemployed (U)
           + employed (E)
•        Unemployed is one who is
         out of work and who either
    1.     Has actively looked for work
           during the previous 4 weeks OR
    2.     Is waiting to be recalled to a job
           after having been laid off

           The Anatomy of Unemployment
•        Employed person is one who          [Insert Table 7-2 here]
         during the reference week:
    1.    Did at least one hour of work
          for pay in the last week
    2.    Worked at least 15 hours as an
          unpaid worker for an enterprise
          owned by a family member
    3.    Was not working, but only
          temporarily absent from work
          (ex. vacation or maturity leave)

              The Unemployment Pool
•   At any point in time there is a given number, or pool,
    of unemployed people, and there are flows in and out of
    the unemployment pool.
•   A person can become unemployed for one of four
     1.   New entrant or reentrant into the LF
     2.   Person who quit a job in order to look for other employment and
          may register as unemployed while searching
     3.   Laid off worker (suspended without pay)
     4.   Worker who lost a job (fired or firm closes)

              The Unemployment Pool
•   There are three ways of moving out of the
    unemployment pool:
     1.   A person may be hired into a new job
     2.   Someone laid off may be recalled
     3.   An unemployed person may stop looking for a job, and thus
          move out of the labor force
•   Unemployment is rising when more people are entering
    the pool than leaving

              Variation in Unemployment
                     Across Groups
•   The aggregate unemployment rate tells us the share of the
    labor force that is unemployed
•   The aggregate number conceals wide variations across
    various segments of the population
    •   Teenagers have much higher unemployment rates than older
    •   Black unemployment is higher than that of their white cohorts
    •   Female unemployment was higher than male unemployment
        through the 1970s, but currently approximately equal

    Cyclical and Frictional Unemployment
•   Frictional unemployment is the unemployment that exists
    when the economy is at full employment
    •   Results from the structure of the labor market, including:
         The nature of jobs in the economy
         Social habits
         Labor market institutions
         Frictional unemployment rate = natural rate of unemployment

•   Cyclical unemployment is unemployment in excess of
    frictional unemployment
    •   Occurs when output is below the full employment level
    •   The presence of cyclical unemployment indicates a downturn in
        the economy

                   Labor Market Flows
•   Labor market turnover (flows     [Insert Table 7-3 here]
    into and out of unemployment
    and employment and between
    jobs) is large
•   Table 7-3 shows the average of
    monthly flows in 2005 into and    People are taking and leaving jobs.
    out of employment within the
    manufacturing sector

             Duration of Unemployment
•   A spell of unemployment is a      [Insert Table 7-4 here]
    period in which an individual
    remains continuously
•   The duration of unemployment
    is the average length of time a
    person remains unemployed
•   Table 7-4 shows the duration
    of unemployment for 2000 and

         Determinants of the Natural Rate
•   The determinants of the natural rate of unemployment, u*:
    duration and frequency of unemployment
    •   Duration of unemployment depends on cyclical factors and on
        the structural characteristics of the labor market:
         The organization of the labor market, including the presence or
          absence of employment agencies, youth employment services, etc.
         The demographic makeup of the labor force

         The ability and desire of the unemployed to keep looking for a
          better job, which depends in part on the availability of
          unemployment benefits

         Determinants of the Natural Rate
•   The determinants of the natural rate of unemployment, u*:
    duration and frequency of unemployment
    •   Frequency: the average number of times per period that workers
        become unemployed
    •   Two basic determinants of the frequency of unemployment:
         Variability of the demand for labor across different firms
         The rate at which new workers enter the labor force, since new
          potential workers begin as unemployed workers
The three determinants of duration and the two
  determinants of frequency of unemployment are the basic
  determinants of the natural rate of unemployment
• Different natural rates for the various demographic
  groups: natural rate aggregates u* across different groups
Estimates of the Natural Rate

   [Insert Figure 7-3 here]

         The Natural Rate vs the NAIRU
•   NAIRU: Non-accelerating inflation rate of
•   Based on the Phillips Curve:  t   t 1   (u  u* )
    where t-1 is used to form expectations about current
•   NAIRU is the rate of unemployment such that inflation
    remains constant: t = t-1

    Hysteresis and the Rising Natural Rate
              of Unemployment
•   Between 1973 and 1988 the U.S. unemployment rate
    stayed well above the estimated natural rate
•   One explanation is unemployment hysteresis: extended
    periods of high unemployment raise the natural rate
    •   Unemployed might become accustomed to not working
    •   Unemployed could become discouraged and stop seeking work
    •   Long unemployment spells might signal to firms that a worker is
        undesirable, and the firms might avoid hiring such workers

    Hysteresis and the Rising Natural Rate
              of Unemployment
•   Unemployment rates vary over time and across countries
•   European countries tend to have higher unemployment
    than the US
•   This reflects more than different economic conditions
•   European labor markets more rigid, in part due to
    institutions that make them so
    •   Firing costs
    •   More generous unemployment benefits
    •   Minimum wage rules
    •   Real-wage inflexibility ↔ strong unions
    •   Low geographic and occupational mobility of labor
                   Unemployment Benefits
•       Unemployment benefits increase the rate of
        unemployment in two ways:
         1.   Unemployment benefits allow for longer job searches
         2.   Lessens the severity of being in and out of jobs
•       Unemployment benefits increase the measured
        unemployment rate through reporting effects
         In order to collect unemployment insurance, a person must be
          considered “in the labor force,” or actively seeking work 
          some seek work even if they do not really want the job to be
          counted as unemployed
          One estimate suggests that reporting effects raise the
           unemployment rate by about half a percentage point
             The Costs of Unemployment
•   Unemployed persons suffer both from their income loss
    and from the related social problems that long periods of
    unemployment cause
    •   Costs of cyclical unemployment:
         Okun’s law tells us that every 1 point increase in unemployment
          reduces output by 2 % points
         Distributional impact of unemployment may be more dire for some
          groups than others (Ex. Teenagers vs. older workers)
         In addition to lost output from unemployment, there is reduced tax
    Social costs of unemployment:
       include increased divorce rates, suicide rates, depression, …
                   The Costs of Inflation
•   Perfectly anticipated inflation: Suppose an economy has
    been experiencing inflation of 5% and the anticipated rate
    of inflation is also 5%, then all contracts will build in the
    expected 5% inflation
    • Nominal interest rates account for anticipated inflation
    • Long term labor contracts account for anticipated inflation

    • Tax brackets are typically adjusted to account for inflation

     Inflation has no real costs, except for two qualifications:
         The costs of holding currency rise along with the rate of inflation,
         The demand for currency decreases

         Menu costs of inflation

                 The Costs of Inflation
•   Full adjustment to inflation not realistic  imperfectly
•   Most contracts are written in nominal terms
    • If inflation is unexpectedly high, debtors repay loans in cheaper
    • If inflation in unexpectedly low, debtors repay loans in more
      valuable dollars (take a loss)
     The possibility of unexpected inflation introduces an element
      of risk, which might prevent some from making some exchanges
      they otherwise would undertake
     Unanticipated inflation redistributes wealth and income

           The Benefits of (Low) Inflation
•   Greasing the wheels argument
•   Wages are downwards sticky in nominal terms
    •   During recession, workers may be willing to accept 0 wage
        growth but not a nominal wage cut
•   Low to moderate inflation makes real wages downward
•   Whether these benefits are tangible is controversial

                   The Costs of Inflation:
                    Empirical Evidence
•   Robert Barro (Inflation and Economic Growth, 1995):
    •   10%-pt increase in inflation lowers growth by 0.2-0.3%-pt
    •   Small effect but can lead to sizeable differences over longer
•   Bruno and Easterly (Inflation and Growth: In Search of a
    Stable Relationship, )
    •   No relationship (neither positive nor negative) between growth
        and inflation for low levels of inflation
    •   Inflation>40% detrimental to growth

             Unemployment, Inflation, and
• Both inflation and unemployment seen as lowering social welfare
→ Misery index: u+
• MacCulloch and DiTella (2001, Preferences over Inflation and
  Unemployment, AER)
    •   Happiness data from surveys in 13 countries (Europe and US)
    •   Unemployment lowers happiness more than inflation
    •   Respondents would be indifferent between 1%-pt increase in unemployment
        and 1.7%-pt increase in inflation
•   Winkelmann and Winkelmann (1998, Economica, Why Are
    Unemployed So Unhappy?)
    •   Unemployment lowers life satisfaction
    •   Most of this is due to non-monetary effect of unemployment , not due to loss
        of income

                 Inflation and Indexation
•   When inflation rates are high and uncertain, governments
    issue indexed debt
    •   A bond is indexed to the price level: either the interest rate or the
        principle or both are adjusted for inflation (or bond value is
        linked to the exchange rate of a foreign currency)
    •   The holder of the indexed bond will typically receive interest
        equal to the stated real rate plus the actual inflation rate  risk
•   Some formal labor contracts include cost of living
    adjustment (COLA) provisions
•   Link increases in money wages to increases in the price
                Inflation and Indexation
•   Indexation may feed an inflation spiral
     Shock causes inflation
     Wages and contracts are indexed
     More inflation follows

•   Need to differentiate between supply and demand
    •   Demand shock: “pure” inflation  firms can afford to pay the
        same real wages and will not be affected by indexation
    •   Supply shock: real wages need to fall and full indexation
        prevents this from happening
 Wage indexation complicates the economy’s adjustment
 to supply shocks

                 Inflation and Indexation
•        Many have argued that the government should adopt
         indexation on a broad scale, including bonds and the
         tax system because:
         Inflation would be easier to live with
         Costs of unanticipated inflation would disappear
•        Governments have been reluctant to index for three
    1.    Indexing makes it harder for the economy to adjust to shocks
          whenever changes in relative prices are needed
    2.    Indexing adds another layer of calculation to most contracts
    3.    Indexation will weaken the political will to fight inflation, lead
          to higher inflation, and perhaps make the economy worse off


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