Chapter 7

The Anatomy of Inflation

and Unemployment

Introduction
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:

Lost production
Undesirable effects on the distribution of income

1.
2.

The costs of inflation depend on the type:

Unanticipated inflation creates significant redistribution of

wealth
Impact of anticipated inflation, especially of moderate levels,
is small
7-2

Unemployment

The greatest single cost of

unemployment is lost
production people who
dont work dont produce

[Insert Figure 7-1 here]

This cost is large: a recession can

imply drop in GDP by 3-5%
Okuns 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
jobs
Workers just entering the labor
force and teenagers are
amongst the hardest hit
7-3

Inflation

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

identify
Unanticipated inflation has distributional implications:

debtors benefit by repaying in cheaper dollars

creditors suffer by being repaid in cheaper dollars

7-4

The Anatomy of Unemployment

Research has revealed five key characteristics of
unemployment in the U.S.

1.
2.

3.

4.
5.

There are large variations in unemployment rates across groups

defined by age, race, or experience.
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.
A significant part of this turnover is cyclical: Layoffs and
separations are high during recessions, and voluntary quits are
high during booms.
Most people who become unemployed in any given month
remain unemployed for only a short time.
Much of the U.S. unemployment consists of people who will be
unemployed for quite a long time.
7-5

The Anatomy of Unemployment

The size of the labor force is
determined by surveys

[Insert Table 7-2 here]

Labor force = unemployed (U)

+ employed (E)

Unemployed is one who is

out of work and who either

1.

2.

Has actively looked for work

during the previous 4 weeks
OR
Is waiting to be recalled to a job
after having been laid off

7-6

The Anatomy of Unemployment

Employed person is one who
during the reference week:

1.
2.

3.

[Insert Table 7-2 here]

Did at least one hour of work

for pay in the last week
Worked at least 15 hours as an
unpaid worker for an enterprise
owned by a family member
OR
Was not working, but only
temporarily absent from work
(ex. vacation or maturity leave)

7-7

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
reasons:
1.
2.

3.
4.

New entrant or reentrant into the LF

Person who quit a job in order to look for other employment and
may register as unemployed while searching
Laid off worker (suspended without pay)
Worker who lost a job (fired or firm closes)

7-8

The Unemployment Pool

There are three ways of moving out of the

unemployment pool:
1.
2.
3.

A person may be hired into a new job

Someone laid off may be recalled
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

7-9

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

workers
Black unemployment is higher than that of their white cohorts
Female unemployment was higher than male unemployment
through the 1970s, but currently approximately equal

7-10

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
7-11

Labor Market Flows

Labor market turnover (flows

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
out of employment within the
manufacturing sector

[Insert Table 7-3 here]

People are taking and leaving jobs.

7-12

Duration of Unemployment

A spell of unemployment is a
period in which an individual
remains continuously
unemployed
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
2003

[Insert Table 7-4 here]

7-13

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

7-14

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
7-15

Estimates of the Natural Rate

[Insert Figure 7-3 here]

7-16

The Natural Rate vs the NAIRU

NAIRU: Non-accelerating inflation rate of unemployment

Based on the Phillips Curve:
*
t t 1 about
(u ucurrent
)
where t-1 is used to form expectations
inflation
NAIRU is the rate of unemployment such that inflation
remains constant: t = t-1

7-17

Hysteresis and the Rising Natural

Rate of Unemployment

Between 1973 and 1988 the U.S. unemployment rate

stayed well above the estimated natural rate
WHY?
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

7-18

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
7-19

Unemployment Benefits
Unemployment benefits increase the rate of
unemployment in two ways:

1.
2.

Unemployment benefits allow for longer job searches

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
7-20

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:

Okuns 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
revenues

Social costs of unemployment:

include increased divorce rates, suicide rates, depression,

7-21

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

7-22

The Costs of Inflation

Full adjustment to inflation not realistic imperfectly

anticipated
Most contracts are written in nominal terms
If inflation is unexpectedly high, debtors repay loans in cheaper
dollars
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

7-23

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

flexible
Whether these benefits are tangible is controversial

7-24

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
periods

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

7-25

Unemployment, Inflation, and

Happiness
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
7-26

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
reducing

Some formal labor contracts include cost of living

adjustment (COLA) provisions
Link increases in money wages to increases in the price
level
7-27

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 economys adjustment

to supply shocks
7-28

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

reasons:

1.
2.
3.

Indexing makes it harder for the economy to adjust to shocks

whenever changes in relative prices are needed
Indexing adds another layer of calculation to most contracts
Indexation will weaken the political will to fight inflation, lead
to higher inflation, and perhaps make the economy worse off
7-29