Chapter 8 – Unemployment and Inflation
• What is the unemployment rate? How the unemployment rate is calculated?
• The significance of the unemployment rate.
• What is the natural rate of unemployment (NRU)? What are the factors that
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determine the NRU?
• What is inflation?
• The costs of inflation.
• Who gains and who loses as a result of inflation?
MGEA06 Week 2 (Recorded Lecture) Iris Au 1
The Unemployment Rate
Defining and Measuring Unemployment
• Statistics Canada carries out a monthly survey called the Labour Force Survey
by interviewing a random sample of 56,000 households across Canada.
• It classifies the adult population (age 15 or above) into 3 groups:
1) Employed (E): those who get a paid job (either full time or part time).
2) Unemployed (U): those who are currently available for work; but do not have a job; and have been actively looking for a job during the past four
3) Not in the labour force (NILF): those who do not have a job and are not
looking for one.
• Once we classify our adult population in these 3 groups, we can calculate the
followings:
Labour force (LF) = # of employed + # of unemployed.
The labour-force participation rate (LFPR) = the percentage of adult
population that is in the labour force:
Labour-force participation rate = Labour force ×100%
Adult population
Unemployment rate (ur) = the percentage of the labour force that is unemployed:
Unemployment rate = # of unemployed ×100% Labour force
Employment rate (er) = the percentage of adult population that is employed:
Employment rate = # of employed ×100% Adult population
MGEA06 Week 2 (Recorded Lecture) Iris Au
The Significance of the Unemployment Rate
• The unemployment rate gives a general picture on what happens in the labour market (i.e., how easy or difficult it is to find a job given the current state of the economy).
• Recall, the unemployment rate varies across regions and age groups.
Teenagers tend to have higher unemployment rate.
The Atlantic region has a higher unemployment rate than the rest of the
country due to its economic structure.
• However, we need to interpret the unemployment rate data carefully because
it might not capture the true picture of what is going on in the labour market.
The Unemployment Rate can Overstate the True Level of Unemployment
• The official measured unemployment rate may overstate the true level of
unemployment because:
Those who claimed themselves as unemployed may not be those who
want to work and could not find one.
It takes times for a worker, even for experienced workers, to find a job.
MGEA06 Week 2 (Recorded Lecture) Iris Au 3
The Unemployment Rate can Understate the True Level of Unemployment
• The official measured unemployment rate omits the followings groups when
calculating the unemployment rate:
1) Discouraged workers – individuals who would like to work but have given
up looking for a job due to unsuccessful job search.
2) Marginally attached workers – individuals who are not currently working
and have stopped seeking employment. However, they have stopped
looking because they are waiting for employment to begin.
3) Underemployed workers – individuals do work, but not in their desired
• Omitting these groups would make the official measured unemployment rate
lower than its true level.
MGEA06 Week 2 (Recorded Lecture) Iris Au 4
The Natural Rate of Unemployment (NRU)
• In this section, we discuss the determination of the economy’s long-run unemployment rate, the natural rate of unemployment.
Frictional Unemployment
• Frictional unemployment is unemployment due to the time workers spend in job search (i.e., it takes time for workers to find themselves a job).
• Frictional unemployment is inevitable because:
• A low level of frictional unemployment is normal and may be good to the economy because it allows workers taking their time to find jobs that best suit their skills.
MGEA06 Week 2 (Recorded Lecture) Iris Au 5
Structural Unemployment
Structural unemployment is unemployment caused by excess supply of labour at the prevailing wage, even in the long run.
It arises from rigidities in the labour market.
Labour supply
Suppose for some reasons, wages cannot fall below W:
• At W, the quantity of labour demanded =
the quantity of labour supplied = excess supply of labour =
MGEA06 Week 2 (Recorded Lecture) Iris Au 6
Labour demand
Quantity of labour, L
• Wage rigidities are caused by:
1) (Binding) Minimum wages, i.e., the minimum wages > the equilibrium or
market clearing wages.
2) Labour unions – they bargain for wages that are higher than the equilibrium (or market clearing) wages.
3) Efficiency wages – firms paid their workers higher than the equilibrium (or market clearing) wages to promote labour productivity.
4) Side effects of government policies
➢Some government policies may have an unintentional impact on the
unemployment rate.
➢For example, the provision of employment insurance (EI) may lead to
higher unemployment. EI may provide incentive for workers to turn down low paid jobs and wait for high paid jobs to become available.
5) Mismatch between employers and employees like a mismatch between the skills that workers possessed and the skills that required by employers.
MGEA06 Week 2 (Recorded Lecture) Iris Au 7
The Natural Rate of Unemployment (NRU)
• The natural rate of unemployment is
The unemployment rate that is normal to the economy.
The economy’s unemployment rate in the long run.
It is the unemployment rate that will not put any pressure on the inflation
Natural unemployment = Frictional unemployment + Structural unemployment Actual unemployment = Natural unemployment + Cyclical unemployment
NRU = Level of frictional unemployment + Level of structural unemployment × 100% Labour force
• Changes in both frictional unemployment and structural unemployment will cause the NRU to change.
• Since factors that affect both frictional and structural unemployment change over time, the NRU is NOT a constant.
MGEA06 Week 2 (Recorded Lecture) Iris Au 8
Changes in Labour Force Characteristics
• As shown in the data, young workers tend to have higher unemployment rate.
• The NRU tends to be higher if a large portion of the labour force is
characterized by young workers.
Changes in Labour Market Institutions
• The presence of strong labour unions may contribute to higher NRU.
• The presence of employment agencies may lower NRU.
• Technological improvement may lead to higher NRU because it lowers the demand for unskilled workers.
MGEA06 Week 2 (Recorded Lecture) Iris Au 9
Changes in Government Policies
• Increase in (binding) minimum wage could lead to higher NRU.
• The provision of employment insurance (EI) might also lead to higher NRU. EI allows unemployed workers to take longer time to find a job.
A generous EI may induce a worker to hold out for higher paying jobs rather than to accept a lower paying job that is available.
• Job training programs and employment subsidies help to lower NRU. Job training programs help unemployed workers to acquire skills that
employers are looking for.
Employment subsidies provide financial incentives for workers to accept new jobs or for employers to offer jobs.
MGEA06 Week 2 (Recorded Lecture) Iris Au 10
Inflation and Deflation
• Inflation refers to a rise in the overall price level.
• Inflation ratet, πt, = Price level in year t – Price level in year t-1 × 100%1
Price level in year t-1
Prices Doesn’t Matter …
• Some argue that we should not worry about inflation as long as the real income does not fall as a result of inflation.
• What this means if the economy experiences an increase in real GDP per capita, we should not overly worry about inflation.
• We can use CPI as a proxy for the price level to compute real GDP per capita. Real GDP per capita = Nominal GDP per capita × 100
1 If the inflation rate is negative, then the economy experiences deflation. MGEA06 Week 2 (Recorded Lecture) Iris Au
… But the Rate of Change of Price Does
• Although the price level does not really matter, the rate of change of the price level (inflation rate) does matter!
• A higher inflation rate imposes costs to the economy.
Shoe-Leather Costs
• We hold cash to facilitate our daily transactions.
• The purchasing power of money is being eroded at a faster rate when inflation
rate is high, and this discourages people from holding money.
• People may have to incur higher transaction costs when they reduce their
money holding. Menu Costs
• The costs of changing prices, normally incurred by firms.
Unit-of-Account Costs
• Money is used to quote prices (i.e., unit of account).
• A high inflation rate makes money a less reliable unit of measurement it
makes it difficult for households and firms to make quality economic decisions.
MGEA06 Week 2 (Recorded Lecture) Iris Au 12
Winners and Losers from Unexpected Inflation
• Unexpected change in inflation rate will lead to arbitrary redistribution of wealth among members in the economy.
• Fisher equation:
Nominal interest rate (i) = Real interest rate (r) + Inflation Rate (π)
MGEA06 Week 2 (Recorded Lecture) Iris Au 13
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