116-1Unemployment and Inflation,Part 216-2Agenda• The Problem of Unemployment.• The Problem of Inflation.16-3The Problem of Unemployment • The costs of unemployment:¾ Loss in output from idle resources:• If full-employment output is $15 trillion, each percentage point of unemployment sustained for one year costs $300 billion according to Okun’s Law – Each percentage point of cyclical unemployment is associated with a loss equal to 2% of full-employment output.16-4The Problem of Unemployment • The costs of unemployment:¾ Loss in output from idle resources:• Workers lose income.• Business firms lose profits.• Government loses tax revenues.– And increases spending for unemployment benefits and other transfer payments.216-5The Problem of Unemployment • The costs of unemployment:¾ Personal or psychological cost to workers and their families.• Especially important for those with long spells of unemployment.16-6The Problem of Unemployment • The benefits of unemployment:¾ There are some offsetting factors:• Unemployment leads to increased job search and acquiring new skills, which may lead to increased future output.• Unemployed workers have increased leisure time, though most wouldn’t feel that the increased leisure compensated them for being unemployed.16-7The Problem of Unemployment • Long-term behavior of the unemployment rate:¾ The changing natural rate:• How do we calculate the natural rate of unemployment?• CBO’s estimates: 5% to 5½% today, similar to 1950s and 1960s; over 6% in 1970s and 1980s.• Why did the natural rate rise in the late 1970s?– Partly demographics as more teenagers and women with higher unemployment rates entered the workforce. 16-8The Problem of Unemployment • Long-term behavior of the unemployment rate:¾ The changing natural rate:• Since 1980, demographic forces have reduced the natural rate of unemployment.– The proportion of the labor force aged 16–24 years fell from 25% in 1980 to 16% in 1998.– This is one of the main reason for the fall in the natural rate of unemployment.316-9Actual and natural unemployment rates16-10The Problem of Unemployment • Long-term behavior of the unemployment rate:¾ The changing natural rate:• Some economists think the natural rate of unemployment is now 4.5% or even lower:– The labor market has become more efficient at matching workers and jobs, reducing frictional and structural unemployment.– Temporary help agencies have become prominent, helping the matching process and reducing the natural rate of unemployment.16-11The Problem of Unemployment • Long-term behavior of the unemployment rate:¾ The changing natural rate:• Increased labor productivity may decrease the natural rate of unemployment:– If increases in real wages lag changes in productivity, firms hire more workers and the natural rate of unemployment will decline temporarily.16-12The Problem of Unemployment • Long-term behavior of the unemployment rate:¾ Measuring the natural rate of unemployment:• Policymakers need a measure of the natural rate of unemployment to use the unemployment rate for setting policy.• Economists disagree about how to measure the natural rate of unemployment and the CBO has often revised its measure.416-13The Problem of Unemployment • Long-term behavior of the unemployment rate:¾ Measuring the natural rate of unemployment:• Staiger, Stock, and Watson found that the natural rate cannot be measured precisely with econometric methods because the confidence interval is very large.16-14The Problem of Unemployment • Long-term behavior of the unemployment rate:¾ Measuring the natural rate of unemployment:• What should policymakers do in response to uncertainty about the natural rate of unemployment?– They may want to be less aggressive with policy than they would be if they knew the natural rate more precisely.– The rise of inflation in the 1970s can be partly blamed on bad estimates of the natural rate. 16-15The Problem of Inflation • The costs of inflation:¾ Perfectly anticipated inflation:• No effect if all prices and wages keep up with inflation.• Even returns on assets may rise exactly with inflation.16-16The Problem of Inflation • The costs of inflation:¾ Perfectly anticipated inflation:• Shoe-leather costs: People spend resources to economize on currency holdings.– The estimated cost of 10% inflation is 0.3% of GNP.• Menu costs: the costs of changing prices.– May be mitigated somewhat by technology.516-17The Problem of Inflation • The costs of inflation:¾ Unanticipated inflation, when π–πe = 0:• Realized real returns differ from expected real returns:– Expected r: re= i –πe.–Actual r: r = i –π.–Actual r differs from expected r by πe–π.• Similar effect on wages and salaries.16-18The Problem of Inflation • The costs of inflation:¾ Unanticipated inflation, when π–πe = 0:• Result: unanticipated transfer of wealth.– From lenders to borrowers when π>πe.– From borrowers to lenders when π<πe.• People want to avoid the risk of unanticipated inflation.– They spend resources to forecast inflation.16-19The Problem of Inflation • The costs of inflation:¾ Unanticipated inflation, when π–πe = 0:• Loss of valuable signals provided by prices:– Confusion over changes in aggregate prices vs. changes in relative prices.– People expend resources to extract correct signals from prices. 16-20The Problem of Inflation • The costs of inflation:¾ The costs of hyperinflation:• Hyperinflation is a very high, sustained inflation – Generally, 50% or more per month.– Hungary in August 1945 had inflation of 19,800% per month.– Bolivia had annualrates of inflation of 1281% in 1984, 11,750% in 1985, 276% in 1986.616-21The Problem of Inflation • The costs of inflation:¾ The costs of hyperinflation:• There are large shoe-leather costs because people minimize cash balances.• People spend many resources getting rid of money as fast as possible.16-22The Problem of Inflation • The costs of inflation:¾ The costs of hyperinflation:• Real tax collections fall because people pay taxes with money whose value has declined sharply.• Prices become worthless as signals, so markets become extremely inefficient.16-23The Problem of Inflation • Fighting inflation: ¾ The role of inflationary expectations:• If rapid money growth causes inflation, why do central banks allow the money supply to