Chapter 7

(Inflation) Why is a relatively constant and predictable inflation rate less harmful to an economy than a rate that fluctuates unpredictably?

A constant inflation rate means less uncertainty about real dollar flows (e.g., incomes, rents, interest of payments) compared with a variable rate. Consequently, there is less risk associated with lending and less unintended redistribution of real output because of unanticipated inflation.

(International Comparisons of Unemployment) How has the U.S. unemployment rate compared with rates in other major economies? Can you offer any reasons why rates on average have differed across major economies since 1981?

During the decades before the Great Recession, unemployment trended down in the United States, trended up in Japan, and remained high in Europe. During the Great Recession of 2007-2009, the unemployment rate spiked in the United States, even briefly exceeding the average in Europe. The rate in Japan remained relatively low. In recent years, the U.S. rate has dropped. Since 1980 the unemployment rate in Europe has averaged 8.3 percent versus a U.S. average of 6.4 percent. The ratio of unemployment benefits to average pay is higher in Europe than in the United States, and unemployment benefits last longer there, sometimes years. So those collecting unemployment benefits have less incentive to find work. What's more, government regulations have made European employers more reluctant to hire new workers because firing them can be difficult. Historically, unemployment has been low in Japan, averaging only 3.5 percent since 1980, because many firms there offer job security for life.

(Inflation and Interest Rates) Using a demand-supply diagram for loanable funds (like Exhibit 11), show what happens to the nominal interest rate and the equilibrium quantity of loans when both borrowers and lenders increase their estimates of the expected inflation rate from 2 percent to 4 percent.

Higher expected inflation reduces the real rate of interest for a given nominal rate. Therefore, at each nominal rate, suppliers are less willing to lend and demanders are more willing to borrow. As a result, supply falls from S to S', demand rises from D to D', and the equilibrium nominal rate rises from i to i'. Because both sides of the market experience the same change in expectations, the nominal rate should adjust to exactly compensate for the higher expected inflation and the total quantity of loans should not change.

(Anticipated Versus Unanticipated Inflation) If actual inflation exceeds anticipated inflation, who will lose purchasing power and who will gain?

In the case described, those who have borrowed at fixed nominal rates will gain purchasing power, and those who have lent at such rates will lose. Also, workers whose wages are not tied directly to the price level will lose

(Inflation) Why do people dislike inflation?

Inflation distorts purchasing power and, especially if variable and unanticipated, causes other problems including the arbitrary redistribution of income and wealth from one group to another, a reduction in the ability to make long-term plans, and an increase in transaction costs due to less transparent relative price changes that force buyers and sellers to pay more attention to prices.

(The Meaning of Full Employment) When the economy is at full employment, is the unemployment rate at zero percent? Why or why not? How would a more generous unemployment insurance system affect the full employment figure?

No, even at "full employment," frictional, seasonal, and structural unemployment still exist. Full employment implies that only cyclical unemployment is zero. A more generous unemployment insurance system might lead to more unemployment because incentives to work would be lower and more people could qualify for benefits for, perhaps, a longer period of time.

(Unemployment in Various Groups) Does the overall unemployment rate offer an accurate picture of the impact of unemployment on each U.S. population group?

No, the overall unemployment rate does not show the wide differences that occur across age, race, and gender categories. For example, blacks have a higher unemployment rate than whites. Teenagers also have higher unemployment rates than adults, while women have higher rates than men do. Wide disparities also exist across geographical regions in the country. For example, unemployment in Midwestern industrial states substantially exceeds the overall unemployment rate. The unemployment rate also does not indicate the duration of unemployment. This is important, because the longer an individual is unemployed, the greater is its impact.

(Sources of Inflation) Using the concepts of aggregate supply and aggregate demand, explain why inflation usually accelerates during wartime.

One of the most important reasons why prices rise so quickly during wartime is that household incomes increase as more workers are employed in the armed forces. Fewer consumer goods are available as production shifts towards military goods. Military spending by the government also rises. Thus, the aggregate demand curve shifts to the right. In some countries, war creates a reduction in aggregate supply if many of the plants and much of the equipment are destroyed. This occurred in both Germany and Japan during World War II. Increasing aggregate demand and falling aggregate supply both lead to higher prices.

(Inflation and Relative Price Changes) What does the consumer price index measure? Does the index measure changes in relative prices? Why, or why not?

The consumer price index measures the price level as the cost of a fixed "market basket" of consumer goods and services. Percentage changes in the cost of this basket are used as a measure of inflation. Because it looks at the overall cost of that basket, it masks changes in relative prices. Within the basket, prices of some goods may be falling, some may be rising more slowly than the overall basket's cost, and others may be rising more rapidly. Goods whose prices are rising more rapidly have an increased relative price compared to goods whose prices are rising more slowly.

(Inflation and Interest Rates) Explain as carefully as you can why borrowers would be willing to pay a higher rate of interest if they expected the inflation rate to increase in the future

The cost of borrowing is the opportunity cost today of purchasing power given up in the future. Thus, an increase in the expected inflation rate means that borrowers can increase their nominal repayment rate without increasing the lost future purchasing power. The real rate of interest falls for the initial lower nominal rate

(Case Study: Hyperinflation in Zimbabwe) In countries such as Zimbabwe, which had problems with high inflation, the increased use of another country's currency (such as the U.S. dollar) became common. Why do you suppose this occurred?

The desire to replace one's currency with some other currency having stable value is the reason. If successful, you don't have to worry about a reduction in purchasing power due to your country's unstable currency because you have moved your cash into a more stable currency.

(Official Unemployment Figures) Explain why most experts believe that official U.S. data underestimate the actual rate of unemployment. What factors could make the official rate overstate the actual unemployment rate?

The official unemployment rate does not include discouraged workers—those who have given up searching for work in the belief that it is futile. In addition, the official rate does not account for underemployment.Because unemployment insurance and most welfare programs require recipients to seek employment, some people may act as if they are looking for work just to qualify for such programs. If these people do not in fact want to find a job, their inclusion among the unemployed tends to overstate the official unemployment figures.

(Unemployment Rate) If people dropped out of the labor force because they could not find work, what would this do to the unemployment rate? Why?

The unemployment rate would decrease. The unemployment rate is calculated as the number of people unemployed divided by the labor force, and when discouraged workers drop out of labor force, both the number of unemployed and the labor force decrease by the number of discouraged workers, which decreases the unemployment rate

(Labor Force) Refer to Exhibit 1 in the chapter to determine whether each of the following statements is true or false. a. Some people who are officially unemployed are not in the labor force. b. Some people in the labor force are not working. c. Everyone who is not unemployed is in the labor force. d. Some people who are not working are not unemployed.

a. False. To be unemployed, a person must be looking for a job. b. True. This would be the unemployed. c. False. Some adults are not looking for a job, or they choose not to work. d. True. To be classified as unemployed, a person must be looking for a job. However, there will be some adults who choose not to do so. There will also be discouraged workers who technically are not unemployed.

(Measuring Unemployment) Suppose that the U.S. noninstitutional adult population is 230 million and the labor force participation rate is 67 percent. a. What would be the size of the U.S. labor force? b. If 85 million adults are not working, what is the unemployment rate?

a. Of 230 million, 67 percent, or 154.1 million. b. Of the 230 million adults in the population, 154.1 million are in the labor force. The population (230 million) minus the number in the labor force (154.1 million) gives the number of people outside the labor force who are not working (75.9 million). Statistics given say that 85 million adults are not working, thus 85 million minus 75.9 million gives the number of people in the labor force who are not working (9.1 million) which is the number that represents the unemployed. The unemployment rate is the percentage of the labor force (not the population) that is unemployed. The unemployment rate is equal to the number of people counted as unemployed (9.1 million) divided by the labor force (154.1 million) expressed as a percentage (5.9 percent).

(Types of Unemployment) Determine whether each of the following would be considered frictional, structural, seasonal, or cyclical unemployment: a. A UPS employee who was hired for the Christmas season is laid off after Christmas. b. A worker is laid off due to reduced aggregate demand in the economy. c. A worker in a DVD rental store becomes unemployed as video-on-demand cable service becomes more popular. d. A new college graduate is looking for employment.

a. Seasonal b. Cyclical c. Structural d. Frictional

(Measuring Unemployment) Determine the impact on each of the following if 2 million formerly unemployed workers decide to return to school full time and stop looking for work: a. The labor force participation rate b. The size of the labor force c. The unemployment rate

a. The labor force participation rate drops because these workers have left the labor force. b. The size of the labor force drops by 2 million. c. The unemployment rate drops because the percentage drop in the number of unemployed is greater than the percentage drop in the labor force.