Analyzing Inflation, Wages, and Unemployment: CPI, Real Wages, and Labor Market - Prof. Ma, Study notes of Microeconomics

Download Analyzing Inflation, Wages, and Unemployment: CPI, Real Wages, and Labor Market - Prof. Ma and more Study notes Microeconomics in PDF only on Docsity! CH 5  The basic tool for measuring inflation is the consumer price index (CPI). The CPI measures the cost of purchasing a fixed basket of goods and services in any period relative to the cost of the same basket of goods and services in a base year. The inflation rate is the annual percentage rate of change in the price level as measured by a price index such as the CPI. (LO1)  A nominal quantity is a quantity that is measured in terms of its current dollar value. Dividing a nominal quantity such as a family's income or a worker's wage in dollars by a price index such as the CPI expresses that quantity in terms of real purchasing power. This procedure is called deflating the nominal quantity. If nominal quantities from two different years are deflated by a common price index, the purchasing power of the two quantities can be compared. To ensure that a nominal payment such as a Social Security benefit represents a constant level of real purchasing power, the nominal payment should be increased each year by a percentage equal to the inflation rate. This method of adjusting nominal payments to maintain their purchasing power is called indexing. (LO2)  The official U.S. inflation rate, based on the CPI, may overstate the true inflation rate for two reasons: First, it may not adequately reflect improvements in the quality of goods and services. Second, the method of calculating the CPI ignores the fact that consumers can substitute cheaper goods and services for more expensive ones.(LO3)  The public sometimes confuses increases in the relative prices for specific goods or services with inflation, which is an increase in the general price level. Since the remedies for a change in relative prices are different from the remedies for inflation, this confusion can cause problems. (LO4)  Inflation imposes a number of true costs on the economy, including “noise” in the price system; distortions of the tax system; “shoe-leather” costs, which are the real resources that are wasted as people try to economize on cash holdings; unexpected redistributions of wealth; and interference with long-term planning. Because of these costs, most economists agree that sustained economic growth is more likely if inflation is low and stable. Hyperinflation, a situation in which the inflation rate is extremely high, greatly magnifies the costs of inflation and is highly disruptive to the economy. (LO4)  The real interest rate is the annual percentage increase in the purchasing power of a financial asset. It is equal to the nominal, or market, interest rate minus the inflation rate. When inflation is unexpectedly high, the real interest rate is lower than anticipated, which hurts lenders but benefits borrowers. When inflation is unexpectedly low, lenders benefit and borrowers are hurt. To obtain a given real rate of return, lenders must charge a high nominal interest rate when inflation is high and a low nominal interest rate when inflation is low. The tendency for nominal interest rates to be high when inflation is high and low when inflation is low is called the Fisher effect. (LO5) CH 6  There are four important trends in wages, employment, and unemployment that we focused on in this chapter. First, over a long period, average real wages have risen substantially both in the United States and in other industrialized countries. Second, despite the long-term upward trend in real wages, real wage growth has slowed significantly in the United States since the early 1970s. Third, in the United States, wage inequality has increased dramatically in recent decades. The real wages of most unskilled workers have actually declined, while the real wages of skilled and educated workers have continued to rise. Fourth, until the recent downturn, employment in the United States in recent decades had grown faster than the working-age population. (LO1)  Trends in real wages and employment can be studied using a supply-and-demand model of the labor market. At a given price level, the productivity of labor and the price of workers' output determine the demand for labor. Employers will hire workers only as long as the value of the marginal product of the last worker hired equals or exceeds the wage the firm must pay. Because of diminishing returns to labor, the more workers a firm employs, the less additional product will be obtained by adding yet another worker. The lower the going wage, the more workers will be hired and thus the demand-for-labor curve slopes downward. Factors that increase the value of labor's marginal product, such as an increase in the price of workers' output or an increase in productivity, shift the labor demand curve to the right. Conversely, changes that reduce the value of labor's marginal product shift the labor demand curve to the left. (LO2)  The supply curve for labor shows the number of people willing to work at any given real wage. The supply curve slopes downward since more people will generally work at a higher real wage. An increase in the working-age population or a social change that promotes labor market participation (such as the changing role of women in the labor force) will increase labor supply and shift the labor supply curve to the right. (LO2)  Improvements in productivity, which raise the demand for labor, account for the bulk of the increase in U.S. real wages over the last century. The slowdown in real wage growth that has occurred in recent decades is the result of slower growth in labor demand, which was caused in turn by a slowdown in the rate of productivity improvement, and of more rapid growth in labor supply. Rapid growth in labor supply, caused by such factors as immigration and increased labor force participation by women, also has contributed to the continued expansion of employment. Recently, there has been some improvement in the rate of growth of productivity and real wages. (LO3)  Two reasons for the increasing wage inequality in the United States are economic globalization and skill-biased technological change. Both have increased the demand for, and hence the real wages of, relatively skilled and educated workers. Attempting to block globalization and technological change is counterproductive, however, since both factors are important in promoting increased productivity. To some extent, the movement of workers from lower-paying to higher-paying jobs or industries will counteract the trend toward wage inequality. A policy of providing transition aid and training for workers with obsolete skills is a more useful response to the problem. (LO3)  The unemployment rate is based on surveys conducted by the Bureau of Labor Statistics. The surveys classify all respondents over age 16 as employed, unemployed, or not in the labor force. The labor force is the sum of employed and unemployed workers—that is, people who have a job or are looking for one. The unemployment rate is calculated as the number of unemployed workers divided by the labor force. The participation rate is the percentage of the working-age population that is in the labor force. (LO4)  The costs of unemployment include the economic cost of lost output, the psychological costs borne by unemployed workers and their families, and the social costs associated with problems like increased crime and violence. The greatest costs are imposed by long unemployment spells (periods of unemployment). Critics of the official unemployment rate argue that it understates “true” unemployment by excluding discouraged workers and involuntary part-time workers. (LO5)  There are three broad types of unemployment: frictional, structural, and cyclical. Frictional unemployment is the short-term unemployment associated with the process of matching workers with jobs in a dynamic, heterogeneous labor market. Structural unemployment is the long-term and chronic unemployment that exists even when the economy is producing at a