CH-7-9 Measuring GDP – Macroeconomics : Book Guide

This Document Contains Chapters 7 to 9 CHAPTER 7 MEASURING GDP Chapter Overview GDP is a powerful and versatile metric. There are good reasons that it is one of the most commonly used tools in macroeconomics. It gives a simple measure of the size of an economy and the average income of its participants. It also allows us to make comparisons over time or across countries. The system of national income accounts gives us a picture of how output, expenditure, and income are linked, and a framework for adding up the billions of daily transactions that occur in an economy. Comparing nominal and real GDP allows us to disentangle the role of increasing prices versus increasing output in a growing economy. The GDP deflator and the inflation rate track changes in overall price levels over time—which, as we’ll see in the next chapter, is a major task in macroeconomics. GDP per capita gives us a sense of the average income within a country, although it doesn’t tell us about the distribution of income or quality of life. Finally, calculating real GDP growth rates shows us in which direction the economy is moving, and is an important indicator of recession or depression. In the next chapter, we’ll dig deeper into the tools that economists use to measure price changes and the cost of living. When we combine these tools with GDP, we have a menu of macroeconomic metrics that will allow us to describe and analyze national and international economies. Learning Objectives LO 7.1 Understand the importance of using the market value of final goods and services to calculate GDP and explain why each component of GDP is important. LO 7.2 Explain the equivalence of the expenditure and income approaches to valuing an economy. LO 7.3 Explain the three approaches that are used to calculate GDP and summarize the categories of spending that are included in the expenditure approach. LO 7.4 Explain the difference between real and nominal GDP. LO 7.5 Calculate the GDP deflator. LO 7.6 Use GDP per capita to compare economies and calculate the real GDP annual growth rate. LO 7.7 Discuss some limitations to GDP, including its measurement of home production, the underground economy, environmental degradation, and well-being. Chapter Outline IT’S MORE THAN COUNTING PEANUTS Valuing an Economy Unpacking the Definition of GDP (LO 7.1) Production Equals Expenditure Equals Income (LO 7.2) Approaches to Measuring GDP (LO 7.3) The Expenditure Approach The Income Approach The "Value-Added” Approach Using GDP to Compare Economies Real versus Nominal GDP (LO 7.4) The GDP Deflator (LO 7.5) Using GDP to Assess Economic Health (LO 7.6) Limitations of GDP Measures Data Challenges (LO 7.7) BOX FEATURE: FROM ANOTHER ANGLE – VALUING HOMEMAKERS BOX FEATURE: FROM ANOTHER ANGLE – THE POLITICS OF GREEN GDP GDP vs. Well-Being BOX FEATURE: REAL LIFE – CAN MONEY BUY YOU HAPPINESS? Beyond the Lecture Reading Assignment: Unpacking the Definition of GDP (LO 7.1) Have students examine the current news release of Gross Domestic Product from the Bureau of Economic Analysis. This is a great way to introduce students to the calculation of GDP and its significance. Writing Assignment: Unpacking the Definition of GDP (LO 7.1) Have students review the National Income Accounts entry in The Concise Encyclopedia of Economics. In the article, Mack Ott underscores the importance of GDP for policy purposes. Then, ask students to write a short essay about the following: Why is GDP and national income accounting important? How is GDP calculated? How is GDP useful for policy decisions? Team Assignment/Class Discussion: Using GDP to Assess Economic Health (LO 7.5) Have students use this data on the World Bank site to examine GDP per capita for a specific country. You may want to assign each student (or group of students) a country to examine. Ask the students to research their country outside of class before the in-class discussion. In class, have students discuss the following: What is GDP per capita for your country? How has GDP per capita changed over time for your country? Can you determine why GDP per capita has changed in this fashion? How does GDP per capita for your country compare to other countries? Reading/Writing Assignment: Data Challenges (LO 7.6) Have students read Hiding in the Shadows by Friedrich Schneider, a publication about the impact of the shadow economy. This is also a great piece for a writing assignment or to stimulate class discussion. Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. Which of the following is NOT included in GDP? [LO 7.1] A new car that is sold to a family Tires that the car manufacturer bought to put on the car Gas that the family puts in the car to drive it Insurance that the family buys for the car Feedback: The tires are an intermediate good. GDP only counts final goods (or else we would be double counting!) 2. What is an intuitive reason why the production approach and expenditure approach should yield the same calculation for GDP? [LO 7.2] A. Because people spend all the money they earn Capital and labor just produce goods and don’t consume them All expenditures by buyers must be income for sellers Households earn from firms by working, and then spend the paycheck at the same firm 3. What is the well-known equation used to measure GDP using the expenditure approach? [LO 7.3] Y = C + G + T Y = Wages - Taxes Y = S + NX + G Y = C + I + G + NX Feedback: GDP is the sum of consumption, investment, government expenditures, and net exports. Wages, taxes, and transfer payments are not counted. 4. We can use real GDP and nominal GDP to calculate_________ [LO 7.4] The growth rate of GDP over time The portion of GDP that belongs to consumption The import/export ratio The GDP deflator Feedback: Part of nominal GDP increases over time will be due to price increases (inflation) rather than real increases in production. The GDP deflator allows us to account for inflation and measure real increases in production. 5. Why might GDP underestimate the level of economic activity in a country? [LO 7.6] It doesn’t include wages It doesn’t include household work It doesn’t include transfer payments D. Imports are subtracted instead of added. Feedback: If I mow my lawn, it’s not counted in GDP. If I pay a lawn care business to mow it, it’s counted in GDP. In both cases, production occurred. Be aware that the other answers are true regarding GDP, but they don’t result in possible underestimation. Solutions to End-of-Chapter Questions and Problems Review Questions U.S. car dealers sell both used cars and new cars each year. However, only the sales of the new cars count toward GDP. Why does the sale of used cars not count? [LO 7.1] Answer: The production of the car was already included in GDP when it was first manufactured. To include the sale of the used car would serve to double-count the car, once as a new car, once as a used car. There is an old saying, “You can’t compare apples and oranges.” When economists calculate GDP, are they able to compare apples and oranges? Explain. [LO 7.1] Answer: The old saying refers to the fact that an apple is different than an orange, although both are types of fruit. Economists compare goods like apples and oranges by calculating the dollar value of oranges and apples produced. If the economy produces 10 apples selling at $1.50 each and 5 oranges selling at $1 each, the economy has produced 10 × $1.50 = $15 worth of apples and 5 × $1 = $5 worth of oranges. It can be concluded that the value of apple production is greater than the value of orange production. To compare goods like apples and oranges, a common denominator must be found and this is why production is converted to dollar terms using market price. More broadly, when economists calculate GDP, they add up the dollar value of production. If the economy produces 10 apples selling at $1.50 each and 5 oranges selling at $1 each, the economy has produced (10 × $1.50) + (5 × $1) = $20 of economic production. When Americans buy goods produced in Canada, Canadians earn income from American expenditures. Does the value of this Canadian output and American expenditure get counted under the GDP of Canada or the United States? Why? [LO 7.2] Answer: GDP is the total sum of goods and services produced within a country’s borders. Goods produced in Canada count in Canada’s GDP even if they are consumed in the U.S. Economists sometimes describe the economy as having a “circular flow.” In the most basic form of the circular flow model, companies hire workers and pay them wages. Workers then use these wages to buy goods and services from companies. How does the circular flow model explain the equivalence of the expenditure and income methods of valuing an economy? [LO 7.2] Answer: In this basic model all firm revenues are turned into wages, and all wages are spent on the firms’ products. Thus, total production in the economy can either be measured by summing up all of the firms’ sales (expenditure method) or all of the workers’ wages (income method). In 2011, the average baseball player earned $3 million per year. Suppose that these baseball players spend all of their income on goods and services each year, and they save nothing. Argue why the sum of the incomes of all baseball players must equal the sum of expenditures made by the baseball players. [LO 7.2] Answer: If nothing from income is left over after spending, then spending must exactly equal income. Determine whether each of the following counts as consumption, investment, government purchases, net exports, or none of these, under the expenditure approach to calculating GDP. Explain your answer. [LO 7.3] The construction of a court house. A taxicab ride. The purchase of a taxicab by a taxicab company. A student buying a textbook. The trading of municipal bonds (a type of financial investment offered by city or state governments). A company’s purchase of foreign minerals. Answer: Courthouses are public institutions and are thus counted as part of government expenditure. In this case, the expenditure is technically an investment by the government. A taxicab ride is a service, so it is counted as consumption. The purchase of a taxicab by the company is an investment. The purchase of a textbook counts as consumption. Neither: Trading financial investments is considered a transfer, which does not go into the calculation of GDP. The purchase of raw materials from a foreign country is considered an import and is therefore counted as part of net exports. If car companies produce a lot of cars this year but hold the new models back in warehouses until they release them in the new-model year, will this year’s GDP be higher, lower, or the same as it would have been if the cars had been sold right away? Why? Does the choice to reserve the cars for a year change which category of expenditures they fall under? [LO 7.3] Answer: If the cars are produced this year, they count in this year’s GDP even if they aren’t sold until next year. If the cars are sold right away, they count as consumption (or as government purchases if they are sold to the government, or as investment if they are sold to a firm). If the cars are not sold but instead put into inventory, then the production is counted as investment. The value-added method involves taking the cost of intermediate outputs (i.e., outputs that will in turn be used in the production of another good) and subtracting that cost from the value of the good being produced. In this way, only the value that is added at each step (the sale value minus the cost of the goods that went into producing it) is summed up. Explain why this method gives us the same result as the standard method of counting only the value of final goods and services. [LO 7.3] Answer: The only difference between the valued-added method and the final-goods method is that the production of the economy is added up along the way instead of being totaled at the end. For example, the height of a staircase is the same whether one measures each individual stair and adds them up as one climbs the stairs or whether one simply climbs all of the way to the top and then measures the total height traveled. Imagine a painter is trying to determine the value she adds when she paints a picture. Assume that after spending $200 on materials, she sells one copy of her painting for $500. She then spends $50 to make 10 copies of her painting, each of which sells for $100. What is the value added of her painting? What if a company then spends $10 per copy to sell 100 more copies, each for $50? What is the value the painter adds then? If it’s unknown how many copies the painting will sell in the future, can we today determine the value added? Why or why not? [LO 7.3] Answer: The value-added approach determines the value of a good or service by subtracting the value of the inputs from the value of the outputs. In this case, the painter originally sold $1,500 worth of paintings, at a cost of $700, which implies that she added $800 in value by painting. After the company sells another $5,000 worth of paintings at a cost of $1,000, we can add $4,000 to the original $1,500. If we can’t know how many copies the painting will sell in the future and at what price, we cannot today know the final value the painter adds through painting. In a press conference, the president of a small country displays a chart showing that GDP has risen by 10 percent every year for five years. He argues that this growth shows the brilliance of his economic policy. However, his chart uses nominal GDP numbers. What might be wrong with this chart? If you were a reporter at the press conference, what questions could you ask to get a more accurate picture of the country’s economic growth? [LO 7.4] Answer: There are many potential problems here. The biggest is that the president is talking only about nominal GDP and not real GDP. If prices are rising 10 percent per year, then the country is not experiencing any real growth; GDP is getting bigger only because prices are rising. Suppose that the GDP deflator grew by 10 percent from last year to this year. That is, the inflation rate this year was 10 percent. In words, what does this mean happened in the economy? What does this inflation rate imply about the growth rate in real GDP? [LO 7.5] Answer: A 10 percent growth rate in the GDP deflator means that, overall, prices in the economy have risen by 10 percent. This inflation rate implies the growth rate in real GDP is essentially 10 percent less than the growth rate in nominal GDP. An inexperienced researcher wants to examine the average standard of living in two countries. In order to do so, he compares the GDPs in those two countries. What are two reasons why this comparison does not lead to an accurate measure of the countries’ average standards of living? [LO 7.4, 7.6] Answer: Two obvious problems are price levels and population. First, if one country has higher price levels than the other, then the nominal GDPs of the two countries are not directly comparable. The country with higher price levels will have a comparably lower real GDP than a country with low price levels. Second, standard of living is better reflected by GDP per capita, not simply total GDP. For example, India’s GDP is 15 times larger than Norway’s, but the average Indian person is quite poor compared with the average Norwegian since there are 1.2 billion Indians and only about 5 million Norwegians. The average Norwegian earns almost 15 times that of the average Indian. In 2010, according to the International Monetary Fund, India had the world’s 10th-highest nominal GDP, the 135th-highest nominal GDP per capita, and the 5th-highest real GDP growth rate. What does each of these indicators tell us about the Indian economy and how life in India compares to life in other countries? [LO 7.6] Answer: With the tenth largest nominal GDP, this statistic tells us that India has a huge economy that produces lots of goods and services. With the 135th highest nominal GDP per capita, this tells us that India is still fairly poor. Its high GDP is a result of being a large country with a huge population, not the result of being rich. Having the fifth highest GDP growth rate means that the standard of living in India is rising rapidly and that the country is becoming more productive. China is a rapidly growing country. It has high levels of bureaucracy and business regulation, low levels of environmental regulation, and a strong tradition of entrepreneurship. Discuss several reasons why official GDP estimates in China might miss significant portions of the country’s economic activity. [LO 7.7] Answer: In order to avoid the bureaucracy and regulation, small business owners may operate their firms in the black market. The economic activity created by these small business owners is real but may be hidden from the view of the government officials collecting economic data. Similarly, official government GDP statistics are not likely to include the costs of environmental destruction in their estimates. Suppose a college student is texting while driving and gets into a car accident causing $2,000 worth of damage to her car. Assuming the student repairs her car, does GDP rise, fall, or stay constant with this accident? What does your answer suggest about using GDP as a measure of well-being? [LO 7.7] Answer: GDP will rise by $2,000 since car repairs are a service produced by the economy. Obviously, the economy is not $2,000 better off because of this accident; $2,000 worth of automobile was destroyed and replaced, but only the replacement, and not the destruction, was included in the basic measure of GDP. This is an example of where GDP is a distinctly imperfect measure of well-being. Problems and Applications Suppose a gold miner finds a gold nugget and sells the nugget to a mining company for $500. The mining company melts down the gold, purifies it, and sells it to a jewelry maker for $1,000. The jewelry maker fashions the gold into a necklace that it sells to a department store for $1,500. Finally, the department store sells the necklace to a customer for $2,000. How much has GDP increased as a result of these transactions? [LO 7.1, 7.3] Answer: Only the market value of final goods and services count in GDP, as including the earlier transactions counts the gold multiple times. Thus, GDP has increased by $2,000, the price of the final necklace produced. Importantly, GDP has not increased by $500 + $1,000 + $1,500 + $2,000 = $5,000. Counting the price at each intermediate step serves to double- (or triple- or quadruple-) count the production. If one chose to use the value-added method of GDP, $500 of value is added by the miner; $500 is added by the mining company ($1,000 − $500); $500 is added by the jewelry maker ($1,500 − $1,000); and $500 is added by the retailer ($2,000 − $1,500). Total value added is $500 + $500 + $500 + $500 = $2,000, the same as in the final-goods method. Table 7P-1 shows the price of inputs and the price of outputs at each step in the production process of making a shirt. Assume that each of these steps takes place within the country. [LO 7.1, 7.3] What is the total contribution of this shirt to GDP, using the standard expenditure method? If we use a value-added method (i.e., summing the value added by producers at each step of the production process, equal to the value of outputs minus the price of inputs), what is the contribution of this shirt to GDP? If we mistakenly added the price of both intermediate and final outputs without adjusting for value added, what would we find that this shirt contributes to GDP? By how much does this overestimate the true contribution? Answer: Using the standard expenditure method, the total contribution of this shirt to GDP is $18. If we use a value-added method (i.e., summing the value added by producers at each step of the production process, equal to the value of output minus the price of inputs), the contribution of this shirt to GDP is $1.10 + $2.40 + $14.50 = $18.00. If we add the totals at each step we wind up with $1.10 + $3.50 + $18.00, or $22.60 in total production: an overestimate of $4.60 3. The U.S. government gives income support to many families living in poverty. How does each of the following aspects of this policy contribute to GDP? [LO 7.2] Does this government’s expenditure on income support count as part of GDP? If so, in which category of expenditure does it fall? When the families buy groceries with the money they’ve received, does this expenditure count as part of GDP? If so, in which category does it fall? If the families buy new houses with the money they’ve received, does this count as part of GDP? If so, in which category does it fall? Answer: Government income support does not count as part of GDP. Government expenditures on goods and services count as part of G (government spending), but transfers of income from one group to another do not count as part of G. When recipients of government transfers spend the money on groceries, this spending counts as C (consumption). The fact that the spending of the government assistance counts as part GDP is why the transfer itself doesn’t count as part of GDP. Counting the government assistance as part of G when it is transferred and then again as C when it is spent would be double-counting the money. When recipients of government transfers spend the money building new housing, this spending counts as I (investment). 4. Given the following information about each economy, either calculate the missing variable or determine that it cannot be calculated. [LO 7.2, 7.3] If C = $20.1 billion, I = $3.5 billion, G = $5.2 billion, and NX = –$1 billion, what is total income? If total income is $1 trillion, G = $0.3 trillion, and C = $0.5 trillion, what is I? If total expenditure is $675 billion, C = $433 billion, I = 105 billion, and G = $75 billion, what is NX? How much are exports? How much are imports? Answer: The expenditure method of calculating the size of an economy involves adding up all spending on goods and services produced in an economy and subtracting spending on imports. The sum of these categories and the equivalence of income (Y) and expenditure give us the equation Y = C (consumption) + I (investment) + G (government purchases) + NX (net exports). Total income = C + I + G + NX = $20.1 + $3.5 + $5.2 − $1 = $27.8 billion. Total income = C + I + G + NX. $1t = $0.5t + I + $0.3t + NX. Solving this, I = $0.2 − NX. Since there are two unknowns (I and NX), neither can be determined. Total income = C + I + G + NX. $675 = $433 + $105 + $75 + NX. Solving for NX, you get NX = $62 billion. Exports and imports cannot be determined. Since NX is positive, exports are greater than imports, but we cannot figure out exact amounts with the information given. 5. Using Table 7P-2, calculate the following. [LO 7.2, 7.3] Total gross domestic product and GDP per person. Consumption, investment, government purchases, and net exports, each as a percentage of total GDP. Consumption, investment, government purchases, and net exports per person. Answer: GDP = C + I + G + NX = $770,000 + $165,000 + $220,000 − $55,000 = $1,100,000. GDP per person = $1,100,000 ÷ 50 = $22,000. (Mathematical note: since both GDP and population are measured in millions this will cancel out so we can ignore it. In other words $1,100,000/50 is the same as $1,100,000 million divided by 50 million. This same principle applies in parts b and c below.) C as a % of GDP = $770,000/1,100,000 = 0.7, or 70%. I as a % of GDP = $165,000/1,100,000 = 0.15, or 15%. G as a % of GDP = $220,000/1,100,000 = 0.2, or 20%. NX as a % of GDP = −$55,000/1,100,000 = 0.05, or 5%. C/person = $770,000/50 = $15,400. I/person = $165,000/50 = $3,300. G/person = $220,000/50 = $4,400. NX/person = −$55,000/50 = −$1,100 6. Determine which category each of the following economic activities falls under: consumption (C), investment (I), government purchases (G), net exports (NX), or not included in GDP. [LO 7.3] The mayor of Chicago authorizes the construction of a new stadium using public funds. A student pays rent on her apartment. Parents pay college tuition for their son. Someone buys a new Toyota car produced in Japan. Someone buys a used Toyota car. Someone buys a new General Motors car produced in the United States. A family buys a house in a newly-constructed housing development. The U.S. Army pays its soldiers. A Brazilian driver buys a Ford car produced in the United States. The Department of Motor Vehicles buys a new machine for printing drivers’ licenses. An apple picked in Washington in October is bought at a grocery store in Mississippi in December. Hewlett-Packard produces a computer and sends it to a warehouse in another state for sale next year. Answer: The stadium is a government purchase. The student is consuming housing services. The parents are purchasing education services. Someone buys a new Toyota car produced in Japan and this increases net exports. Not included in GDP. Only the initial production of a good is included in GDP (in this case, Japan’s GDP). The person is consuming an automobile. New home construction is included in GDP as residential investment. The government is spending on national defense services. Net exports rise for the United States. In Brazil, net exports fall and consumption rises, leading to no net change in the Brazilian GDP. The government is spending money on goods and services. The apple is produced and consumed in the United States, increasing consumption. The computer is counted as inventory. 7. Table 7P-3 shows economic activity for a very tiny country. Using the expenditure approach determine the following. [LO 7.3] a. Consumption. Investment. Government purchases. Net exports. GDP. Answer: $707,000. $600,000. $800,000. -$200,000. $1,907,000. 8. During the recent recession sparked by financial crisis, the U.S. economy suffered tremendously. Suppose that, due to the recession, the U.S. GDP dropped from $14 trillion to $12.5 trillion. This decline in GDP was due to a drop in consumption of $1 trillion and a drop in investment of $500 billion. The U.S. government, under the current president, responded to this recession by increasing government purchases. [LO 7.3] Suppose that government spending had no impact on consumption, investment, or net exports. If the current presidential administration wanted to bring GDP back up to $14 trillion, how much would government spending have to rise? Many economists believe that an increase in government spending doesn’t just directly increase GDP, but that it also leads to an increase in consumption. If government spending rises by $1 trillion, how much would consumption have to rise in order to bring GDP back to $14 trillion? Answer: To counteract a $1 trillion drop in C and a $0.5 trillion drop in I, you need to raise G by $1.5 trillion (assuming the increase in G doesn’t affect any other variables in the equation— expenditures = C + I + G + NX). To counteract a $1 trillion drop in C and a $0.5 trillion drop in I with only $1 trillion in increased G, C would also have to rise by $0.5 trillion. 9. Assume Table 7P-4 summarizes the income of Paraguay. [LO 7.3] Calculate profits. Calculate the GDP of Paraguay using the income approach. What would GDP be if you were to use the value-added approach? What would GDP be if you were to use the expenditure approach? Answer: Profits = Total business expenditures – Total business revenues = $9 billion. Wages + Interest + Rental income + Profits = $8.3 + $0.7 + $9 = $18 billion. $18 billion: All methods of calculating GDP result in the same value. $18 billion: All methods of calculating GDP result in the same value. 10. Table 7P-5 provides information about the cost of inputs and the value of output for the production of a road bike. Note there are four different stages of production. [LO 7.3] a. What value is added by the supplier of the raw materials? What value is added by the tire maker? What value is added by the maker of the frame and components? What value is added by the bike mechanic? What value is added by the bike store? What is the total contribution of the bike to GDP? Answer: $190 = ($20 × 2) + $80 + $70. The raw materials include the rubber for two tires, the aluminum, and the other component materials. $20 = ($30 – $20) × 2. Value added is the difference between the value of the good produced ($30 per tire in this case) and the cost of purchased materials ($20 per tire). c. $100 = $250 – ($80 + $70). $40 = $350 – [$250 + ($30 × 2)]. $150 = $500 – $350. $500 = Value of final good = sum of value added = $190 + $20 + $100 + $40 + $150 11. Imagine that the United States produces only three goods: apples, bananas, and carrots. The quantities produced and the prices of the three goods are listed in Table 7P-6. [LO 7.4] a. Calculate the GDP of the United States in this three-goods version of its economy. Suppose that a drought hits the state of Washington. This drought causes the quantity of apples produced to fall to 2. Assuming that all prices remain constant, calculate the new U.S. GDP. Assume, once again, that the quantities produced and the prices of the three goods are as listed in Table 7P-6. Now, given this situation, carrot sellers decide that the price of carrots is too low, so they agree to raise the price. What must be the new price of carrots if the U.S. GDP is $60? Answer: GDP is the sum of the dollar value of the goods and services produced in a country. In this case, GDP = $2 × 5 (apples) + $1 × 10 (bananas) + $1.50 × 20 (carrots) = $50. The new GDP = $2 × 2 (apples) + $1 × 10 (bananas) + $1.50 × 20 (carrots) = $44. After carrot sellers raise the price of carrots, the equation becomes $2 × 5 + $1 × 10 + P × 20 = $60, where P is the price of carrots. We must solve for P, subtracting 20 from both sides leaving 20(P) = 40. Now divide both sides by 20, leaving P = $2. Based on Table 7P-7, calculate nominal GDP, real GDP, the GDP deflator, and the inflation rate in each year, and fill in the missing parts of the table. Use 2014 as the base year. [LO 7.4] Answer: Nominal GDP = Sum of quantity × Price for each year. Real GDP = Sum of quantity in each year × Price in base year (2014). GDP deflator = (Nominal GDP/Real GDP) x 100 for each year. Inflation rate = [(New deflator − Old deflator)/Old deflator] × 100. Suppose that the British economy produces two goods: laptops and books. The quantity produced and the prices of these items for 2015 and 2016 are shown in Table 7P-8. [LO 7.4, 7.5] Let’s assume that the base year was 2015, so that real GDP in 2015 equals nominal GDP in 2015. If the real GDP in Britain was $15,000 in 2015, what was the price of books? Using your answer from part a, if the growth rate in nominal GDP was 10 percent, how many books must have been produced in 2016? Using your answers from parts a and b, what is the real GDP in 2016? What was the growth rate in real GDP between 2015 and 2016? Answer: GDP is the sum of the dollar value of the goods and services produced in a country. In 2015: $15,000 = 50($200) + 1,000(P), where P is the price of books. Solving for P, we get a price per book of $5. The first thing we need to do is calculate nominal GDP in 2016 if nominal GDP has grown 10%. GDP(2016) = GDP(2015) × 1.1 = $16,500. Now set $16,500 = 100($150) + Q($10), where Q is the quantity of books produced. Solving for Q, we find that 150 books must have been produced. Using 2015 as the base year, to find real GDP in year 2016, you take the quantities produced in year 2016 multiplied by the prices in 2015. Real GDP(2016) = 100($200) + 150($5) = $20,750. The change in real GDP = (New GDP − Old GDP)/Old GDP = ($20,750 − $15,000)/$15,000 = 0.383 = 38.3%. Based on Table 7P-9, calculate nominal GDP per capita in 2015 and 2016, and the real GDP growth rate between the two years. Which countries look like they experienced recession in 2015–2016? [LO 7.6] Answer: Nominal GDP/capita = Nominal GDP/Population Real GDP growth rate = (Real GDPnew – Real GDPold)/Real GDPold A recession is defined as a period of significant decline in economic activity. Both Germany and the US have negative real GDP growth year over year indicating that they are both likely experiencing a recession. Egypt and Ghana are both experiencing significant growth, so they are clearly not in recession. Argentina is a borderline case. It is experiencing very slow but positive GDP growth. Table 7P-10 describes the real GDP and population of a fictional country in 2015 and 2016. [LO 7.6] What is the real GDP per capita in 2015 and 2016? What is the growth rate in real GDP? What is the growth rate in population? What is the growth rate in real GDP per capita? Answer: Real GDP per capita equals real GDP divided by population. The only trick here is to get the right number of zeroes on the billions and millions. The real GDP per capita in 2015 is $10 billion/1.0 million = $10,000. The real GDP per capita in 2016 is $12 billion/1.1 million = $10,909. The growth rate of GDP is [($12 million – $10 million)/$10 million] × 100 = 20 percent. The growth rate in population is [(1.1 million – 1.0 million)/1 million] × 100 = 10 percent. The growth rate in per capita GDP is [(10,909 – 10,000)/10,000] × 100 = 9 percent. 16. Table 7P-11 shows data on population and expenditures in five countries, as well as the value of home production, the underground economy, and environmental externalities in each. [LO 7.6, 7.7] Calculate GDP and GDP per capita in each country. Calculate the size of home production, the underground economy, and environmental externalities in each country as a percentage of GDP. Calculate total and per capita “GDP-plus” in each country by including the value of home production, the underground economy, and environmental externalities. Rank countries by total and per capita GDP, and again by total and per capita “GDP-plus.” Compare the two lists. Are the biggest and the smallest economies the same or different? Answer: GDP = C + I + G + NX. GDP per capita = GDP/population. The size of home production, the underground economy, and environmental externalities in each country as a percentage of GDP is the value of each term divided by GDP. The total can be found by summing up the individual percentages. GDP-plus = GDP + home production + underground economy + environmental externalities (which are generally negative so this subtracts from GDP). GDP-plus per capita = GDP-plus/Population. As can be seen from the table, the parts in GDP-plus that are not counted in GDP can make a big difference. The biggest change comes in comparing Bohemia and Saxony. Under GDP per capita Bohemia is about two-thirds richer than Saxony. Under GDP-plus per capita, Bohemia is more than 2.8 times richer than Saxony. 17. Suppose a parent was earning $20,000 per year working at a local firm. The parent then decides to quit his job in order to care for his child, who was being watched by a babysitter for $10,000 per year. Does GDP rise, fall, or stay constant with this action, and how much does GDP change (if at all)? [LO 7.7] Answer: GDP falls because the parent is not working in the labor force and is providing a do-it-yourself service. Previously, GDP generated by the father and the babysitter (by the income method) would have been $20,000 (from the father’s job) + $10,000 (from the babysitter’s job) = $30,000. After the change, the GDP generated is $0 since the father watching his own children is not a market transaction and therefore not counted in GDP. Thus, GDP falls $30,000. The fact that household work is not counted as part of GDP if conducted by a member of the family but is counted as part of GDP if a market transaction takes place is a clear failing of using GDP as a way to measure economic well-being. CHAPTER 8 THE COST OF LIVING Chapter Overview What can a dollar buy? The answer today is not the same as it will be next year, and it’s not the same in New York City as it is in Iowa City. The result is that a nominal dollar amount in a particular time or place is just part of the answer. What we really care about is the purchasing power of that dollar amount. That’s what determines how much you can buy at the store. In this chapter, we’ve developed tools that allow us to track changes in the overall price level. These tools help us understand how the purchasing power of a dollar changes over time and across locations. Using the cost of a constant market basket allows us to construct a price index that shows relative price levels over time, such as the CPI. It also allows us to construct price indexes that show relative purchasing power in different places, such as the World Bank’s International Comparison Program (ICP) index. Using price indexes, we can adjust economic variables such as wages, income, GDP, and interest rates to see the difference between their nominal and real values. This lets us answer questions like “What would today’s salaries have bought in our grandparents’ time?” or “How rich are people in other countries relative to the United States?” It can also help us make better choices when deciding how to invest money, write contracts, or set up policies that account for the effects of inflation. This chapter and the previous one have introduced the basic language and metrics of macroeconomics. We’ve discussed output and prices, and how to measure both the size of an economy and the cost of living there. In the next chapter, we’ll move to another fundamental economic concern: how to maintain steady employment levels and avoid periods of high unemployment. Learning Objectives LO 8.1 Understand the importance of a market basket in tracking price changes. LO 8.2 Calculate and use a price index to measure changes in the cost of living over time. LO 8.3 Name the two main challenges the BLS faces when measuring price changes and outline how it responds to these challenges. LO 8.4 Calculate the inflation rate and recognize alternative measures. LO 8.5 Use a price index to adjust nominal variables into real variables. LO 8.6 Understand how indexing keeps the real value of a payment constant over time. LO 8.7 Explain what purchasing power parity is. LO 8.8 Use a price index to calculate PPP-adjusted variables and compare the cost of living across different places. Chapter Outline THANK YOU FOR NOT SMOKING The Cost of Living BOX FEATURE: REAL LIFE – THE COSTS OF LIVING IN NEW YORK CITY VS. IOWA CITY Measuring Price Changes over Time The Market Basket (LO 8.1) Consumer Price Index (LO 8.2) The Challenges in Measuring Price Changes (LO 8.3) BOX FEATURE: REAL LIFE – THE GOOGLE PRICE INDEX Using Price Indexes The Inflation Rate (LO 8.4) Deflating Nominal Variables (LO 8.5) BOX FEATURE: FROM ANOTHER ANGLE – THE WEALTHIEST AMERICAN? Adjusting for Inflation: Indexing (LO 8.6) BOX FEATURE: WHAT DO YOU THINK? – COLAS FOR BETTER OR WORSE Accounting for Price Differences across Places Purchasing Power Parity (LO 8.7) Purchasing Power Indexes (LO 8.8) PPP-Adjustment BOX FEATURE: REAL LIFE – COUNTING THE POOR, GIVE OR TAKE 400 MILLION Beyond the Lecture Class Media: The Inflation Rate (LO 8.4) Have students view this brief clip from the movie “Austin Powers: International Man of Mystery” (show Chapter 6 on the DVD). In the movie, Dr. Evil proposes a $1 million ransom in the 1990s, which is worth far less in real terms than it was during the 1960s time period that Dr. Evil remembers. Class Activity: Consumer Price Index (LO 8.2) Have students convert past prices to current prices. This article includes the price of a number of goods and services from 1968. (It is interesting to have students practice inflation calculations using actual prices from the 1960s.) Additionally, the CPI data can be found here. Class Activity: The Challenges in Measuring Price Changes (LO 8.3) Use the information on this website to highlight differences in the quality of television over time. Prices and pictures for some models are included. When compared to prices and quality today, students will start to understand one of the main challenges in measuring inflation. Class Discussion: Purchasing Power Parity (LO 8.5) Review and discuss the Big Mac Index from The Economist, a fun way to portray the concept of purchasing power parity. 1. What currencies does the Big Mac Index suggest are overvalued or undervalued? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. Why is the Consumer Price Index (CPI) useful? [LO 8.1, 8.2] It tracks the prices of stocks It gives a measure of housing prices It is an accurate predictor of economic recession It tracks changes in the cost of living Feedback: Housing is just part of the market basket used for the CPI. 2. Which of the following is the largest portion of the typical urban consumer’s spending in the CPI? [LO 8.1, 8.2, 8.3] Housing Food Transportation D. Health Care Feedback: Can include rent and mortgage payments, as well as things like electricity bills. 3. The inflation rate is ___________ and is calculated by ____________. [LO 8.4] constant; the difference in CPI from year to year the size of the change in the price level; the percentage change in the CPI from year to year the change in the amount that consumers buy each year; housing price values the change in consumer confidence; increases in new home sales 4. Which of the following is NOT a method used to report inflation? [LO 8.4] percent change in the CPI percent change in the PPI percent change in stock market activity the GDP deflator 5. Which of the following is true regarding purchasing power parity (PPP)? [LO 8.5] PPP almost never exists PPP holds mostly true, but only across developed countries PPP exists because of easily and electronically traded currencies Trade restrictions increase the likelihood of PPP occurring Feedback: Almost never holds due to transaction costs, non-tradable goods, and trade restrictions. Solutions to End-of-Chapter Questions and Problems Review Questions If we want to measure changes in the cost of living, why don’t we track difference in each household’s actual expenditures from one year to the next, rather than the difference in the cost of a market basket? Offer several reasons why this method would fail to capture changes in the overall price level accurately. [LO 8.1] Answer: We don’t track changes in actual expenditures from year to year because we want to be sure we are measuring changes in prices and not changes in quantities. Households change the types and amounts of goods and services they buy for several reasons. First, as certain goods become more expensive, consumers may substitute away to different goods whose prices have not increased as rapidly. Furthermore, people’s consumption patterns may change due to tastes or changes in income that have nothing to do with changing prices. Finally, innovation can lead to the introduction of new products or improvements in existing products. Changes in spending on these goods are difficult to attribute to simple changes in price. There are many different types of market baskets that economists measure. For example, the market basket for consumers—called the Consumer Price Index—tracks the prices associated with the typical consumer’s purchases of goods and services. The Producer Price Index tracks the prices of the goods and services purchased by firms. A third type of market basket is the Home Price Index, which tracks the value of residential housing. In what scenarios would each of these market baskets be useful? [LO 8.1] Answer: Measuring the cost of living for a typical consumer is probably best addressed through a broad-based index like the CPI. Besides being helpful in examining price changes that might affect businesses, the PPI is also useful as a gauge of future CPI inflation since businesses typically pass on some of their increases in input costs to consumers. A Home Price Index is useful for measuring differences in the cost of living between different cities. It is well known that some cities like New York City and San Francisco are more costly to live in than other regions of the country, but it is difficult to easily and accurately measure every price difference between cities. By measuring the difference in housing prices, which are a large portion of a typical household's budget and are also the budget item that varies most widely from city to city, differences in the overall cost of living can be approximated. Why is the list of the highest-grossing films of all time dominated by movies made within the last 10 years? (Hint: Did The Star Wars: The Force Awakens, made in 2015, really sell considerably more movie tickets than the classic Gone with the Wind, or is something else going on?) [LO 8.2] Answer: Given the price of tickets has risen over time, studios can make more money, in nominal terms, selling tickets now than in the past. It’s a lot easier to sell $100 million worth of tickets when tickets are $15 each than when they are only 8 cents apiece. A second reason, although not related to the topic of prices, is that the population has grown over time. In 1939, the year Gone with the Wind was released, the U.S. population was only about 131 million; in contrast, the U.S. population in 2015 was 326 million. That’s 195 million additional ticket buyers now as opposed to 75 years ago. How would you use the concept of the Consumer Price Index to compare prices across different locations? [LO 8.2] Answer: You could use the concept of the CPI to compare prices across locations by creating a basket with the same goods in two different places and then measuring how the prices changed in each basket over a set period of time. For example, if you wanted to compare the prices in Iowa City and Kansas City, you would compare the prices of the same goods in both cities over time. What types of goods and services would a basket measuring the inflation rate for farmers include? Why doesn’t the BLS calculate the price levels for a market basket approximating the purchases of farmers? [LO 8.3] Answer: A basket for farmers might include many of the goods we normally buy—bread or jeans, for example—but it might include fewer eggs or vegetables than the basket for the average urban consumer. (Farmers would be able to raise or grow these things themselves.) The market basket probably also would include fertilizers and seeds to grow crops. The BLS does not measure price increases for farmers because less than 1 percent of the current American population are farmers. It would be a lot of work and effort to explicitly measure the price level for such a small segment of the population. Does the CPI represent the actual change in the cost of living for any given household? Explain why or why not. [LO 8.3] Answer: No. The CPI measures the cost living for an average (urban) household. Every household consumes slightly different types of goods, which may be more or less expensive than another household’s consumption basket. The CPI measures the cost of living for a typical household, but individual households may experience inflation that is higher or lower than that measured by the change in the CPI. Suppose wages rise in China, leading to an increase in the price of toys imported from China. How would this change affect the CPI, PPI, and the GDP deflator in the United States? [LO 8.4] Answer: In the United States, imported Chinese toys are part of the CPI (since Chinese toys are part of the basket of goods and services an average household might consume) but are not part of the GDP deflator (since Chinese toys are not part of the U.S. GDP). Typically, toys are not used as inputs for producers, so they would not be part of the PPI either. Thus, the U.S. CPI would rise, but the PPI and GDP deflator would be unchanged. In China, if all of these toys are exported, the CPI (and PPI) would not change, but the GDP deflator would rise. Of course, an increase in wages would likely affect other industries outside of exporting sectors, leading to increases in the CPI and PPI of China as well. If the growth rate in nominal income is larger than the inflation rate (as measured by the change in the CPI or the GDP deflator), has the real value of income grown? [LO 8.4] Answer: Any time a nominal value is rising faster than the inflation rate, the real value will be rising. The intuition is that real income is rising by the rate of nominal income growth but falling by the rate of inflation. As long as nominal income growth outpaces inflation, real incomes will be rising. To convince yourself of this, try a simple numerical example. Think back to the equation earlier in the chapter for the value of 1969 income in 2009 dollars: 1969real2009 = 1969nominal x (CPI2009/CPI1969) To make the calculations easier, suppose 1969nominal = 10,000 and CPI1969 = 100. Now suppose 2009nominal rises by 10% over 1969nominal and CPI2009 rises 5% over CPI2009: 2009nominal = 11,000 (10% higher than 1969), and CPI2009 = 105 (5% higher than 1969) Now calculate 1969real and see whether it is higher or lower than 2009real: 2009real = 2009nominal = 11,000 1969real = 10,000 x (105/100) = 10,500 So, real income has risen between 1969 and 2009. You can try this with any combination of numbers. As long as nominal income is rising faster than the CPI, 2009real will be greater than 1969real. What is the better measure of inflation to determine how much should be paid to employees for cost-of-living adjustments: the Producer Price Index (PPI) or the CPI? Why? [LO 8.5] Answer: Remember that the typical employee, when he or she leaves work, becomes a typical consumer. Thus, an employee’s cost of living is closely approximated by the CPI, and therefore employee’s wages should be adjusted by the CPI, not the PPI. Why are people unlikely to buy Big Macs in the places where they are relatively cheap according to purchasing power parity and sell them where they are relatively more expensive, in order to make a profit? [LO 8.4, LO 8.6] Answer: The transaction costs would be too high. It would be expensive to transport Big Macs from one country to another just to make a few cents. Furthermore, there is little resale market for used Big Macs, not to mention the fact that the Big Macs would spoil quickly. Thus, we would not expect the price of Big Macs to equalize around the world. Commodities like gold, however, are generally sold at very similar prices all over the globe, since gold can be cheaply transported, easily resold, and doesn’t degrade over time. In many poor countries, even middle-class families may have full-time servants, a luxury reserved for only the very wealthiest households in rich countries like the United States. How does the existence of low-cost domestic help affect PPP-adjusted GDP statistics in poor countries? [LO 8.7, 8.8] Answer: Domestic help is relatively cheap in poor countries, but due to immigration laws and other factors, it cannot easily be imported into rich countries, so the price of domestic help doesn’t tend to equalize across countries. Thus, since consumption baskets include domestic help (and other services that can be provided cheaply in poor countries), prices tend to be lower in poor countries. This tends to increase the PPP-adjusted GDP in poor countries relative to non-adjusted GDP statistics. Would Kentucky, a state with a very low cost of living, have a PPP-adjusted GDP higher or lower than its GDP calculated without PPP-adjustment? Why? [LO 8.8] Answer: Kentucky will have a higher GDP after adjusting for PPP. Since Kentucky has a low cost of living, a given number of dollars will purchase more goods and services in Kentucky than in a state with a higher cost of living. GDP without a PPP adjustment simply counts up the number of dollars earned in Kentucky, while GDP with a PPP adjustment accounts for how much those dollars can buy. Since dollars can buy more in Kentucky than in some other places, Kentucky’s PPP-adjusted GDP will be higher than its non-adjusted GDP. Problems and Applications 1. Subscribing to the theory that life is indeed a beach, the residents of La Playa spend all of their money on three things: Every year, they collectively buy 250 bathing suits, 600 tubes of sunscreen, and 400 beach towels. Using the data in Table 8P-1, calculate the following. [LO 8.1] a. The total cost of this basket each year from 2013 through 2016. b. How much the price of this basket has changed from year to year in percentage terms. Answer: To find the price of each basket, multiply the quantities in the first column by the corresponding price in each of the other columns and then sum the results. To find the change in the price of the baskets, simply subtract each year’s sum from the previous year’s sum. To find the percentage change from year to year, subtract the current year’s sum from the previous year’s sum, and then divide this amount by the previous year’s sum. To convert a decimal to a percentage, simply multiply the decimal by 100. 2. Suppose a typical American consumer purchases three goods, creatively named good A, good B, and good C. The prices of these goods are listed in Table 8P-2. [LO 8.1] If the typical consumer purchases two units of each good, what was the percentage increase in the price paid by the consumer for this basket between 2015 and 2016? If the typical consumer purchases 10 units of good B and 2 units of both good A and good C, what was the percentage increase in the price paid by the consumer for this basket? Given your answers to parts a and b, what is the relationship between the market basket and the percentage price change? Answer: Cost of basket in 2015 = 2($10)) + 2($5) +2($1) = $32. Cost of basket in 2016 = 2($15) + 2($4) +2($2) = $42. Prices have increased by ($42 – $32)/$32 = 0.3125, or 31.25%. Cost of basket in 2015 = 2($10) + 10($5) +2($1) = $72. Cost of basket in 2016 = 2($15) + 10($4) +2($2) = $74. Prices have increased by ($74 – $72)/$72 = 0.0278, or 2.78%. The overall change in the cost of the market basket is affected by how many units of each good one purchases. If two goods are rising in price at different rates, but the market basket contains more of good A than good B, then the rate of increase of the overall market basket will be closer to the rate of increase of A rather than B. In part a, the market basket contains the same number of units of each good, so the price changes are weighted equally. In this case, the rate of inflation is just the average of the percentage change in the three prices. In part b, the market basket contains more units of good B, so the large increase in the price of good A does not carry as much weight as it did in part a. As a result, the inflation rate is much lower. Using the data in Table 8P-3, calculate the CPI in each year, using 2010 as a base year. [LO 8.2] Answer: CPI in year x = (Cost of basketyear x /Cost of basketbase year) × 100 Inflation rate = percent change in CPI = [(CPInew – CPIold)/CPIold]× 100 Note: when calculating the inflation rate it is best to use the calculated CPI values and not the rounded values to avoid rounding error. Year Price of basket ($) CPI Percent change in CPI 2010 20,000 100 -- 2011 21,500 = (21,500/20,000) x 100 = 107.5 = (107.5 − 100)/100 = 0.075. or 7.5% 2012 22,800 = (22,800/20,000) x 100 = 114 = (114 − 107.5)/107.5 = 0.060, or 6.0% 2013 26,150 = (26,160/20,000) x 100 = 130.75 = (130.75 − 114)/114 = 0.147, or 14.7% 2014 28,825 = (28,825/20,000) x 100 = 144.125 = (144.125 − 130.75)/130.75 = 0.102, or 10.2% 2015 32,700 = (32,700/20,000) x 100 = 163.5 = (163.5 − 144.125)/163.5 = 0.134, or 13.4% Table 8P-4 lists the prices and quantities consumed of three different goods from 2014– 2016. [LO 8.2] For 2014, 2015, and 2016, determine the amount that a typical consumer pays each year to purchase the quantities listed in the table. Using the amounts you found in part a, calculate the percentage change in the amount the consumer paid from 2014 to 2015, and from 2015 to 2016. Why is it problematic to use your answers to part b as a measure of inflation? Suppose we take 2014 as the base year, which implies that the market basket is fixed at the 2014 consumption levels. Using 2014 consumption levels, now find the rate of inflation from 2014 to 2015 and from 2015 to 2016. (Hint: First calculate the cost of the 2014 market basket using each year's prices and then find the percentage change in the cost of the basket.) e. Repeat the exercise from part d, now assuming that the base year is 2015. f. Why were your answers from parts d and e different? Answer: Multiply the quantity by the price for each good and then sum up for each year. In 2014, the consumer pays $10(10) + $5(18) + $1(10) = $200. In 2015, the consumer pays $15(8) + $3(30) + $2(5) = $220. In 2016, the consumer pays $20(5) + $4(25) + $5(10) = $250. The change between 2014 and 2015 is ($220 – $200)/$200 = 0.1, or 10%. The change between 2015 and 2016 is ($250 – $220)/$220 = 0.136, or 13.6%. It is problematic to use your answers to part b as a measure of inflation because the growth found in part b includes both price changes as well as consumption changes. Using 2014 as the base year, one needs to calculate the price of the market basket in each year using the quantities in 2014 but the prices for each year. In 2014, the consumer pays $10(10) + $5(18) + $1(10) = $200. In 2015, the consumer pays $15(10) + $3(18) + $2(10) = $224. In 2016, the consumer pays $20(10) + $4(18) + $5(10) = $322. The change between 2014 and 2015 is ($224 – $200)/$200 = 0.12, or 12%. The change between 2015 and 2016 is ($322 – $224)/$224 = 0.4375, or 43.75%. Using 2015 as the base year, one needs to calculate the price of the market basket in each year using the quantities in 2015 but the prices for each year. In 2014, the consumer pays $10(8) + $5(30) + $1(5) = $235. In 2015, the consumer pays $15(8) + $3(30) + $2(5) = $220. In 2016, the consumer pays $20(8) + $4(30) + $5(5) = $305. The change between 2014 and 2015 is ($220 – $235)/$235 = −0.064, or −6.4%. The change between 2015 and 2016 is ($305 – $220)/$220 = 0.386, or 38.6%. The answers from parts d and e are different because using 2014 and 2015 as base years puts different weights on the goods. 5. Which of the following goods have likely required hedonic quality adjustment over time if they were included in the Consumer Price Index (CPI) [LO 8.3] a. Laptop computers. Cellphones. Salt. Televisions. Housing. Tennis rackets. Answer: A hedonic quality adjustment is required when the features of the good being measured change over time. The hedonic quality adjustment method removes any price differential attributed to a change in quality by adding or subtracting the estimated value of that change from the price of the old item. Yes. Laptop computers have changed over time. Older models were larger, heavier, and slower to operate. Yes. More features have been added to cell phones over time, and cell phones now are a part of every basket. That wasn’t the case when they had spotty reception, cost $4,000, and were purchased only by high-level executives. No. Salt likely doesn’t need hedonic adjustment; it will always be the same chemical formula. Yes. The televisions of today are far more complex and offer a far more vivid display than the TVs of just a decade ago. No. In general, housing in terms of shelter doesn’t need any sort of adjustment. Over time, the quality of the goods within the house changes, but the housing itself doesn’t change very much. Yes. Today’s tennis rackets use space-age materials, like carbon fiber and titanium, while the rackets of yesteryear were made of wood. 6. Use Table 8P-5 to calculate core and headline inflation in each time frame relative to the base year, assuming that each category is weighted equally in the calculation of headline inflation. [LO 8.2, 8.4] 2012 to a base year. 2016 to a base year. 2012 to 2016. Answer: Headline inflation includes food and energy whereas core inflation does not. Since food and energy prices are much more volatile than the prices of other goods and services, these items are removed to get a better measure of what is happening to the prices of other goods and services. We know the CPI value in the base year is equal to 100. From the base year to 2012: Core: (102 − 100)/100 = 0.02, or 2%. Headline: We know core inflation is 2%. The percentage change in the prices of food and energy is (120 - 100)/100 = 0.20, or 20%. Since the overall CPI is equally weighted between the two, we can take an average of the two inflation rates. Headline inflation is therefore (20% + 2%)/2 = 11%. From the base year to 2016: Core: (107 − 100)/100 = 0.07, or 7%. Headline: Core inflation is 7% and the percentage change in the prices of food and energy is 5%. Therefore, headline inflation is (7% + 5%)/2 = 6%. 2012 to 2016: Core: (107 − 102)/102 = 0.049, or 4.9%. Headline: 4.9% core and (105 − 120)/120 = -0.125 or −12.5% food and energy. Weight: 50/50, so the average of the two = [4.9% + (−12.5%)]/2 = −3.8%. Table 8P-6 shows the GDP deflator and CPI over five recent years. How much did prices change between years in each measure? By what percent did prices change between years for each measure? Calculate the annual inflation rate and then the inflation rate across the entire time period. [LO 8.4] Answer: Percent change in CPI = (CPInew – CPIold)/CPIold. The same equation holds for the GDP deflator. Year GDP deflator Change in GDP deflator CPI Change in CPI 2012 100 - 100 - 2013 105 (105 − 100)/100 = 0.05, or 5% 104 (104 − 100)/100 = 0.04, or 4% 2014 112 (112 − 105)/105 = 0.067, or 6.7% 110 (110 − 104)/104 = 0.057, or 5.7% 2015 123 (123 − 112)/112 = 0.098, or 9.8% 113 (113 − 110)/110 = 0.027, or 2.7% 2016 127 (127 − 123)/123 = 0.033, or 3.3% 120 (120 − 113)/113 = 0.062, or 6.2% 2012-2016 - (127 − 100)/100 = 0.27, or 27% - (120 − 100)/100 = 0.20, or 20% The median American household earned $9,387 in 1973 and $53,657 in 2014. During that time, though, the CPI rose from 44.4 to 236.7. [LO 8.5] Calculate the total growth rate in nominal median household income from 1973 to 2014. Calculate the total growth rate in real median household income from 1973 to 2014. Answer: It is worth noting that these are the real numbers from the U.S. Census. The fact that the median household has experienced almost no real income growth over the past 40 years is a primary concern for modern macroeconomists. Nominal growth rate = (53,657 – 9,387)/9,387 = 4.716, or 471.6%. First one needs to calculate the real income in 1973 and 2014 in 2014 dollars. 1973real2014 = 1973nominal × (CPI2014/CPI1973) = 9,387 × (236.7/44.4) = 50,043. Real income in 2014 in 2014 dollars is by definition the same as nominal income. Alternatively, it may help to see the numbers: 2014real2014 = 2014nominal × (CPI2014/CPI2014) = 53,657 × (236.7/236.7) = 53,657. Next one needs to calculate the increase in real income. Real growth rate = (53,657 – 50,043)/50,043 = 0.072, or 7.2%. Using Table 8P-7, find the real value of a $1,000 payment to be received each year given the following CPI values. Next, find the amount that this $1,000 should be adjusted to, in order to keep its real value at $1,000. [LO 8.5, LO 8.6] Answer: To find the purchasing power of $1,000 in various years, use the equation from the chapter and calculate the real values in 2013 dollars. Example: Value of $1,000 received in 2014 in 2013 dollars: 2014real2013 = 2014nominal × (CPI2013/CPI2014) Use 2013 as the base year. To find the cost of living adjusted payment, one simply needs to increase the payment at the same rate as the CPI. This can be done by multiplying the original $1,000 payment by the current year CPI and then dividing by the original year (2013) CPI. Year CPI Real value of $1,000 (in $2005) Cost of living adjusted payment 2013 100 2005real2005 = 2005nominal x (CPI2005/CPI2005) = 1,000 x (100/100) = $1,000 =1,000 x (CPI2005/CPI2005) = 1,000 x (100/100) = $1,000 2014 103 2006real2005 = 2006nominal x (CPI2005/CPI2006) = 1,000 x (100/103) = $970.87 =1,000 x (CPI2006/CPI2005) = 1,000 x (103/100) = $1,030 2015 105 2007real2005 = 2007nominal x (CPI2005/CPI2007) = 1,000 x (100/105) = $952.38 =1,000 x (CPI2007/CPI2005) = 1,000 x (105/100) = $1,050 2016 110 2008real2005 = 2008nominal x (CPI2005/CPI2008) = 1,000 x (100/110) = $909.09 =1,000 x (CPI2008/CPI2005) = 1,000 x (110/100) = $1,100 Suppose General Electric paid its line workers $10 per hour in 2015 when the Consumer Price Index was 100. Suppose that deflation occurred and the aggregate price level fell to 80 in 2016 [LO 8.5, LO 8.6] What must GE pay its workers in 2016 in order to keep the real wage fixed? What did GE need to pay its workers in 2016 if it wanted to increase the real wage by 10 percent? If GE kept the wage fixed at $10 per hour in 2016, in real terms, what percentage increase in real wages did its workers get? Answer: We need the real hourly wage in 2016 measured in 2015 dollars to be equal to $10. The equation is 2016real2015 = 2016nominal × (CPI2015/CPI2016) = $10. Plugging in the CPIs, we get $10 = 2016nominal × (100/80). Multiplying both sides by (80/100), we get $8 = 2016nominal. GE needed to pay its workers 10 percent more than the answer in part a, or $8.80 per hour (= $8 × 1.1). First, we need to find out what the real wage was in 2016 in 2015 dollars. The equation is 2016real2015 = 2016nominal × (CPI2015/CPI2016), so 2016real2015 = $10 × (100/80) = $12.50. The real wage in 2015 measured in 2015 dollars is the same as the nominal wage by definition. Alternatively, it may help to see the numbers: 2015real2015 = 2015nominal × (CPI2015/CPI2015) = $10 × (100/100) = $10. Next, we need to calculate the increase in real wages. Real growth rate = ($12.50 – $10)/$10 = 0.25, or 25%. Table 8P-8 shows the prices of a tall Starbucks latte in countries around the world. Using the data, and the fact that a latte costs $3 in the United States, calculate how much a country’s currency is under- or overvalued according to purchasing power. First, calculate the implied exchange rate for each country. Next, calculate the "latte index" for each country using the Big Mac index formula from the chapter. [LO 8.7] Answer: The first step is to calculate what the exchange rate would have to be if the theory of purchasing power parity holds true. To do this, we divide the cost of a latte in the foreign currency by the cost of the latte in the United States. Next, we use the equation from the “Big Mac Index” from the chapter = [(PPP implied exchange rate – official exchange rate)/official exchange rate] × 100. Country Price Official exchange rate Implied exchange rate if PPP holds Cost of US latte Thailand 60 baht 30 baht/$ 60/3 = 20 baht/$ (20 − 30) x 100/30 = −33.3% Argentina 15 pesos 6 pesos/$ 15/3 = 5 pesos/$ (5 − 6) x 100/6 = −16.7% U.K. 2 pounds 0.5 pounds/$ 2/3 = .67 pounds/$ (0.67 − 0.5) x 100/0.5 = 34.0% Japan 450 yen 80 yen/$ 450/3 = 150 yen/$ (150 − 80) x 100/80 = 87.5% An employee asks her boss whether she can transfer offices so that she can work in a different part of the country. The boss responds positively and says that the employee can choose to work in Cleveland, Miami, or New York City. The boss then hands the employee a list, as shown in Table 8P-9, of the salaries that she would earn in the different cities and the average price levels in those same cities [LO 8.7, 8.8] From a standpoint of maximizing the employee’s consumption possibilities, which office should she choose? What would be the minimum salary in New York City the boss could offer the employee to make the employee indifferent between moving to Cleveland and to New York City? Answer: We cannot just compare the salaries in the three locations directly because the price levels are different. We need to calculate the real salary in each location and we will choose to do this by adjusting all salaries to Cleveland dollars. Using the equation from the chapter: 1969real2009 = 1969nominal × (CPI2009/CPI1969), switch 1969 for New York City or Miami and 2009 for Cleveland. Now the value of New York City income in Cleveland dollars is NYCrealCleveland = NYCnominal × (CPICleveland/CPINYC). Cleveland = 80,000 × (100/100) = $80,000. Miami = 120,000 × (100/155) = $77,419. New York City = 150,000 × (100/210) = $71,429. The employee makes the most money in Cleveland after adjusting for the cost of living. The manager needs to offer a nominal salary in New York City such that the real salary in “Cleveland dollars” is at least $80,000. Using the equation from part a: NYCrealCleveland = NYCnominal × (CPICleveland/CPINYC). Substitute in $80,000 for NYCrealCleveland and solve for NYCnominal. $80,000 = NYCnominal × (100/210). Multiplying each side by 210/100 yields $168,000 = NYCnominal. 13. Calculate the PPP-adjusted GDP for each of four countries, using the information found in Table 8P-10. [LO 8.6] Answer: Using the equation in the text for PPP adjustment, we find that: PPP-adjusted GDP = GDPnominal x [1/(100% + purchasing power index)]. Country GDP Price-level comparison PPP-adjusted GDP Ona $10,000 6% =10,000 x [1/(1 + 0.06)] = 10,000 x 1/1.06 = $9,434 Rye $12,700 −27% =12,700 x [1/(1 – 0.27)] = 12,700 x 1/0.73 = $17,397 Zolfo $14,100 −10% =14,100 x [1/(1 – 0.10)] = 14,100 x 1/0.9 = $15,667 Avon $23,400 20% =23,400 x [1/(1 + 0.20)] = 23,400 x 1/1.20 = $19,500 CHAPTER 9 UNEMPLOYMENT AND THE LABOR MARKET Chapter Overview Most of our adult lives are spent working, and finding a great job can be a key to happiness. At the same time, not being able to find the right job—or not being able to find any job at all—can be one of the toughest life experiences. The labor market is in many ways like any other market. It’s driven by the forces of supply and demand, and we can describe an equilibrium wage rate where the quantity of labor supplied equals the quantity of labor demanded. But there are differences too: Minimum wages, bargaining by labor unions, and efficiency wages can all cause the wage rate to be above the market-clearing level for extended periods, which leads to unemployment. We’ve discussed how the official unemployment rate is measured. Since the unemployment rate doesn’t always give a full picture of labor-market conditions, economists and policy-makers often pore over other measures, such as the labor-force participation rate. We’ve described the main reasons for unemployment. Frictional and structural unemployment occur naturally; they will exist in any labor market regardless of policy. They are caused by people switching between jobs or shifting from one sector to another. Another type of unemployment, cyclical unemployment, mirrors the overall health of the economy and the business cycle. In boom times, jobs get created and cyclical unemployment is small. But jobs are lost when the economy weakens, and cyclical unemployment rises. Economists debate how much the rules of the labor market affect the overall rate of unemployment. We’ve seen that labor-market policies often come with important trade-offs: Policy-makers have to decide how generous to make unemployment benefits. Providing more support for the unemployed may be desirable from a social perspective, but when benefits are too generous, incentives to actively search for a job are diminished. Similarly, raising minimum wages helps workers on the bottom rungs of the labor market, but raising minimum wages can also make it harder for unemployed workers to find jobs. Unemployment is not something that occurs in isolation from the rest of the economy. In fact, one of the most powerful ways to reduce unemployment is to generate sustained economic growth in the overall economy. In the next chapter, we focus on this important economic challenge: How can policy and resources be combined to create healthy economic growth? Learning Objectives LO 9.1 Explain how economists measure employment and unemployment. LO 9.2 Explain how wage rates above equilibrium cause unemployment. LO 9.3 Explain why there is a natural rate of unemployment in an economy. LO 9.4 Explain why there is a cyclical component of unemployment. LO 9.5 Identify factors that may stop wages from falling to the equilibrium level. LO 9.6 Describe the challenges policy-makers face when designing unemployment insurance and understand how this and related policies can affect rates of unemployment. Chapter Outline WHAT DOES IT MEAN TO BE UNEMPLOYED? Defining and Measuring Unemployment (LO 9.1) Measuring Unemployment Beyond the Unemployment Rate Where Do the Data Come from? BOX FEATURE: WHERE CAN IT TAKE YOU? LABOR ECONOMIST Equilibrium in the Labor Market (LO 9.2) Categories of Unemployment Natural Rate of Unemployment (LO 9.3) Cyclical Unemployment (LO 9.4) Public Policies and Other Influences on Unemployment BOX FEATURE: FROM ANOTHER ANGLE – IMMIGRATION’S EFFECTS ON THE LABOR MARKET Factors that May Stop Wage Rates from Falling (LO 9.5) Unemployment Insurance (LO 9.6) BOX FEATURE: REAL LIFE – UNEMPLOYMENT AND DEVELOPING COUNTRIES Other Factors: Taxes and Worker Rights BOX FEATURE: WHAT DO YOU THINK? – YOUTH EMPLOYEES ON TRIAL Beyond the Lecture Class Media: Measuring Unemployment (LO 9.1) Have students view this video produced by mint.com to illustrate the technicalities in finding the unemployment rate. The video shows a series of jobless and underemployed people, yet only one of them is counted as officially unemployed. 1. What would a different method of counting jobless people do to the unemployment rate? What would happen if we included discouraged workers? Class Assignment/Discussion: Measuring Unemployment (LO 9.1) Have students examine the current news release of the Employment Situation Summary from the Bureau of Economic Analysis. This is a great way to introduce students to the calculation of unemployment/employment and its significance. Table A is ideal for practice with calculations. You can assign them to do calculations and discuss in class, or just discuss the numbers in the release (and what they mean). Class Discussion: Measuring Unemployment (LO 9.1) When discussing unemployment, you’ll of course mention to your students that discouraged workers are not considered unemployed – in fact, they’re not in the labor force at all. You’ll also recall that underemployed workers and part time workers are still counted as employed. Questions to discuss include: Would we get a more “true” picture of joblessness if we counted discouraged workers as unemployed? Is there a way to count underemployed or part-time workers (who want full-time jobs) as “partially unemployed”? Could the fact that we don’t count these groups as unemployed lead us into falsely believing the economy is stronger than it really is? Do you think opposing political parties may want to show different types of joblessness data depending on which party is in power? You can also see the video produced by mint.com above to see further points on this. Team Assignment/Class Discussion: Measuring Unemployment and the Natural Rate of Unemployment (LO 9.1, LO 9.3) Have students examine unemployment for a specific country; unemployment by country data can be found here. You may want to have each student (or group of students) pick a specific country to examine. Then, ask the students to research their country before the class discussion. In class, have them consider the following: 1. Why are there differences in rates of unemployment by country? What causes these differences? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. Which of the following people is considered unemployed? [LO 9.1] Allie, who has her Ph.D., but is working at Wal-Mart Bert, who wants a full-time job but can only find part-time work Cameron, who has been jobless for such a long time that he quit looking for jobs Dave, who went on two job interviews last week, but still hasn’t been hired by anyone Feedback: You have to be looking for work to be considered in the labor force and unemployed. Working any hours means you’re employed, even if you have skills way beyond your job. 2. All other things equal, the unemployment rate is higher for ____________. [LO 9.1] People who don’t have a high school diploma People who are retired Asians People between the ages of 35 - 45 Feedback: People with less education experience higher rates of unemployment. 3. Wages above equilibrium can cause unemployment because of the high wages result in ________ quantity demanded for labor and _______ quantity supplied of labor. [LO 9.2] A. higher; higher higher; lower lower; higher D. lower; lower Feedback: The gap between the quantity supplied of labor (people wanting to work) and the quantity demand for labor (firms wanting to hire people) is the unemployment. 4. Why might the official unemployment rate underestimate joblessness? [LO 9.1, 9.2, 9.3] It doesn’t include discouraged workers It doesn’t include retired people It doesn’t include students It doesn’t include stay-at-home parents Feedback: A bit tricky. The unemployment rate doesn’t include ANY of the mentioned people. However, we can imagine that retirees, students, (and most likely) stay-at-home parents are not wanting to work or will be looking for a job. However, a discouraged worker might want to work, but has just given up looking. But since they aren’t actively looking, we don’t count them in the labor force. 5. Marco is a trained as a VCR repairman, and can’t find a job. Which of the following types of unemployment would we use to describe Marco’s situation? [LO 9.3, 9.4] A. Cyclical Frictional Structural Classical Solutions to End-of-Chapter Questions and Problems Review Questions During the 1960s societal norms regarding working women were changing, and many women who had been housewives began working outside the home. How would you expect this new norm to change the labor-force participation rate? What about the unemployment rate? [LO 9.1] Answer: Growing opportunities for women to work outside the home increased the laborforce participation rate as women either found jobs or spent time looking for jobs. Determining whether an increase in the number of women in the labor force changes the unemployment rate takes a bit more care. If one assumes there are a fixed number of jobs in the economy, every job taken by a woman (or immigrant or minority or any other group) would take a job away from someone else. Thus, unemployment would rise because more people would be searching for the same number of jobs. However, the assumption that the number of jobs in an economy is fixed is typically incorrect and often referred to as the “lump of labor fallacy.” An increase in the number of women in the workforce tends to lead to an increase in the equilibrium number of jobs, increasing the employment/population ratio and having little effect on the unemployment rate in the long run. Empirically, the labor-force participation rate averaged 59.2 percent in the 1960's and 66.7 percent in the 1990's. The employment/population ratio rose from 56.4 percent to 62.9 percent between the two decades. Unemployment was relatively unchanged across this time period, averaging 4.9 percent in the 1960's and 5.8 percent in the 1990's, even though the 1990's number was biased upward by cyclical unemployment caused by a recession in the early part of the decade. In the short run more women entering the labor force might lead to an increase in the unemployment rate, especially if women find they are lacking skills and education. The natural rate of unemployment was in fact higher in the 1970's and 1980's before falling in the 1990's. List at least five types of people who do not have paid jobs but would nevertheless not be considered unemployed. [LO 9.1] Answer: To be unemployed, one needs to not have a job but be actively searching for one. Anyone without a job but not actively searching would be neither employed nor unemployed. Examples include students, retirees, many disabled persons, persons institutionalized or incarcerated, homemakers, full-time volunteers, and discouraged workers who do not have a job but have given up looking for work. Compare two countries, one that has unlimited unemployment insurance and one in which workers are eligible for 26 weeks of unemployment insurance. Explain one reason why the country with more unemployment insurance may have a higher equilibrium unemployment rate. [LO 9.2] Answer: Workers in the country with unlimited unemployment benefits have less incentive to search diligently for work since they will receive benefits for an unlimited period of time even if they don’t find work. Thus, they are more likely to remain unemployed than workers in a country with benefits limited to 26 weeks, who have a very strong incentive to find a new job within the 26 weeks before they lose their benefits. Suppose the president of a country comes to you to ask your advice. The country is currently at 8 percent unemployment, and the president wishes to reduce unemployment in the country to 3 percent. As an economist, you determine that the country’s natural rate of unemployment is 5 percent. What advice would you give the president? [LO 9.3] Answer: There are several potential things you could tell the president. First, since the current unemployment rate is 8 percent and the natural rate is 5 percent, the country must be suffering from cyclical unemployment. Anything the president can do to stimulate the economy is likely to reduce the unemployment rate closer to 5 percent. However, the president should also pick a different target. The natural rate of unemployment is "the minimum level of unemployment that is unavoidable in a dynamic economy," and in general, any attempts to reduce unemployment below this number are likely to result in a lot of effort for little gain. So, economic recovery should bring the unemployment rate down closer to 5 percent, but there is no reason to believe the economy can get all of the way to 3 percent. There are ways to reduce the natural rate of unemployment (although probably not to 3 percent, at least in the U.S.). The government can provide retraining for those with structural unemployment issues. Lowering unemployment compensation and eliminating the minimum wage are also likely to reduce the natural rate of unemployment. Innovation often requires “creative destruction,” in which the new product or technology makes previous products or technologies obsolete. For example, when the personal computer was invented, typewriters became useless; hence, the personal computer “destroyed” the typewriter. This process of creative destruction often results in structural unemployment because workers who knew how to build and maintain the old products have skills that are no longer in demand. Do you think the government has a role in either limiting how often new products are created or in helping those workers who are displaced because of the new product? [LO 9.3] Answer: Almost certainly the government shouldn’t limit how often new products are introduced. Word processors, for example, have clearly made the economy more efficient and made the world a better place for almost everyone─except typewriter manufacturers and repairers. That being said, there is certainly a case to be made to help out those hurt by technological changes, although for the most part this is more of a normative (that is, subjective or opinion-based) response than a positive or objective one. Suppose the National Bureau of Economic Research (NBER) just came out with a report suggesting that the economy will soon dip into recession. How do you think the levels of frictional, structural, and cyclical unemployment will change as the recession begins? What will happen to the labor-force participation rate? [LO 9.4] Answer: Certainly, the biggest change is that cyclical unemployment will rise. The effects on frictional and structural unemployment are ambiguous. Frictional unemployment may rise as new graduates or other people losing their jobs for normal "course of life" reasons will find it harder to get new jobs. On the other hand, given a bad job market, people may stay in school or their existing job longer, reducing frictional unemployment. Structural unemployment is not likely to change much over the short run, as recessions do little to change the underlying rate of labor market evolution. The labor-force participation rate is likely to fall. Potential workers facing a bad job market are more likely to stay in school, stay at home, or retire early rather than look for a job. What happens to a country’s levels of frictional, structural, and cyclical unemployment, as well as its labor-force participation rate, as a recession drags on for an extended period of time? [LO 9.4] Answer: A recession will increase cyclical unemployment and generally have an ambiguous effect on frictional and structural unemployment. As a recession drags on, however, workers who have been unemployed for a long period of time begin to see their skills deteriorate and therefore may move from simply cyclically unemployed to structurally unemployed. Thus, a lengthy recession may have bad long-run effects on the labor market, even once the economy has technically recovered from the recession. In a lengthy recession one should definitely expect the labor-force participation rate to fall as workers who have been unable to find work for a long period of time become discouraged and drop out of the labor market. 8. What happens to a country’s levels of frictional, structural, and cyclical unemployment, as well as its labor-force participation rate, as a country begins to recover from a deep recession? [LO 9.4] Answer: As a country recovers from a recession, cyclical unemployment will clearly fall and the labor-force participation rate will rise. The effects on frictional and structural unemployment are somewhat ambiguous; however, there is reason to believe that frictional unemployment may actually rise, counter-balancing a portion of the fall in cyclical unemployment. Better job prospects will draw some people from out of the labor force back in. To the extent that not all of the new job searchers will be able to find work, frictional unemployment may rise. The net effect, however, will be a fall in the total unemployment rate. 9. Give two reasons why it may be rational for a firm to offer wages above the minimum wage. [LO 9.5] Answer: The old adage is “you get what you pay for.” Paying higher wages is likely to attract higher-quality workers, who will be more productive. Paying higher wages also induces higher effort from employees, since highly paid workers have more to lose if they lose their jobs. Finally, highly paid workers are less likely to leave their jobs, and since recruiting and training employees is expensive, reducing job turnover is valuable to firms. In France, labor laws typically made it very difficult or even illegal for firms to fire workers during economic downturns. How would these laws affect cyclical unemployment as well as frictional and structural unemployment? (Hint: Think about how these laws affect firms’ decisions to hire workers in the first place.) [LO 9.4, 9.5] Answer: Making it difficult to fire employees during economic downturns will reduce cyclical unemployment. That’s the obvious part of the question. These laws, however, make it far riskier to hire workers in the first place, since firms will be unable to fire them in the case of a recession. Since firms are more reluctant to hire in the first place, frictional and structural unemployment is likely to be higher. The net effect on unemployment is ambiguous, but overall, one should expect a higher natural rate of unemployment in France but lower peaks of unemployment during recessions. Laws like this make it very hard to find work in the first place, but also make the jobs that workers do have more secure. Unemployment is often called a lagging or trailing indicator because unemployment tends to rise sometime after the economy begins to slow down, and unemployment begins to fall again after the economy begins to rebound. In other words, unemployment trails GDP. Why do you think this might be the case? [LO 9.5] Answer: It is expensive and unpleasant for firms to fire or lay off workers. Thus, firms will avoid getting rid of employees at the first sign of an economic downturn and will often wait until a recession is firmly in place before they start getting rid of workers. Thus, the rise in unemployment trails the fall in GDP. Likewise, it is expensive to recruit and train new employees, so firms typically wait until a recovery is well underway before they start hiring again. Again, the fall in unemployment trails the rise in GDP. The traditional goal of a government is to maximize its citizens’ welfare. Given this goal, would you suggest getting rid of unemployment insurance? How would your answer change if the goal of the government is to maximize employment? [LO 9.6] Answer: Obviously this question is a normative one, so there is no one right answer. That being said, most people benefit from having a safety net that protects them from economic variations that are beyond their control. Unemployment insurance helps people just during the time that they need help the most, so it can easily be argued that the unemployment insurance safety net improves citizens’ welfare on average. On the other hand, it is clear that unemployment insurance reduces workers’ incentives to find new jobs when they lose their old ones, which decreases employment. Whether unemployment insurance is a “good” thing clearly depends on what government is trying to maximize. In the United States during regular economic times, the maximum length of time a worker can collect unemployment insurance is 26 weeks. During recessions, however, Congress often increases the length of time in which workers can collect benefits. During the recent financial crisis, workers could collect benefits for up to 99 weeks in some states. Comment on the advantages and disadvantages of this system. [LO 9.6] Answer: With a 26-week limit on unemployment insurance, workers have a strong incentive to search diligently for work since their benefits last only a short period of time. In normal times, this amount of time should be sufficient for a worker to find a new job, so unemployed workers are provided with an adequate safety net while also given appropriate incentives to find work. In a recession, however, there will be more unemployed workers and fewer firms hiring, so 26 weeks may not be sufficient for the typical person to find a new job. Raising the length of time a worker can receive benefits keeps the safety net in place while acknowledging the additional difficulty in finding work in a bad economy. Of course, raising the length of time an unemployed individual is eligible for benefits will generally prolong the amount of time a person stays out of work. Problems and Applications 1. For each of the following situations, is Rick Alexander (from the chapter-opening story) counted as employed, unemployed, or not in the labor force by the Bureau of Labor Statistics? [LO 9.1] Alexander is self-employed in his old job as a carpenter. Alexander moves to Florida and begins looking for work. Alexander feels discouraged looking for work and stops applying for jobs. Alexander starts looking for work again. Alexander starts work at a new job. Answer: Alexander is employed if he has a job, unemployed if he doesn’t have a job but is actively looking for one, and not in the labor force if he doesn’t have a job but isn’t searching for one. Self-employment is a type of job, so Alexander is employed. Alexander no longer has a job but is looking for one, so he is unemployed. Alexander doesn’t have a job but isn’t looking, so he is neither employed nor unemployed. He is not in the labor force. Alexander still doesn’t have a job but is now looking for one, so he is back to being unemployed. Alexander finally has a job again, so he is employed. 2. Consider the economy whose data appear in Table 9P-1. [LO 9.1] What is the unemployment rate? What is the labor-force participation rate? Answer: Unemployment rate = Unemployed/Labor force = 10,000/60,000 = 0.167, or 16.7%. Labor-force participation rate = Labor force/Population = 60,000/100,000 = 0.60, or 60%. 3. Table 9P-2 uses data for the year 2016, adjusted to be comparable to each other. All population values are in thousands. Fill in the blanks in the table. [LO 9.1] In part a, you should have found that the unemployment rates of the three countries differ significantly from one another. Suggest three possible reasons to explain why the countries might have different unemployment rates. [LO 9.3, 9.4] Answer: (1) Labor force = Employed + Unemployed = 64,460 + 2,160 = 66,620. Unemployment rate = Unemployed/Labor force = 2,160/(64,460 + 2,160) = 3.2%. Labor-force participation rate = Labor force/Working-age population = 66,620/110,849 = 60.1%. Employed = Labor force – Unemployed = 31,164 – 3,520 = 27,644. Unemployment rate = Unemployed/Labor force = 3,520/31,164 = 11.3. Labor-force participation rate = Labor force/Working-age population, so Working-age population = Labor force/Labor-force participation rate = 31,164/0.561 = 55,551. Labor-force participation rate = Labor force/Working-age population = 46,096/77,066 = 59.8. Unemployment rate = Unemployed/Labor force, so Unemployed = Unemployment rate × Labor force = 0.057 × 46,096 = 2,627. Labor force = Employed + Unemployed, so Employed = Labor force – Unemployed = 46,096 – 2,627 = 43,469 There are multiple possible reasons for this: Germany could have a lower natural rate of unemployment than France. Germany could be in an expansion and have lower cyclical unemployment. France could have higher (and binding) minimum wages. Japan could have a more liberalized labor market, leading to lower frictional unemployment. France could have more generous unemployment benefits. 4. Assume the equilibrium wage rate is $6. Draw a graph of the labor market to answer the following questions. [LO 9.2] When the government introduces a minimum wage of $5.50, does unemployment increase, decrease, or stay the same compared to unemployment at the equilibrium wage? When the government introduces a minimum wage of $6.50, does unemployment increase, decrease, or stay the same compared to unemployment at the equilibrium wage? Answer: Since the equilibrium wage is above the government-mandated minimum wage, the minimum wage will not be binding. Firms will already be paying above the set minimum wage, and, therefore, the minimum wage will have no effect on the wage paid or the unemployment rate. Since the government-mandated minimum wage is above the equilibrium wage, in this case, the minimum wage is binding. The wages paid to workers will rise, but so will unemployment. 5. Assume that the labor demand equation for a fictional country is Ld = 30 − w, where w is the wage per hour worked and Ld is the number of workers demanded by firms. Assume also that the labor supply equation for that country is Ls = 0.5(w), where Ls is the number of people willing to work. [LO 9.2, 9.5] Find the equilibrium wage and quantity of labor employed. At the equilibrium wage, how many people are unemployed? How would the number of unemployed change if the supply of workers increased? Answer: Set Ld = Ls. 30 – w = 0.5(w). Add w to both sides, leaving 30 = 1.5(w). Divide both sides by 1.5, leaving 20 = w. Plugging 20 into either Ld or Ls, we get the equilibrium quantity of labor employed = 10. Since Ld = Ls, there is no unemployment. At the equilibrium wage rate, the labor market exactly clears. If the supply of workers increases, then the labor supply curve will shift to the right. As long as the wage is free to quickly adjust, Ld will still exactly equal Ls, so no unemployment will occur. The equilibrium wage will fall and employment will rise. One major cause of unemployment in the real-world economy is that wages do not always quickly adjust to changes in labor supply or demand so that the labor market is not always in perfect equilibrium. 6. Suppose a firm’s labor demand equation is Ld = 40 − 2(w) and the labor supply equation that it faces is Ls = −20 + 3(w), where w is the wage per hour worked, Ld is the number of workers demanded by firms, and Ls is the number of people willing to work. [LO 9.2, 9.5] a. Find the equilibrium wage and quantity of labor employed. b. The workers, thinking that their wages are too low, decide to strike. After tense negotiations, the firm decides to raise the wage by 50 percent. After the wage increase, how many people are unemployed? Answer: Set Ld = Ls. 40 – 2w = −20 + 3w. Add 2w and 20 to both sides, leaving 60 = 5w. Divide both sides by 5, leaving 12 = w. Plugging 12 into either Ld or Ls, we get the equilibrium quantity of labor employed = 16. Since Ld = Ls, there is no unemployment. At the equilibrium wage rate, the labor market exactly clears. Now the wage rate is increased by 50 percent from 12 to 18. At w = 18, Ld = 40 – 2(18) = 4, and Ls = −20 + 3(18) = 34. Since the quantity of labor demanded is 4 and the quantity of labor supplied is 34, there is an excess supply or surplus of labor, better known as unemployment, of 30 units. 7. Classify each of the following situations as either frictional, structural, or cyclical unemployment. [LO 9.3, 9.4] Maria has started looking for work after taking time off to have a baby. Juan left high school without graduating and can’t find any jobs he is qualified for. Rohit had a job working on Wall Street but lost his job during the financial crisis. Adam has just arrived in a new city and is looking for work. Max wants to work as an air steward, but because the airline industry is heavily unionized there are very few jobs available. Jada has just lost her job in a web start-up that was affected by a downturn in the economy. Answer: Remember, frictional unemployment is unemployment caused by a worker changing his or her location, job, or career. Structural employment occurs due to a mismatch between the skills workers can offer and the skills in demand in the economy. Cyclical unemployment occurs when people become temporarily unemployed due to an economic downturn. Frictional unemployment: Returning from work after childbirth is a natural life change. Structural unemployment: Juan lacks the skills to engage in productive work. Cyclical unemployment: The financial crisis is a temporary economic downturn. Frictional unemployment: Changing cities is a natural life change. Structural unemployment: Unions alter the demand structure for labor in the airline industry. Cyclical unemployment: Her job was lost due to a temporary economic downturn. 8. For each of the following situations, would the unemployment rate increase, decrease, or stay the same? [LO 9.5] A company begins paying efficiency wages above the equilibrium wage rate. The number of workers covered by union contracts falls. The government extends the duration of unemployment insurance. Answer: Efficiency wages raise the wage rate above the equilibrium level, increasing unemployment. Unions raise the wage rate above the equilibrium level. A reduction in unions will therefore bring wage rates closer to the equilibrium level, reducing unemployment. Increasing the duration of unemployment insurance reduces unemployed workers’ incentives to find work increasing the unemployment rate. Suppose a country has a 26-week limit on the duration that an unemployed person receives unemployment benefits. You collect some data and notice that workers in their 26th week of unemployment benefits somehow manage to find jobs at a much higher rate than other unemployed workers. What would this statistic tell you about the incentives involved with unemployment insurance? [LO 9.6] Answer: The fact that large numbers of people find jobs during the last week of benefits suggests that unemployed workers receiving unemployment checks have an incentive to wait until their benefits run out before seriously looking for work or taking new jobs. Understanding that unemployment benefits give workers the incentive to not look for work until their benefits run out, suppose an economist suggested that instead of giving workers up to 26 weeks of unemployment benefits that end once the person finds work, a person who loses his or her job would just get a single big check for 26 weeks of benefits, regardless of how long the worker is unemployed. What are the advantages and disadvantages of this idea? [LO 9.6] Answer: Because unemployed workers would get 26 weeks of benefits regardless of how soon they find new jobs, these workers have an incentive to look for work right away since they don’t lose benefits the moment they find a new job. Thus, the advantage of this idea is that it is likely to reduce unemployment by increasing the incentives to look for work earlier. The disadvantage of the idea is that it would be costly. All workers would be compensated for a full 26 weeks of unemployment; under the previous 26-week limit, any workers finding jobs before 26 weeks are up don’t receive benefits, thus reducing total unemployment payments. Solution Manual for Macroeconomics Dean Karlan, Jonathan Morduch 9781259813436