CHAPTER 22 6/3 8/3 10/3

Why Unemployment Is a Problem

Unemployment results in
● Lost incomes and production
● Lost human capital

The population is divided into two groups:

● The working-age population—the number of people aged 16 years and older who are
not in jail, hospital, or some other institution
● People too young to work (under 16 years of age) or in institutional care

The working-age population is divided into two groups:

● People in the labor force
● People not in the labor force
The labor force is the sum of employed and unemployed workers.

Three Labor Market Indicators

● The unemployment rate
○ is the percentage of the labor force that is unemployed
○ (Number of people unemployed ÷ labor force)x 100
○ The unemployment rate increases in a recession and reaches its peak value
after the recession ends.
● The employment-to-population ratio
○ is the percentage of the working-age population who have jobs.
○ (Employment ÷ Working-age population) x100.
● The labor force participation rate
○ is the percentage of the working-age population who are members of the
labor force
○ (Labor force ÷ Working-age population) x 100

Other Definitions of Unemployment

The purpose of the unemployment rate is to measure the underutilization of labor resources.
But the official measure is an imperfect measure because it excludes
● Marginally attached workers
● Part-time workers who want full-time jobs

A marginally attached worker is a person who currently is neither working nor looking for
work but has indicated that he or she wants and is available for a job and has looked for
work sometime in the recent past.

A discouraged worker is a marginally attached worker who has stopped looking for a job
because of repeated failure to find one.
Unemployment can be classified into three types:
● Frictional unemployment
○ is unemployment that arises from normal labour market turnover.
○ Frictional unemployment is a permanent and healthy phenomenon of a
growing economy
● Structural unemployment
○ is unemployment created by changes in technology and foreign competition
that change the skills needed to perform jobs or the locations of jobs.
○ Structural unemployment lasts longer than frictional unemployment.
● Cyclical unemployment
○ is the higher than normal unemployment at a business cycle trough and lower
than normal unemployment at a business cycle peak.
○ A worker who is laid off because the economy is in a recession and is then
rehired when the expansion begins experiences cyclical unemployment

“Natural” Unemployment
● Natural unemployment is the unemployment that arises from frictions and structural
change when there is no cyclical unemployment.
● Natural unemployment is all frictional and structural unemployment.
● The natural unemployment rate is natural unemployment as a percentage of the
labour force.
The natural unemployment rate changes over time and is influenced by many factors.
Key factors are
● The age distribution of the population
● The scale of structural change
● The real wage rate
● Unemployment benefits

Full employment is defined as the situation in which the unemployment rate equals the
natural unemployment rate.
When the economy is at full employment, there is no cyclical unemployment or,
equivalently, all unemployment is frictional and structural.

Real GDP and Unemployment Over the Cycle

● Potential GDP is the quantity of real GDP produced at full employment.
● Potential GDP corresponds to the capacity of the economy to produce output on a
sustained basis.
● Real GDP minus potential GDP is the output gap.
● Over the business cycle, the output gap fluctuates and the unemployment rate
fluctuates around the natural unemployment rate.

The price level is the average level of prices and the value of money.
A persistently rising price level is called inflation.
A persistently falling price level is called deflation.
We are interested in the price level because we want to
● Measure the inflation rate or the deflation rate
● Distinguish between money values and real values of economic variables.
Unpredictable inflation or deflation is a problem because it
● Redistributes income
● Redistributes wealth
● Lowers real GDP and employment
● Diverts resources from production

The Consumer Price Index, or CPI, measures the average of the prices paid by urban
consumers for a “fixed” basket of consumer goods and services.

Constructing the CPI involves three stages:

● Selecting the CPI basket
● Conducting a monthly price survey
● Calculating the CPI

The CPI basket is based on a Consumer Expenditure Survey, which is undertaken

infrequently

Calculating the CPI

● Find the cost of the CPI basket at base-period prices.
● Find the cost of the CPI basket at current-period prices.
● Calculate the CPI for the current period.
● CPI = (Cost of basket at current-period prices ÷ Cost of basket at base-period prices)
× 100.

Inflation rate = [(CPI this year – CPI last year) ÷ CPI last year] x 100.

The CPI might overstate the true inflation rate for four reasons:
● New goods bias
● Quality change bias
● Commodity substitution bias
● Outlet substitution bias

Personal Consumption Expenditure Deflator

● =(Nominal consumption expenditure ÷ Real consumption expenditure) 100
● PCE deflator is a broader measure of the price level than the CPI because it includes
all consumption expenditure.

GDP Deflator
● GDP deflator is like the PCE deflator except it includes the prices of all goods and
services that are counted in GDP.

CHAPTER 23
Economic growth is the sustained expansion of production possibilities measured as the
increase in real GDP over a given period.
Calculating Growth Rates
The economic growth rate is the annual percentage change of real GDP.
The economic growth rate tells us how rapidly the total economy is expanding.
Real GDP per person is real GDP divided by the population.
Real GDP per person grows only if real GDP grows faster than the population grows

Real GDP can increase for two distinct reasons:

● The economy might be returning to full employment in an expansion phase of the
business cycle.
● Potential GDP might be increasing.
Potential GDP is the quantity of real GDP produced when the quantity of labour employed is
the full-employment quantity.
The return to full employment in an expansion phase of the business cycle isn’t
economic growth.
The expansion of potential GDP is economic growth.

The Rule of 70 states that the number of years it takes for the level of a variable to double is
approximately 70 divided by the annual percentage growth rate of the variable.

Economic growth occurs when real GDP increases.

But a one-shot increase in real GDP or a recovery from recession is not economic growth.
Economic growth is the sustained, year-on-year increase in potential GDP.

CHAPTER 24
The study of finance looks at how households and firms obtain and use financial resources
and how they cope with the risks that arise in this activity.

The study of money looks at how households and firms use it, how much of it they hold,
how banks create and manage it, and how its quantity influences the economy.

Physical capital is the tools, instruments, machines, buildings, and other items that have
been produced in the past and that are used today to produce goods and services.

The funds that firms use to buy physical capital are called financial capital.

Gross investment is the total amount spent on purchases of new capital and on replacing
depreciated capital.

Depreciation is the decrease in the quantity of capital that results from wear and tear and
obsolescence.

Net investment is the change in the quantity of capital.

Net investment = Gross investment - Depreciation

Wealth is the value of all the things that people own.

Saving is the amount of income that is not paid in taxes or spent on consumption goods and
services.
Saving increases wealth.
Wealth also increases when the market value of assets rises—called capital gains—and
decreases when the market value of assets falls—called capital losses.

These funds are supplied and demanded in three types of financial markets:
1- Loan markets
Businesses often want short-term finance to buy inventories or to extend credit to
their customers. Sometimes they get this finance in the form of a loan from a bank.
Households often want to finance to purchase big-ticked items, such as automobiles
mortgage – a legal contract that gives ownership of a home to the lender in the event that
the home borrower fails to meet the agreed loan payments.

2-Bond markets
A bond is a promise to make a specified payments on specified dates
Bonds issued by firms or government are traded in the bond market.
The term of the bonds might be long (decades) or short (just a month or two)

3-Stock markets
A stock is a certificate of ownership and claim to the firm’s profit.
A stock market is a market in which shares of stocks of corporations are traded.

A financial institution is a firm that operates on both sides of the markets for financial
capital.
It is a borrower in one market and a lender in another.
Key financial institutions are
● Commercial banks
● Government-sponsored mortgage lenders
● Pension funds
● Insurance companies

A financial institution’s net worth is the total market value of what it has lent minus the
market value of what it has borrowed.
If net worth is positive, the institution is solvent and can remain in business.
But if net worth is negative, the institution is insolvent and will go out of business.

The interest rate on a financial asset is the interest received expressed as a percentage of
the price of the asset.

The market for loanable funds is the aggregate of all the individual financial markets.
Funds that Finance Investment
Funds come from three sources:
1. Household saving S
2. Government budget surplus (T – G)
3. Borrowing from the rest of the world (M – X)

The nominal interest rate is the number of dollars that a borrower pays and a lender
receives in interest in a year expressed as a percentage of the number of dollars borrowed
and lent
The real interest rate is the nominal interest rate adjusted to remove the effects of inflation
on the buying power of money.
The real interest rate is approximately equal to the nominal interest rate minus the inflation
rate.

The quantity of loanable funds demanded depends on

1.The real interest rate
2. Expected profit

The demand for loanable funds is the relationship between the quantity of loanable funds
demanded and the real interest rate when all other influences on borrowing plans remain the
same.
Business investment is the main item that makes up the demand for loanable funds.

When the expected profit changes, the demand for loanable funds changes.
Other things remaining the same, the greater the expected profit from new capital, the
greater is the amount of investment and the greater the demand for loanable funds.

The quantity of loanable funds supplied depends on

1-The real interest rate
2. Disposable income (disposable income is the income earned minus taxes).
When disposable income increases, other things remain the same, savings
increases.
3. Expected future income
The higher the households expected future income, other things remaining the same,
the smaller is the saving today.
4. Wealth
The higher the household's wealth, other things remain the same, the smaller is the
saving.
5. Default risk
The risk that a loan will not be repaid is called default risk. The greater that risk, the
higher the interest rate needed to induce a person to lend and the smaller is the supply for
loanable funds.

The supply of loanable funds is the relationship between the quantity of loanable funds
supplied and the real interest rate when all other influences on lending plans remain the
same.
Saving is the main item that makes up the supply of loanable funds.

The loanable funds market is in equilibrium at the real interest rate at which the quantity of
loanable funds demanded equals the quantity of loanable funds supplied.