Macroeconomics Canadian 3rd Edition

Krugman Solutions Manual

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Chapter 8
Unemployment and Inflation

What’s New in the Third Edition?

• Updated business case.
Chapter Objectives
• Explain how unemployment is measured.
• Explain how to calculate the unemployment rate.
• Discuss the significance of the unemployment rate for the economy.
• Explain the relationship between the unemployment rate and economic growth.
• Define the factors that determine the natural rate of unemployment.
• Discuss the economic costs of inflation.
• Explain how inflation and deflation create winners and losers.
• Explain why policy makers try to maintain a stable rate of inflation.
Teaching Tips

The Unemployment Rate

Creating Student Interest
• Ask students to estimate the current value of the unemployment rate and ask them whether they
think the current rate is above or below the long-run average unemployment rate. You can find a
link to the current data under Web Resources. You can also present the unemployment rate specific
to your area (if it is different from the national average). Ask students how they think the
unemployment rate is calculated. If, for example, you were to calculate the unemployment rate in
the classroom, would it be accurate to find out how many people in the room had no job, and then
divide this number by the number of people in the room?
• Use Handout 8(23)-1 to help students learn to calculate important labor statistics.

Presenting the Material

Students often ask how the unemployment rate is determined. You can find an explanation for how
employment data is collected on the Statistics Canada website at: http://www.statcan.gc.ca/pub/71-543-
g/71-543-g2017001-eng.htm .
• Explain how the Labour Force Survey is used to categorize people based on whether they are
employed, unemployed, in the labor force, or not in the labor force. Present the hypothetical family
(described below) and have students determine where they would be counted if the family were
part of the LFS. Use the descriptions to point out the definition of a discouraged worker.
o Female (head of household)—45, worked full time during the month as
computer analyst
o Male—50, laid off last year, did not work or look for work during the month
o Female—22, not working, applied for positions in retail sales during the month
o Male—15, worked part time during the month at a restaurant

Chapter 8 krugman 1
 o Male—70, retired
o Female—68, worked 30 hours per week as a substitute middle school teacher
• The unemployment rate is an indicator of how easy it is for individuals to find a job. It also
indicates the potential for lost output, since GDP will generally fall when the unemployment rate
rises. This inverse relationship is illustrated in Figure 8(23)-5 of the text with a scatter plot of
historical data on the real GDP growth rate and the unemployment rate. As an exercise you could
have the students visit the Statistics Canada website to find unemployment rate data and growth
rate data for real GDP and ask them to recreate this diagram for some given date range.

• There are some limitations associated with the reported unemployment rate:
o It can overestimate the actual rate of unemployment because some people intentionally do
not take the first job they are offered but rather take additional time to search for a job.
o It can underestimate the actual rate of unemployment because discouraged workers cease
looking for a job and thus are no longer counted as unemployed, even though they would
really like to work.
o The unemployment rate can vary widely across age, gender, and racial groups.
These differences are not reflected in the most commonly reported overall unemployment rate.
These differences are illustrated in Figure 8-3 of the text.

Chapter 8 krugman 2
 • Define the labor force participation rate and report the value for select years beginning in 1976
(http://www5.statcan.gc.ca/cansim/a26?lang=eng&retrLang=eng&id=2820087&&pattern=&stB
yVal=1&p1=1&p2=31&tabMode=dataTable&csid=). Have students speculate about why the
value has changed over time. Next, have them think about whether the labor force participation
rate could increase over the next few years. What would have to happen to cause it to increase?
The Natural Rate of Unemployment
Creating Student Interest
• Ask students if they can think of different reasons people are unemployed. Some possible
responses include: people are just entering the labor force for the first time, they are reentering the

Chapter 8 krugman 3
 labor force after taking time off to have a baby, they lost their job because the economy went into
a recession, or their job has been outsourced to India. Explain to students that economists
categorize unemployed persons according to the primary reason they do not have a job. These
categories include frictional unemployment, cyclical unemployment, and structural
unemployment.
• Use Handout 8(23)-2 to help students understand the different types of unemployment.

Presenting the Material

• Begin by distinguishing between the three types of unemployment discussed in this chapter—
frictional unemployment, structural unemployment, and cyclical unemployment. Use a specific
real-world example of each to make these concepts less abstract to the students. In addition, when
discussing the concept of structural unemployment, use a graph of the labor market, such as the
one shown in Figure 8(23)-9 in the text, to illustrate the manner in which structural unemployment
is created by a government-set minimum wage. This is potentially interesting for students given
the increasing number of states that are increasing their minimum wages by a significant amount
(http://srv116.services.gc.ca/dimt-wid/sm-mw/rpt1.aspx). Afterward, define the term natural rate
of unemployment and discuss those factors that can affect the value of the natural rate of
unemployment in an economy.

Inflation and Deflation

Creating Student Interest
• Ask students to estimate the current rate of inflation. Ask them if they can think of a time when
Canada experienced deflation (they may know that there was deflation during the Great
Depression). Show students the current and historical inflation data (see website listed under Web
Resources).
• Use Handout 8(23)-3 to help students think about the interest rate effects of inflation.

Presenting the Material

Chapter 8 krugman 4
 • Ask students how they would feel if all prices in the economy doubled. Then ask them how they
would feel if all prices doubled and at the same time their wages doubled. Make sure they see that
if both doubled, their real wage would be the same. Make clear that the level of prices doesn’t
matter, but the rate of change in prices does.
• Explain why the rate of change in prices matters using the three types of inflation costs: shoe-
leather costs, menu costs, and unit-of-account costs. Also make clear that these are the overall
costs to the economy. As far as individuals are concerned, there is also a transfer from the “losers”
from inflation to the “winners” from inflation. Explain how borrowers gain from getting money
now, when it will buy more (before inflation) and paying it back later (after inflation), when it
won’t buy as much. Lenders, on the other hand, give the money when it will buy more and only
get it back after it won’t buy as much.
• Finally, make sure students understand that when inflation is expected, people will build that
expectation into their decisions. Lenders will charge higher nominal interest rates, workers will
require higher wages, and so on. If everyone correctly anticipates inflation, everyone builds in the
expected inflation correctly and there are no “winners” or “losers.” Only unanticipated inflation
will decrease real values (e.g., interest rates/wages).

Common Student Pitfalls

• Unemployment benefits. Since most students have never filed for unemployment
benefits, they may erroneously believe that individuals can collect unemployment
whenever they are not working, regardless of the reason. Explain that this is not the case;
for example, workers who are on strike or are fired for misconduct cannot collect
unemployment benefits.
• Gaining or losing from inflation. Students may incorrectly think that inflation adversely
affects all individuals in the economy in the same manner. Explain that this is not the case,
as inflation can aid some individuals. For example, borrowers of money are aided by
unexpected inflation, since the real value of the money they repay in the future on the loans
they hold has less purchasing power than when they initiated the loans.
• Disinflation versus deflation. Students may confuse the terms disinflation and deflation.
Emphasize that disinflation is the process of lowering inflation that has become embedded
in expectations through keeping the unemployment rate above the natural rate for an
extended period. By contrast, deflation is a falling aggregate price level.

Chapter Outline
Opening Example: The Bank of Canada (BOC) took extraordinary steps in the wake of the financial
crisis in 2007 to 2009, cutting the overnight rate to a historically low level and leaving it there for six years
before raising it in January 2015. The decision came after the Bank was convinced that the two primary
goals of macroeconomic policy—low unemployment and price stability—were sufficiently stable to allow
the increase.

I. The Unemployment Rate

Chapter 8 krugman 5
 A. Defining and measuring unemployment
1. Employment is the number of people currently employed in the economy, either full
time or part time.
2. Unemployment is the number of people who are actively looking for work but aren’t
currently employed.
3. The labor force is equal to the sum of employment and unemployment.
4. The labor force participation rate is the percentage of the population 16 or older that is
in the labor force.
5. The unemployment rate is the percentage of the total number of people in the labor force
who are unemployed.
B. The significance of the unemployment rate
1. The unemployment rate can overstate the true level of unemployment because it is
normal for workers to spend some time searching for a job even when jobs are plentiful.
2. The unemployment rate can also understate the true level of unemployment because it
doesn’t include the number of discouraged workers, underemployed workers, or
marginally attached workers.
3. The unemployment rate can vary widely across different age, gender, and racial groups.
This is shown in Figure 8(23)-3 in the text.
C. Growth and unemployment
1. There is a strong inverse relationship between growth in real GDP and changes in the
unemployment rate. This inverse relationship is illustrated using actual data in Figure
8(23)-5 in the text.

II. The Natural Rate of Unemployment

A. Job creation and job destruction
1. Structural change can be responsible for job losses and new jobs created.
2. Poor performance at individual companies also leads to job loss for their employees.
3. Continual job creation and job destruction are a feature of modern economies.
B. Frictional unemployment
1. Frictional unemployment is unemployment due to the time workers spend in search of
a job.
C. Structural unemployment
1. In structural unemployment, more people are seeking jobs in a particular labor market
than there are jobs available at the current wage rate, even when the economy is at the
peak of the business cycle.
2. The labor demand curve indicates that when the price of labor—the wage rate—
increases, firms demand less labor.
3. The labor supply curve indicates that when the wage rate increases, more workers are
willing to supply labor.
4. The equilibrium wage is determined by the supply and demand for labor.
5. At the equilibrium wage there is frictional unemployment but not structural
unemployment.

Chapter 8 krugman 6
 6. The minimum wage may be binding for less skilled workers. It affects the wages that
people are actually paid and can lead to structural unemployment.
7. By bargaining collectively, labor unions can often win higher wages from employers
than workers would have obtained by bargaining individually.
8. Efficiency wages are wages that employers set above the equilibrium wage rate as an
incentive for better employee performance.
9. Public policy designed to help workers who lose their jobs can have the side effect of
reducing a worker’s incentive to quickly find a new job.
D. The natural rate of unemployment
1. The natural rate of unemployment is the unemployment rate that arises from the effects
of frictional and structural unemployment.
2. Cyclical unemployment is the deviation of the actual rate of unemployment from the
natural rate of unemployment due to downturns in the business cycle.
E. Change in the natural rate of unemployment
1. Changes in labor force characteristics (such as the age of workers), changes in labor
market institutions (such as the increased number of temporary employment agencies),
and changes in government policies (such as a higher minimum wage) have an effect on
the natural rate of unemployment.

A. The level of prices doesn’t matter . . .

1. The real wage is the wage rate divided by the price level.
2. Real income is income divided by the price level.

B. . . . But the rate of change of prices does

1. It is important to distinguish between the level of prices and the inflation rate, or the
percent increase in the overall level of prices per year.
2. Changing prices have several costs, including shoe-leather costs, menu costs, and unit-
of-account costs.
C. Winners and losers from inflation
1. If the actual inflation rate is higher than expected, borrowers gain at the expense of
lenders. If the inflation rate is lower than expected, lenders will gain at the expense of
borrowers.
D. Inflation is easy, disinflation is hard.

Case Studies in the Text

Economics in Action
Failure to Launch—This EIA discusses the employment experience of university graduates, from 1990–
2016.
Ask students the following questions:

Chapter 8 krugman 7
 1. What was the unemployment rate among recent university graduates who are male following
the Great Recession? (Answer: The rate went above 10% after the Great Recession.)
2. How long did this above normal unemployment last? (Answer: The unemployment lasted well
after the recession, into 2016.)
Structural Unemployment in Spain—This EIA looks at the unemployment rate in Spain.
Ask students the following questions:
1. What was Spain’s unemployment rate at the height of the housing boom? (Answer: 8%, high
compared to Canada.)
2. What is Spain’s natural rate of unemployment? Why is it so high? (Answer: 15 to 17%, mostly
due to laws making firing workers difficult and labor unions.)
Israel’s Experience with Inflation—This EIA presents the example of inflation in Israel in the mid-1980s.
Ask students the following questions:
1. What is meant by the term “clean” inflation? (Answer: inflation without a concurrent war or
political instability.)
2. Give an example of each of the types of inflation costs during Israel’s mid-1980s inflation.
(Answer: shoe-leather costs: standing in line at the bank; menu costs: restaurants’ not listing
prices; unit-of-account costs: frequently changing store prices.)
Business Case
AskforTask—This business case discusses the rise in temporary employment, especially found in online
services that help match temporary workers with employers seeking temporary workers.

Web Resources

For Canadian data: The following websites provide information on unemployment and inflation:
The most recent unemployment rate data can be quickly accessed from Statistics Canada’s home page:
http://www.statcan.gc.ca/start-debut-eng.html, under “Latest indicators”. The “Unemployment rate”
option there contains an excellent summary of the latest Labour Force Survey (LFS). There is a link there
to Labour Force Information (Cat. 71-001-XWE) that reports the results of the LFS.The Consumer price
index annual data goes back to 1914. This is available in CANSIM series V41693271 in Table 3260021.
This uses a 2011 basket and is normalized so that the value in 2002 is 100. The consumer price index
(monthly) for individual cities and provinces is found in CANSIM Table 3060020.
For United States’ data: the Bureau of Labor Statistics—https://www.bls.gov/. historical inflation data for
the United States—https://www.inflationdata.com/.
For European data—http://ec.europa.eu/Eurostat

Chapter 8 krugman 8
Handout 8-1
Date_________ Name____________________________ Class________ Professor________________

Numbers Game

Number of people employed 120,500

Number of people unemployed 4,050
Population 367,000

Given the above data, compute:

1. The number of people in the labor force

2. The labor force participation rate

3. The unemployment rate

Chapter 8 krugman 9
Answers:

1. The number of people in the labor force: 4,050 + 120,500 = 124,550

2. The labor force participation rate: 124,550/367,000 = 33.9%
3. The unemployment rate: (4,050 / (4,050+120,500) × 100) = 3.25%

Chapter 8 krugman 10
Handout 8-2
Date_________ Name____________________________ Class________ Professor________________
Name That Unemployment

Classify the people described in each of the following scenarios as either frictionally, structurally, or
cyclically unemployed.
1. Phil is currently unemployed because the tire factory where he used to work installed robots, which
replaced 500 laborers, including Phil.

2. Jessica is unemployed because she is in the process of reentering the labor force after taking time
off to have a baby.

3. Mary is unemployed because she lost her job at McDonald’s after the province increased the
minimum wage.

4. Barry is unemployed because he was laid off by the automobile factory when the economy entered
a severe, prolonged recession.

5. Sandy left her former job at an accounting firm a month ago. She is in the process of interviewing
for a similar position at six different accounting firms, although she has not yet accepted a job.

All About the Natural Rate of Unemployment

Answer the following questions.

1. What do economists mean by the natural rate of unemployment?

2. Describe four factors that can affect the natural rate of unemployment and indicate the
impact of each on the value of the natural rate of unemployment in an economy.

3. What can you deduce if the actual rate of unemployment exceeds the natural rate of
unemployment?

Chapter 8 krugman 11
Answers:

Name That Unemployment

1. Phil is structurally unemployed.

2. Jessica is frictionally unemployed.
3. Mary is structurally unemployed.
4. Barry is cyclically unemployed.
5. Sandy is frictionally unemployed.

All About the Natural Rate of Unemployment

1. The natural rate of unemployment is the normal unemployment rate around which the actual
rate of unemployment fluctuates. It is measured as follows:
Natural rate of unemployment = Frictional unemployment rate +
Structural unemployment rate
2. Possible answers:
i. An increase in unemployment benefits can increase the natural rate of unemployment.
ii. An increase in the number of new workers in the labor force increases the natural rate
of unemployment.
iii. A decline in union membership decreases the natural rate of unemployment.
iv. An increase in labor productivity decreases the natural rate of unemployment.

3. If the actual rate of unemployment is greater than the natural rate of unemployment, then
some workers are cyclically unemployed and the economy may be in a recessionary phase of
the business cycle.

Chapter 8 krugman 12
Handout 8-3
Date_________ Name____________________________ Class________ Professor________________
Getting Real with Interest Rates

Compute the answers to the following questions.

1. Samantha invested $2,500 of her savings in a certificate of deposit that pays an annual 4.25%
rate of interest. The current annual inflation rate is 5%. Has Samantha made a wise
investment from an economic perspective?

2. William wants to earn a real annual interest rate on his investment of at least 7%. If the annual
rate of inflation is 4%, what is the minimum nominal rate of interest William would be willing
to accept on his investment?

Chapter 8 krugman 13
Answers:

1. Samantha has not made a wise investment, as the real interest rate she is earning on this
investment is negative. The real interest rate Samantha is earning is computed as follows:

Real interest rate = Nominal interest rate – Rate of inflation

Real interest rate = 4.25% – 5% = –0.75%

2. William must receive a minimum nominal annual rate of interest equal to 11%, which is computed
as follows: Real interest rate = Nominal interest rate – Rate of inflation

7% = Nominal interest rate – 4%

Nominal interest rate = 11%

Chapter 8 krugman 14
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