Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

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Chapter 19: Gross Domestic Product, Unemployment, and Inflation

Figure 19.1 Recessions affect us all, businesses, employees, and consumers.​ [1]

U.S. RECESSION BEGAN LAST DECEMBER,
ECONOMISTS SAY 
[1]

"The U.S. economy officially sank into a recession last December, which means that the downturn is already longer than the average for all recessions since World War II, according to the committee of economists responsible for dating the nation's business cycles.

In declaring that the economy has been in a downturn for almost 12 months, the National Bureau of Economic Research confirmed what many Americans had already been feeling in their bones. But private forecasters warned that this downturn was likely to set a new postwar record for length and is likely to be more painful than any recession since 1980 and 1981."

The New York Times, December 2, 2008.

U.S. Second-Quarter GDP Rose 3.1% [2]

"U.S. economic output grew at a 3.1% annual rate in the second quarter, slightly stronger than previously thought and marking the best growth in two years.

The economy at its core remains stable, as steady job growth and a booming stock market encourage households to spend. Consumers, accounting for more than two-thirds of economic demand, increased spending at a 3.3% rate in the second quarter."

                   The Wall Street Journal, September 29, 2017.

19.1 Objectives for Chapter 19

After reading this chapter, you should be able to:

  • Use the definitions of GDP, real GDP, unemployment, and inflation and interpret articles about changes in each in daily newspapers.
  • Understand problems with the calculations and designs of each measure.
  • Discuss the costs of inflation and unemployment.
  • Explain the effects and the importance of changes in real GDP per capita.

​In this chapter, we explore in greater detail the concepts of gross domestic product, unemployment, and inflation. We will look at how we measure GDP and evaluate some of its strengths and weaknesses as a tool to measure our well-being. We will look at how we measure unemployment and inflation and identify their costs. With these measures, we begin the study of macroeconomics in depth. The forces of supply and demand determine the outcomes of each individual market. Very similar concepts will help you understand how and why the overall economy functions.​

19.2 Gross Domestic Product – Meaning and Components

The process of measuring national production and income is a key component of the work of macroeconomists. The data describe the millions of economic transactions that occur each day. The resulting summary data are used in the press and television news as a basis for describing and forecasting economic conditions. Economic activity is most often measured by how much is produced in an economy over a specific time period – the gross domestic product or GDP. Commentators compare countries’ economies by using GDP. Politicians compare one country’s production now with what it was in the past. Economists use a variety of GDP measures to indicate economic progress. GDP figures are often used to define standards of living.

19.3 Gross Domestic Product Defined

Every month, the Bureau of Economic Analysis releases its estimate of U.S. economic activity as measured by the total number of goods and services produced in the preceding quarter. Gathering accurate data on GDP takes time and sets up a race within the BEA between timeliness and accuracy. The GDP figures for each quarter are revised twice after the initial release as more accurate data become available. But we cannot just add every automobile, house, hamburger, and so on together. That number is the proverbial “adding apples and oranges” and would have little meaning. For example, one new house is worth much more than one more hamburger.

Instead, the prices of each good and service are multiplied by the quantities of each good produced. The resulting spending on each good is added to spending on every other good. The total is the total value of all the goods and services produced in a year. To avoid counting goods and services more than once in the process of generating the data, the statisticians use only the value of “final” goods and services. Final goods and services are those goods and services that are received by their final users. That means wholesale goods, raw materials, and inputs are not directly counted. Their values are included in the price of the goods when they are sold to the final user. Only the value of the final good is included in GDP.

Let’s think about why GDP does not include the sale of intermediate goods. What would happen if the statisticians counted a good when it is sold to a wholesaler, then again when it is sold to a retail firm, and then again when it is sold to the final customer? Counting the value at all of those steps would create a number that is much greater than the market value of the good or service and overstates the value of what is produced. So GDP just includes the final sale, which encompasses the value added at each of the steps mentioned above. (Changes in business inventories of goods are also included, although inventories are not strictly purchased by the product’s final users.)

GDP includes the goods and services produced in one specific year. If something is sold this year but produced in a previous year, it is not counted in GDP. Thus, used cars and houses are not counted in GDP, because they were produced in an earlier year. The intention is to measure current production, not what was produced in the past.

It is gross domestic product because we count all of the computers, machines, and factories that are replacing ones that have worn out or are no longer used. This does tend to overstate actual well-being because some of the production simply replaces already existing goods that are wearing out or depreciating. Net domestic product is total production minus the depreciation of existing machines and factories.

It is gross domestic product in that only goods and services produced within the borders of the country are counted. Goods produced abroad, even if produced by a company owned by U.S. citizens or having headquarters in the U.S., are not included.

Question 19.01

Question 19.01

Which of the following would not be counted in GDP in 2017: Used textbooks sold at the student bookstore, BMWs made in Greenville, SC, Boston Red Sox Tickets. Why?

Hover here to see the hint for Question 19.01.
Click here to see the answer to Question 19.01.​

19.3.1 Components of GDP

As we introduced in chapter three, GDP is divided into production of goods and services in four categories: consumption, investment, government, and net exports. The BEA utilizes data on each of these components via surveys collected by various agencies such as the U.S. Census Bureau, The Bureau of Labor Statistics, and the Internal Revenue Service.

19.3.2 Consumption and Investment

Economists and statisticians differ somewhat on how they define consumption and investment. In essence, to an economist, goods and services that we use up (or consume) in a relatively short period of time are considered to be consumption. Food, entertainment, many types of clothing, gasoline, and rent are good examples.

Goods and services that benefit us in the future are described as investments. Individuals buy houses, cars, and refrigerators. Those goods benefit buyers now, but also continue to provide services in the future. Theoretically, economists describe the portion that provides current benefits (this year) as consumption and the portion that provides future benefits (next year and beyond) as investment. To see this more concretely, consider a firm that purchases a new sewing machine. The initial purchase price of the sewing machine is considered an investment in the company’s future. The shirts that the machine sews each year will be considered part of consumption in whichever year the shirts are sold.

Businesses buy factories, tools, and machines (and spend on research and development) to help them increase production in the future. Governments build roads and school buildings to provide services in the future. All are investments to an economist.

​In an economic way of thinking, going to college includes some consumption and some investment. Enjoying friends, attending sporting events, simply enjoying reading and learning is consumption. Enhancing one’s ability to earn and learn in the future is the investment part of a college education. However, the GDP statistics count all of education spending as consumption. The data are a bit misleading because of that.

But this is not the only problem. GDP statisticians are faced with the challenge of accurate measurement. They do not count all that an economist might consider to be investments as an investment in the GDP accounts. They treat almost all individual spending as consumption – current enjoyment of goods and services. The one exception is the production of a new house. It is a large expense and will provide a place to live for a long time to come. By building a new house, the nation increases its ability to produce housing services in the future. (In fact, they estimate the rental value of owner-occupied housing to be part of consumption spending since it is the current service provided by a new house.)

The GDP statisticians include spending on new factories, tools, machines, and inventories within investment. All are used to help us produce more in the future. With the exception of new houses, the rest of investment spending is done by individuals functioning as parts of businesses, not individuals acting as consumers. Even some of what we call government spending is to a large degree an investment. One of the best examples is spending on infrastructure, including highways, bridges, and airports. It is counted as part of government spending, not as a part of investment, in the GDP accounts.

19.3.3 Government

Local, state, and federal governments purchase and produce goods and services. Some examples are obvious – schools, roads and highways, education, national defense, and police and fire protection are a few. These are all included in GDP. However, a significant part (more than 40 percent) of actual government budgets is not included in GDP. Governments make payments to individuals that are intended to change incomes. The most important example is social security. Unemployment compensation and welfare payments are also part of what is called transfer payments. In theory, income is being transferred (by taxes) from some individuals (for example, young workers) to others (for example, older retirees). The reason that transfer payments are not included in GDP is that the payments themselves are not production of goods and services.

19.3.4 Net Exports

Individual consumers, businesses, and governments abroad buy goods and services produced in the U.S. These are U.S. exports. Because exports are goods and services produced in the U.S., they are counted in GDP.

Individuals, businesses, and government in the U.S. also buy goods and services produced abroad. This spending is treated in a special way in the GDP accounts. U.S. imports are not goods and services produced in the U.S. in a year, and therefore should not be included in the U.S. GDP.

To calculate GDP, the production of goods and services, the statisticians add spending on consumption of goods and services, investment spending on goods, government spending on goods and services, and foreign spending on U.S. exports. Some of that spending in each category is actually on goods and services not produced in the U.S. and thus should not be counted in GDP. We actually calculate GDP by adding consumption, investment, government, and export spending and subtracting spending on imports. This is because we are calculating gross domestic product.

GDP = Consumption + Investment + Government + Exports – Imports

The last part of the equation (exports – imports) is often described as net exports. If it is a positive number, the U.S. has a surplus in its balance of trade. If it is negative, as it is in the U.S. now, the U.S. has a deficit in its balance of trade. Both are commonly referred to as trade surpluses and trade deficits. While the balance of trade can vary from year to year, the U.S. has experienced an average trade deficit of 2.9 percent of GDP over the last thirty years.

ECN19_Figure19.1_new19.2-01.jpg
Figure 19.2: For the last thirty years, imports have exceeded exports. Net Exports is the difference between imports and exports.

In thinking about GDP, it is often useful to think of total spending rather than total production. That is facilitated in domestic product accounts by the way components of GDP are defined. Anything produced is either sold to its final purchaser or else held as inventory by some business, whether producer, wholesaler, or retailer. The sum of spending for final products plus changes in businesses’ inventories is therefore equal to the market value of production.​

19.3.5 Spending Equals Production

A special relationship exists between what consumers, businesses, and governments plan or intend to spend and what they actually spend. Spending on final goods and services (produced in the U.S.) will not always equal U.S. production of final goods and services. When planned spending is less than production, the leftover production goes into inventories of businesses and is then actually counted as part of investment spending. Thus, if planned spending is less than production, actual spending equals planned spending plus the unplanned spending. Overall, spending still equals total production.

Sometimes planned spending is greater than production. In this case, businesses are able to satisfy that spending by using goods already produced that are part of inventories. Now, investment in inventories decreases. This is counted as a negative investment, and actual spending falls to equal actual production.

In essence, the relationship is that spending and production are the same. Adjustments in inventories are what make that equality work.

19.4​ Income

Another fundamental equality in the GDP accounts is that spending equals income. Every penny of every dollar you ever spend becomes income to someone. If you spend money at a store, a portion goes to wages of employees. Another portion goes for rent (income to the building’s owners). Some goes to buy the goods being sold (that amount also becomes income to those manufacturing the wholesale goods). Finally, any portion left after paying those expenses is profit and that is income to the owners of the business.

Table 19.1: Here it can be seen that the spending by a consumer of toothpaste is equal to the income that all parties receive from the purchase of the toothpaste.​

When the statisticians add all of the numbers together, there is one other part of spending that is not included in income. Sales and excise taxes are part of spending but do not provide income directly to any individuals.

We end with a relationship that basically states that in the overall economy, spending is equal to the amount of production which in turn is equal to income.

19.4.1​ Wages and Benefits

Table 19.2: The vast majority of all income in the United States comes in the form of wages, salaries, and benefits to workers.​​

Wages, salaries, and benefits make up, by far, the largest portion of total income. Fringe benefits include pensions, medical insurance, and the employer part of social security payments.

​19.4.2 Corporate Profits

Revenues to corporations minus expenses are corporate profits. Those profits, whether or not they are actually paid to stockholders in the form of dividends, are treated as incomes to the owners of the business, the stockholders.​

19.4.3 Other Income

Proprietors’ income includes earnings of small businesses and professionals like lawyers and physicians. It includes what would normally be considered to be salaries and a portion that would be considered to be profit. Rental income includes rental receipts and artists’ royalties on such things as books and CDs. Net interest is net because it is interest payments earned by individuals (the gross) minus the interest paid by individuals.

Question 19.02

Assume that the following are the only data needed to calculate gross domestic product. Calculate GDP and its components as well as total income. Use your best judgment with the information given.

question description
Premise
Response
1

Consumption

A

$5.9 trillion

2

Investment

B

$5.9 trillion

3

Government

C

$1.3 trillion

4

Exports

D

$1.5 trillion

5

Imports

E

$0.6 trillion

6

GDP

F

$3.2 trillion

7

Total income

G

$0.5 trillion

​19.4.4 Are There Better Measures of Standards of Living?

GDP is a measure of all of the goods and services produced in a year, but that is not a very good measure of the standard of living or even of our overall well-being. The most obvious weakness is that GDP includes the prices of goods and services so that the values of each can be added. If prices increase, and the production of each good and service stays the same in a year, measured GDP will increase. And if it is just price increasing, then everything in the economy has simply become more expensive. Because of this, it is difficult to say that our well-being or standard of living has increased. An alternative measure is used to correct this weakness. Real GDP is the value of all of the final goods and services produced in a year using prices that do not change from year to year.

But even then, if real GDP rises, but population increases even more rapidly, real GDP per person (or per capita) actually falls. We are worse off on average. Thus, an even better measure would be real GDP per person. Furthermore, if we are using real GDP to compare countries, it makes sense to adjust the measure by the number of people in an economy. China has a larger real GDP than Switzerland, but when adjusted by population, real GDP per capita (per person) is significantly less in China. For these reasons, it is standard to refer to real GDP per capita as the standard of living in any country at any given point in time.​

19.4.5 Other Weaknesses

Real GDP per capita as a measure of standard of living is attractive to use because it is relatively easy to measure and understand. Simply dividing the total output of an economy by the number of people living in the country leaves much to be desired as a standard of living. Alternative measures, such as Gross National Happiness, have been proffered but have yet to gain traction. 

A few potential problems have already been mentioned. GDP is calculated by adding up all of the goods and services produced, each multiplied by its price. If prices increase, GDP increases whether or not actual production increases. A better measure of well-being would be a measure of whether the number of goods and services increase independently of prices - real GDP.

ECN19_Figure19.3_updated.jpg
Figure 19.3: Relative to the distribution of income in 1982, the share of income going to the highest quintile have risen while the share going to the rest of society has fallen.

Real GDP per capita does not describe the distribution of income in a society. Studies have shown that many people judge their own well-being by comparing their economic situation to others they know. If the distribution of income within an economy is particularly uneven, then people outside of the favored group tend to feel unhappy with their lot in life. Their incomes might be remaining constant or perhaps declining even though real GDP per capita is rising. Economists typically track the distribution of income by fifths. While real GDP per capita has been increasing in the U.S. from the early 1970s to now, individuals toward the bottom end of the income distribution have not experienced the increases in income enjoyed by individuals at the upper end. Over the past 34 years of recorded data in the U.S., all but the top quintile of earners have seen their share of aggregate income decrease. The share of total income earned by the bottom fifth of the income distribution shrank by 24% of what it was in 1982, while the income share going to the top fifth increased by nearly 16% over the same time period.

​It is exceedingly difficult to measure all productive activity within an economy. Certain kinds of goods and services are included, while others are excluded when they probably should not be. As total income increases, individuals tend to reduce the number of hours they work. The amount of leisure enjoyed increases. If leisure increases, real GDP per capita is reduced. Unpaid household work is not included, but may be of great benefit. If a person mows her own lawn, the service is not counted. However, if she hires someone to do it for her, real GDP per capita increases. But there has been no change in the amount produced. There has been only an increase in market activity. This omission, along with leisure, means that GDP significantly understates output.

Expenditures on crime prevention and national defense, for example, may not always represent an increase in a nation’s well-being. Of two countries with identical real GDPs per capita, would you argue that one spending twenty-five percent of its resources on crime prevention and national defense is just as well-off as the other one that finds it only has to spend five percent? The latter country certainly is using its resources to produce goods and services that may provide more satisfaction.

An expanding economy often creates significant pollution. Real GDP per capita will increase, but it is conceivable that individuals would actually be worse off. The additional goods and services may not justify the increased costs of pollution.

19.4.5.1 Caveat on comparing countries based upon GDP

The U.S. has the best data collection process in the world. The Bureau of Economic  Analysis, part of the U.S. Department of Commerce, for example, calculates GDP using three different approaches to ensure accuracy in its estimates. Even those are revised three separate times to include data that take longer to compile. Given the literal quadrillions of transactions, it is impressive that the accounts measure levels and changes in economic activity so well. The GDP measures quantify only production, spending, and income. It is still common for some journalists, politicians, and even economists to use differences in real GDP per capita among nations as evidence of different standards of living. Differing measurement techniques and data availability make accurate cross-country comparisons difficult. But even if those problems are solved, comparisons between countries or between two time periods within a single country are still difficult; thus we should be careful about using these figures to compare standards of living of different societies.​

19.5 An Exercise

With each of the following, indicate whether the spending described should be included in GDP and if so under what category or categories – Consumption, Investment, Government, or Net Exports.

Question 19.03

A share of stock purchased from another individual on the New York Stock Exchange

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.04

A share of IBM stock purchased from IBM is ____________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.05

A BMW made in Germany sold to an individual in the U.S. is ___________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Does not affect total GDP

Question 19.06

A Toyota made in Tennessee and sold in the U.S. is _________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.07

A Social Security payment is _________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.08

A new school building paid for with state and federal money is ________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.09

A new baseball glove that is not sold is __________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.10

A house purchased from another family is ___________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.11

A new house purchased from the builder is ____________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.12

A Chevrolet produced in Detroit sold to an Argentine company is _________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.13

A college education purchased by an individual is

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.14

A concert produced by a nonprofit corporation is __________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.15

Question 19.15

Give two reasons why gross domestic product is not a suitable measure of the well-being of the nation.

Hover here to see the hint for Question 19.15.
​Click here to see the answer to Question 19.15.

​With each of the following, indicate whether the spending described should be included in GDP and if so under what category or categories – Consumption, Investment, Government, or Net Exports.

Question 19.16

The monthly apartment rent is _____________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.17

The value of plumbing an individual does herself in her house is __________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.18

The value of plumbing an individual does in her neighbor's house for which she is paid is ___________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.19

The cost of pollution produced by automobiles is ____________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.20

Pollution of a river by a factory which results in the company saving money is ____________.

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.21

A policeman's salary

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included

Question 19.22

A new automobile which is produced in the U.S. and purchased by an individual in the U.S.? Purchased by a company in the U.S.? By a government in the U.S.?

A

Consumption

B

Investment

C

Government

D

Net Exports

E

Not included


Question 19.23

Question 19.23

Suggest a measure of material well-being and explain its advantages and disadvantages.

​​Hover here to see the hint for Question 19.23.
Click here to see the answer to Question 19.23.

19.6 Unemployment

 U.S. Adds 75,000 Jobs in May, Well Below Expectations [3]

"The unemployment rate held at 3.6%, a nearly 50-year low, while wages grew 3.1% from a year earlier, also falling below expectations."

                    The Wall Street Journal, Jun 7, 2019

A fundamental indicator of a vibrant economy is the ability for individuals to find gainful employment. The health of an economy rises and falls with the number of people who seek for but cannot find employment. On the first Friday of every month, the U.S. Department of Labor announces the previous month’s unemployment rate. Bankers, investors, financial firms, savers, forecasters, and policy makers all pay attention to what that figure is. Even the stock market is often affected by changes. Why so much attention? What are the costs of unemployment? 

19.6.1 The Unemployment Rate

The rate of unemployment describes the percentage of the labor force that is looking for, but cannot find, a job. To be included in the labor force an individual must be a non-institutionalized civilian above the age of 16 who is either working or looking for work. In May of 2019, there were nearly 162.6 million people included in the labor force. Almost 6 million people in the labor force (3.6 percent) were unable to find work.

19.6.2 Personal Costs

The personal costs should be obvious. If one does not have a job, then it becomes very difficult to support yourself or your family. Bankruptcy increases. Poverty increases. And it gets even worse. The likelihood of suicide, crime, and marital problems increases when one is unemployed. Obviously, unemployment is not a very pleasant experience.

19.6.3 Societal Costs

To make matters even worse, society as a whole also suffers. The fact that some workers are unemployed means that we are not producing as much as we could. We are wasting resources and we are not able to enjoy the fruits of that labor – either the goods and services produced or the economic and social problems solved. We are not being economically efficient and, in addition, we will never be able to make that lost production up. It is gone forever.

In fact, there is empirical evidence supporting Okun’s law, which states for every one percent increase in unemployment, real GDP decreases by approximately 2 percent. With around 162 million individuals in the labor force, Okun’s law implies that a 1 percent increase in unemployment not only translates into 1.62 million more people without jobs; the economy will be producing almost $380 billion less in goods which is, for example, almost one-quarter of what we spend on housing each year. In other words, we are giving up significant production and the accompanying income for that 1 percent higher unemployment.

​We count as unemployed those individuals who do not have jobs and are actively looking for work. If someone has a job, they are counted as employed. The unemployment rate is the most commonly reported statistic and refers to the percentage of the labor force that is unemployed. The labor force is all of those persons who are either looking for work or who have work.

ECN19_Figure19.4_Updated.ai.png
Figure 19.4: The rate of unemployment in the United States has fluctuated from a low of less than 4% in the late 1990s to just over 10% in the depths of the great recession.​

​Overall unemployment rates can be deceiving for a host of reasons. While the current unemployment is near an historic low point, unemployment rates vary tremendously among individuals with different amounts of education, different locations, different races, and sometimes different genders.

When the national unemployment rate (June, 2019) was 3.6 percent, the highest rates among states were New Mexico and Alaska at 5.0 and 6.5% respectively. The lowest rates were in Colorado (3.4%) and North Dakota (2.3%). Of the 50 largest metropolitan areas in the country, Denver, Colorado has the lowest unemployment rate of 2.7 percent. Chicago-Naperville-Elgin, IL-IN-WI Metropolitan Statistical Area, Cleveland-Elyria, OH Metropolitan Statistical Area, and Detroit-Warren-Dearborn, MI Metropolitan Statistical Area were tied at the highest unemployment rate of 3.8, 3.8 , and 3.9 percent.

Teenagers suffered unemployment rates of 13.2 percent. African Americans experienced an unemployment rate of 7.4 percent; Hispanics, a rate of 5.1; and whites, a rate of 3.8 percent. Adult men had an unemployment rate of 4.0 percent, as did adult women. College graduates benefited from unemployment rates of 2.4 percent; high school graduates experienced a rate of 4.5; those with less than a high school education experienced rates of 6.9 percent.

Economists and politicians track rates of unemployment in part because it can represent a problem within the economy. With headline unemployment rates near historic low levels, it can be tempting to imagine that the economy is close to full employment. There are, however, other facets of the labor market to consider. One potential issue to consider is the extent to which the population engages in the labor market as a whole. The labor force participation rate shows the percentage of all individuals who are 16 years or older and are either currently working or are actively searching for employment. When viewed in combination with the overall unemployment rate, the participation rate can create a richer depiction of the status of employment in an economy. The participation rate is the lowest it has been since the mid-1970s. An aging population, (the percentage of the population aged 65 and over has grown by nearly 20 percent since 2008), decreased demand for lower-skilled, low-educated workers, and increasingly long spells of unemployment have all contributed to declining rates of labor force participation.

ECN19_Figure19.5_updated-01.jpg
Figure 19.5: The fraction of eligible workers who are either working or looking for work has been decreasing over the last twenty years.

An individual by definition must be either currently working or looking for work to be included in the official statistics. Looking for work can become quite frustrating the longer you go without finding a job. This frustration can discourage job seeker from continuing to search for work. According to the Bureau of Labor Statistics, the average duration of unemployment from 1948 to 2008 was 13.5 weeks. Over the last decade since the Great Recession, that average duration has grown to over 30 weeks. Once a person has given up the hope of finding employment, they cease to be considered part of the labor force and thus would cause the unemployment rate to decrease as a consequence of their decision to call off their search. 

When jobs become scarce, many people tend to take any job offer they can find. Simply having employment does not always indicate that all is well for individuals; another consideration is underemployment. An alternative metric (called U6) that captures the fraction of individuals who are either unemployed, marginally attached (those who desire to work, but have not looked for employment in 12 months), or are employed part-time but wish for full-time employment. As of May, 2019, while the headline unemployment rate was 3.6%, the unemployment rate when accounting for those working part-time who desire full-time work along with those who have given up looking for work stood at 7.1%.

Question 19.24

Question 19.24

Describe your interpretation of why unemployment is undesirable. What are the costs?

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19.7​ The Causes of Unemployment

​While the costs are relatively easy to understand, the causes are much more difficult. It helps if we divide the causes into four primary categories.

The first kind of unemployment is known as seasonal unemployment. As its name implies, this type of unemployment occurs with changes in seasons. The size of the labor force varies over time as school schedules, weather, and major holidays dictate. As summer ramps up, many people enter the labor force looking for employment. This predictably leads to an increase in the unemployment rate. As summer winds down, the demand for lifeguards wanes. This source of unemployment is regular and predictable in an economy which would obscure more subtle change taking place in the labor force which is why most reported unemployment figures are adjusted to remove seasonally-influenced unemployment.

The second kind of unemployment is known as structural unemployment. This is a tough type of unemployment to solve. It means that the workers looking for work cannot find work for which they are qualified. Sometimes it is lack of skills that is the cause – a high school dropout, for example. But other times, it could be a much more skilled worker without a work opportunity. Automation poses a risk to workers in what economists have called “routine” jobs. As technology advances, the possibility of driverless tractor trailers could threaten to supplant some of the nearly 1.8 million heavy and tractor-trailer truck drivers in the U.S. alone. The solutions to such shifting sectoral demand for labor are often retraining, relocating, or developing a willingness to learn a whole new occupation.

The third category of causes can be listed under frictional unemployment. There seems to be “friction” in the labor market. Not every worker can find a job as soon as they start looking. And sometimes people want to look around at a number of jobs to try to find the one best suited for their skills and interests. On top of that, not every employer wants to hire immediately, without taking the time to consider a number of candidates. Even when the economy is growing rapidly and all the entering workers find jobs relatively quickly, there will still be some people unemployed for “frictional” reasons. And even when there are no workers structurally unemployed, there will still be some unemployment as people go through the normal process of looking for work. While there may not be a solution to what some would call a non-problem, there are ways that we can try to make the amount of frictional unemployment as low as possible.

​The final category is cyclical unemployment. Some unemployment is caused by the economy growing more slowly than it must in order to provide jobs for the new entrants into the workforce. Every year, more people enter the workforce than leave it, whether by retiring, attending school, or becoming discouraged. If spending in the economy is falling, workers may be laid off. If it is rising, but not rising as fast as the growth in the labor force, it is likely that the number of individuals who are unemployed will increase. Cyclical unemployment is unemployment caused by business cycles and fluctuations in the rate of growth in spending. Policies to help the economy grow more rapidly will tend to reduce this kind of unemployment.

How might each of the following affect the amount of frictional unemployment?

Question 19.25​

Question 19.25

Increase in unemployment compensation payments.

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Question 19.26

Question 19.26

A new law that requires some employers to offer jobs for the lifetime of the employee.

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Question 19.27

Question 19.27

Increased availability of job openings on the internet.

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Question 19.28

Question 19.28

Better career placement and counseling centers on college campuses.

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19.7.1​ Full Employment

​Most observers would say that in 2017 we were very close to a level of employment that we describe as “full employment.” To be somewhat awkward, we are very close to the full employment level of unemployment. What that means is there is little or no cyclical unemployment. Later in the semester, we will use a number of other terms that have slightly different emphases (see the table below). But for right now, we will concentrate on “full employment,” meaning that the only kind of unemployment we are experiencing is frictional, and in some cases a bit of structural, but with zero cyclical unemployment. We will use this concept to identify the level of real GDP that can be produced when we are at “full employment.” We will label that as the full-employment level of real GDP or the “potential” level of real GDP, meaning that the potential amount of output is what we can produce at full-employment.

Alternative terms for full employment are:

  • Natural rate of unemployment. The economy will “naturally” return to this level of unemployment, given sufficient time. Same as full employment.
  • NAIRU. Non-accelerating inflation rate of unemployment. Same as full employment.

Question 19.29

Question 19.29

"Our system of payroll taxes and unemployment benefits spreads the costs of unemployment over the entire population. But it does not eliminate the basic economic cost." Are these two statements true or false? Why?

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Use the following information to answer the next three questions: There are 2,000 people living in your country, all of whom are in the labor force. The table below shows the number of citizens in each of these categories:

           ​Frictionally Unemployed                    10
                               Seasonally Unemployed                     0
                               Structurally Unemployed                   30
               Cyclically Unemployed       40

Question 19.30

What is the unemployment rate in your country?

A

1%

B

2%

C

4%

D

8%

E

10%

Question 19.31

The natural rate of unemployment in your country is:

A

1%

B

2%

C

4%

D

8%

E

10%

Question 19.32

What can the unemployment rate you found above tell you about the economy? It is:

A

In a boom

B

In a bust

C

At full employment

Question 19.33

There are 100,000 citizens able to participate in the workforce in the land of Productivia. If 75,000 people are working, what is the unemployment rate in Productivia?

A

100%

B

75%

C

25%

D

0%

E

unable to determine

​19.8 Inflation

“The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is ‘taxed’ in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 100 percent income tax, but doesn’t seem to notice that 5 percent inflation is the economic equivalent.” - Warren Buffett

Inflation can be defined as sustained increases in prices of most goods or continual increases in the average price level.  Sustained and continual means that inflation is more than just a one-time increase in prices.

U.S. Consumer Prices Rose 0.5% in September on Higher Gasoline Costs [4]

                   ​- Headline from October 13, 2017 Wall Street Journal

​Some countries, such as Brazil, Russia, and Mexico, have experienced rapid inflation of 10, 20, or 30 percent per month. The U.S. also experienced annual rates of inflation of more than 10 percent in the 1970s and early 1980s. The U.S. has had significantly lower rates of inflation for most of the time since the late 1970s. In the last several years, inflation has been around 2 percent per year, some years a bit higher, some less.

A price index is used by economists to track changes in the prices of goods and services over time. In order to ensure that an index captures only the changes in the prices of goods, rather than changes in consumption over time, the items being consumed in an index are held fixed over time. This is generally called the basket of goods. As long as the basket of goods remains unchanged, any change in the cost of purchasing the basket over time can be attributed solely to changes in the average prices of goods in the basket. To see how a price index works, let us construct a breakfast-food price index. The table below contains the prices and quantities of orange juice, pancakes, and bacon purchased by a typical restaurant in 2016 and 2017.



Table 19.3: The breakfast price index quantity and prices.​

In order to measure how prices have changed between the two years, we can ask, “How much would it cost us to buy the same amount of orange juice, pancakes, and bacon that we purchase in 2016 in 2017?” That is to say, we compare the expenditures of a typical restaurant on the basket with 2017 prices to expenditures on the same basket with 2016 prices.

​A price level of 1.234 in 2017 says that purchasing the same basket of food items in 2017 as you did in 2016 would cost you 1.234 times as much as it did in 2016. Another interpretation is that prices have increased, on average, 23.4 percent from 2016 to 2017.

Different baskets of goods are used for different price indices. Common indices used to measure inflation are the consumer price index (the CPI), the producer price index (PPI), and the GDP deflator. The CPI measures the prices that typical consumers pay. The PPI is a type of wholesale goods index, and the GDP deflator measures prices in all parts of the GDP. The GDP deflator is sometimes labeled the GDP implicit price deflator. A similar measure (calculated somewhat differently) is simply called the “GDP price index.”​

19.9 The Consumer Price Index

The CPI is the most widely used price index and the index we will focus on during this course. The index and changes in it are important to taxpayers, many workers, retirees receiving social security payments, participants in financial markets, and government officials. Many wage contracts and union agreements are “indexed” to changes in the CPI. What that means is that wages in a contract will increase periodically by the same percentage as the CPI. An early use of similar indexes was to adjust soldiers’ salaries in the Revolutionary War.

Social security benefits are increased each January 1 at the same rate as inflation in the previous year (actually, October 1 to the next September 30). The CPI is used to measure that inflation. Federal tax brackets and personal exemptions on federal tax returns are also adjusted to reflect movements in the CPI. And many other private and public agreements use the index. Because of that importance, the monthly announcements of changes in the CPI receive considerable press attention.

The CPI is the ratio of the average prices paid by consumers in one period to the average prices paid in what is called a base year. To make it a bit more confusing, the base year is actually a range from 1982 to 1984. The CPI creates an estimate of what the typical consumer might buy and measures the prices of that estimate in one year compared to another. Prices for more than 100,000 items each month are gathered from stores throughout the country. Although the base year for the CPI is 1983, the basket of goods is updated to account for obsolescence of items due to technological innovation.

The CPI is expressed as an index number. At the end of June 2017, the CPI was 243.8. That means the market basket of goods and services costs 143.8 percent more in June of 2017 than it did in 1982-1984, the base years. (The index was set equal to 100 in 1982-84.) To calculate the index, add the prices times the quantities of all goods and services in the market basket for the base year. (For simplicity, we will describe the base year as 1983.) Then we take the same quantities that were purchased in 1983 and multiply each by the prices for the same goods in another year, say 2017. (The numerator and the denominator are the sums of all of the quantities and prices for that year.) Then we divide the 2017 total by the 1983 total. We multiply by 100 simply to come up with numbers that are a bit easier to interpret.

​The meaning of an index of 243.8 is that prices have gone up by 143.8 percent since 1983. They are 2.438 times those of 1983. A simpler interpretation is that a good, if average, that cost $100 in 1983, now costs $243.80. Or one that cost $1 in 1983, now costs $2.44.

The base year index in 1983 would be:

Question 19.34

The index in January 2007 was 202.416 and was 211.081 in January, 2008. What was the inflation rate for the 12 month period? Please answer in percent and round to one decimal place.

19.9.1​ Cautions

ECN19_Figure_19.6-01.jpg
Figure 19.6: When goods whose prices are subject to volatility are taken out of CPI, Core CPI shows less variability than it’s more popular metric.

​Price indexes are important pieces of data. However, there are weaknesses. For example, the market basket applies to a typical consumer. If an individual happens to match those patterns exactly, the consumer price index will describe what is happening to the prices that that particular individual pays. However, for most of us, the consumer price index will be misleading. The average individual in Los Angeles uses a lot of gasoline; significantly more than people in New York. In a period in which gasoline prices increase significantly, inflation will be understated in Los Angeles and overstated in New York. To account for prices that are subject to volatility, some items, such as gasoline, are omitted from CPI to calculate Core CPI.

Not everyone consumes the group of goods that are included in CPI. Even though the CPI is used to adjust social security payments to retired individuals, it is not clear that the typical consumer’s market basket is one that is appropriate for elderly retired individuals. The elderly, for example, use more medical services than most young consumers. Goods and services vary in importance in consumers’ budgets, the average prices in the ratio are weighted averages. Most college students spend more on tuition than on movie tickets. It makes sense then to give tuition a bigger weight in the index than movie tickets. Assume that you are buying only those two goods. If tuition increased by 10 percent one year and the price of movie tickets did not change, a typical average would say that the average price level increased by 5 percent. But if 99 percent of your spending is on tuition, the tuition increase should get a much higher weight. Inflation is much closer to 10 percent than 5 percent.

ECN19_Figure19.7-01.jpg
Figure 19.7: Not all prices move in lockstep. This can be seen by tracking different groupings of goods over time. Higher education and medical expense have seen prices increasing faster than average over the last 45 years.

​Over the last 35 years, higher education and medical expenses have grown faster than the rate of inflation as measured by the CPI.

There is considerable concern that the CPI consistently overstates inflation for the vast majority of the population. There are a variety of reasons. Two of the most important are the changing quality of goods and changes in the market basket in response to changes in prices.

19.9.1.1 Quality

If the sticker price of an automobile increases by five percent in a year and the estimated quality of that car has increased by five percent, what has happened to the price that is used in a price index? What would a “quality-adjusted” price index say about inflation?

There really has not been an increase in the price. But a price index that simply uses the same number of automobiles and enters a price that is five percent higher will overstate the actual effects of inflation. The problem becomes an important one when there are significant increases in quality. Computers and software are particularly difficult to measure. The qualities of financial services are notorious for being difficult to measure.

19.10.1.2 Quantity

The CPI has a fixed market basket. As some prices increase and others stay the same or increase at a slower rate, consumers will likely shift spending from the more expensive goods to the less expensive ones as much as possible. The effects of the increased prices are smaller because of that change in quantities. The CPI will overstate that effective rate of inflation because it does not change the market basket.

19.10​ Costs of Inflation

Question 19.35

Question 19.35

Describe your interpretation of why inflation is undesirable. What are the costs?

​​Hover here to see the hint for Question 19.35.
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19.10.1 Real Wages Are Lowered. Reality or Myth?

One of the most commonly heard objections to inflation is that our wages and wage increases are taken from us by inflation. In fact, it may be this belief that causes most of the dislike of higher rates of inflation. Yet let’s look at the facts. Wages and prices seem to increase at very similar rates. An increase in inflation is quickly followed in most circumstances by a more rapid rate of increase in wages. A slowdown in the rate of inflation is soon followed by a decrease in the rate of increase in wages.

On average, our wage increases are not taken from us by inflation. In fact, largely due to increases in productivity of workers over time, wages increase more rapidly than inflation. That means our real wages tend to rise. Our nominal wages tend to increase more rapidly with higher inflation and more slowly when inflation is low.

However, for those on fixed incomes, inflation does indeed lower the value of that income. If one is unfortunate enough to have a wage that adjusts very slowly, then that individual will be hurt by inflation. People whose wages adjust quickly are not damaged. One of the true concerns with inflation is that it penalizes some, and not others, with no real rational reason.​

19.10.2 Lenders and Borrowers Are Hurt and Helped. Reality or Myth?

With inflation, the money a lender gives to a borrower is worth more than the money returned when the loan is paid off. For example, with inflation of 10 percent, the $100 lent at the beginning of the year will be able to buy only $90 worth of goods when it is repaid at the end of the year. So, the lender is hurt. Can you work out a statement of why the borrower is helped?

This would be true if it were not for the fact that interest rates change when inflation is expected. Why would a lender lend money if the lender expected inflation? Lenders will normally raise interest rates in order to compensate themselves for the expected inflation.

If I lend you my car for a week, I might charge you a fee for my inconvenience of not having the car. However, if I also expect that some damage will be done (the equivalent of inflation lowering the value of the $100 when it is paid back), I will ask you to pay even more. Only when the damage is unexpected, will I be hurt by the damage. Only when the inflation is unexpected, will the lenders be hurt by inflation.​

19.10.3 The Tax System Is Distorted. Reality or Myth?

Two examples of tax distortions follow. Inflation and our tax system create results that do not tax the same real incomes in the same fashion. The first example is one of capital gains. Capital gains are the appreciation in the value of an asset, such as a stock or a house, over time. A tax is owed on the gain in the value of the asset when the asset is sold. With inflation, the gain is not all a real gain. Some of it is due to inflation.

The second example is a tax on interest income. Interest income normally includes a portion that in essence compensates lenders or depositors for inflation. Because a portion of that compensation is taxed away, the lender is not fully compensated for inflation.

1. Capital gains over a 10-year period. (Assume that in both situations, there is a 10 percent real appreciation.)

Table 19.4: When there is inflation, the rise in the prices of goods can lead to dramatically higher taxes.​

(Actual real appreciation is 10 percent in both cases. In case 1 and in case 2, real appreciation increases the value of the asset by $20,000. In case 2, the 50 percent inflation also increases the value from $200,000 to $300,000, that is, approximately 50 percent of the original value.)

Table 19.5: When there is inflation, the rise in the prices of goods can lead to dramatically higher taxes.​

​With zero inflation, the real after-tax profit in case 1 is $17,000. With fifty percent inflation in case 2, the real after-tax profit would be the $102,000 nominal profit minus the $100,000 needed to simply compensate the owner for inflation. The real after-tax profit would actually be a profit of only $2,000. Projects with the same real before-tax profit turn out to have drastically different results due to the combination of the tax system and inflation. The important effects are that while the project may well be undertaken with little inflation, it is significantly less likely to be done in the second case.

2. Interest income with two different rates of inflation.

Nominal interest rates will be equal to the real interest rate plus the expected rate of inflation. Thus with higher expected inflation, nominal interest rates will tend to be higher. The figures in the two cases below show what happens to after-tax real income when we experience increased rates of inflation. In both cases, assume that the real rate of interest is 4%.

Table 19.6: Inflation Increases the Nominal Rate of Interest​​

  After-tax income (in case 1) = (7%) - (7% x .25) = 5.25%

          After-tax income (in case 2) = (14%) - (14% x .25) = 10.5%

Real after-tax income = (nominal after tax income) minus (the rate of inflation in both cases)

           Real after-tax income (in case 1) =   5.25% - 3% = 2.25%     

           Real after-tax income (in case 2) =   10.5% - 10% = -.5%

The higher inflation rate results in an after-tax income that is significantly less. The two situations were the same in terms of real incomes before taxes.​

19.10.4 Shoe Leather Costs. Reality or Myth?

The concept is described as a shoe leather cost because shoe leather is worn out in crossing the street to the banks. The label is facetious, but the cost is real and quite important.

Nominal interest rates rise with inflation. Large corporations end the day with large amounts of cash in their cash registers and checking accounts. With high interest rates, they are going to go to the bank more often. It is not of much worry when interest rates are 3 percent, but at 10 percent, the opportunity cost of leaving money in the cash register (not earning interest) is much greater. Thus shoe leather is worn out walking across the street to the bank at night and back across again the next morning. We are not truly worried about shoe leather, but increased resources are devoted to managing money.

Individuals are hired, and money management departments are expanded. Those resources could be used to provide us with other goods and services (again, a failure to be economically efficient). There is an endless string of possibilities that might expand our production possibilities frontier. 

19.10.5​ Menu Costs. Reality or Myth?

​Increased rates of inflation mean that the menus in restaurants must be changed more often, and catalogue companies have to rewrite their catalogues. Changing the menus and catalogs and price lists are not significant to the economy as a whole, however, just as in the case of shoe leather costs, the concept is significant.

If all prices are changing and changing rapidly, the rate of change in prices can become quite varied. As a result, it becomes more difficult to predict prices that a business can charge and to predict how its costs will change. In short, there is an increase in uncertainty and as a result, less business may be done. Fewer long-term contracts are signed. Thus we may not be as economically efficient as we could be. There are less investment and less economic expansion. We would be better off without as much inflation.

As we will see when we discuss policy, one way in which we can reduce inflationary pressures is to slow down the rate of growth in spending in the economy. That may, in some cases, result in a recession, rising unemployment, and falling output. That too can be a potential cost of inflation. Many observers would add a general dislike and unhappiness with rapidly changing prices as part of inflation’s costs.

Real income redistribution, unintended outcomes of the tax system, increased allocation of resources to money and financial management, and increased difficulty in forecasting costs and prices and the resulting reduction in investment and expansion are all real costs of inflation.

Meet the (New) Beetles [5]

"By almost every measure, the word ‘more’ applies to the New Beetle (1998). Compare the 2-liter, 4-cylinder, 115-horsepower engine with, say, the 57-horsepower power plant of the 1970 Beetle. [...] At $15,700, the new car is 36 percent more expensive than a Beetle from 1977 (the last year the hard-topped car was sold in this country) would be in 1998 dollars."

                          -The New York Times, March 22, 1998

Additional information:         CPI for 1977 = 60.6
           CPI for 1998 = 161.3

Question 19.36

What was the price of the 1977 Beetle in 1998 dollars?


Question 19.37

What did the 1977 Beetle cost in 1977 dollars?

Question 19.38

Question 19.38

How would you take into account the changes in the quality of the Beetle in calculating the increase in the price of a Beetle? (What if the 1998 Beetle was actually 20 percent better than the 1977 Beetle?)

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Question 19.39​

Question 19.39

Why should we concern ourselves with inflation?

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19.12 Summary

  • ​Gross domestic product (GDP) measures the value of the production of final goods and services in an economy in a year.
  • Real GDP measures the actual output while holding prices constant. Real GDP per capita is a superior, yet imperfect, measure of economic well-being in an economy when compared to GDP and real GDP.
  • Use of human resources is measured by unemployment rates and by total number of employed individuals.
  • The costs of unemployment are personal and societal. The income that is lost by individuals is personal. The real GDP that is not produced can never be regained and is a cost of all of society.
  • The most commonly reported and discussed measure of inflation is the consumer price index, a measure of prices of goods and services that the typical consumer buys.
  • The costs of inflation are primarily in the increased expense of managing financial assets and in the discouragement of investment decisions.​

19.13 Key Concepts in Chapter 19

  Gross Domestic Product
  Unemployment
  Full employment
  Costs of unemployment
  Inflation
  Price indexes
  Costs of inflation

19.14 Glossary

Consumer price index: A price index that measures changes in the average price of goods and services purchased by a typical consumer.

Consumption: Spending by households, including durable goods (washing machine, stereos, and cars), non-durable goods (food, clothing, and gasoline), and services (haircuts, medical care, education).

Cyclical unemployment: Unemployment caused by business cycles and fluctuations in the rate of growth in spending.

Exports: Goods and services produced in the United States and sold abroad.

Frictional Unemployment: Unemployment caused by workers entering the labor force, voluntarily changing jobs or by being temporarily laid off or fired.

Full employment level of real GDP: The amount of output that would be produced if the labor force is at full employment.

Full employment: The highest employment can be at any one time without causing an acceleration of inflation.

GDP deflator: A price index for all goods and services included in GDP. The measure compares the cost of the present basket of goods and services relative to the cost of that basket in a base year.

GDP: The market value of all of the final goods and services produced annually within a nation.

Government spending: The sum of federal government, state, and local government purchases of goods and services.

Imports: Goods produced abroad and purchased domestically.

Inflation: The rate of increase in the overall level of prices of goods and services in the economy.

Investment: When used in reference to GDP or the entire economy, it is any business spending intended to increase future output. For example, goods purchased by firms that consist of new factories, and new machines and inventory investment (change in inventories at business firms). It also includes new homes.

Labor force: The number of individuals who have jobs plus the number who are actively looking for work.

Labor force participation rate: The percentage of the population, 16 years and over, that is either employed or actively looking for work.

Menu Costs: The costs to firms of having to continually change the prices they charge and pay.

Net exports: Exports of goods and services minus imports of goods and services.

Price indexes: Index numbers that measure how the average prices of goods in a “market basket” change through time

Producer price index: A price index that measures the typical level of producers’ prices or prices at the wholesale level.

Real GDP per capita: Real GDP per person; real GDP divided by population.

Real GDP: The real value of all final goods and services produced in an economy. Real GDP is measured in dollars adjusted for changes in the overall price level.

 Shoe leather costs: When inflation is high, currency and non-interest bearing checking accounts are undesirable because they are rapidly declining in purchasing power. Businesses will make extra efforts and hire managers to avoid holding much money; these resources are the shoe leather costs of inflation.

Structural unemployment: Unemployment resulting from workers skills not matching job openings.

Unemployment rate: The percentage of the labor force that is unemployed.


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Answer Keys:

Answer to Question 19.01

​GDP includes the value of all new, domestically produced, final goods and services. Because the textbooks are used, they would not be included in GDP. The value of the services rendered to resell the textbook would be included though.

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Answer to Question 19.15

GDP does not measure non-market activity, e.g., home repairs done by owners; or does not measure leisure. In addition, real GDP includes some items that we might prefer not to have such as crime prevention and disaster recovery. If we incur ecological costs in the process of producing goods and services, they are not subtracted. Nor is the distribution of income included in gross domestic product.

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Answer to Question 19.23

Your answer might focus on real GDP per capita. It might include first why GDP is important and then why GDP can be adjusted by prices and the number of individuals in the economy to make it a superior measure of material well-being. Some of the weakness of real GDP per capita include knowing what to count and what not to count and determining whether our dollars are being spent in a way that truly makes us better off.

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Answer to Question 19.24

Being unable to find gainful employment, especially the longer the search for employment takes, can have devastating consequences for a family. Without an income, it can be difficult to put food on the table, pay bills, and keep a roof over your head without assistance. The government has some safety-net programs to assist individuals who cannot find work, but none of these programs are permanent, nor will they serve as a generous substitute for a paycheck. When large numbers of individuals are unemployed, the programs designed to help them become fiscally strained, people begin to lose faith in the promise of a better future, and general social unrest can occur.

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Answer to Question 19.25

With an increase in unemployment compensation, individuals looking for work may be able to afford to take more time looking for work. This can be a good thing if we consider that it takes time to find work that is a good match for an individual’s job skills. If many people take more time, frictional unemployment will increase.

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​Answer to Question 19.26

Employers must be more cautious in hiring decisions and look at more potential employees. If that increases the time it takes to hire workers, frictional unemployment will be higher.

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​Answer to Question 19.27

People may be able to find appropriate jobs more quickly, thus lowering the frictional unemployment rate.

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​Answer to Question 19.28

New college graduates may spend less time unemployed. Again, the effect is to lower the frictional unemployment rate.

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Answer to Question 19.29

These two statements are true. Unemployment benefits are paid to unemployed persons and thereby lessen the personal loss from being unemployed. The benefits are paid by taxing those working, thus spreading the personal costs from the unemployed to include those employed. Because unemployment benefits do not come close to replacing lost wages, nor do they persist indefinitely, it does not eliminate the economic cost of unemployment.

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Answer to Question 19.35

The expected rate of inflation is an important factor in the interest that people pay on loans. If inflation turns out to be different than what is expected, someone in that long-term financial transaction is going to be losing out in real terms. Inflation can also affect the taxes that you pay for various types of income such as interest income, capital gains, and potentially the bracket that determines the marginal rate you pay in income taxes. In addition, if you are thinking ahead, individuals who may be living on fixed incomes will not be able to afford to buy as many goods and services as they did last year. 

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Answer to Question 19.38

The Beetle has improved in quality with two examples mentioned in the article – more horsepower and it is faster. One way to adjust the price for quality changes is to identify what individuals would pay for those increases in quality. Statisticians often measure how much people would pay for the higher quality. For example, if people would be willing to pay 20 percent more for that increase in horsepower, then we might say that the quality of the Beetle has increased by 20 percent.

The author says the price of the Beetle increased by 36 percent. But if we have 20 percent more car, in terms of quality,  the “quality-adjusted” price of the Beetle would have actually only increased by approximately 16 percent (36 percent – 20 percent). All of that analysis means that the 36 percent increase in the price is not an actual increase in price. Some or all of it may have been offset by an increase in quality.

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Answer to Question 19.39

​High inflation can cause price distortions that cause us to allocate scarce resources inefficiently. For example, we spend more time than we ought to managing money when inflation is high. We also spend time and resources changing prices more often than if inflation were low. Unpredictable inflation reallocates wealth arbitrarily between borrowers and lenders and employers and employees. Unpredictable inflation also makes investing and saving riskier and reduces both which ultimately reduces future well being.

​Click here to return to Question 19.39.









Data Sources:

Figure 19.2

Figure 19.3

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Figure 19.5

Figure 19.6

Figure 19.7


Image Citations:

[1] Image courtesy of Take_our_picture_please under CC BY-SA 3.0



The value of all of the final goods and services produced in a country in a year.
Focus on the definition of GDP.
Spending by households, including durable goods (washing machine, stereos, and cars), non-durable goods (food, clothing, and gasoline), and services (haircuts, medical care, child care, dry cleaning, and data processing).
When used in reference to GDP or the entire economy, it is any spending intended to increase future output. For example, goods purchased by individuals and firms that consist of fixed investment (new factories, new machines, and new houses) and inventory investment (change in inventories at business firms).
Social security, unemployment compensation, and welfare benefits. All are in principle transferring income from one group of individuals to another.
Goods and services produced domestically and sold abroad.
Goods produced abroad and purchased domestically.
Real GDP per person; real GDP divided by population.
Does it capture all economic activity? Does it reflect the well-being of everyone in the economy?
Think about what GDP actually measures and how that number is reflective of how well-off any individual in the economy is. Would improvements in one reflect improvements in the other? How might you adjust GDP to more closely reflect individual well-being?
Number without jobs and actively looking for work.
The percentage of the labor force that is unemployed.
Number of unemployed plus number employed.
The percentage of the population, 16 years and over, that is either employed or actively looking for work.
Imagine this on a personal level. How does it affect the economy if there are many people like you who cannot find work?
Predicable unemployment caused by changes in seasons.
Unemployment caused by a mismatch of skills and job opportunities.
Unemployment caused by the normal process of leaving jobs, getting fired, graduating from school, and searching for new jobs.
Unemployment caused by business cycles.
Would you be eager to take the first job offer you received if unemployment benefits were very generous?
Put yourself in an employer’s shoes. How long would you search for the right employee if you knew that you would be stuck with him for life?
How much time does it take to find a job opening? Would you have to quit in order to search for a job?
What does this do to the odds of you finding employment?
Zero cyclical unemployment. The lowest unemployment can be without causing an increase in the rate of inflation.
The amount of output that can be produced if we are at a level of full employment. Sometimes also called the potential level of real GDP.
Is everyone who is unemployed on unemployment benefits?
A continual increase in the average price level.
What exactly is inflation a measure of? How is it used in the economy?
You want to be able to compare like goods with each other. Do you think that people would be willing to pay more for a higher-quality Beetle? What does that tell you about the real change in the price of Beetles over those 22 years?
Who is helped by inflation? Who is hurt by inflation? Do all prices change at the same rate?