Lecture: Measuring Inflation & Unemployment
Lecture script · about 15–20 minutes spoken · Week 3
Opening
Think about a nurse who has a new 4% raise. It feels like a win. But the groceries, the rent, and the gas all cost more than they did last year. So is the nurse ahead or behind? Or think about a restaurant owner deciding whether to raise menu prices, or a city workforce office counting how many residents are still looking for work. All three are reading the same two numbers: how fast prices are rising, and how many people can't find a job.
Those two numbers are this week's work. In Week 1 we looked at the economy as a whole, and we saw that a point inside the frontier means idle workers. In Week 2 we measured output with GDP, and we learned to pull price changes apart from real output with the GDP deflator. This week we use that same real-versus-nominal habit on prices and paychecks. Then we count the people behind the word "unemployment."
Here's the plan for this lecture. First we'll build a price index from a shopping list. Then we'll turn it into an inflation rate, and use that rate on a paycheck. After that we'll count the labor market, find the people the count leaves out, and sort the jobless into three types. Next, in Week 4, Economic Growth & Productivity, the same percentage-change idea will measure how fast a whole economy grows.
1. One basket, priced twice
Picture your own regular week of spending. A few pizzas with friends, a coffee most mornings, a textbook now and then. Now imagine writing that list down, exactly, and pricing the same list again a year later. If the total went up, it can't be because you bought more. The list didn't change. Only the prices did.
That fixed list has a name. A market basket is a fixed list of goods and services, with a set quantity of each, whose total cost is tracked from year to year. Because the list never changes, only price changes can move the total.
And the number built from it has a name too. The Consumer Price Index, or CPI, compares the cost of a fixed market basket that households buy in a given year with the cost of the same basket in the base year, times 100. So you take this year's cost, divide it by the base year's cost, and multiply by 100. In the base year, you're dividing a number by itself. That means the CPI is always 100 there.
Here's a way to hold onto why the basket stays fixed. Imagine stepping on a bathroom scale while wearing a heavy backpack one day and no backpack the next. The change on the scale wouldn't tell you much about your own weight. A fixed basket is like weighing yourself with the same backpack every time. Whatever changes, you know it wasn't the backpack.
Pause and try this. Your spending on food went up this year because you started eating out more. Does that, by itself, push the CPI up?
Think about what stays the same from year to year.
Here's the answer. No. The CPI prices the same basket every year, so buying more doesn't move it; only higher prices for that same basket do.
2. Pricing the campus basket
Let's put real numbers on that list. I'm using an illustrative basket, built for this course, not real data. It holds 10 pizzas, 20 coffees, and 4 textbooks. In the base year, a pizza costs 8 dollars, a coffee costs 3, and a textbook costs 15.
So 10 pizzas at 8 dollars is 80 dollars. Then 20 coffees at 3 dollars is 60. And 4 textbooks at 15 dollars is 60. Add them up, and the basket costs 200 dollars. Divide 200 by 200, multiply by 100, and the CPI is 100. That's the base year, right where the definition says it should be.
Now jump to year 2. The pizza goes up to 9 dollars. The coffee goes up to 3.30. The textbook stays at 15. Same 10 pizzas, now 90 dollars. Same 20 coffees, now 66 dollars. Same 4 textbooks, still 60. The basket now costs 216 dollars.
Divide 216 by 200 and multiply by 100, and the year-2 CPI is 108. Say that in words: the same basket costs 8 percent more than it did in the base year.
One small habit will save you trouble later. A CPI is a level, like a reading on a gauge. So it doesn't get a percent sign. You say "the CPI is 108," never "108 percent."
And here's one shortcut people try that doesn't work. They add up the three prices and compare those totals. That skips the quantities. The basket holds 20 coffees but only 4 textbooks, so a coffee price change should count for more. Multiply each price by its quantity first, then add.
Pause and try this. Of the three items in the basket, which one did nothing to push the year-2 CPI above 100?
Compare each item's price in the two years.
Here's the answer. The textbooks. They cost 15 dollars in both years, so their 60 dollars stayed the same, and all of the rise came from pizza and coffee.
3. From a level to a rate
Think about a road trip. The mile marker tells you where you are. Your speed tells you how fast you're moving. Those are different numbers, and you need both. The CPI is the mile marker. Inflation is the speed.
The inflation rate is the percentage change in a price index from one period to the next: the new level minus the old level, divided by the old level, times 100.
Let's run it from the base year to year 2. The CPI went from 100 to 108. The change is 8. Divide 8 by the starting level, 100, and multiply by 100, and you get 8%. Prices rose 8 percent.
Now year 3. The same basket costs 226.80 dollars, so the CPI is 113.4. The change from year 2 is 113.4 minus 108, which is 5.4. Now comes the step people skip. Divide that 5.4 by the starting level, which is year 2's 108. Then multiply by 100. That gives 5%. Prices rose 5 percent from year 2 to year 3.
Notice what happened. The CPI kept climbing, from 108 to 113.4. But inflation slowed, from 8% to 5%. A rising index doesn't mean inflation is speeding up. It means prices are still going up.
That gap of 5.4 has its own name. Index points are the plain difference between two readings of a price index; they measure distance on the index, not a percentage change. The 5.4 becomes a rate only after you divide by where you started.
Here's the trap that catches almost everyone once. A CPI of 108 looks like "8% inflation this year." In year 2 that happens to be true, because the starting level was 100. But it only works in the first year after the base year. After that, the starting level isn't 100 anymore, and subtracting 100 gives the wrong speed.
Pause and try this. Someone says inflation must have sped up in year 3, because the CPI of 113.4 is bigger than 108. What went wrong?
Ask yourself whether they're reading a level or a rate.
Here's the answer. They read the level, not the speed. Year 3's rate compares 113.4 with 108, and that works out to 5%, which is slower than the 8% before it.
4. What a raise really buys
Let's bring this home to a paycheck. Imagine two pay stubs, last year's and this year's. This year's has more dollars printed on it. Whether you can buy more with it depends on what happened to prices.
So economists look at pay two ways. A nominal wage is pay measured in the dollars a worker receives at the time, with no adjustment for what those dollars can buy. A real wage is pay measured by the goods and services it can buy. And the shortcut that connects them says a real wage change is about the nominal wage change minus the inflation rate.
Back to the nurse from the opening. The raise was 4%. Over that same year, prices rose 5%. So 4 minus 5 gives about negative 1. The raise was a real pay cut of about 1 percent. The paycheck has more dollars, but they buy about 1 percent less.
I say "about" on purpose. The subtraction shortcut is close when both rates are small, but it isn't exact. It's a quick estimate you can do in your head.
There's a second way to see the same idea. Say a weekly paycheck is 540 dollars in year 2, when the campus basket's CPI is 108. Divide 540 by 108, and you get 5. Multiply by 100, and you get 500. So 540 dollars in year 2 buys what 500 dollars bought in the base year. That 500 is the paycheck's real value.
Before we leave prices, two honest caveats. Because the basket is fixed, the CPI can overstate inflation when shoppers switch to cheaper goods or when quality improves. And the GDP deflator from Week 2 prices everything in GDP, while the CPI prices what households buy, so the two need not move together.
Pause and try this. Suppose the nurse's raise had been 5% instead, with prices still rising 5%. What happened to the nurse's real wage?
Use the same shortcut: the raise minus inflation.
Here's the answer. About nothing. Five minus 5 is zero, so the paycheck buys about the same as before, even though it has more dollars.
5. Counting who works and who's looking
Now let's leave the store and walk into a job fair. Some people there have jobs and want better ones. Some have no job and are looking hard. And plenty of adults in town never come at all. They're retired, or studying full-time, or caring for family. To measure unemployment, economists first sort every adult into one of three groups.
You're employed if you have a job and work for pay or profit, part-time or full-time. You're unemployed if you have no job, you're available to work, and you've actively looked for work recently. The labor force is everyone who is employed or unemployed: everyone working or actively looking. Everyone else is outside the labor force.
From those groups come two rates. The unemployment rate is the number of unemployed people divided by the labor force, times 100. The labor-force participation rate is the labor force divided by the adult population aged 16 and over, times 100.
Let's run an illustrative labor market, built for this course, not real data. It has 200,000,000 adults. Of them, 114,000,000 are employed and 6,000,000 are unemployed. Add those two, and the labor force is 120,000,000 people.
The unemployment rate is 6,000,000 divided by 120,000,000, times 100. That's 5%. In words, 5 of every 100 people in the job market are looking and don't have work. The participation rate is 120,000,000 divided by 200,000,000, times 100. That's 60%. So 60 of every 100 adults are working or looking. The other 80,000,000 adults are outside the labor force.
Keep your eye on the two bottom numbers. Unemployment divides by the labor force. Participation divides by all adults. Mixing them up is the most common slip in this topic.
Pause and try this. If someone divides the 6,000,000 unemployed by all 200,000,000 adults, what rate do they get, and why is it wrong?
Think about who belongs in the job market.
Here's the answer. They get 3%. It's wrong because retirees and full-time students aren't in the job market, so the unemployment rate divides by the labor force, not all adults.
6. The people the count leaves out
Picture someone who lost a job a while ago. At first they sent out applications every week. Nothing came back. Over time they stopped applying, because they came to believe no job was out there for them. They still want work. But they are no longer searching.
That person has a name in this course. A discouraged worker is a person who wants a job but has stopped looking because they believe none is available. The survey counts that person as outside the labor force, not as unemployed.
That rule has a strange side effect. When a jobless person stops looking, they leave the unemployed count and the labor force at the same time. Both the top and the bottom of the unemployment rate shrink. So the rate can fall even when nobody finds a job.
Here's an illustrative town, built for this course. Its labor force is 4,800 people, and 240 of them are unemployed. Divide 240 by 4,800, times 100, and the rate is 5%. Now 50 people stop looking. The unemployed count falls to 190, and the labor force falls to 4,750. Divide 190 by 4,750, times 100, and the rate is 4%.
The rate fell from 5% to 4%, and not one person was hired. That's a real limitation of the measured rate. It's also why careful readers check the participation rate too, which would fall in this town as well.
Pause and try this. In that town, did the drop from 5% to 4% mean the job market got better?
Think about who left the count, and why.
Here's the answer. No. Nobody was hired; 50 people gave up looking, which shrank both the unemployed count and the labor force.
7. Three reasons people are out of work
Not every job loss has the same cause. Think of three people without work. One quit to move closer to family and is now interviewing. One spent years in a trade that new technology replaced. One was laid off when a downturn cut customer spending everywhere. Economists sort these three into three types, by cause.
Frictional unemployment is joblessness that comes from the ordinary time it takes workers and employers to find and match with each other, such as a new graduate searching for a first job. The jobs exist; matching takes time. Some of this is healthy. It means people are finding work that fits.
Structural unemployment is joblessness that comes from a lasting mismatch between the skills or locations of workers and the jobs on offer, such as when new technology replaces a trade. Think of a film-photo lab technician after cameras went digital. The openings nearby need different skills, so this can last longer.
Cyclical unemployment is the extra joblessness that appears when spending across the economy falls in a recession and that shrinks again in an expansion. Think of a hotel housekeeper laid off when travel spending dropped, with the hotel planning to rehire once guests return. We'll meet the business cycle behind it in Week 6.
Here's the question that sorts them. Ask why the person is out of work, not how long. Then ask one more thing. If spending across the economy recovered, would this job come back? If yes, it's cyclical. If the job is gone for good, it's structural. If the job is there and the match is still being made, it's frictional.
Pause and try this. A nursing graduate is spending a few weeks choosing between hospital offers. Which type of unemployment is that?
Ask whether the jobs exist and what's taking time.
Here's the answer. Frictional. The jobs are there, and the graduate is taking the ordinary time it takes to match with one.
Closing
Let's pull it together. The CPI prices one fixed basket over and over, and it equals 100 in the base year. Our campus basket went from 200 to 216 dollars, so the CPI went from 100 to 108. The inflation rate is the speed, not the level: 8% into year 2, then 5% into year 3, once you divide by the starting level. A real wage change is about the raise minus inflation, so a 4% raise against 5% inflation is a real cut of about 1%. The labor force is the employed plus the unemployed, and the illustrative market gave a 5% unemployment rate and a 60% participation rate. Discouraged workers fall outside the count, which can make the rate drop with no one hired. And joblessness comes in three types, sorted by cause: frictional, structural, and cyclical.
Next in this module, read the Readings & Resources page, then work through the lecture tutorial, the practice set, and the quiz. And in Week 4, Economic Growth & Productivity, you'll use this same percentage-change formula to measure how fast an economy grows.
Built with The Course Maker · samples.thecoursemaker.com