Macroeconimics

Chapter 5

Use the following data to work Problems 1 to 3.
The IMF World Economic Outlook reports the unemployment rates in the table.
1. What do these numbers tell you about the phase of the business cycle in the United States, Euro area, and Japan in 2008?
2. What do these numbers tell us about the relative size of the natural unemployment rates in the United States, the Euro area, and Japan?
3. Do these numbers tell us anything about the relative size of the labor force participation rates and employment-to-population ratios in the three regions?

4. Michigan: Unemployment Record Holder Michigan now holds a dubious record: It leads the U.S. in joblessness. The state’s unemployment rate was 8.5% in May while the U.S. unemployment rate was only 5.5%. The reason is clear: Detroit’s emphasis on big trucks and sport-utility vehicles has turned sour. But even though the official unemployment numbers look awful, the reality is worse. The official number does not reflect those who have given up looking for a job.
Business Week, June 24, 2008
a. Why is the reality of the unemployment problem in Michigan actually worse than the 8.5% unemployment rate statistic?
b. Is this higher unemployment rate in Michigan frictional, structural, or cyclical? Explain.
5. The Great Inflation Bias In 1996 the Boskin Commission was established to determine the accuracy of the CPI. The commission concluded that the CPI overstated inflation by 1.1%. The commission described four biases in the way the CPI was determined.
Fortune, April 3, 2008
a. What are the main sources of bias that are generally believed to make the CPI overstate the inflation rate? By how much did Boskin estimate the CPI overstates the inflation rate?
b. Do the substitutions among different kinds of meat make the CPI biased up or down?
c. Why does it matter if the CPI overstates or understates the rate of inflation?

Solutions to Problems
The IMF World Economic Outlook reports the unemployment rates in the table.
1. What do these numbers tell you about the phase of the business cycle in the United States, Euro area, and Japan in 2008?
The unemployment rate rose in the United States, so it might well be the case that the United States was entering a recessionary period. The unemployment rates in the Euro area and Japan hardly changed, so the phase of the business cycle likely did not change in these locations. It might be that the Euro area was in a recession and Japan an expansion because the unemployment rate was higher in the Euro zone than Japan. But it might also be the case that the natural unemployment rate in the Euro area was substantially higher than in Japan.
2. What do these numbers tell us about the relative size of the natural unemployment rates in the United States, the Euro area, and Japan?
These numbers cover only two years, so making inferences about the relative size of the natural unemployment rates is potentially dangerous. To the extent that these data are representative, the natural unemployment rate is likely the highest in the Euro area and the lowest in Japan.
3. Do these numbers tell us anything about the relative size of the labor force participation rates and employment-to-population ratios in the three regions?
The numbers tell us nothing about the relative sizes of the labor force participation rates or the employment-to-population ratios in these three regions.

4. a. The unemployment problem is worse than the 8.5 percent unemployment rate indicates for three reasons. First, the unemployment rate does not include marginally attached workers, such as discouraged workers. Second, the unemployment rate does not include part-time workers would want full-time jobs. Finally the unemployment rate counts only workers who are currently unemployed. If a company has announced that it will be laying off workers in the future, its workers are measured as employed even though they will shortly join the ranks of the unemployed. b. The higher unemployment rate in Michigan is structural. Consumers are decreasing the number of U.S.-made large cars in favor of foreign-made smaller cars. And to the extent that consumers are buying U.S.-made cars, they are generally smaller cars, many of which are not manufactured in Michigan. So the skills possessed by Michigan workers are not the skills needed for jobs and the location of workers in Michigan is not the location of available jobs.
5. a. The Boskin Commission presented four reasons why the CPI overstates the inflation rate. The four sources of bias are the new goods bias (new goods often cost more than the good they replace); quality change bias (price hikes might reflect quality changes); commodity change bias (changes in relative price lead consumers to switch away from goods and services whose price has risen more rapidly than other goods and services); and, outlet substitution bias (people buy from lower-priced sources when prices rise). The Boskin Commission estimated that the CPI overstates the inflation rate by 1.1 percentage points. b. Substitutions among different types of meat biases the CPI upward because the CPI ignores these substitutions. For instance, if the price of beef rises and the price of chicken does not change, then consumers respond by switching from beef to chicken. Consumers will eat (approximately) the same amount of protein as before but the substitution of chicken for beef means that their expenditure on protein will not change by the full amount of the price rise for beef. The CPI ignores this substitution and assumes that people buy the same amount of beef as before. Therefore the CPI erroneously reports that expenditure on protein has risen by the full amount of the price hike of beef. The article says that when consumers respond to a change in relative price by switching from one type of meat to another, the price of the new type can’t be compared to the price of the old type because consumers prefer the old type of meat to the new one. However the article’s statement can’t be literally true because consumers generally cannot think the second type of meat ranks at zero compared to the first type of meat. Hence allowing for no substitution biases the CPI upward because consumers will substitute from one meat to another when relative prices change. c. Many decisions depend on the CPI and any errors in the CPI will lead to errors in these decisions. For instance, some wage contracts are linked to the CPI. If the CPI overstates inflation, then the firms pay too much and some workers might lose their jobs if the firm decides to fire them. Conversely if the CPI understates inflation, then workers are paid too little. Additionally the government links about a third of its expenditures, including Social Security payments, to the CPI, If the CPI overstates inflation, then government outlays rise more rapidly than justified whereas if the CPI understates inflation, then outlays do not rise enough to offset the true inflation rate.