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Part 2
114 The Macroeconomy: Aggregate Supply and Demand



The Employed The first category is the simplest to define. It includes everyone cur-
rently at work, including part-time workers. Although some part-timers work less than a
full week by choice, others do so only because they cannot find suitable full-time jobs.
Nevertheless, these workers are counted as employed, even though many would consider
them “underemployed.”

The Unemployed The second category is a bit trickier. For persons not currently
working, the survey first determines whether they are temporarily laid off from a job to
which they expect to return. If so, they are counted as unemployed. The remaining work-
ers are asked whether they actively sought work during the previous four weeks. If they
did, they are also counted as unemployed.

Out of the Labor Force But if they failed to look for a job, they are classified
as out of the labor force rather than unemployed. This seems a reasonable way to draw
the distinction”after all, not everyone wants to work. Yet there is a problem:
Research shows that many unemployed workers give up looking for jobs after a while.
These so-called discouraged workers are victims of poor job prospects, just like the
A discouraged worker is
an unemployed person who officially unemployed. But when they give up hope, the measured unemployment
gives up looking for work rate”which is the ratio of the number of unemployed people to the total labor force”
and is therefore no longer
actually declines.
counted as part of the labor
Involuntary part-time work, loss of overtime or shortened work hours, and discouraged
force.
workers are all examples of “hidden” or “disguised” unemployment. People concerned
about such phenomena argue that we should include them in the official unemployment
rate because, if we do not, the magnitude of the problem will be underestimated. Others,
however, argue that measured unemployment overestimates the problem because, to
count as unemployed, potential workers need only claim to be looking for jobs, even if they
are not really interested in finding them.



TYPES OF UNEMPLOYMENT
Frictional unemploy- Providing jobs for those willing to work is one principal goal of macroeconomic policy.
ment is unemployment How are we to define this goal?
that is due to normal
We have already noted that a zero measured unemployment rate would clearly be an in-
turnover in the labor
correct answer. Ours is a dynamic, highly mobile economy. Households move from one state
market. It includes people
to another. Individuals quit jobs to seek better positions or retool for more attractive occupa-
who are temporarily be-
tions. These and other decisions produce some minimal amount of unemployment”people
tween jobs because they
are moving or changing who are literally between jobs. Economists call this frictional unemployment, and it is un-
occupations, or are unem- avoidable in our market economy. The critical distinguishing feature of frictional unemploy-
ployed for similar reasons. ment is that it is short-lived. A frictionally unemployed person has every reason to expect to
find a new job soon.
Structural unemploy-
A second type of unemployment can be difficult to distinguish from frictional unemploy-
ment refers to workers
ment but has very different implications. Structural unemployment arises when jobs are
who have lost their jobs
because they have been eliminated by changes in the economy, such as automation or permanent changes in de-
displaced by automation, mand. The crucial difference between frictional and structural unemployment is that, unlike
because their skills are no
frictionally unemployed workers, structurally unemployed workers cannot realistically be
longer in demand, or be-
considered “between jobs.” Instead, their skills and experience may be unmarketable in the
cause of similar reasons.
changing economy in which they live. They are thus faced with either prolonged periods of
Cyclical unemployment unemployment or the necessity of making major changes in their skills or occupations.
is the portion of unemploy- The remaining type of unemployment, cyclical unemployment, will occupy most of
ment that is attributable to
our attention. Cyclical unemployment rises when the level of economic activity declines,
a decline in the economy™s
as it does in a recession. Thus, when macroeconomists speak of maintaining “full employ-
total production. Cyclical
ment,” they mean limiting unemployment to its frictional and structural components”
unemployment rises during
which means, roughly, producing at potential GDP. A key question, therefore, is: How
recessions and falls as
much measured unemployment constitutes full employment?
prosperity is restored.




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Chapter 6 115
The Goals of Macroeconomic Policy




P O L I C Y D E B AT E
Does the Minimum Wage Cause Unemployment?
Elementary economic reasoning” in 1991, and in California after the
summarized in the simple supply-de- statewide minimum wage was in-
mand diagram to the right”suggests creased in 1988. In none of these
S
that setting a minimum wage (W in cases did a higher minimum wage
D
the graph) above the free-market seem to reduce employment”
wage (w in the graph) must cause in contrast to the implications of
A B
unemployment. In the graph, unem- simple economic theory.
W
Hourly Wage
ployment is the horizontal gap be- The research of Card and Krueger,
tween the quantity of labor supplied and of others who reached similar
w
(point B) and the quantity demanded conclusions, was controversial from
(point A) at the minimum wage. the start, and remains so. Thus, a
Indeed, the conclusion seems so policy question that had been
elementary that generations of deemed closed now seems to be
economists took it for granted. The open: Does the minimum wage re-
S D
argument seems compelling. Indeed, ally cause unemployment?
earlier editions of this book, for exam- Resolution of this debate is of
ple, confidently told students that a more than academic interest. In
higher minimum wage must lead to 1996, President Clinton recom-
higher unemployment. mended and Congress passed an in-
Number of Workers
But some surprising economic re- crease in the federal minimum
search published in the 1990s cast wage”justifying its action, in part,
serious doubt on this conventional wisdom.* For example, econo- by the new research suggesting that unemployment would not rise
mists David Card and Alan Krueger compared employment changes as a result. The same research was cited in 2007, when Congress
at fast-food restaurants in New Jersey and nearby Pennsylvania after debated and then enacted a three-stage increase in the minimum
New Jersey, but not Pennsylvania, raised its minimum wage in wage that will bring it up to $7.25 by the summer of 2009. Eco-
1992. To their surprise, the New Jersey stores did more net hiring nomic research can have consequences.
than their Pennsylvania counterparts. Similar results were found for
*See David Card and Alan Krueger, Myth and Measurement: The New Economics of the Mini-
fast-food stores in Texas after the federal minimum wage was raised mum Wage (Princeton, N.J.: Princeton University Press; 1995).




HOW MUCH EMPLOYMENT IS “FULL EMPLOYMENT”?
John F. Kennedy was the first president to commit the federal government to a specific nu-
merical goal for unemployment. He picked a 4 percent target, which was rejected as being
unrealistically ambitious in the 1970s. But when the government abandoned the 4 percent
unemployment target, no new number was put in its place. Instead, we have experienced
a long-running national debate over exactly how much measured unemployment corre-
sponds to full employment”a debate that continues to this day. Full employment is a
situation in which everyone
In the early 1990s, many economists believed that full employment came at a measured
who is willing and able to
unemployment rate as high as 6 percent. Others disputed that estimate as unduly pes-
work can find a job. At full
simistic. Then real-world events decisively rejected the 6 percent estimate. The boom of
employment, the measured
the late 1990s pushed the unemployment rate below 5 percent by the summer of 1997, unemployment rate is still
and it remained there every month until September 2001”even falling as low as 3.9 per- positive.
cent in 2000. All this left economists guessing where full employment might be. Official
government reports issued in early 2008 estimated the full-employment unemployment
rate to be around 5 percent. But no one was totally confident in such estimates.


UNEMPLOYMENT INSURANCE: THE INVALUABLE CUSHION
One major reason why America™s unemployed workers no longer experience the
complete loss of income that devastated so many during the 1930s is our system of



Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 2
116 The Macroeconomy: Aggregate Supply and Demand



unemployment insurance”one of the most valuable institutional innovations to
Unemployment
insurance is a government emerge from the trauma of the Great Depression.
program that replaces some Each of the 50 states administers an unemployment insurance program under federal
of the wages lost by eligible
guidelines. Although the precise amounts vary, the average weekly benefit check
workers who lose their jobs.
in 2007 was $288, which amounted to just under half of average weekly earnings. While
a 50 percent drop in earnings poses very serious problems, the importance of this
50 percent income cushion can scarcely be exaggerated, especially because it may be
supplemented by funds from other welfare programs. Families that are covered by un-
employment insurance rarely go hungry or are dispossessed from their homes when
they lose their jobs.
Eligibility for benefits varies by state, but some criteria apply quite generally. Only
experienced workers qualify, so persons just joining the labor force (such as recent col-
lege graduates) or reentering after prolonged absences (such as women returning to the
job market after years of child rearing) cannot collect benefits. Neither can those who
quit their jobs, except under unusual circumstances. Also, benefits end after a stipu-
lated period of time, normally six months. For all of these reasons, only 37 percent of
the 7.1 million people who were unemployed in an average week in 2007 actually
received benefits.
The importance of unemployment insurance to the unemployed is obvious. But signifi-
cant benefits also accrue to citizens who never become unemployed. During recessions,
billions of dollars are paid out in unemployment benefits. And because recipients proba-
bly spend most of their benefits, unemployment insurance limits the severity of recessions
by providing additional purchasing power when and where it is most needed.
The unemployment insurance system is one of several cushions built into our economy
since 1933 to prevent another Great Depression. By giving money to those who become
unemployed, the system helps prop up aggregate demand during recessions.
Although the U.S. economy is now probably “depression-proof,” this should not be a
cause for too much rejoicing, for the many recessions we have had since the 1950s”most
recently in 2001 (plus concern about another in 2008)”amply demonstrate that we are far
from “recession-proof.”
The fact that unemployment insurance and other social welfare programs replace a sig-
nificant fraction of lost income has led some skeptics to claim that unemployment is no
longer a serious problem. But the fact is that unemployment insurance is just what the
name says”an insurance program. And insurance can never prevent a catastrophe from
occurring; it simply spreads the costs among many people instead of letting all of the costs
fall on the shoulders of a few unfortunate souls. As we noted earlier, unemployment robs
the economy of output it could have produced, and no insurance policy can insure society
against such losses.
Our system of payroll taxes and unemployment benefits spreads the costs of unemploy-
ment over the entire population. But it does not eliminate the basic economic cost.
In that case, you might ask, why not cushion the blow even more by making unem-
ployment insurance much more generous, as many European countries have done? The
answer is that there is also a downside to unemployment insurance. When unemploy-
ment benefits are very generous, people who lose their jobs may be less than eager to look
for new jobs. The right level of unemployment insurance strikes an appropriate balance
between the benefits of supporting the incomes of unemployed people and the costs of
raising the unemployment rate a bit.


PART 3: THE GOAL OF LOW INFLATION
Both the human and economic costs of inflation are less obvious than the costs of unem-
ployment. But this does not make them any less real, for if one thing is crystal clear about
inflation, it is that people do not like it.



Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 6 117
The Goals of Macroeconomic Policy



When inflation is low, it barely registers as a problem in national public opinion polls.
But when inflation is high, it often heads the list”generally even ahead of unemploy-
ment. Surveys also show that inflation, like unemployment, makes people unhappy. The purchasing power
Finally, studies of elections suggest that voters penalize the party that occupies the White of a given sum of money
House when inflation is high. The fact is beyond dispute: People dislike inflation. The is the volume of goods and
question is, why? services that it will buy.



INFLATION: THE MYTH AND THE REALITY
At first, the question may seem ridiculous. During inflationary times, people pay




SOURCE: The Wall Street Journal”Permission,
higher prices for the same quantities of goods and services they had before. So more
and more income is needed just to maintain the same standard of living. Is it not ob-
vious that this erosion of purchasing power”that is, the decline in what money will




Cartoon Features Syndicate.
buy”makes everyone worse off?


Inflation and Real Wages
This would indeed be the case were it not for one very significant fact. The wages
that people earn are also prices”prices for labor services. During a period of infla-

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