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0:04
[Music]
0:21
Caterpillar, Inc. fared well during the 2007-2009 recession due to the worldwide demand for construction and mining equipment. But by 2013, growth in developing countries slowed and the demand for Caterpillar's equipment declined. The company announced in 2010 it would lay off 260 workers from its South Milwaukee plant. At the time of the layoffs, the U.S. unemployment rate was 7 percent, well above the normal level of about 5.5 percent.
0:55
Some economic advisers and economists did not expect the economy to reach a normal level again until 2018. At the beginning of 2016, Caterpillar announced layoffs in the US and China. The company says because of continued low demand for mining products, it will place about 120 employees in both office and production positions at the East Peoria campus on indefinite layoff. The actions, including five plant closings, will result in a net reduction of about 670 jobs.
1:33
In this chapter we will begin a deeper look into the economy, what we measure and why it is measured, and where those data can be found. We will also explore methods of analysis to filter through the information in a way that reveals facts and meaning most useful to framing our responses to economic conditions.
2:01
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2:07
Each month the U.S. Bureau of the Census conducts the Current Population Survey to collect data needed to compute the monthly unemployment rate. The Department of Labor's Bureau of Labor Statistics, the BLS, uses these data to calculate the unemployment rate. People are considered employed if they worked during the week before the survey or if they were temporarily away from their jobs. People are considered unemployed if they did not work in the previous week but were available
2:41
for work and had actively looked for work during the previous four weeks. The labor force is the sum of employed and unemployed workers in the economy. The unemployment rate is the percentage of the labor force that is unemployed. Discouraged workers are people who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them. The labor force participation rate is the percentage of the working-age population in
3:14
the labor force. The employment-population ratio measures the percentage of the working age population that is employed.
3:25
In economics, a discouraged worker is a person of legal employment age who is not actively seeking employment or who does not find employment after long-term unemployment. This is usually because an individual has given up looking or has had no success in finding a job, hence the term "discouraged".
3:50
Taken for its fundamental definition, the Unemployment rate is simply the number of unemployed people in the economy, divided by the size of the labor force. A definitive code for this is U-3 as these data are collected by the Bureau of Labor Statistics, the BLS. Closely related to the unemployment rate, is the labor force participation rate. It is the size of the labor force divided by the working-age population in the labor force.
4:20
This begins the process of expressing not the unemployment rate, but instead the Employment Rate. This is further filtered into the Employment-Population Ratio, which is the percentage of the working-age population that is employed. On this screen we can see how this restates the 7.3% Unemployment Rate seen earlier, into the Employment-Population Ratio of 58.6%. These reports give substantially different assessments of the economy, but both accurately report the data as analyzed.
4:57
The unemployment rate is not a perfect measure of the current state of joblessness. During a recession, an increase in the number of discouraged workers occurs, but these workers are not counted as unemployed. The BLS counts people as employed if they hold part-time jobs even if they lost a full time job and would prefer to hold a full-time job again. This gives rise to the term under-employed because people often accept part-time jobs paying lower rates just to make financial ends-meet.
5:33
There are other problems that cause the measured unemployment rate to misstate the extent of joblessness. The survey that is used to measure the unemployment rate does not verify the responses of people included in the survey. A person might claim to be actively looking for a job to remain eligible for government programs. Other people might be employed but engaged in underground or illegal activities.
6:03
The labor force participation rate determines the amount of labor that will be available to the economy from a given population. U-6 data indicate total number of unemployed people, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force. The higher the labor force participation rate, the more labor will be available and the higher
6:38
a country's level of GDP. The labor force participation rate of adult men has declined gradually since 1948, but the labor force participation rate of adult women has increased sharply. The overall labor force participation rate rose from 59% in 1948 to 64% in 2012.
7:03
Rates of unemployment are discussed and debated, generally focusing attention on the idea and belief that people should be able to work and better themselves through their efforts. The Normative discussion generally concludes that a dropping employment rate for men is a bad signal because opportunities in the economy are decreased. You can consider for yourself if it is truly a bad thing when we look at changes in demographics
7:31
placing more men and women in college longer resulting in higher total attainment of a college level education, and the increase of early retirement based on the enhanced capabilities of those professionals. Also consider people who have paid into Social Security insurance coverage through their working life and when needed are able to take advantage of disability insurance coverage for unexpected personal disabilities.
8:00
Once, those opportunities were not available to the working person, but today they open a door of opportunity to avoid having to work with a performance hampering disability. Labor Force Participation may be decreasing, but the causes are not always a bad thing. Sometimes it is useful to make the Normative analysis, even for an economist. Different groups in the population can have very different unemployment rates.
8:29
For example, in August 2013, Asians had a lower unemployment rate, and African Americans had a higher unemployment rate, than the overall rate. When all groups were considered together, college graduates held a substantially lower unemployment rate than did high school graduates, and even lower than high school dropouts. Not shown on this graph is the difference in earnings between these three groups.
8:57
In the modern U.S. economy, the typical unemployed person stays unemployed for a relatively brief period of time, although that time lengthens significantly during a recession. In mid-2013, the average period of unemployment was 36 weeks. By May, 2016, the Duration of Unemployment had dropped to about 27 weeks. Prior to the Recession in 2001, the period of unemployment generally lasted for 10 to 20 weeks, averaging around 15.
9:35
The employment-to-population ratio is a macroeconomic statistic that takes the ratio of the total working age of the labor force currently employed to the total working age population of a region, municipality or country. Although a rate below 59% was witnessed until about 1975, its peak in 2000 to almost 65% benefited workers and the US economy, and led to disgruntled perceptions about the current rate below 60%.
10:08
The BLS uses the establishment survey, sometimes called the payroll survey, to measure total employment in the economy. This monthly survey samples about 300,000 business establishments to provide information on the total number of persons who are employed and on a company payroll. Despite some drawbacks, the establishment survey has the advantage of being determined by actual payrolls. In recent years, some economists have come to rely more on establishment survey data
10:42
than on household survey data in analyzing current labor market conditions. Personally, this is one of my go-to data sets when I assess the current rate of employment in a state, region, the country, or in other countries.
11:00
To avoid long waits in supplying data, such as the employment data from the establishment survey, to policymakers and the general public, government agencies typically issue preliminary statistics they revise as additional information becomes available. For example, the BLS initially reported that employment declined by 159,000 jobs during September 2008. After additional data became available, the BLS revised its estimate to show that employment had declined by 459,000 jobs during the month.
11:36
We need to take these surveys at face value. On one hand they give rapid data where we can recognize changes from one period to the next. Ask the question: are jobs being added, or cut? Which groups are most affected by these changes? Updates are made as a normal sequence of events, and this is alright. I would rather have an early estimate that is close, rather than wait months to get a specific number. If these data are super-important to your business needs, then consider generating them
12:11
for yourself!
12:15
The U.S. economy creates and destroys millions of jobs every year. The creation and destruction of jobs results from changes in consumer tastes, technological progress, and the successes and failures of entrepreneurs in responding to the opportunities and challenges of shifting consumer tastes and technological change. When the BLS announces each month the increases or decreases in the number of people employed and unemployed, these are net figures.
12:50
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12:55
Unemployment analysis in the United States focuses on the causes and measures of U.S. unemployment and strategies for reducing it. Job creation and unemployment are affected by factors such as economic conditions, global competition, education, automation, and demographics. These factors can affect the number of workers, the duration of unemployment, and wage levels. Employment expanded consistently during the 1990s, but has been inconsistent since due to recessions in 2001 and 2007 to 09.
13:35
By some measures, the number of persons employed regained its 2007 pre-crisis peak only in 2014, but the labor force participation rate remained below its 2007 level. Unemployment generally falls during periods of economic prosperity and rises during recessions, creating significant pressure on public finances as tax revenues fall and social safety net costs increase.
14:05
For many people, being unemployed is what it is - being without a job. But as we investigate causes for unemployment we can see some factors that come about because of business cycles, some because of changes in technology and some because we as employees did not maintain our level of proficiency in the use of technologies needed for to maintain our position in the industry we selected. You will see in this class how I have structured specific sections to prevent Structural Unemployment
14:39
for you as you enter the workforce. Keep your attention on these types of unemployment. We will talk about them more.
14:48
Most workers spend time engaging in a job search, and most firms spend time searching for people to fill job openings. Frictional unemployment is short-term unemployment that arises from the process of matching workers with jobs. There will always be some workers who are frictionally unemployed because they are between jobs and in the process of searching for a new one. Some unemployment is due to seasonal factors, such as weather or fluctuations in demand during different times of the year.
15:26
Seasonal unemployment refers to unemployment due to factors such as weather, variations in tourism, and other calendar-related events. Not all of these are negative factors. Consider the ski instructor who needs snow on the mountain to get back to work, or the salmon fishing guide in need of some good rains to pull the fish upstream.
15:51
Structural unemployment is unemployment that arises from a persistent mismatch between the skills or attributes of workers and the requirements of jobs. This type of unemployment can last for longer periods than frictional unemployment because workers need time to learn new skills. We see this consideration come to the fore in economies where new technologies are evolving at a rapid rate and are adopted by businesses positioning themselves to take advantage.
16:23
Workers need to match the rate of technological change to maintain their value. You came to this class to learn of Macroeconomics, and in the process I assign you a term report and presentation where you are required to use a word processor and presentation software. What does this have to do with economics, you might ask? This has a lot to do with expectations as Structural Unemployment puts you in position
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of graduating college with the wealth of opportunities while using FREE software applied to real life scenario. If you do not enter the workforce with these skills, proven with experiences learned in college, you will not make that entry into the position you desire. It may start as Frictional Unemployment as you seek that job, but under it may reside Structural Unemployment issues because of your preparation for the technologically advanced workplace.
17:20
Bill Gates at the Microsoft Corporation made a solid business decision to provide free MS Office and Operating System software to college students and professors, because they know that if you graduate college knowing how to use these software, employers will purchase them in the workplace. But, if you complete your degree without a firm knowledge of how to use the software, when it was provided free of charge, then employers will view this as evidence that
17:49
you are not on the cutting edge of technology, even when it was given to you at no cost. This is where the Macroeconomics Term Report comes into play. Use MS Office software with Style Sheets to create the Cover Page, Title Page, Table of Contents, List of Figures, Acronyms Used, References, and Literature Cited. All of these features are displayed on the Tech Tools for Student Success with videos to show you how to use them.
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I put you through these tasks in this class because I care about your success as I have structured events in this class to prevent Structural Unemployment on the day you graduate. I have it set up for your involvement, now it is up to you to make it happen.
18:35
When the economy moves into recession, many firms find their sales falling and cut back on production. As production falls, firms lay off workers. Cyclical unemployment is unemployment caused by a business cycle recession. The USA and most global economies experienced the Great Recession in 2007-09, and as you have seen in these class videos, we are currently in a continuation of the contraction cycle to put the economy into what may be called the Greater Recession.
19:10
This continues to put pressure on the job market, working against your efforts to find gainful employment. The natural rate of unemployment is the normal rate of unemployment, consisting of frictional unemployment plus structural unemployment. The natural rate of unemployment is also called the full-employment rate of unemployment. Full employment, in macroeconomics, is the level of employment where there is no cyclical or deficient-demand unemployment.
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It is defined by the majority of mainstream economists as being an acceptable level of unemployment somewhere around 5%. The discrepancy from 0% unemployment arises due to non-cyclical types of unemployment, such as frictional unemployment, there will always be people who have quit or have lost a seasonal job and are in the process of getting a new one, and structural unemployment, the mismatch between worker skills and job requirements.
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Unemployment around 5% is seen as necessary to control inflation in capitalist economies, to keep inflation from accelerating, that is, from rising from year to year. This view is based on a theory centering on the concept of Non-Accelerating Inflation Rate of Unemployment, or NAIRU; in the current era, the majority of mainstream economists mean NAIRU when speaking of "full" employment. The NAIRU has also been described by Milton Friedman, among others, as the "natural" rate of unemployment.
20:42
Having many names, it has also been called the structural unemployment rate. Currently, it is around 5% when measured using the techniques currently employed by Federal Agencies in our economy.
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Bank of America Corp has been reported to be cutting jobs at its investment banking and capital markets operations. According to Business Insider, the bank might already be cutting down on jobs in Asia, Europe and the US. In a March 2016 update by Bloomberg, the bank has fired at least 15 employees from its investment banking division in Asia. The layoffs include 12 directors and three managing directors. Moreover, Bank of America let go of several employees holding junior positions.
21:31
It is important to note that investment banks around the globe are making changes to the way they operate in attempts to cut down on expenses and overall costs. Market turmoil amid uncertainty around oil and commodity prices and fears of slowing emerging economies have led to slowdown in trading and deal making. Majority of the banks have been cutting down on jobs and exiting low return businesses that are prone to threats from slowing economies.
22:01
These moves allow management to divert focus on business opportunities that hold better prospects. Bank of America is joining firms across Wall Street in paring back staff amid Q1 2016, for investment banking and trading revenues. Bank of America is responding to Cyclical contraction events, placing laid off employees into the cyclically unemployed category.
22:29
You saw this figure in the Chapter 19 video, as another representation of the rate of unemployment in the USA. You can see now how unemployment rates come with several caveats about what is being reported and what it means. I am fairly certain you have not seen this depiction of unemployment in our economy, at over 23%. Specifically, I call it the Currently Not Employed rate, based on the trend of employment since the conclusion of the Great Depression in 1939.
23:01
I made this analysis using data available through the FRED portal. Using the Number of Employed People I created a trend-line in Excel from initiation of the data through February 2001. I used this breaking point to recognize a point of change in the US economy where full recovery has not yet been achieved. The actual number of employed people after the 2001 recession did not reacquire the level of employment projected by the historic trend.
23:31
The rate of job growth increased after 2002, but not to the expected levels. The Great Recession 2007-2009 dropped employment levels even more and still, as of 2016, the rate of new job growth has not been achieved to the levels expected, resulting in the 43.6 million job deficit in May 2016. I challenge you to experiment with these data, and make your own projection of our current employment position using these techniques.
24:08
[Music] of this discussion Milton you made quite a specific statement you said that we have only two choices we can either restrain the economy and get inflation down and tolerate more important unemployment temporarily or we can try to stimulate the economy enemy and get both more inflation and more unemployment now Walter I know there are many occasions at least on which you disagree with Milton I guess this may be
24:38
one of them you would say I gather and I don't want to put words into your mouth that no we can't stimulate the economy and thereby reduce unemployment without down the road getting both more inflation and more unemployment goodness now that is a question of fact reasonably this kind of disagreement between you two and there are many others of this sort should be amenable to resolution by observation and testing and something that scientists would call
25:07
proof is it or isn't it if it is how come you're so disagree well yeah let's try to let's try to disentangle that I think in pure clarity as a matter of fact we can show that in the recovery from the deepest recession since the Great Depression namely the 73 to April 75 recession we had stimulus from tax cuts and from relatively easy money and so forth that translated not into higher prices but into higher production and more jobs and so forth the record of the
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past of the three years from April 75 to April 78 pretty well shows that the inflation rate stayed pretty steady the rate of employment rose dramatically and so on then there's the next question and this goes more to the heart of what Milton was saying a while ago what about the use of restrictive monetary and fiscal policy to try to squeeze inflation out of the economy now there we've had but you're going to stop before you get to that because let's
26:14
keep the discussion under them because your chart you are saying well I'm going to take the first effect of the policy and not look at later of things there is no quarrel a dispute between knowingly or between those who analyze things different ways but the initial effects of a more expensive policy will be felt an output not in inflation the problem is of what you are now greeted with is the hangover from precisely those expensive policies we argument the scientific proposition that underlies
26:45
the view I said is that there is a difference in the time lag between the difference in the time which it takes for expansive monetary or fiscal policy to affect output and the time which it takes to affect inflation within the history of the United States and if countries like the United States it has taken something like six to nine months from a more expansionary policy in 1975 it was even less than that it's taken between six and nine months on the
27:18
average before a more expansionary policy affects output it increases incomes and the begin with that certainly does take the form of more out there and more employment but that's a first effect we have to carry it all the way through and at the same time it sets in motion forces which later will come out in inflation so that the evidence from history for the United States and countries like that is that it takes another 18 months before it comes out of
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inflation so if we take those 3 years the inflation actually came down during the first year and a half of the expansion but it came down as a result of what had happened two years earlier with very monetary restraints that had produced the severe recession had a carryover and they enabled you for an interim period of a year-and-a-half to have both increasing employment and reduced inflation but then beginning in the fall of 76 December 76 you started
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to get the delayed effects there were more explanatory policies now again if we turn to the other side which you were going to abusing restraint policy you will agree that you also have those different effects
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[Music]
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Governments can reduce the level of frictional unemployment with policies that speed up the process of matching unemployed workers with unfilled jobs. Governments can help reduce structural unemployment with policies that aid worker retraining. Some government policies, can add to the level of frictional and structural unemployment. In the United States and most industrial countries, the unemployed are eligible for unemployment insurance payments.
29:03
The unemployed spend more time searching for jobs because they receive these payments. Unemployment insurance helps the unemployed maintain at least a reduced income amount and some of their spending, which lessens the personal hardship of being unemployed. In the United States, many unemployed workers are typically eligible to receive unemployment insurance payments equal to about half of their previous wage for six months, although this period is often extended by congress during recessions.
29:37
In many other countries workers are eligible to receive unemployment payments for a year or more, and payments may equal 80% of their previous wage. In 1938 the federal government enacted the minimum age law, if the minimum wage is set above the market wage the quantity supplied of labor will be greater than the quantity of labor demanded. As a result, the unemployment rate will be higher than it would have been without the minimum wage.
30:07
Labor unions are organizations of workers that bargain with employers for higher wages and better working conditions for their members. In unionized industries, the wage is usually above what otherwise would be the market wage, but most economists believe that this does not result in an increase in the overall unemployment rate because only about 9% of workers outside the government sector are unionized.
30:38
An efficiency wage is an above-market wage that a firm pays to increase workers' productivity. Efficiency wages are another reason economies experience some unemployment even when cyclical unemployment is low. Consider the Efficiency Wage as I have, from the standpoint of an employer in the Natural Resources Consulting business. While operating my own businesses I have assembled some fantastic people capable of doing meaningful work; efficiently and with purpose.
31:10
I sought people who understand Mission Intent: that is, doing what is intended from design to implementation. Efficiency Wages were paid, not to incentivize performance, but instead to recognize and reward professionalism while at work. For these people in my employ, I have paid Efficiency Wages, that is, a wage above the market for each position. I did not want to encourage employees to perform at standards, I wanted people who would overachieve
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in the delivery of services, make good decisions, and not spend company time looking for a different job paying slightly more money. It also enabled me to expect them to each give the extra effort when needed for the good of the company. Sometimes it was seen with the employee accepting deployment to a remote site to execute a task, and not worrying about one extra day for the project that tapped into a weekend. They stayed to get the job done right, and complete it.
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For my business, it meant extra travel was avoided and that saved money, for the employee it increased their sense of accomplishment and take home pay. All of this resulted in clients who acknowledged the strength of my team who were on the spot to answer client's questions and even demonstrate some technologies to their staff who wanted to catch up with our team members.
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[Music]
32:42
The price level is a measure of the average prices of goods and services in the economy. The inflation rate is the percentage of increases in the price level from one year to the next. The GDP deflator is the broadest measure of the price level, but to know the impact of inflation on the typical household, the deflator can be misleading. Changes in the consumer price index come closest to measuring changes in the cost of living as experienced by the typical household.
33:15
The CPI is the most watched Bureau of Labor Statistics dataset as it explains much of the cost of living for the average consumer. I also include discussion of the Producer Price Index, the PPI, because it explains much of the same types of information for the average business. For me and much of the business world, the PPI is the continuously updated Business Inflation Rate indicator. It is a double-edged dagger showing the monthly changes in costs to production, while also
33:49
showing monthly changes in prices a business will see in the marketplace for goods and services sold.
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To obtain prices of a representative group of goods and services for the CPI, the BLS surveys 30,000 households on their spending habits. The survey is used to construct a market basket of 211 types of goods and services used by the typical urban family of four. The consumer price index measures the average change over time in the prices a typical urban family of four pays for the goods and services they purchase.
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One year is chosen as the base year, and the value of the CPI is set equal to 100 for that year. In any other year the CPI equals the ratio of the dollar amount necessary to buy the market basket in that year divided by the dollar amount necessary to buy the market basket in the base year, multiplied by 100. The CPI is sometimes called the cost-of-living index.
35:02
We can look at these examples of a simplified basket of goods in 1999, 2014 and 2015. Recognize the BLS considers the quantity of each good purchased, and the price paid each year. See how holding quantity and goods constant through time, gives a representation of the changes in prices paid by consumers. Using the math shown here, you can measure how prices have changed from one year to the next. The base year quantity is held constant, making a bit of a bias in the data collection process.
35:41
Eye exams, pizzas, and books are a good selection of products, but think about 1999 and the availability of personal communication devices at that time. Personally, in the early 1990s I used a repeater-based two-way radio and a bag-phone for emergency purposes. I knew where all the payphones were located so I could call when needed. While working overseas at a remote logging camp, I used a satellite phone that looked
36:11
like a laptop computer aimed at a satellite to make phone calls around the world. Were these in the BLS Market Basket of Goods in 1999? Probably not, so the current quantity and price of the typical personal communication device today, a Smart Phone, is not yet in their Market Basket of Goods: making a "new product bias". Maybe it is time for the BLS to play some catch-up? Another challenge of the Market Basket of Goods is the ease of consumers to switch from
36:44
one product to a substitute because of price changes: substitution bias. When the price of beef goes up, the people demand more chicken if that price stays constant. If the price of chicken goes up, then the demand for fish goes up. The basket of Goods gives good indication of price changes, but it is not a perfect measure of the cost of living.
37:11
Despite its shortcomings, the CPI is the most reliable non-biased source of consumer price reporting in the country. Because of this, unions have anchored to the CPI in negotiations with companies to link wage increases to the annual changes in the CPI. "If the cost of living increases 3%, then we want our employees to get paid 3% more, just to keep up with the cost of living." It sounds attractive on the face of it, but think about contractions in the economy when a recession hits.
37:47
Should wage negotiations include a reduction in employee salaries when the CPI goes down? On the other side of it, many professional employees increase their capabilities through time and justify an increase greater than the CPI rate of increase. Negotiating increases equal to the CPI may slow the natural rate of wage increases.
38:13
The CPI is the most widely used measure of consumer inflation. It is important that the CPI be as accurate as possible, but there are four biases that cause the CPI to misstate the true inflation rate: substitution bias, increase in quality bias, new product bias, and outlet bias. I spoke about most of these, but the outlet bias needs a mention because the BLS does not include big outlet stores, like Costco.
38:47
For decades, analysts have known that consumers can benefit when new stores and delivery channels offer lower prices. Examples of these "new outlets" have included chain store supermarkets, supercenters, "big box" discounters, warehouse clubs, and the internet. Non-traditional shopping formats have captured significant share from "traditional grocery" expenditures. Two categories of alternative retail outlets called "high-spend" outlets, which are low
39:21
price, one-stop shopping destinations, including supercenters like Wal-Mart and Kmart, warehouse clubs like Sam's Club, and Costco, and mass merchants like Wal-Mart Super Centers and Target as the primary outlets for these "high-spend" expenditures. These outlets are not considered by the BLS when calculating the CPI each month. For me personally, these account for about 90% of my household's spending habits for food and non-durable goods. But for the LBS, they do not enter the picture at all.
40:00
In addition to the GDP deflator and the CPI, the government also computes the producer Price Index, PPI, which is an average of the prices received by producers of goods and services at all stages of the production process. Changes in the PPI can give an early warning of future movements in the CPI. As I have said before, this is an index I watch weekly for business activities. It tells about what businesses experience for operating costs and revenue patterns.
40:34
It creates the business rate of inflation with much more meaning than the CPI does for my business operations.
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[Music]
40:49
Price indexes give us a way of adjusting for the effects of inflation so that we can compare dollar values from different years. Economic variables that are calculated in current-year prices are referred to as nominal variables. To correct for the effects of inflation, we can multiply a nominal variable by the fraction of the CPI price index, with current date CPI value in the numerator, and past CPI in the denominator to obtain a Real value: that is, one that is stated in current terms.
41:23
In this case, put the $25,000 per year income in 1987 on par with the $52,640 per year salary today - with inflation factored out. We would call the $25,000 a year salary the NOMINAL wage because that was what was paid on the date of transaction. When inflation is factored out and it becomes $52,640, it is called a REAL wage amount and referenced for what the REAL date is: in this case April 2016. The effects of freezing wages can have consequences for employees and the company.
42:01
In this case, Caterpillar and employees agreed to freeze wages in 2013 for 5 years. If the CPI increases to 260 in 2018, then employee wages will decrease in purchasing power by over 10%.
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[Music]
42:26
The difference between nominal and real values is important when money is being borrowed and lent. Because it is corrected for the effects of inflation, real interest rate provides a better measure of the true cost of borrowing and the true return to lending than does the nominal interest rate. The nominal interest rate is the stated interest rate on a loan. The real interest rate is the nominal interest rate minus the inflation rate.
42:54
For the economy as a whole, we can measure the nominal interest rate as the interest rate on three-month U.S. Treasury bills, or even as the CPI rate of change through time. This is a super simple conversion for you to be able to make. Start with the annual interest rate you agreed to pay on your student loans, then subtract the rate of inflation from it, you are left with your REAL interest rate. If you currently pay 5% annual nominal interest rate, and the current 3-month treasury bills
43:25
are 0.33%, your REAL interest rate is 4.67%. Consider a student loan in 1980 at 9.75%. The 3-Month treasury Bills were 14.31%, making a Real Interest rate 4.56%. After 35 years, the Real Interest Rate on a student loan looks about the same, in Real Terms!
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[Music]
43:58
Although inflation does not reduce the affordability of goods and services to the average consumer, it still imposes costs on the economy. Inflation affects the distribution of income. Some people will find their incomes rising faster than the rate of inflation, and so their purchasing power will rise. Other people will find their incomes rising slower than the rate of inflation, and so their purchasing power will fall.
44:25
The extent to which inflation redistributes income depends, in part, on whether the inflation is anticipated, and reactions are suitably made.
44:36
When inflation is anticipated, its main costs are that paper money loses value. Anyone holding paper money will find its purchasing power decreasing each year by the rate of inflation. To avoid this cost, workers and firms try to hold as little money as possible. Firms that print catalogs listing prices of products will have to reprint them more frequently. Stores will devote more time and labor to changing prices. Menu costs are the costs to firms of changing prices.
45:10
It causes prices to become sticky, in that once reduced to print in a catalog and stated as applied to a date range, consumers will be able to purchase at the fixed cost until a new catalog is made. Broad adoption of Internet sales has changed this aspect of business for many industries. Today, unlike 30 years ago, prices can be changed overnight, at little cost to the selling business.
45:38
Inflation rates are double-tough to accurately estimate. During the 1980s the rate of inflation climbed to 18%, and home buyers agreed to pay as much as 20% Nominal on a home loan, because the Real Rate was only 2%. When inflation subsided to 5% in 1986, those home buyers were saddled with a 30 year mortgage at 15% Real interest rate on their new home. Folks scrambled to refinance their houses to get back on top of the fixed rate mortgage they agreed to take.
46:15
In the real estate market of 2016, qualified borrowers can take fixed rate home loans for as low as 3.90% Nominal. The Real interest rate may be only 3.67%, and if inflation climbs again to 4%, the borrower will be up on their loan position, as the 4% inflation rate for the 3.90% Nominal borrower, will become positive 0.10% Real Interest Rate. The borrower is making money by locking in the fixed rate while inflation was low.
46:51
Some people think falling prices are a welcoming event! The reality of prolonged and systemic dropping prices is known as Deflation. When it happens across the economy, people will stop making durable good purchases because "it will be cheaper next month". Businesses close, people lose their jobs, and the economy screeches to a stop. This happened in the USA Great Depression of the 1930s, and more recently in Japan in the 1990s.
47:22
In the USA we are still recovering from the 2007-09 Great Recession, and I am watching the dropping PPI rates along with many of my Economist Colleagues to see when full recovery will be seen.
47:40
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