CFA Level 1 (2009) - 2

Study Session 5

Cross-Reference to CFA Institute Assigned Reading #22 - Monitoring Jobs and the Price Level

seeking workers. Unemployment resulting from this job search activity, referred to as frictional unemployment, is always with us as employers expand or contract their businesses and workers move, are fired, or quit to seek other opportunities.

2.Structural unemploymenr is caused by (structural) changes in the economy thar e1iminare some jobs while generating others for which unemployed workers are not qualified. Structuralunemploymenr differs from frictional unemployment in rhat rhe unemployed workers do not currently have the skills needed ro perform the newly created jobs.

3.Cyclical unemployment is caused by changes in the general level of economic output. When the economy is operating at less than full capacity, cyclical unemployment is present.

Full employment is the condition that exists when the economy has no cyclical unemploymcnt. Note, however, that borh structural and frictionalunemplovment continuc to exist even when rhc ccononw is at full cmpIO\·meIH. In other words. some Icvel or ullemp!o"mCl1l j, cxpeLlcd "hcll rllC CCOn011ll' j, ar "(ull CmpIO\'ll1cnt." The sum or'thc frictional and srructural uncmplo:'ment rale, is called rhL' natural rate of unemploymenr.

Potential GDP i, rhc (thcorctical) level of output thc CCOllUI11\' can produce when uncmpluvmcl1l is ar rhc natural ratc. \X'hcn real CDP falls hel<w' po[cl1lial GDP, cvclical unemp!oymenr increascs. \Xlhen real GDP rises to\\'ard ;llla beyond potential GOP. cyclical unemplovmenr decreases. Economists have a range of opinions on what the "natural" rate of unemployment really is, so estimates of potential GOP and cyclical unemployment will differ.

LOS 22.d: Explain and calculate the consumer price index (CPI) and the inflation rate, describe the relation between the CPI and the inflation rate, and explain the main sources of CPI bias.

The consumer price index (CpO is the best known indicator of U.S. inflation, The CPI measures the average price for a defined "basket" of goods and services that represents the purchasing patrerns of a typical urban household. The Bureau of Labor Statistics (BLS) reportS the CPI monthly,

The BLS constructs the CPI in three stages:

1.Select the cpr basket. The first step is to determine whar goods and services a typical household buys, The BLS surveys a large sample of consumers to find out what percentage of their income they spend on which items, These percentages become the weights for each of the more than 80,000 goods in the overall index. The current weights for the eight major categories in the CPI are shown in Figure 1,

Study Session 5

Cross-Reference to CFA Institute Assigned Reading #22 - Monitoring Jobs and the Price Level

Figure 1: Relative Importance in the CPI as of December 2007*

. Source: Hureau of Lahor Statistics, l'.S. Department or Labur

Conduct a monthly price survey. Ever:' month the BLS records the prices of every item in the C:PI in 30 urban areas. The survel'ors also record any changes in the individual products, such :IS package sizes, and adjust prices to make them comparable to past price,.

3.Calculate the CPI. This calculation is done in three steps.

Step I: Find the cost of the CFI basket for the reference base period. Step 2: Find the cost of the CPI basket for the current period.

Step 3: Calculate the CPI for both periods. The formula for the index is:

CPI = cost of basket at current prices xl 00 cost of basket at base period prices

Example: Calculating a consumer price index

The following table shows price information for a simplified basket of goods. Calculate a CPI for this basket in the current period.

Srudy Session 5

Cross-Reference to CFA Institute Assigned Reading #22 - Monitoring Jobs and the Price Level

Answer:

Reference base period

The inflarion rate is rhe percenrage change in the price level from a year ago. The cpr is one of the primary indicawrs used w measure rhe inflation rate. As measured by the CPr, the inflarion rate is given by the following formula:

Example: Calculating the inflation rate based on CPI

The cpr for all items was 202.9 in june 2006 and 194.5 in june 2005. The cpr for all items less energy was 203.6 in june 2006 and 198.5 in june 2005. Calculate and interpret the inflation rate based on these two measures.

Answer:

all items: 202.9 -194.5 xl 00 = 4.3% 194.5

As measured by the cpr, the inflation rate for goods excluding energy was less than the inflation rate for all items over this 12-month period. This means energy prices must have been increasing faster than the overall price level.

Smdy Session 5 -

Cross-Reference to CPA Institute Assigned Reading #22 - Monitoring Jobs and the Price Level

Example: Using the CPI to calculate real price changes

In 1980 the average gasoline price in the U.S. was $1.23/gaUon and in 2006 it was $2;60/gallon. The urban consumer price index (1967 = 100) was 246.8 in 1980 and 603.9 in 2006. What was the change in real gasoline prices over the period?

Answer:

We can use the cpr to convert the 2006 price to a 1980 equivalent price or to convert the 1980 price wits 2006 equivalent in order to calculate the real price change.

So the real price of gas declined by 1.063 -1 = -13.6% 1.23

(l)men to 2006 price: $1.23 (603. 9 J = $3.01 246.8

6r;:·.9 -1 = 144.7%, so the inflation adjusted gasoline price actually declined over 246.8

the period.

CPI Bias

The cpr is widely believed to overstate the true rate of inflation. The price data the BLS collects reflect long-term structural shifts that should nor be included in a measure of the price level. The most significant biases in the cpr data include:

•New goods. Older products are often replaced by newer but initially more expensive products. This biases the index because some newly-available goods perform the same function as different lower-priced goods in the base-year market basket.

•Quality changes. rf the price of a product increases because the product has improved, the price increase is not due to inflation, but still causes an increase in the price index.

•Commodity substitution. Even in an inflation-free economy. prices of goods relarive to each other change all the time. When two goods are substitutes for each other, consumers increase their purchases of the relatively cheaper good and buy less of the

relatively more expensive good. Over time such changes can make the CPI's fixed basket of goods a less accurate measure of typical household spending.

•Outlet substitution. When consumers shift their purchases tOward discount outlets and away from convenience outlets, they reduce their cost of living in a way the cpr does not capture.

Study Session 5

Cross-Reference to CFA Institute Assigned Reading #22 - Monitoring Jobs and the Price Level

Estimates are that the cpr overstates inflation by about 1% per year. This upward bias in [he cpr distorts economic decisions. Many employment contracts with cost-of- living adjustments are based on the rare of increase in the CPl. A substantial portion of government spending, such as entir/ement payments, increases automatically with the

CPl. The BLS is attempting to reduce the bias by surveying consumers more frequently and re-evaluating [he weighting method.

Srudy Session 5

Cross-Reference to CFA Institute Assigned Reading #22 - Monitoring Jobs and the Price Level

KEy CONCEPTS

LOS 22.a

A person who is available for work is considered unemployed if he is actively seeking work. waiting ro be called back ro a job. or waiting for the starr date of a new job.

The main labor market indicarors include the unemployment rate, the labor force parricipation rate, and the employment-ro-population ratio.

LOS 22.b

Increases in aggregate hours worked and the real wage rate, which is primarily determined by labor productivity, both lead to increases in real GDP and economic expansIOn.

LOS 22.l

Fricriollal lIIll'mplo\·Ill<.:IH result:- ['l'llm th<.: rimc' it takl" for <':l11f"!OI'er, and cmplo\'l'c> l(l find each other. Structural Unel11p]OI'ment result, from long-rerm economic changes thal require workers [(J gain new skills to fill new jobs. Cyclical unemploymenr exists when the economy is producing less than irs potential output.

"Full emplovment" refers lO a situation where the economy has reached irs pmenria! level of GDP because cyclical unemploymenr is zero. although borh frictional and structural unemployment are always present. The sum of the average rates of frictional anJ structural employment is called the natural rarc of unemployment.

LOS n.d

The Consumer Price Index (CPl) is a measure of the average prices of goods and services designed ro represenr the purchases of a typical urban household.

The inflation rate is measured as the annual percentage change in the CPI.

year-ago CPI

Because of biases that arise from new goods, quality improvements, and consumers' decisions ro make substitutions among goods and seek lower-priced shopping outlets, the CPI is believed to overstate the true rate of inflation by about] % per year.

Study Session 5

Cross-Reference to CPA Institute Assigned Reading #22 - Monitoring Jobs and the Price Level

CONCEPT CHECKERS

1.The unemployment rate is defined as the number of unemployed as a percentage of the:

A.labor force.

B.working-age population.

C.civilian noninstitutional population.

2. Which of the following indicators moves inversely with the business cycle?

A.Unemployment rate.

B.Labor force participation rate.

C.Employment-to-population ratio.

3.Which measure of the labor market includes "discouraged workers?"

A.Labor force.

B.\X/orkillg age populatiun.

C . .'\:ul11hc"J" of unen1p/o\·cd.

C. When the plant was modernized, Jones lost heriob because she did nor have the skill needed to operate the new equipment.

Use the following hypothetical information about the conditions in the labor market to answer Question 6.

6.What is the unemployment rate:

A.5.3%.

B.6.8%. C. 7.9%.

Study Session 5

Cross-Reference to CFA Institute Assigned Reading #22 - Monitoring Jobs arid the Price Level

7. The value of an hour's labor in terms of goods and services is called:

A.the real wage rate.

B.the nominal wage rate. e. rotal labor compensation.

Use the following table to answer Questions 8 ro 10.

CPI data for a recent 12-month period:

A.)()4.

B.::'.()::'..

C. .'\90.

9. The ann ual inflation rale as measured hv cpr was closest ro:

A.3(~o.

B _ 40f().

c:. 'i%.

10.Given the bias that is generally believed to exisl in the CPr. the true ratc of inflation was most Likely:

A.5%.

B.4%.

c:.'i%.

Study Session ')

Cross-Reference to CFA Institute Assigned Reading #22 - Monitoring Jobs and the Price Level

ANSWERS - CONCEPT CHECKERS

1. A The unemployment rate is the number of unemployed as a percentage of the labor force.

AThe unemployment rare increases when CDP decreases, and decreases when GOP increases. The orher indicarors move in the same direCtion as the business cycle.

3.B Discouraged workers arc not employed and not seeking employment, and are therefore not counted as parr of the labor force or among the unemployed. They are, however, included in the working·age population.

4.C One of the causes of frictional unemployment is that information regarding prospecrive employees and employers is costly and sometimes hard ro find. The other cause of frictional unemployment is that hOth em ployees and employers rna)' spend some time looking for information that will match them Uf).

-'. c: SttllctllralUnelllploymellt cxists \\'h01 ch'lng<:, in the ClOI1UIll:' clilllill,1[C )(H1[c' jobs whilegCllcrarillf. Ilc'\\' joh o!)cninp for which unellll'lo\'.cd workers arc nor (ju,liificd.

BUnelllplomlcnt rate ~ (number of unJID!l't.:)Yf9).1 (number in the labur forccr..1n rhis

problem, household workers, students,...rctirces. a;;J 'the disabled arc 'not consi'dered unemplol'td. Thus. rhe unellll'lovmcnl'l"n~":~s'c:"_~l1ia;td;ls:I!?;,OOO) ; (J <)O.()OO) ~

6.8%

A The real wage rate measures the purchasing power of an ho't~r''s'\~b(;r.'The-n'ornlnal wage rate is the money value or an hour's labor. Productivity is output per hour ot" labor,

one of the determinants of the real wage rate. Total labor compensation is one of the measures of the real wage rare.

8.B 0.4(160) + 0.6(230) = 202.0

9.B current index level = 202.0 (from Question #8)

year-ago index level = 0.4(151) + 0.6(223) = 194.2

lO. A The CPI calculation is generall: believed [(I ~ldJ about I<~'i) to thc acrm! inflation rate.

The following is a review of the Economics principles designed [0 address the learning outcome statements set forth by CFA InstituteOY • This topic is also covered in:

AGGREGATE SUPPLY AND AGGREGATE

DEMAND

Study Session 5

EXAM Focus

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LOS 2.1.a: Explain the factors that influence real GOP and bng-run and shonrun aggregate supply, explain movement along the long-run and short-run aggregate supply curves (LAS and SAS) and discus" tht !"easnm for chanp;e:: :;i potential GOP alla aggregate supply.

Aggregate supply refers ro the amount of goods and services produced by an econom.l". Aggregate supply is a function of the price level. Just as in goods markets, higher prices bring about a greater amount of supply in the shorr run. Figure 1 illustrates a shorr run aggregate supply (SAS) curve and a long run aggregate supply (LAS) curve. The overall price level in the economy is on the verrical axis and the rea] level of output of goods and services (real COP) is on the horizontal axis.

Figure 1: Aggregate Supply in the Long Run and Short Run

Price l.':vel

Long-run aggregate supply (LAS)

Shorr-run aggregate supply (SAS)

~IV