Level 1 CFA® Exam:
Unemployment & Inflation
Unemployment - Definitions
Let’s begin with definitions related to unemployment.
A person able to work who is actively seeking employment but is currently without a job is considered to be unemployed. You should notice here that people that can work but don’t seek employment are not included in the category of unemployed. We call them voluntarily unemployed.
Labor force consists of all people who are employed and unemployed. So, an unemployment rate is the ratio of the unemployed to the labor force.
Activity ratio is equal to the labor force divided by the number of all people in the country that are at working age. Usually, this means people between 16 and 64 years of age. The greater the activity ratio, the better because it means that the number of people that are voluntarily unemployed is low.
Underemployed are those who have qualifications to work in a much better-paid job but cannot find it.
Discouraged worker is someone who has given up looking for a job (he/she is not counted in the labor force).
Voluntarily unemployed are those who don’t want to work even if they have the opportunity and those who retired early.
We distinguish 3 types of unemployment and they are:
- frictional unemployment,
- structural unemployment, and
- cyclical unemployment.
Frictional unemployment is associated with a natural movement of people across regions and their voluntary job change. In other words, people are not working because they have just left one job and are about to start another. This type of unemployment is regarded to be – to some extent – voluntary, so governments don’t fight it.
Structural unemployment is caused by a mismatch between the demand for and supply of labor. We may also define this mismatch as a mismatch between human skills and the type of offered work when demand and production are changing. Governments struggle in their fight with structural unemployment because it requires a lot of money, resources, and time.
Cyclical unemployment occurs when the aggregate demand for labor is low as a result of downturns in overall business activity. As soon as the economic situation improves, cyclical unemployment declines.
Inflation - Definitions
Inflation is a rise in the general level of the prices of goods over a period of time. Note that a single increase in price does not constitute inflation. The price growth must be continuous. Inflation is measured by the inflation rate.
We can calculate the inflation rate using this CFA exam formula:
Disinflation is when the inflation rate falls in a given period but remains above 0%.
Deflation is when the level of prices falls in a given period, in other words when the inflation rate is below 0%.
Hyperinflation is defined as very large inflation (e.g. 100%/year).
Stagflation is the combination of stagnation (characterized by high unemployment) and inflation.
Core inflation index is an inflation index that doesn’t include food and energy prices, i.e. products with very volatile prices.
To measure an inflation rate for a given year, we need to know the value of the price index at the end of the year and the value of the price index at the beginning of the year. To obtain a reliable inflation rate, the key factor is to define a price index and measure its value accurately. The price indices that you should know include:
- the consumer price index, and
- the producer price index.
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Economists distinguish between 2 types of inflation, namely:
- cost-push inflation, and
- demand-pull inflation.
Cost-push inflation is the result of a reduced level of aggregate supply, which in turn is caused by an increase in real prices of factors of production, for example, the cost of labor, energy, or oil.
The second type of inflation, that is demand-pull inflation, is the result of the steady growth of aggregate demand, which translates into higher prices and wages and a temporary increase in the volume of production in the economy above its potential, which causes inflation.
- A person able to work who is actively seeking employment but is currently without a job is considered to be unemployed.
- Labor force consists of all people who are employed and unemployed.
- An unemployment rate is the ratio of the unemployed to the labor force.
- Frictional unemployment is associated with a natural movement of people across regions and their voluntary job change.
- Structural unemployment is caused by a mismatch between the demand for and supply of labor.
- Cyclical unemployment occurs when the aggregate demand for labor is low as a result of downturns in overall business activity.
- Inflation is a rise in the general level of the prices of goods over a period of time.
- If the inflation rate falls within a certain time period, but remains above 0%, we deal with disinflation.
- The opposite of inflation is deflation, which occurs when the level of prices falls in a given period. Deflation is a negative inflation rate.
- When inflation gets out of control and the rate is, let’s say 100% or more per year, we deal with hyperinflation.
- Disinflation is positive inflation and we talk about it when inflation is decreasing from period to period. Deflation is negative inflation.
- Core inflation is an index that doesn’t include food and energy prices because of their high volatility.
- Stagflation occurs when we deal with stagnation and inflation at the same time.
- The Laspeyres price index is based on a fixed basket of goods and services (fixed composition, aka. weights) representing the base level of consumption.
- To eliminate the limitations associated with the substitution of goods, the Paasche price index is used
- Fisher index is the geometric mean of the product of the Laspeyres index and the Paasche index.
- Cost-push inflation is the result of a reduced level of aggregate supply.
- Demand-pull inflation is the result of the steady growth of aggregate demand.