EC101: Semester 1, 2021

Tutorial 4 Solutions

1. Full employment implies there is no unemployment. Evaluate this statement.

Full employment is defined as the situation in which the unemployment rate equals the

natural unemployment rate. When the economy is at full employment, there is no cyclical

unemployment or, equivalently, all unemployment is frictional and structural. Thus, the

above statement is incorrect.

2. Differentiate between different types of unemployment.

 Frictional unemployment is unemployment that arises from normal labour market turnover.

The creation and destruction of jobs requires that unemployed workers search for new jobs.

 Structural unemployment is unemployment created by changes in technology and foreign

competition that change the skills needed to perform jobs or the locations of jobs.

 Cyclical unemployment is the higher than normal unemployment at a business cycle trough

and lower than normal unemployment at a business cycle peak. A worker laid off because the

economy is in a recession and is then rehired when the expansion begins experiences cyclical

unemployment.

3. Due to the rise in inflation measured by CPI, the government announces an increase in the wage rates

will be indexed to CPI. Comment on this policy.

Consumer Price Index is widely used measure of price level. However, CPI might overstate

the true inflation rate due to new goods bias, quality change bias, commodity substitution

bias and outlet substitution bias. Thus, the indexation would be biased and would

incorrectly justify a rise in the wage rate. This might boost consumption spending and

result even higher inflation rate.

4. How is GDP deflator different from CPI?

Consumer Price Index (CPI) looks at price changes of fixed basket of goods and service

consumed by a typical urban consumer. GDP deflator looks at price changes of all goods

and services. GDP deflator is a much broad measure of price level than CPI. Thus, inflation

rate computed on the basis of GDP deflator is more likely to be an accurate measure of

inflation.

5. You are an economist hired to survey the labour market performance in Samoa. Briefly, describe

some of the indicators you are going to use.

Some of the indicators that can be used are:

To deepen our understanding, it would be good to compute the above indicators by gender

or at village or district level. I would also analyze youth unemployment rates. An extensive

survey of macroeconomic performance and critical analysis of different labour market

policies also need to be undertaken to improve our understanding of labour market.

6. What are the four main ways in which the CPI is an upward-biased measure of the price level?

The CPI is biased upward because of the new goods bias, the quality change bias,

commodity substitution bias and outlet substitution bias.

New Goods bias: there is a tendency to not count new goods as part of a price index because the CPI is a fixed
basket and includes commonly used goods and services. New products are not commonly used yet, so they are
not included, which also means that their effects on prices do not show up in the CPI. The quality change bias
points out that part of the reason goods and services rise in price is because their quality is improved.
Commodity substitution bias occurs because consumers substitute away from goods and services that have risen
in the price more than other goods and services. Outlet substitution bias occurs because consumers will use
discount stores more frequently when goods and services rise in price.

7. Discuss the problems that arise from the CPI bias?

The upward bias in the CPI distorts private contracts and government outlays that include

formulas based on CPI change as a measure of inflation. If the intent is to maintain the real

value of a payment, indexing payments to the CPI will in fact increase the real value of

payments over time if the CPI has an upward bias. In one year, the effect of the bias may

not be much, but it will accumulate over time. Close to one third of federal government

outlays are indexed to the CPI.

8. Consider the following data (measured in thousands) for labour market in the Island of Z.

Number of employed individuals 10327.9

Number of unemployment individuals ?

Total number of individuals in the labor force 10822.4

Total number of individuals not in the labour force ?

Number of Individuals in 15-25 5000

Number of Individuals in 26-36 4000

Number of Individuals in 37-46 3000

Number of Individuals in 47-56 2000

Number of Individuals in 57-64 2712.8

Number of employed individuals + Number of unemployed individuals = Total

number of individuals in the labour force.

10327.9 + X = 10822.4

X = 10822.4 - 10327.9

X = 494.50

b) Compute the number of individuals who are not in the labour force.

Total number of individuals in the labour force + Total number of individuals not in

the labour force = Total number of individuals in the working age population.

i. Total number of individuals in the working age population

Number of Individuals in 15-25 5000

Number of Individuals in 26-36 4000

Number of Individuals in 37-46 3000

Number of Individuals in 47-56 2000

Number of Individuals in 57-64 2712.8

Total 16712.8

ii. 16712.8 – 10822.4 = 5890.4

c) Compute the unemployment rate.

(Unemployed / labour force) *100 = (494.50/10822.4) *100 = 4.6%

d) Compute the labour force participation rate.

(Labour force / working age population) *100 = (10822.40/16712.80) *100 = 64.8%