Unemployment & Inflation worksheet

Unemployment & Inflation: answer key

1. 1. (B) Structural unemployment occurs when workers' skills or locations no longer match what employers need. When operations relocate overseas, the domestic worker faces a fundamental mismatch that retraining or relocation can't quickly fix. This is distinct from frictional (temporary job-switching), cyclical (demand-driven by recessions), or seasonal unemployment (predictable patterns).

2. 2. (D) The BLS definition requires either employment or active job search to be counted in the labor force. Discouraged workers have stopped looking, so they're excluded from the labor force entirely. This exclusion is a well-known limitation of the official unemployment rate because it drops as workers give up, even though the underlying job market hasn't improved. Part-time workers, by contrast, ARE counted as employed.

3. 3. (C) Inflation rate = ((New CPI - Old CPI) / Old CPI) × 100 = ((162 - 150) / 150) × 100 = (12 / 150) × 100 = 8.0%. Option A confuses absolute change (12 points) with the percentage change. Option D incorrectly uses the new CPI as the denominator.

4. 4. (B) The short-run Phillips curve is downward-sloping: lower unemployment is associated with higher inflation, and vice versa. This reflects the short-run tradeoff policymakers face, because aggregate demand policy can reduce unemployment only at the cost of higher inflation. In the long run, this tradeoff breaks down, and the Phillips curve becomes vertical at the natural rate.

5. 5. (B) The natural rate is what remains when the economy operates at potential GDP and cyclical unemployment equals zero. It reflects frictional unemployment (job transitions) and structural unemployment (skill/location mismatches). These causes persist even in a healthy economy, which is why the natural rate will never hit zero. The CBO estimated the natural rate at around 4.4% for 2024.

6. 6. (B) Negative supply shocks raise production costs across the economy simultaneously, pushing up inflation at any given unemployment level. On a Phillips curve graph, the SRPC shifts up and to the right, creating stagflation. The 1973 OPEC embargo quadrupled oil prices within months and produced exactly this pattern. Demand-side policy can't address both problems at once, which is why the Keynesian Phillips curve framework largely collapsed during the 1970s.

7. 7. (B) Friedman and Phelps, working independently in the late 1960s, argued that the Phillips curve tradeoff disappears in the long run. Workers and firms eventually adjust their inflation expectations, which means any attempt to push unemployment below the natural rate through monetary expansion produces only higher inflation with no lasting employment gains. The LRPC is therefore vertical at the natural rate. The 1970s experience vindicated this view, and Volcker's aggressive policy response in 1981-82 confirmed that only by accepting a severe recession could entrenched inflation be broken.

8. 8. (C) Cyclical unemployment is tied directly to the business cycle. When aggregate demand falls during recessions, firms cut production and lay off workers across many industries simultaneously. The 2008-2009 financial crisis and the early weeks of the COVID pandemic in 2020 produced dramatic spikes in cyclical unemployment. When the economy recovers to potential GDP, cyclical unemployment disappears. Option A describes frictional unemployment. Option B describes structural unemployment.

9. 9. (C) Substitution bias is one of the three measurement problems identified by the 1996 Boskin Commission. When beef prices rise, consumers often switch to chicken. The CPI's fixed basket assumes everyone keeps buying beef at the higher price, which overstates the true cost-of-living increase. Combined with new-product bias and quality-change bias, these distortions overstate measured inflation by an estimated 0.8-1.1% per year, which matters substantially for programs like Social Security COLA that use CPI directly. Option D describes "core CPI," which is a different measure.

10. 10. (B) Real wages reflect purchasing power. The real wage change is approximately the nominal wage change minus inflation: 3% - 5% = -2%. Workers' purchasing power falls by 2% because prices rose faster than paychecks. This is why unanticipated inflation is especially harmful to workers on fixed nominal contracts, pensioners on non-indexed benefits, and creditors holding fixed-rate loans, because their real incomes erode with each price level increase.

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