ECON 121 Discussion: Week 5

Slides available here:

All discussion slides here:

First Midterm and Office Hours Change

Your first midterm is next week in class on Friday (Feb. 21st)

  • No calculators

  • Know the formulas, but undertanding concepts is more important: any math with be mental math


I will be holding office hours on Thursday (Feb. 20th) from 12 - 1 PM in UH 817

  • I will not be holding office hours at my usual Friday 10 - 11 AM time since this would be right after the exam

  • I will have my usual office hours on Monday (3 - 4 PM) and Wednesday (1 - 2 PM)

Feel free to come if you have any questions about material while you’re studying for the midterm

Today’s Plan



  1. Review unemployment and the relationship between inflation and interest rates
  2. Do some interest rate and unemployment practice problems

Inflation and Unemployment

Chapter 8

Inflation and Interest Rates

In the last two discussion sections we briefly calculated inflation rates: the percent change in the price level

  • Notice that inflation is not the levels of prices, it’s the change in the price level
    • Inflation is not high prices, it’s increases in prices


Interest rates and inflation are closely related:

\[ \text{Real interest rate } (\%) = \text{nominal interest rate } (\%) - \text{inflation rate } (\%) \]

Just like with real vs. nominal GDP:

  • “Nominal” interest rate = the interest rate you get (or pay) when you save (or borrow) money
  • Inflation rate = how much prices are changing
  • “Real” interest rate = the rate of interest after adjusting for price changes

Increasing prices decrease the purchasing power of a dollar: it’s the same thing with interest rates

What Are Interest Rates?

This and the next slide aren’t in Chapter 8, but it’s useful context and some of it will be covered later in the course


Interest is the cost of borrowing someone else’s money.

There is no one interest rate: the rate you get on a savings account or a loan will vary due to a lot of factors (like the length or riskiness of a loan)


A banking example of how this works:

  1. You put money into a savings account at a bank

  2. The bank uses your money to make a loan to someone else (e.g., a business or someone buying a house)

  3. The bank’s lending is not riskless: what if the business goes bankrupt or the home buyer loses their job? The bank charges a relatively higher rate to the borrower to compensate for the risk that they won’t be paid back.

  4. The bank pays you a (smaller) interest rate for your saving account: they’re borrowing money from you!

What Are Interest Rates?

In the U.S., economists and financiers typically care the most about the rates of interest on U.S. Treasury bills

  • These are loans to the U.S. government: you buy a bill from the Treasury Department and the government promises to pay you back after some time, with interest

We’ll be talking about these interest rates again when we cover the Federal Reserve system

Unemployment

An economy’s labor force is the sum of all adults who are either

  1. employed: working full or part time

  2. unemployed: people who aren’t employed but are actively seeking work in the past four weeks

    • Notice this does not count everyone who doesn’t have a job since it doesn’t include people who don’t have a job and aren’t looking for one

We consider the total number of working-age adults to be everyone 16 or older. We often care about two important rates measuring how many people are (or aren’t) working:

\[ \text{Unemployment Rate} = \frac{\text{Unemployed workers}}{\text{Labor force}} \times 100 \]

\[ \text{Labor Force Participation Rate} = \frac{\text{Labor force}}{\text{Everyone 16 and older}} \times 100 \]

These values are based on a monthly US Census survey of ~100,000 people asking a variety of labor-related questions

Practice Problem #1

You’re thinking about buying a house. Your bank sets the interest rate on your mortgage (a loan for buying real estate) at 7%. You think inflation will be 3% during the life of the mortgage.

If you’re right about the inflation rate, what would be the real interest rate that you pay the bank?

Practice Problem #1

You’re thinking about buying a house. Your bank sets the interest rate on your mortgage (a loan for buying real estate) at 7%. You think inflation will be 3% during the life of the mortgage.

If you’re right about the inflation rate, what would be the real interest rate that you pay the bank?

Answer

The real interest rate on the mortgage would be 4%:

\[ \begin{align} \text{Real interest rate} &= \text{nominal interest rate} - \text{inflation rate} \\ &= 7\% - 3\% \\ &= 4\% \end{align} \]

Practice Problem #1

You’re thinking about buying a house. Your bank sets the interest rate on your mortgage (a loan for buying real estate) at 7%. You think inflation will be 3% during the life of the mortgage.

Say you’re wrong and prices actually decrease, so there’s deflation. The inflation rate is actually -3%! Are you better or worse off than you were expecting to be? Is your bank better or worse off?

Practice Problem #1

You’re thinking about buying a house. Your bank sets the interest rate on your mortgage (a loan for buying real estate) at 7%. You think inflation will be 3% during the life of the mortgage.

Say you’re wrong and prices actually decrease, so there’s deflation. The inflation rate is actually -3%! Are you better or worse off than you were expecting to be? Is your bank better or worse off?

Answer

Now the real interest rate is… \[ \begin{align} \text{Real interest rate} &= 7\% - (- 3\%) \\ &= 10\% \end{align} \]

You’re worse off. Your bank is better off. The value (purchasing power) of the money you’re paying to your bank is higher than it was before you took out the loan, which is terrible for you but great for your bank.

Practice Problem #1

You’re thinking about buying a house. Your bank sets the interest rate on your mortgage (a loan for buying real estate) at 7%. You think inflation will be 3% during the life of the mortgage.

Thinking about the deflation situation again: does this mean that your mortgage payments increased? Decreased? Stayed the same?

Practice Problem #1

You’re thinking about buying a house. Your bank sets the interest rate on your mortgage (a loan for buying real estate) at 7%. You think inflation will be 3% during the life of the mortgage.

Thinking about the deflation situation again: does this mean that your mortgage payments increased? Decreased? Stayed the same?

Answer

The actual amount of money you paid to your bank stayed the same. But because of deflation, the value of that money increased: you could buy more with it now than you used to be able to! You’d rather not be paying as much as you are to your bank.

Practice Problem #2

True or false…


  1. …nominal interest rates can be negative.


  1. …real interest rates can be negative.

Practice Problem #2

True or false…


  1. …nominal interest rates can be negative.

Answer

False (almost always). Negative nominal interest rates would mean that you pay the bank to have a savings account. Would you do this?

  1. …real interest rates can be negative.

Answer

True. If the inflation rate is higher than the nominal interest rate, this can happen. The 10-year real interest rate was negative during the first year of the Covid-19 pandemic!

Practice Problem #3

According to the BLS, in January 2025 in the the U.S.

  • there were 272,685,000 adults (16 or older)
  • the labor force was 170,744,000 people
  • there were 6,849,000 people unemployed

What are some reasons that could explain the difference between the number of working-age adults and the labor force?

Practice Problem #3

According to the BLS, in January 2025 in the the U.S.

  • there were 272,685,000 adults (16 or older)
  • the labor force was 170,744,000 people
  • there were 6,849,000 people unemployed

What are some reasons that could explain the difference between the number of working-age adults and the labor force?

Answer

There are many reasons, including

  • Retirement

  • Going to school (without working)

  • Home responsibilities (stay-at-home parenting or caretaking for family members)

  • Illness or disability that prevents someone from working or seeking work

Practice Problem #3

According to the BLS, in January 2025 in the the U.S.

  • there were 272,685,000 adults (16 or older)
  • the labor force was 170,744,000 people
  • there were 6,849,000 people unemployed

What was the labor force participation rate? What was the unemployment rate?

Practice Problem #3

According to the BLS, in January 2025 in the the U.S.

  • there were 272,685,000 adults (16 or older)
  • the labor force was 170,744,000 people
  • there were 6,849,000 people unemployed

What was the labor force participation rate? What was the unemployment rate?

Answer

\[ \begin{align} \text{LFPR} &= \frac{170,744,000}{272,685,000} \times 100 \\ &\approx 62.6\% \end{align} \]

Check the math

\[ \begin{align} \text{Unemployment rate} &= \frac{6,849,000}{170,744,000} \times 100 \\ &\approx 4\% \end{align} \]

Check the math

Practice Problem #4

Let 1983 be the base year (so 1983’s CPI is 100).

In 2023, the CPI was 305. In 2024, the CPI was 314. Was there inflation between 2023 and 2024? What was the inflation rate?

Practice Problem #4

Let 1983 be the base year (so 1983’s CPI is 100).

In 2023, the CPI was 305. In 2024, the CPI was 314. Was there inflation between 2023 and 2024? What was the inflation rate?

Answer

Yes! The aggregate price level, represented by the CPI, increased between 2023 and 2024 so there was inflation.

The inflation rate is the percentage change in the CPI between the two years:

\[ \begin{align} \text{Inflation rate} &= \frac{314 - 305}{305} \times 100 \\ &= 2.95% \end{align} \]

Practice Problem #4

Let 1983 be the base year (so 1983’s CPI is 100).

In 1929, the stock market crashed. The Great Depression began and hit its worst point around 1932. In 1929 the CPI was 17.1 and in 1932 it was 13.7. Was there inflation or deflation between 1929 and 1932? What was the inflation rate?

Practice Problem #4

Let 1983 be the base year (so 1983’s CPI is 100).

In 1929, the stock market crashed. The Great Depression began and hit its worst point around 1932. In 1929 the CPI was 17.1 and in 1932 it was 13.7. Was there inflation or deflation between 1929 and 1932? What was the inflation rate?

Answer

This was a deflationary period. The aggregate price level decreased between 1929 and 1932.

\[ \begin{align} \text{Inflation rate} &= \frac{13.7 - 17.1}{17.1} \times 100 \\ &\approx -19.9% \end{align} \]