Hubbard Obrien MacroEconomics 2nd edition chapter 12

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Hubbard Obrien MacroEconomics 2nd edition chapter 12

1. Chapter 12 Unemployment and Inflation Alcatel-Lucent Contributes to Unemployment When we study macroeconomics, we are looking at the big picture: total production, total employment, and the price level. Of course, the big pic-ture is determined by the decisions of millions of individual consumers and firms. Lucent Technologies has been involved in developing many impor-tant innovations, including equip-ment for long-distance television transmission, the transistor, the Unix computer operating system, and Wi- Fi wireless broadband technology. When total employment in the United States declined during 2001, Lucent contributed to the decline. In 2000,Lucent employed 175,000 workers. It began laying off large numbers of workers during 2001. By 2005, Lucent employed only 31,500 workers. In December 2006, Lucent merged with the French technology firm Alcatel to form the new firm Alcatel-Lucent. Unfortunately, the new firm continued to have problems. In January 2007, Alcatel-Lucent reported that during the fourth quarter of 2006, its sales had fallen by 16 percent, while its profits were near zero. According to Chief Executive Patricia Russo, the quarter “proved challenging from a market per-spective, driven by a shift in spending from some of our large North American customers and heightened competition in the global wireless market.” In the face of this growing competition from communications-technology rivals such as Ericsson of Sweden and Huawei of China, the company could not increase revenue, and so its only option was to reduce costs. Less than one month after the company reported its disappointing earnings, Ms. Russo announced the elimination of 12,500 jobs. Alcatel-Lucent’s decision will ultimately leave thousands of people unemployed. In this chapter, we will focus on measuring changes in unem-ployment and changes in the price level, or inflation. Because unemploy-ment and inflation are both impor-tant macroeconomic problems, it is important to understand how they are measured. For an example of a news-paper discussion of newly released government statistics on unemploy-ment, read AN INSIDE LOOK on page xxx. Sources: Carol Matlock, “The Reasons for Alcatel’s ‘Shocking’ Miss,” BusinessWeek Online, January 24, 2007; and “Unix’s Founding Fathers,” Economist, June 10, 2004.

2. LEARNING Objectives After studying this chapter, you should be able to: 12.1 Define unemployment rate and labor force participation rate and understand how they are computed, page xxx. 12.2 Identify the three types of unemployment, page xxx. 12.3 Explain what factors determine the unemployment rate, page xxx. 12.4 Define price level and inflation rate and understand how they are computed, page xxx. 12.5 Use price indexes to adjust for the effects of inflation, page xxx. 12.6 Distinguish between the nominal interest rate and the real interest rate, page xxx. 12.7 Discuss the problems that inflation causes, page xxx. 373 Economics in YOUR Life! Should You Change Your Career Plans if You Graduate During a Recession? Suppose that you are about to graduate from college with a bachelor’s degree in engineering. You plan to seek a job in manufacturing. If the economy is currently in a recession and the unemploy-ment rate is a relatively high 7 percent, should you change your career plans? Should you still try for a job in manufacturing, or should you try to enter another industry or, perhaps, stay in school to get a master’s degree? As you read this chapter, see if you can answer these questions. You can check your answers against those we provide at the end of the chapter. >> Continued on page xxx

3. 374 PA R T 5 | Macroeconomic Foundations 12.1 LEARNING OBJECTIVE Labor force The sum of employed and unemployed workers in the economy. Unemployment rate The percentage of the labor force that is unemployed. Unemployment and inflation are the macroeconomic problems that are most often discussed in the media and during political campaigns. For many mem-bers of the general public, the state of the economy is summarized in just two measures: the unemployment rate and the inflation rate. In the 1960s, Arthur Okun, who was chairman of the Council of Economic Advisers during President Lyndon Johnson’s administration, coined the term misery index, which adds together the inflation rate and the unemployment rate to give a rough measure of the state of the economy. As we will see in later chapters, although inflation and unemployment are important problems, the long-run success of an economy is best judged by its ability to generate high levels of real GDP per person. We devote this chapter to discussing how the government measures the unemployment and inflation rates. In particular, we will look closely at the statistics on unemployment and inflation that the federal government issues each month. 12.1 | Define unemployment rate and labor force participation rate and understand how they are computed. Measuring the Unemployment Rate and the Labor Force Participation Rate At 8:30 A.M. on a Friday early in each month, the U.S. Department of Labor reports its estimate of the previous month’s unemployment rate. If the unemployment rate is higher or lower than expected, investors are likely to change their views on the health of the economy. The result is seen an hour later, when trading begins on the New York Stock Exchange. Good news about unemployment usually causes stock prices to rise, and bad news causes stock prices to fall. The unemployment rate can also have impor-tant political implications. In most presidential elections, the incumbent president is reelected if unemployment is falling early in the election year but is defeated if unem-ployment is rising. This relationship held true in 2004, when the unemployment rate was lower during the first six months of 2004 than it had been during the last six months of 2003, and incumbent George W. Bush was reelected. The unemployment rate is a key macroeconomic statistic. But how does the Department of Labor prepare its estimates of the unemployment rate, and how accurate are these estimates? We will explore the answers to these questions in this section. The Household Survey Each month, the U.S. Bureau of the Census conducts the Current Population Survey (often referred to as the household survey) to collect data needed to compute the unem-ployment rate. The bureau interviews adults in a sample of 60,000 households, chosen to represent the U.S. population, about the employment status of everyone in the house-hold 16 years of age and older. The Department of Labor’s Bureau of Labor Statistics (BLS) uses these data to calculate the monthly unemployment rate. People are consid-ered employed if they worked during the week before the survey or if they were tem-porarily away from their job because they were ill, on vacation, on strike, or for other reasons. People are considered unemployed if they did not work in the previous week but were available for work and had actively looked for work at some time during the previ-ous four weeks. The labor force is the sum of the employed and the unemployed. The unemployment rate is the percentage of the labor force that is unemployed. People who do not have a job and who are not actively looking for a job are classi-fied by the BLS as not in the labor force. People not in the labor force include retirees, homemakers, full-time students, and people on active military service, in prison, or in mental hospitals. Also not in the labor force are people who are available for work and who have actively looked for a job at some point during the previous 12 months but who have not looked during the previous four weeks. Some people have not actively looked

4. C H A P T E R 1 2 | Unemployment and Inflation 375 Discouraged workers People who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them. Not available for work (homemakers, retirees, full-time students, etc.) 77.8 million Available for work but not currently working 1.4 million Discouraged workers 0.4 million Not currently looking because of childcare responsibilities or transportation or other problems 1.0 million Employed 146.0 million Unemployed 7.8 million Labor force 153.8 million Not in labor force 79.2 million Working-age population 233.0 million Figure 12-1 | The Employment Status of the Civilian Working-Age Population, March 2008 In March 2008, the working-age population of the United States was 233.0 million. The working-age population is divided into those in the labor force (153.8 million) and those not in the labor force (79.2 million). The labor force is divided into the employed (146.0 million) and the unemployed (7.8 million). Those not in the labor force are divided into those not available for work (77.8 million) and those available for work (1.4 million). Finally, those available for work but not in the labor force are divided into discouraged workers (0.4 million) and those currently not working for other reasons (1.0 million). Source: U.S. Department of Labor, Employment Situation Summary,March 2008. for work lately for reasons such as transportation difficulties or childcare responsibili-ties. Other people who have not actively looked for work are called discouraged workers. Discouraged workers are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them. Figure 12-1 shows the employment status of the civilian working-age population in March 2008.We can use the information in the figure to calculate two important macro-economic indicators: • The unemployment rate. The unemployment rate measures the percentage of the labor force that is unemployed: Using the numbers from Figure 12-1, we can calculate the unemployment rate for March 2008: 7.8million 153.8million × 100 = 5.1%. Number of unemployed Labor force × 100 = Unemployment rate.

5. 376 PA R T 5 | Macroeconomic Foundations Labor force participation rate The percentage of the working-age population in the labor force. • The labor force participation rate. The labor force participation rate measures the percentage of the working-age population that is in the labor force: For March 2008, the labor force participation rate was: 153.8million 233.0million × 100 = 66.0%. Labor force Working-age population × 100 = Labor force participation rate. Solved Problem|12-1 What Happens if You Include the Military? In the BLS household survey, people on active military ser-vice are not included in the totals for employment, the labor force, or the working-age population. Suppose people in the military were included in these categories. How would the unemployment rate and the labor force participation rate change? SOLVING THE PROBLEM: Step 1: Review the chapter material. This problem is about calculating the unem-ployment rate and the labor force participation rate, so you may want to review the section “Measuring the Unemployment Rate and the Labor Force Participation Rate,” which begins on page xxx. Step 2: Show that including the military decreases the measured unemployment rate. The unemployment rate is calculated as: Number of unemployed Labor force × 100. Including people in the military would increase the number of people counted as being in the labor force but would leave unchanged the number of people counted as unemployed. Therefore, the unemployment rate would decrease. Step 3: Show that including the military increases the measured labor force partic-ipation rate. The labor force participation rate is calculated as: Labor force Working-age population × 100. Including people in the military would increase both the number of people in the labor force and the number of people in the working-age population by the same amount. This change would increase the labor force participation rate because adding the same number to both the numerator and the denom-inator of a fraction that is less than one increases the value of the fraction. To see why this is true, consider the following simple example. Suppose that 100,000,000 people are in the working-age population and 50,000,000 are in the labor force, not counting people in the military. Suppose that 1,000,000 people are in the military. Then, the labor force participation rate excluding the military is: 50 000 000 100 000 000 100 50 , , , , × = %,

6. C H A P T E R 1 2 | Unemployment and Inflation 377 >> End Solved Problem 12-1 and the labor force participation rate including the military is: , , , , 51 000 000 101 000 000 × 100 = 50 . 5 %. YOUR TURN: For more practice, do related problem 1.7 on page xxx at the end of this chapter. Problems with Measuring the Unemployment Rate Although the BLS reports the unemployment rate measured to the tenth of a percentage point, it is not a perfect measure of the current state of joblessness in the economy. One problem that the BLS confronts is distinguishing between the unemployed and people who are not in the labor force. During an economic recession, for example, an increase in discouraged workers usually occurs, as people who have had trouble finding a job stop actively looking. Because these workers are not counted as unemployed, the unem-ployment rate as measured by the BLS may significantly understate the true degree of joblessness in the economy. The BLS also counts people as being employed if they hold part-time jobs even though they would prefer to hold full-time jobs. In a recession, counting as “employed” a part-time worker who wants to work full time tends to under-state the degree of joblessness in the economy and make the employment situation appear better than it is. Not counting discouraged workers as unemployed and counting people as employed who are working part time, although they would prefer to be working full time, has a substantial effect on the measured unemployment rate. For example, in March 2008, if the BLS counted as unemployed all people who were available for work but not actively looking for a job and all people who were in part-time jobs but wanted full-time jobs, the unemployment rate would have increased from 5.1 percent to 9.1 percent. There are other measurement problems, however, that cause the measured unem-ployment rate to overstate the true extent of joblessness. These problems arise because the Current Population Survey does not verify the responses of people included in the survey. Some people who claim to be unemployed and actively looking for work may not be actively looking.A person might claim to be actively looking for a job to remain eligi-ble for government payments to the unemployed. In this case, a person who is actually not in the labor force is counted as unemployed. Other people might be employed but engaged in illegal activity—such as drug dealing—or might want to conceal a legitimate job to avoid paying taxes. In these cases, individuals who are actually employed are counted as unemployed. These inaccurate responses to the survey bias the unemploy-ment rate as measured by the BLS toward overstating the true extent of joblessness.We can conclude that, although the unemployment rate provides some useful information about the employment situation in the country, it is far from an exact measure of jobless-ness in the economy. Trends in Labor Force Participation The labor force participation rate is important because it determines the amount of labor that will be available to the economy from a given population. The higher the labor force participation rate, the more labor will be available and the higher a country’s levels of GDP and GDP per person. Figure 12-2 highlights two important trends in labor force participation rates of adults aged 20 and over in the United States since 1950—the rising labor force participation rate of adult women and the falling labor force participa-tion rate of adult men. The labor force participation rate of adult males has fallen from 89 percent in 1948 to 76 percent in 2007. Most of this decline is due to older men retiring earlier and younger men remaining in school longer. There has also been a decline in labor force participation among males who are not in school but who are too young to retire.

7. 378 PA R T 5 | Macroeconomic Foundations | Making What Explains the Increase in “Kramers”? Cosmo Kramer is the name of Jerry Seinfeld’s next-door neighbor on the popular television comedy Seinfeld. One of the Connection the running jokes on the program is Kramer’s ability to support himself without appar-ently ever holding a job. In recent years, there has been an increase in the number of men who seem to be following Kramer’s lifestyle. In 1967, only 2.2 percent of men between the ages of 25 and 54 who were not in school did no paid work at all during the year. By 2006, 9.4 percent of men in this age category did not work. The rate of nonworking men is even higher among some groups. For example, about 20 percent of men aged 25 to 54 who lack a high school degree do not have a job and are not look-ing for one. More than half of nonworking men receive Social Security Disability Insurance. Under this program, people with disabilities receive cash payments from the federal government and receive medical benefits under the Medicaid program. In 1984, Congress passed legislation that made it easier for people with disabilities that are difficult to verify medically, such as back injuries or men-tal illnesses, to qualify for disability payments. In addition, the value of disability payments has increased faster than the wages of low-skilled workers. The result is that some men who in the past might have been working or actively looking for work are now being supported by disability payments and are not in the labor force. An increasing share of nonworking men, however, are not disabled. How do non-working men who do not receive disability payments support themselves, and how do they spend their time? Most nonworking men live with their parents, wives, or other rel-atives. Many of these men appear to rely on these other household members for food, clothing, and money. A recent study by Jay Stewart of the Bureau of Labor Statistics shows that most nonworking men are not substituting nonmarket work—such as child-care or housework—for market work. Instead, nonworking men engage in leisure activ-ities, such as sports, watching television, or sleeping during the hours freed up by not ˛Figure 12-2 Trends in the Labor Force Participation Rates of Adult Men and Women Since 1948 The labor force participation rate of adult men has declined gradually since 1948, but the labor force participation rate of adult women has increased significantly, leaving the overall labor force participation rate higher today than it was in 1948. Source: U.S. Bureau of Labor Statistics. Why do more men seem to be adopting Kramer’s lifestyle?

8. C H A P T E R 1 2 | Unemployment and Inflation 379 working. Stewart concludes that “the average day of a nonworking man looks very much like the average day-off of a man who works full time.” Sources: Alan Krueger, “A Growing Number of Men Are Not Working, So What Are They Doing?”New York Times,April 29, 2004, p. C2; and Jay Stewart, “Male Nonworkers: Who Are They and Who Supports Them?” Demography, Vol. 43, No. 3, August 2006, pp. 537–552. YOUR TURN: Test your understanding by doing related problem 1.9 on page xxx at the end of this chapter. The decline in labor force participation among adult men has been more than offset by a sharp increase in the labor force participation rate for adult women, which rose from 32 percent in 1948 to 61 percent in 2007. As a result, the overall labor force partic-ipation rate for adult workers rose from 59 percent in 1948 to 68 percent in 2007. The increase in the labor force participation rate for women has several causes, including changing social attitudes due in part to the women’s movement, federal legislation out-lawing discrimination, increasing wages for women, and the typical family having fewer children. Unemployment Rates for Demographic Groups Different groups in the population can have very different unemployment rates. Figure 12-3 shows unemployment rates for different demographic groups in March 2008, when the unemployment rate for the entire population was 5.1 percent.White adults had an unemployment rate of 3.5 percent. The unemployment rate for black adults was 7.1 per-cent, or more than twice the rate for white adults. Teenagers have higher unemployment rates than adults. The black teenage unemployment rate of 30.6 percent was the highest for the groups shown. How Long Are People Typically Unemployed? The longer a person is unemployed, the greater the hardship. During the Great Depression of the 1930s, some people were unemployed for years at a time. In the mod-ern U.S. economy, the typical unemployed person stays unemployed for a relatively brief period of time. Table 12-1 shows for March 2008 the percentage of the unemployed who had been unemployed for a given period of time. Eighty-three percent of the people Figure 12-3 Unemployment Rates in the United States by Demographic Group, March 2008 The unemployment rate of black adults is more than twice that of white adults, and the unemployment rate of black teenagers is more than twice that of white teenagers. The adult unemployment rates apply to persons aged 20 and over who are in the labor force. The teenage unemployment rates apply to persons aged 16 to 19 who are in the labor force. Note: People identified as Hispanic may be of any race. Source: U.S. Department of Labor, Employment Situation Summary,March 2008.

9. 380 PA R T 5 | Macroeconomic Foundations TABLE 12-1 Duration of Unemployment LENGTH OF TIME UNEMPLOYED PERCENTAGE OF TOTAL UNEMPLOYED Less than 5 weeks 36.0% 5 to 14 weeks 32.8 15 to 26 weeks 14.5 27 weeks or more 16.7 Source: U.S. Department of Labor, Employment Situation Summary, March 2008. unemployed in that month had been unemployed for less than six months. Half had been unemployed for eight weeks or less. The important conclusion is that, except in severe recessions, the typical person who loses a job finds another one or is recalled to a pre-vious job within a few months. The Establishment Survey: Another Measure of Employment In addition to the household survey, the BLS uses the establishment survey, sometimes called the payroll survey, to measure total employment in the economy. This monthly survey samples about 300,000 business establishments. An establishment is a factory, a store, or an office. A small company typically operates only one establishment, but large companies may operate many establishments. The establishment survey provides infor-mation on the total number of persons who are employed and on a company payroll. The establishment survey has three drawbacks. First, the survey does not provide informa-tion on the number of self-employed persons because they are not on a company pay-roll. Second, the survey may fail to count some persons employed at newly opened firms that are not included in the survey. Third, the survey provides no information on unem-ployment. Despite these drawbacks, the establishment survey has the advantage of being determined by actual payrolls rather than by unverified answers, as is the case with the household survey. In recent years, some economists have come to rely more on estab-lishment survey data than on household survey data in analyzing current labor market conditions. Some financial analysts who forecast the future state of the economy to help forecast stock prices have also begun to rely more on establishment survey data than on household survey data. Table 12-2 shows household survey and establishment survey data for the months of February and March 2008. Notice that the household survey, because it includes the TABLE 12-2 | Household and Establishment Survey Data for February and March 2008 HOUSEHOLD SURVEY ESTABLISHMENT SURVEY FEBRUARY MARCH CHANGE FEBRUARY MARCH CHANGE EMPLOYED 145,993,000 145,969,000 −24,000 137,926,000 137,846,000 −80,000 UNEMPLOYED 7,381,000 7,815,000 +434,000 LABOR FORCE 153,374,000 153,784,000 +410,000 UNEMPLOYMENT RATE 4.8% 5.1% +0.3% Source: U.S. Department of Labor, Employment Situation Summary, March 2008. Note: The sum of employed and unemployed may not equal the labor force due to rounding.

10. C H A P T E R 1 2 | Unemployment and Inflation 381 self-employed, gives a larger total for employment than does the establishment survey. The household survey provides information on the number of persons unemployed and on the number of persons in the labor force. This information is not available in the establishment survey. In the household survey, employment fell by 24,000 between February and March 2008, while it fell by 80,000 in the establishment survey. This dis-crepancy is partly due to the slightly different groups covered by the two surveys and partly to inaccuracies in the surveys. Job Creation and Job Destruction Over Time One important fact about employment is not very well known: The U.S. economy cre-ates and destroys millions of jobs every year. In 2006, for example, about 30.8 million jobs were created, and about 29.1 million jobs were destroyed. This degree of job cre-ation and destruction is not surprising in a vibrant market system where new firms are constantly being started, some existing firms are expanding, some existing firms are con-tracting, and some firms are going out of business. The creation and destruction of jobs results from changes in consumer tastes, technological progress, and the success and fail-ures of entrepreneurs in responding to the opportunities and challenges of shifting con-sumer tastes and technological change. The volume of job creation and job destruction helps explain why the typical person who loses a job is unemployed for a relatively brief period of time. When the BLS announces each month the increases or decreases in the number of per-sons employed and unemployed, these are net figures. That is, the change in the number of persons employed is equal to the total number of jobs created minus the number of jobs eliminated. Take, for example, the months from June to September 2007. During that period, 7,249,000 jobs were created, and 7,484,000 were eliminated, for a net decrease of 235,000 jobs. Because the net change is so much smaller than the total job increases and decreases, the net change gives a misleading indication of how dynamic the U.S. job mar-ket really is. The data in Table 12-3 reinforce the idea of how large the volume of job creation and job elimination is over a period as brief as three months. The table shows the number of establishments creating and eliminating jobs during the period from June through September 2007. During these three months, 13 percent of all private sector jobs were either created or destroyed. Fifty-five percent of establishments either eliminated jobs or added new jobs. About 367,000 new establishments opened, creat-ing 1.43 million new jobs, and 359,000 establishments closed, eliminating 1.35 mil-lion jobs. TABLE 12-3 Establishments Creating and Eliminating Jobs, June-September 2007 NUMBER OF NUMBER OF ESTABLISHMENTS JOBS ESTABLISHMENTS CREATING JOBS Existing establishments 1,519,000 5,821,000 New establishments 367,000 1,428,000 ESTABLISHMENTS ELIMINATING JOBS Existing establishments 1,585,000 6,134,000 Closing establishments 359,000 1,350,000 Source: U.S. Bureau of Labor Statistics, Business Employment Dynamics: Third Quarter 2007, May 21, 2008.

11. 382 PA R T 5 | Macroeconomic Foundations 12.2 LEARNING OBJECTIVE Frictional unemployment Short-term unemployment that arises from the process of matching workers with jobs. Figure 12-4 The Annual Unemployment Rate in the United States, 1950–2007 The unemployment rate rises during reces-sions and falls during expansion. Shaded areas indicate recessions. Source: U.S. Bureau of Labor Statistics. 12.2 | Identify the three types of unemployment. Types of Unemployment Figure 12-4 illustrates that the unemployment rate follows the business cycle, rising dur-ing recessions and falling during expansions. Notice, though, that the unemployment rate never falls to zero. To understand why this is true, we need to discuss the three types of unemployment: • Frictional unemployment • Structural unemployment • Cyclical unemployment Frictional Unemployment and Job Search Workers have different skills, interests, and abilities, and jobs have different skill require-ments, working conditions, and pay levels. As a result, a new worker entering the labor force or a worker who has lost a job probably will not find an acceptable job right away. Most workers spend at least some time engaging in job search, just as most firms spend time searching for a new person to fill a job opening. Frictional unemployment is short-term unemployment that arises from the process of matching workers with jobs. Some frictional unemployment is unavoidable. As we have seen, the U.S. economy cre-ates and destroys millions of jobs each year. The process of job search takes time, so there will always be some workers who are frictionally unemployed because they are between jobs and in the process of searching for new ones. Some unemployment is due to seasonal factors, such as weather or fluctuations in demand for some products or services during different times of the year. For example, stores located in beach resort areas reduce their hiring during the winter, and ski resorts reduce their hiring during the summer. Department stores increase their hiring in November and December and reduce their hiring after New Year’s Day. In agricultural areas, employment increases during harvest season and declines thereafter. Construction workers experience greater unemployment during the winter than during the summer. Seasonal unemployment refers to unemployment due to factors such as weather, variations in tourism, and other calendar-related events. Because seasonal unemployment can make the unemployment rate seem artificially high during some months and artificially low during other months, the BLS reports two unemployment

12. C H A P T E R 1 2 | Unemployment and Inflation 383 Structural unemployment Unemployment arising from a persistent mismatch between the skills and characteristics of workers and the requirements of jobs. rates each month—one that is seasonally adjusted and one that is not seasonally adjusted. The seasonally adjusted data eliminate the effects of seasonal unemployment. Economists and policymakers rely on the seasonally adjusted data as a more accurate measure of the current state of the labor market. Would eliminating all frictional unemployment be good for the economy? No, because some frictional unemployment actually increases economic efficiency. Frictional unemployment occurs because workers and firms take the time necessary to ensure a good match between the attributes of workers and the characteristics of jobs. By devoting time to job search, workers end up with jobs they find satisfying and in which they can be productive. Of course, having more productive and better-satisfied workers is also in the best interest of firms. Structural Unemployment By 2007, computer-generated three-dimensional animation, which was used in movies such as Shrek and Ratatouille, had become much more popular than traditional hand-drawn two-dimensional animation. Many people who were highly skilled in hand-drawn animation lost their jobs at Walt Disney Pictures, Dreamworks, and other movie studios. To become employed again, many of these people either became skilled in computer-generated animation or found new occupations. In the meantime, they were unemployed. Economists consider these animators structurally unemployed. Structural unemployment arises from a persistent mismatch between the job skills or attributes of workers and the requirements of jobs. While frictional unemployment is short term, structural unemployment can last for longer periods because workers need time to learn new skills. For example, employment by U.S. steel firms dropped by more than half between the early 1980s and the early 2000s as a result of competition from foreign pro-ducers and technological change that substituted machines for workers.Many steelwork-ers found new jobs in other industries only after lengthy periods of retraining. Some workers lack even basic skills, such as literacy, or have addictions to drugs or alcohol that make it difficult for them to perform adequately the duties of almost any job. These workers may remain structurally unemployed for years. Cyclical Unemployment When the economy moves into recession, many firms find their sales falling and cut back on production. As production falls, they start laying off workers.Workers who lose their jobs because of a recession are experiencing cyclical unemployment. For example, Freightliner, which is the leading manufacturer of trucks and other commercial vehicles in North America, laid off workers from its heavy truck plants during the recession of 2001. As the economy recovered from the recession, Freightliner began rehiring those workers. The Freightliner workers had experienced cyclical unemployment. Full Employment As the economy moves through the expansion phase of the business cycle, cyclical unemployment will eventually drop to zero. The unemployment rate will not be zero, however, because of frictional and structural unemployment. As Figure 12-4 shows, the unemployment rate in the United States is rarely below 4 percent. When the only remaining unemployment is structural and frictional unemployment, the economy is said to be at full employment. Economists consider frictional and structural unemployment as the normal underly-ing level of unemployment in the economy. The fluctuations around this normal level of unemployment, which we see in Figure 12-4, are mainly due to the changes in the level of cyclical unemployment. This normal level of unemployment, which is the sum of fric-tional and structural unemployment, is referred to as the natural rate of unemployment. Economists disagree on the exact value of the natural rate of unemployment, and there is good reason to believe it varies over time. Currently, most economists estimate the nat-ural rate to be about 5 percent. The natural rate of unemployment is also sometimes called the full-employment rate of unemployment. Cyclical unemployment Unemployment caused by a business cycle recession. Natural rate of unemployment The normal rate of unemployment, consisting of frictional unemployment plus structural unemployment.

13. How Should We Categorize the Unemployment at Alcatel-Lucent? We saw at the beginning of this chapter that the technology firm Alcatel-Lucent has experienced sharp declines in employ-ment 384 PA R T 5 | Macroeconomic Foundations over the past few years. Was the unemployment caused by the layoffs at Alcatel- Lucent frictional unemployment, structural unemployment, or cyclical unemployment? In answering this question, we should acknowledge that categorizing unemployment as frictional, structural, or cyclical is useful in understanding the sources of unemployment, but it can be difficult to apply these categories in a particular case. The Bureau of Labor Statistics, for instance, provides estimates of total unemployment but does not classify it as frictional, structural, or cyclical. Despite these difficulties, we can roughly categorize the unemployment at Alcatel-Lucent. We begin by considering the three basic reasons the layoffs occurred: the long-lived decline in some of the telecommunications products Alcatel-Lucent sells; the recession of 2001 that reduced the demand for the firm’s products; and the failure of the firm’s managers to compete successfully against other firms in the industry. Each reason corresponds to a category of unemployment. Because the demand for the telecom-munications products Alcatel-Lucent sells—particularly products used with fiber-optic cable networks—declined for a significant period, employment at Lucent and competing firms also declined. Between late 2000 and mid-2002, employment in the telecommu-nications industry declined by more than 500,000. Certain cate-gories of employees, such as optical engineers, had difficulty finding new jobs. They were structurally unemployed because they were not able to find new jobs without learning new skills. Some of the decline in Alcatel-Lucent’s sales was due to the 2001 recession rather than to long-term problems in the telecommunications industry. So, some of the workers who lost their jobs during that period were cyclically unemployed. Finally, in 2006, Alcatel-Lucent had difficulty competing with other communications-technology firms and as a result experienced declining sales, which led to further layoffs. Some workers who lost their jobs at Alcatel-Lucent were able to find new jobs at the firm’s competitors after relatively brief job searches. These workers were frictionally unemployed. YOUR TURN: Test your understanding by doing related problem 2.4 on page xxx at the end of this chapter. 12.3 | Explain what factors determine the unemployment rate. Explaining Unemployment We have seen that some unemployment is caused by the business cycle. In later chapters, we will explore the causes of the business cycle, which will help us understand the causes of cyclical unemployment. In this section, we will look at what determines the levels of frictional and structural unemployment. Government Policies and the Unemployment Rate Workers search for jobs by sending out resumes, registering with Internet job sites such as Monster.com, and getting job referrals from friends and relatives. Firms fill job open-ings by advertising in newspapers, participating in job fairs, and recruiting on college campuses. Government policy can aid these private efforts. Governments can help reduce the level of frictional unemployment by pursuing policies that help speed up the 12.3 LEARNING OBJECTIVE Making the | Connection The people who lost their jobs at Alcatel-Lucent fit into more than one category of unemployment.

14. C H A P T E R 1 2 | Unemployment and Inflation 385 process of matching unemployed workers with unfilled jobs. Governments can help reduce structural unemployment through policies that aid the retraining of workers. For example, the federal government’s Trade Adjustment Assistance program offers training to workers whose firms laid them off as a result of competition from foreign firms. Some government policies, however, can add to the level of frictional and structural unemployment. These government policies increase the unemployment rate either by increasing the time workers devote to searching for jobs, by providing disincentives to firms to hire workers, or by keeping wages above their market level. Unemployment Insurance and Other Payments to the Unemployed Suppose you have been in the labor force for a few years but have just lost your job. You could probably find a low-wage job immediately if you needed to—perhaps at Wal-Mart or McDonald’s. But you might decide to search for a better, higher-paying job by sending out resumes and responding to want ads and Internet job postings. Remember from Chapter 1 that the opportunity cost of any activity is the highest-valued alternative that you must give up to engage in that activity. In this case, the opportunity cost of continu-ing to search for a job is the salary you are giving up at the job you could have taken. The longer you search, the greater your chances of finding a better, higher-paying job, but the longer you search, the greater the opportunity cost of the salary you are giving up by not working. In the United States and most other industrial countries, the unemployed are eligi-ble for unemployment insurance payments from the government. In the United States, these payments are equal to about half the average wage. The unemployed spend more time searching for jobs because they receive these payments. This additional time spent searching raises the unemployment rate. Does this mean that the unemployment insurance program is a bad idea? Most economists would say no. Before Congress established the unemployment insurance program at the end of the 1930s, unemployed workers suffered very large declines in their incomes, which led them to greatly reduce their spending. This reduced spending contributed to the severity of recessions. Unemployment insurance helps the unemployed maintain their income and spending, which lessens the personal hardship of being unemployed and also helps reduce the severity of recessions. International Comparisons In the United States, unemployed workers are typi-cally eligible to receive unemployment insurance payments equal to about half their previous wage for only six months. After that, the opportunity cost of continuing to search for a job rises. In many other high-income countries, such as Canada and most of the countries of Western Europe, workers are eligible to receive unemploy-ment payments for a year or more, and the payments may equal 70 percent to 80 percent of their previous wage. In addition, many of these countries have generous social insurance programs that allow unemployed adults to receive some government payments even after their eligibility for unemployment insurance has ended. In the United States, very few government programs make payments to healthy adults, with the exception of the Temporary Assistance for Needy Families program, which allows single parents to receive payments for up to five years. Although there are many reasons unemployment rates may differ across countries, most economists believe that because the opportunity cost of job search is lower in Canada and Western Europe, unemployed workers in those countries search longer for jobs and, therefore, the unemployment rates in those countries tend to be higher than in the United States. Figure 12-5 shows the average yearly unemployment rate for the 10-year period from 1998 to 2007 for the United States, Canada, Japan, and several Western European countries. The United States and Japan provide unemployment insurance payments for only a short period of time, and their average unemployment rate during these years was lower than for the other countries shown.Many European countries also have laws that make it difficult for companies to fire workers. These laws create a disincentive for firms to hire workers, which also contributes to a higher unemployment rate.

15. 386 PA R T 5 | Macroeconomic Foundations Figure 12-5 | Average Unemployment Rates in the United States, Canada, Japan, and Europe, 1998-2007 The unemployment rate in the United States is usually lower than the unemployment rates in most other high-income coun-tries, partly because the United States has tougher requirements for the unemployed to receive government payments.These requirements raise the costs of searching for a better job and lower the unemployment rate. Source: Organization for Economic Cooperation and Development. Minimum Wage Laws In 1938, the federal government enacted a national minimum wage law.At first, the lowest legal wage firms could pay workers was $0.25 per hour.Over the years, Congress gradually has raised the minimum wage; by 2009, it will reach $7.25 per hour. Some states and cities also have minimum wage laws. For example, in 2008, California set its minimum wage at $8.00 per hour, and the minimum wage in San Francisco in 2008 was $9.36 per hour. If the minimum wage is set above the market wage determined by the demand and supply of labor, the quantity of labor supplied will be greater than the quantity of labor demanded. Some workers will be unemployed who would have been employed if there were no minimum wage. As a result, the unemploy-ment rate will be higher than it would be without a minimum wage. Economists agree that the current minimum wage is above the market wage for some workers, but they disagree on the amount of unemployment that has resulted. Because teenagers generally have relatively few job-related skills, they are the group most likely to receive the mini-mum wage. Studies estimate that a 10 percent increase in the minimum wage reduces teenage employment by about 2 percent. Because teenagers and others receiving the minimum wage are a relatively small part of the labor force, most economists believe that, at its present level, the effect of the minimum wage on the unemployment rate in the United States is fairly small. Labor Unions Labor unions are organizations of workers that bargain with employers for higher wages and better working conditions for their members. In unionized industries, the wage is usually above what otherwise would be the market wage. This above-market wage results in employers in unionized industries hiring fewer workers, but does it also increase the overall unemployment rate in the economy? Most economists would say the answer is “no” because only about 9 percent of workers outside the government sec-tor are unionized. Although unions remain strong in a few industries, such as airlines,

16. C H A P T E R 1 2 | Unemployment and Inflation 387 automobiles, steel, and telecommunications, most industries in the United States are not unionized. The result is that workers who can’t find jobs in unionized industries because the wage is above its market level can find jobs in other industries. Efficiency Wages Many firms pay higher-than-market wages, not because the government requires them to or because they are unionized, but because they believe doing so will increase their profits. This link may seem like a paradox.Wages are the largest cost for many employ-ers, so paying higher wages seems like a good way for firms to lower profits rather than to increase them. The key to understanding the paradox is that the level of wages can affect the level of worker productivity.Many studies have shown that workers are moti-vated to work harder by higher wages. An efficiency wage is a higher-than-market wage that a firm pays to motivate workers to be more productive. Can’t firms ensure that workers work hard by supervising them? In some cases, they can. For example, a tele-marketing firm can monitor workers electronically to ensure that they make the required number of phone calls per hour. In many business situations, however, it is much more difficult to monitor workers.Many firms must rely on workers being moti-vated enough to work hard. In fact, the following is the key to the efficiency wage: By paying a wage above the market wage, a firm raises the costs to workers of losing their jobs because most alternative jobs will pay only the market wage. The increase in pro-ductivity that results from paying the high wage can more than offset the cost of the wage, thereby lowering the firm’s costs of production. Because the efficiency wage is above the market wage, it results in the quantity of labor supplied being greater than the quantity of labor demanded, just as do minimum wage laws and unions. So, efficiency wages are another reason economies experience some unemployment even when cyclical unemployment is zero. | Making Why Does Costco Pay Its Workers So Much More Than Wal-Mart Does? The concept of efficiency wages raises the possibility that firms might find it more profitable to pay higher wages even when it the Connection is possible to pay lower wages.We might expect that a firm would maximize profits by paying the lowest wages at which it was able to attract the number of workers needed. But if low wages significantly reduce worker productivity, then paying higher wages might actually reduce costs and increase profits.Wal-Mart and Costco are competitors in the discount department store industry, but the two companies have taken different approaches to compensating their workers. Wal-Mart employs more than 1.3 million workers in the United States, more than three times as many as McDonald’s, which is the second largest employer. Becoming a sales associate at Wal-Mart is one way to begin a career in retailing that may ulti-mately lead to a high-paying job. About three-quarters of Wal- Mart’s store managers started as hourly workers. But Wal-Mart’s hourly workers receive relatively low wages. In 2007, Wal-Mart paid its hourly workers on average about $10.50 per hour. In con-trast, the lowest wage that Wal-Mart’s rival Costco pays is about Costco’s relatively high wages and health benefits reduce employee turnover and raise morale and productivity. $11 per hour, and the average wage is about $17 per hour. Costco’s benefits also are more generous, with about 90 percent of its employees covered by medical insurance, as opposed to about 50 percent at Wal-Mart. Why does Costco pay wages so much higher than Wal-Mart pays? Costco’s chief executive officer, Jim Sinegal, argues that paying high wages reduces employee turnover and raises morale and productivity: “Paying good wages and keeping your Efficiency wage A higher-than-market wage that a firm pays to increase worker productivity.

17. 388 PA R T 5 | Macroeconomic Foundations 12.4 LEARNING OBJECTIVE Price level A measure of the average prices of goods and services in the economy. Inflation rate The percentage increase in the price level from one year to the next. people working for you is very good business. . . . Imagine that you have 120,000 loyal ambassadors out there who are constantly saying good things about Costco. It has to be a significant advantage for you.” But it is likely that not all the difference between the wages Costco pays and the wagesWal-Mart pays is due to Costco’s employing a strategy of pay-ing efficiency wages. Unlike Wal-Mart, Costco charges a fee of at least $45 per year to shop in its stores. The typical Costco store stocks only about 4,000 items as opposed to the 100,000 items that the average Wal-Mart store stocks. Costco stores also stock more high-priced items, such as jewelry and consumer electronics. As a result, the average income of Costco customers is about $74,000, more than twice as high as the average income of Wal-Mart customers. One observer concludes that Costco pays higher wages thanWal-Mart “because it requires higher-skilled workers to sell higher-end products to its more affluent customers.” So, even if Costco were not pursuing a strategy of paying efficiency wages, it is likely it would still have to pay higher wages thanWal-Mart does. Sources: Alan B. Goldberg and Bill Ritter, “Costco CEO Finds Pro-Worker Means Profitability,” ABCNews.com, August 2, 2006; Lori Montgomery,“Maverick CEO Joins Push to Raise Minimum Wage,”Washington Post, January 30, 2007; and John Tierney, “The Good Goliath,”New York Times, November 29, 2005. YOUR TURN: Test your understanding by doing related problem 3.7 on page xxx at the end of this chapter. 12.4 | Define price level and inflation rate and understand how they are computed. Measuring Inflation One of the facts of economic life is that the prices of most goods and services rise over time. As a result, the cost of living continually rises. In 1914,Henry Ford began paying his work-ers a wage of $5 per day, which was more than twice as much as other automobile manu-facturers. Ford’s $5-a-day wage provided his workers with a middle class income because prices were so low. In 1914, Ford’sModel T, the best-selling car in the country, sold for less than $600, the price of a man’s suit was $15, the price of a ticket to a movie theater was $0.15, and the price of a box of Kellogg’s Corn Flakes was $0.08. In 2009, with the cost of living being much higher than it was in 1914, the minimum wage law will require firms to pay a wage of at least $7.25 per hour, more than Ford’s highly paid workers earned in a day. Knowledge of how the government’s employment and unemployment statistics are compiled is important in interpreting them. The same is true of the government’s statis-tics on the cost of living. As we saw in Chapter 11, the price level measures the average prices of goods and services in the economy. The inflation rate is the percentage increase in the price level from one year to the next. In Chapter 11, we introduced the GDP deflator as a measure of the price level. The GDP deflator is the broadest measure we have of the price level because it includes the price of every final good and service. But, for some purposes, it is too broad. For example, if we want to know the impact of inflation on the typical household, the GDP price deflator may be misleading because it includes the prices of products such as large electric generators and machine tools that are included in the investment component of GDP but are not purchased by the typical household. In this chapter, we will focus on measuring the inflation rate by changes in the consumer price index because changes in this index come closest to measuring changes in the cost of living as experienced by the typical household.We will also briefly discuss a third measure of inflation: the producer price index. The Consumer Price Index To obtain prices of a representative group of goods and services, the BLS surveys 30,000 households nationwide on their spending habits. It uses the results of this survey to con-struct a market basket of 211 types of goods and services purchased by the typical urban

18. C H A P T E R 1 2 | Unemployment and Inflation 389 Consumer price index (CPI) An average of the prices of the goods and services purchased by the typical urban family of four. Food and beverages 14.9% Housing 42.4% Other goods and services Education and communication Recreation 5.6% Medical care 6.2% Apparel 3.7% 3.3% Transportation 17.7% 6.1% Figure 12-6 | The CPI Market Basket, December 2007 The Bureau of Labor Statistics surveys 30,000 households on their spending habits. The results are used to construct a market basket of goods and services purchased by the typical urban family of four. The chart shows these goods and ser-vices, grouped into eight broad categories. The percentages represent the expenditure shares of the categories within the market basket.The categories housing, transportation, and food make up about three-quarters of the market basket. Source: Bureau of Labor Statistics. family of four. Figure 12-6 shows the goods and services in the market basket, grouped into eight broad categories. Almost three-quarters of the market basket falls into the cat-egories of housing, transportation, and food. Each month, hundreds of BLS employees visit 23,000 stores in 87 cities and record prices of the goods and services in the market basket. Each price in the consumer price index is given a weight equal to the fraction of the typical family’s budget spent on that good or service. The consumer price index (CPI) is an average of the prices of the goods and services purchased by the typical urban family of four. One year is chosen as the base year, and the value of the CPI is set equal to 100 for that year. In any year other than the base year, the CPI is equal to the ratio of the dollar amount necessary to buy the market basket of goods in that year divided by the dollar amount necessary to buy the market basket of goods in the base year,multiplied by 100. Because the CPI measures the cost to the typical family to buy a representative bas-ket of goods and services, it is sometimes referred to as the cost-of-living index. A simple example can clarify how the CPI is constructed. For purposes of this exam-ple, we assume that the market basket has only three products: eye examinations, pizzas, and books: Base year (1999) 2008 2009 EXPENDITURES EXPENDITURES (ON BASE-YEAR (ON BASE-YEAR PRODUCT QUANTITY PRICE EXPENDITURES PRICE QUANTITIES) PRICE QUANTITIES) Eye examinations 1 $50.00 $50.00 $100.00 $100.00 $85.00 $85.00 Pizzas 20 10.00 200.00 15.00 300.00 14.00 280.00 Books 20 25.00 500.00 25.00 500.00 27.50 550.00 Total $750.00 $900.00 $915.00

19. 390 PA R T 5 | Macroeconomic Foundations Suppose that during the base year of 1999, a survey determines that each month, the typical family purchases 1 eye examination, 20 pizzas, and 20 books. At 1999 prices, the typical family must spend $750.00 to purchase this market basket of goods and services. The CPI for every year after the base year is determined by dividing the amount neces-sary to purchase the market basket in that year by the amount required in the base year, multiplied by 100. Notice that the quantities of the products purchased in 2008 and 2009 are irrelevant in calculating the CPI because we are assuming that households buy the same market basket of products each month. Using the numbers in the table, we can calculate the CPI for 2008 and 2009: FORMULA APPLIED TO 2008 APPLIED TO 2009 100 122 ⎛ $ $ 915 750 ⎝ ⎜ ⎞ ⎠ ⎟ × = 100 120 ⎛ $ $ 900 750 Expenditures in the current year Expendi CPI × = ⎝ ⎜ ⎞ ⎠ ⎟ How do we interpret values such as 120 and 122? The first thing to recognize is that they are index numbers, which means they are not measured in dollars or any other units. The CPI is intended to measure changes in the price level over time.We can’t use the CPI to tell us in an absolute sense how high the price level is, only how much it has changed over time.We measure the inflation rate as the percentage increase in the CPI from one year to the next. For our simple example, the inflation rate in 2009 would be the percentage change in the CPI from 2008 to 2009: ⎛ − 122 120 120 × 100 = 1 . 7 %. ⎝ ⎜ ⎞ ⎠ ⎟ Because the CPI is designed to measure the cost of living, we can also say that the cost of living increased by 1.7 percent during 2009. Is the CPI Accurate? The CPI is the most widely used measure of inflation. Policymakers use the CPI to track the state of the economy. Businesses use it to help set the prices of their products and the wages and salaries of their employees. Each year, the federal government increases the Don’t Let This Happen to YOU! Don’t Miscalculate the Inflation Rate Suppose you are given the data in the following table and are asked to calculate the inflation rate for 2007. YEAR CPI 2006 202 2007 207 It is tempting to avoid any calculations and simply to report that the inflation rate in 2007 was 107 percent because 207 is a 107 percent increase from 100. But 107 percent would be the wrong answer. A value for the CPI of 207 in 2007 tells us that the price level in 2007 was 107 per-cent higher than in the base year, but the inflation rate is the percentage increase in the price level from the previous year, not the percentage increase from the base year. The correct calculation of the inflation rate for 2007 is: ⎛ − 207 202 202 × 100 = 2 . 5 %. ⎝ ⎜ ⎞ ⎠ ⎟ YOUR TURN: Test your understanding by doing related problem 4.3 on page xxx at the end of this chapter. = tures in the base year ×100

20. C H A P T E R 1 2 | Unemployment and Inflation 391 Social Security payments made to retired workers by a percentage equal to the increase in the CPI during the previous year. In setting alimony and child support payments in divorce cases, judges often order that the payments increase each year by the inflation rate, as measured by the CPI. It is important that the CPI be as accurate as possible, but there are four biases that make changes in the CPI overstate the true inflation rate: • Substitution bias. In constructing the CPI, the BLS assumes that each month, con-sumers purchase the same amount of each product in the market basket. In fact, consumers are likely to buy fewer of those products that increase most in price and more of those products that increase least in price (or fall the most in price). For instance, if apple prices rise rapidly during the month while orange prices fall, con-sumers will reduce their apple purchases and increase their orange purchases. Therefore, the prices of the market basket consumers actually buy will rise less than the prices of the market basket the BLS uses to compute the CPI. • Increase in quality bias. Over time, most products included in the CPI improve in quality: Automobiles become more durable and side air bags become standard equipment, computers become faster and have more memory, dishwashers use less water while getting dishes cleaner, and so on. Increases in the prices of these prod-ucts partly reflect their improved quality and partly are pure inflation. The BLS attempts to make adjustments so that only the pure inflation part of price increases is included in the CPI. These adjustments are difficult to make, so the recorded price increases overstate the pure inflation in some products. • New product bias. For many years, the BLS updated the market basket of goods used in computing the CPI only every 10 years. That meant that new products introduced between updates were not included in the market basket. For example, the 1987 update took place before cell phones were introduced. Although millions of American households used cell phones by the mid-1990s, they were not included in the CPI until the 1997 update. The prices of many products, such as cell phones, HD-DVD players, and computers, decrease in the years immediately after they are introduced. If the market basket is not updated frequently, these price decreases are not included in the CPI. • Outlet bias. During the mid-1990s, many consumers began to increase their pur-chases from discount stores such as Sam’s Club. By the late 1990s, the Internet began to account for a significant fraction of sales of some products. Because the BLS con-tinued to collect price statistics from traditional full-price retail stores, the CPI was not reflecting the prices some consumers actually paid. Most economists believe these biases cause changes in the CPI to overstate the true inflation rate by one-half of a percentage point to one percentage point. That is, if the CPI indicates that the inflation rate was 3 percent, it is probably between 2 percent and 2.5 percent. The BLS continues to take steps to reduce the size of the bias. For example, the BLS has reduced the size of the substitution and new product biases by updating the market basket every 2 years rather than every 10 years. The BLS has reduced the size of the outlet bias by conducting a point-of-purchase survey to track where consumers actually make their purchases. Finally, the BLS has used statistical methods to reduce the size of the quality bias. Prior to these changes, the size of the total bias in the CPI was probably greater than 1 percent. The Producer Price Index In addition to the GDP deflator and the CPI, the government also computes the producer price index (PPI). Like the CPI, the PPI tracks the prices of a market basket of goods. But, whereas the CPI tracks the prices of goods and services purchased by the typical household, the PPI tracks the prices firms receive for goods and services at all Producer price index (PPI) An average of the prices received by producers of goods and services at all stages of the production process.

21. 392 PA R T 5 | Macroeconomic Foundations stages of production. The PPI includes the prices of intermediate goods, such as flour, cotton, yarn, steel, and lumber, and raw materials, such as raw cotton, coal, and crude petroleum. If the prices of these goods rise, the cost to firms of producing final goods and services will rise, which may lead firms to increase the prices of goods and services purchased by consumers. Changes in the PPI therefore can give an early warning of future movements in the CPI. 12.5 | Use price indexes to adj

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