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Presentation on theme: "©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part."— Presentation transcript:

1 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Introduction to Macroeconomics: Unemployment, Inflation, and Economic Fluctuations

2 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER INTRODUCTION We now focus our attention on macroeconomics and, in particular, on two key concepts that are at the heart of macroeconomics and economic policymaking—unemployment and inflation. To those who have just lost a job, unemployment ranks high on the stress meter. To an elderly person who is living on a fixed income, inflation and the loss of purchasing power may be just as threatening. 2

3 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Macroeconomic Goals The three major macroeconomic goals include: Maintaining employment of human resources at relatively high levels; Maintaining prices at a relatively stable level so that consumers and producers can make better decisions; Achieving a high rate of economic growth, meaning a growth in output per person over time. 10.1

4 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The term real gross domestic product (RGDP) is used to measure output or production. The term real is used to indicate that the output is adjusted for the general increase in prices over time. Gross domestic product (GDP) is defined as the total value of all final goods and services produced in a given period of time. Three Major Macroeconomic Goals

5 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978 (the Humphrey– Hawkins Act) commit the U.S. government to pursue policies that will lead to full employment and stable prices. It first acknowledged formally primary macroeconomic goals.

6 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Unemployment figures are reported by the U.S. Department of Labor on a monthly basis. The news of lower unemployment usually sends stock prices higher; and the news of higher unemployment usually sends stock prices lower. Politicians are also concerned about the unemployment figures because elections often hinge precariously on whether unemployment has been rising or falling Employment and Unemployment

7 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A loss of a job can mean financial insecurity and a great deal of anxiety. High rates of unemployment in a society can increase tensions and despair. The Consequences of High Unemployment

8 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Society loses some potential output of goods when some of its productive resources—human or nonhuman—remain idle, and potential consumption is reduced. Clearly, then, a loss in efficiency occurs when people willing to work and equipment able to produce remain idle.

9 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. When discussing unemployment, economists and politicians refer to the unemployment rate. To calculate the unemployment rate, you must first understand another important concept—the labor force. It includes the number of people over the age of 16 who are available for employment. What is the Unemployment Rate?

10 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The civilian labor force figure excludes people in the armed services and those in prisons or mental hospitals. Other people regarded as outside the labor force include homemakers, retirees, and full-time students. This is because they are not considered currently available for employment.

11 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12 To calculate the unemployment rate, we simply divide the number of unemployed by the number in the civilian labor force:

13 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. In August 2011, the number of civilians unemployed in the United States was 14 million, and the civilian labor force totaled million. Thus the unemployment rate in August 2011 was 9.1 percent. Unemployment rate = 14 Million/153.6 million = x 100 = 9.1 percent

14 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The worst employment downturn in U.S. history occurred during the Great Depression, which began in late 1929 and continued until Unemployment rose from only 3.2 percent of the labor force in 1929 to more than 20 percent in the early 1930s, and double-digit unemployment persisted through The Worst Case of U.S. Unemployment

15 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Unemployment since 1960 ranged from a low of 3.5 percent in 1969 to a high of 10.8 percent in The financial crisis of 2008 led to unemployment rates of 9.4 percent by mid Before 1960, variations in unemployment were more pronounced. Variations in the Unemployment Rate

16 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17 Discouraged workers are those that quit looking for a job in periods of prolonged recession, thinking that the chances of landing a job are very bleak. Individuals who have not actively sought work for four weeks are not counted as unemployed; instead, they fall out of the labor force. Are Unemployment Statistics Accurate Reflections of the Labor Market?

18 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. People looking for fulltime work who grudgingly settle for part-time jobs are counted as “fully” employed, even though they are only “partly” employed. At least partially balancing these two biases in government employment statistics, however, is the number of people who are over-employed—that is, working overtime or at more than one job.

19 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A number of jobs in the underground economy (e.g., drug dealing, prostitution, gambling, and so on) are not reported. In addition, many people may claim they are seeking work when, in fact, they may just be going through the motions so they can continue to collect unemployment compensation or receive other government benefits.

20 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Unemployment usually varies greatly across different segments of the population and over time. According to the Bureau of Labor Statistics, the unemployment rate across the sexes and races among college graduates is significantly lower than for those who do not complete high school. Who are the Unemployed?

21 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. College graduates have lower unemployment rates than people who have some college education but did not complete their bachelor’s degrees (8.2 percent). The incidence of unemployment varies widely among the population.

22 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Unemployment tends to be greater among the very young, among blacks and other minorities, and among workers with few skills.

23 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Considering the great variations in unemployment for different groups in the population, we calculate separate unemployment rates for groups classified by sex, age, race, family status, and type of occupation. Some would regard teenage unemployment a lesser evil than unemployment among adults, because most teenagers have parents or guardians on whom they can rely for subsistence.

24 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 Teenagers have the highest rates of unemployment. Do you think it would be easier for them to find jobs if they had more experience and higher skill levels? DIGITA L VISION/GETTY IMAGES

25 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

26 According to the Bureau of Labor Statistics, the four main categories of unemployed workers are Job losers (those who have been temporarily laid off or fired). Job leavers (those who have quit their jobs). Categories of Unemployed Workers

27 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Reentrants (those who worked before and are reentering the labor force). New entrants (those entering the labor force for the first time—primarily teenagers).

28 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

29 Even though unemployment is painful to those who have no source of income, reducing unemployment is not costless. In the short run, a reduction in unemployment may come at the expense of a higher rate of inflation, especially if the economy is close to full capacity, where resources are almost fully employed. How Much Unemployment?

30 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Trying to match employees with jobs can quickly lead to significant inefficiencies, because of mismatches between a worker’s skill level and the level of skill required for a job. That is, the skills of the employee may be higher than those necessary for the job, resulting in what economists call underemployment. Another source of inefficiencies is placing employees in jobs beyond their abilities.

31 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Because of the problems associated with accurately measuring the unemployment rate the Bureau of Labor Statistics (BLS) calculates alternative measures of labor underutilization, as shown in Table 1. 31

32 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32

33 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The duration of unemployment is equally as important as the amount of unemployment. It is useful to look at the average duration of unemployment to discover what percentage of the labor force is unemployed longer than a certain period, say 15 weeks. How Long are People Usually Unemployed?

34 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

35 The duration of unemployment tends to be greater when the amount of unemployment is high and smaller when the amount of unemployment is low. For example, in 2000 when the economy had low levels of unemployment, 45 percent of the unemployed had been unemployed for less than 5 weeks and 77 percent less than 15 weeks. Unemployment of any duration, of course, means a potential loss of output. This loss of current output is permanent; it is not made up when unemployment starts falling again.

36 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The percentage of the working age population that is in the labor force is what economists call the labor force participation rate. The increase in the labor force participation rate can be attributed in large part to the entry of the baby boomers into the labor force together with an increase in the women’s labor force participation rate. Labor Force Participation Rate

37 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Over the last several decades, the number of women working shifted dramatically, reflecting the changing role of women in the workforce. Today the labor force participation rate for men has fallen to roughly 70 percent, as many men stay in school longer and opt to retire earlier.

38 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

39 Types of Unemployment Frictional unemployment is the temporary unemployment that results from the search time that occurs when people are searching for suitable jobs and firms are looking for suitable workers. People seeking work do not usually take the first job offered to them. Likewise, firms do not usually take the first person they interview. People and firms engage in a search to match up skills and interests. While the unemployed are looking, they are frictionally unemployed. 10.3

40 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Whether the unemployment is due to having been fired, or from having voluntarily quit, frictional unemployment is short term and results from normal turnover in the labor market, as when people change from one job to another.

41 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A certain amount of frictional unemployment may be good for the economy, because workers who are temporarily unemployed may find jobs that are better suited to their skill level. Even though the amount of frictional unemployment varies somewhat over time, it is unusual for it to be much less than 2 percent of the labor force. Actually, frictional unemployment tends to be somewhat greater in periods of low unemployment, when job opportunities are plentiful. This high level of job opportunity stimulates mobility, which, in turn, creates some frictional unemployment. Should We Worry About Frictional Unemployment?

42 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Like frictional unemployment, structural unemployment is related to occupational movement or mobility—in this case, to a lack of mobility. It occurs when workers lack the necessary skills for jobs that are available or have particular skills that are no longer in demand. Structural Unemployment

43 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Structural unemployment, like frictional unemployment, reflects the dynamic dimension of a changing economy. Over time, new jobs open up that require new skills, while old jobs that required different skills disappear.

44 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Another reason for structural unemployment is that low-skilled workers are frequently unable to find desirable long-term employment. Since they acquired no new skill from the old job, they may not find a long-term secure job. That is, structural workers cannot be said to be “in-between jobs” like those who are frictionally unemployed. Structural unemployment is more long term and serious than frictional unemployment because these workers do not have marketable skills.

45 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45 What type of unemployment would occur if these coal miners lost their jobs as a result of a permanent reduction in demand for coal and needed retraining to find other employment? Usually, structural unemployment occurs because of workers’ lack of skills or long-term changes in demand. Consequently, it generally lasts for a longer period than does frictional unemployment. © KAREN KASMAUSKI/CORBIS

46 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Frictional and structural unemployment are simply unavoidable in a vibrant economy. To a certain extent, both can be viewed as phenomena resulting from imperfections in the labor market. Some Unemployment is Unavoidable

47 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. It takes time for suppliers of labor to find the demanders of labor services, and it takes time and money for labor resources to acquire the necessary skills. Bringing together demanders and suppliers of labor services does not occur instantaneously since information and job searches are expensive.

48 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Often, unemployment is composed of more than just frictional and structural unemployment. In years of relatively high unemployment, some joblessness may result from short-term cyclical fluctuations in the economy. We call this type cyclical unemployment. Whenever the unemployment rate is greater than normal, such as during a recession, it is due to cyclical unemployment. Most attempts to solve the cyclical unemployment problem emphasized increasing aggregate demand to counter recession. Cyclical Unemployment

49 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. When the unemployment rate is high, numerous economic and social hardships result. The economic costs are the forgone output when the economy is not producing at its potential level. According to Okun’s Law (really, a rule of thumb), a 1 percent increase in cyclical unemployment reduces output by 2 percentage points. Thus, we can actually estimate the economic costs of not producing at our potential output. The costs are particularly high for those groups with the least skills—the poorly educated and teenagers with little work experience. The Cost of Cyclical Unemployment

50 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Over the period in which annual unemployment data are available, the median, or “typical,” annual unemployment rate has been at or slightly above 5 percent. Some economists call this typical unemployment rate the natural rate of unemployment. The Natural Rate of Unemployment

51 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Abnormally high unemployment exists when unemployment rises well over 5 percent, and abnormally low unemployment when it falls below 5 percent. The natural rate of unemployment of approximately 5 percent roughly equals the sum of frictional and structural unemployment when they are at their maximums.

52 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Thus, unemployment rates below the natural rate reflect the existence of below- average levels of frictional and structural unemployment. Unemployment rates above the natural level show the existence of cyclical unemployment. In short, the natural rate of unemployment is the unemployment rate when the economy is experiencing neither a recession nor a boom.

53 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The natural rate of unemployment is also called the full employment rate of unemployment. It can change over time as technological, demographic, institutional, and other conditions vary. Baby boomers, Internet and improvements in job placement, and new work requirements of welfare laws can change the natural rate of unemployment.

54 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. When all the resources of an economy— labor, land, and capital— are fully employed, the economy is said to be producing its potential output. It means that the economy is providing employment for all who are willing and able to work with no cyclical unemployment. Full Employment and Potential Output

55 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. It also means that capital and land are fully employed. At the natural rate of unemployment, all resources are fully employed, the economy is producing its potential output, and no cyclical unemployment is present.

56 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. In contrast, when the economy is experiencing cyclical unemployment the unemployment rate is greater than the natural rate and the economy is producing less than potential output. It is also possible for the economy to temporarily exceed potential output, as workers put in overtime or moonlight by taking on extra employment.

57 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

58 Reasons for Unemployment In many markets, prices adjust to the market equilibrium price and quantity, and no prolonged periods of shortage or surplus occur. However, in labor markets, obstacles prevent wages from adjusting and balancing the quantity of labor supplied and the quantity of labor demanded. 10.4

59 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The market equilibrium wage equates the quantity demanded of labor with the quantity supplied of labor. When the quantity of labor supplied is greater than the quantity of labor demanded, an excess quantity supplied of labor— unemployment —exists. Why Does Unemployment Exist?

60 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. More people want to work at the going (nonequilibrium) wage than employers want to hire, and those who are not able to find work are “unemployed.” Three reasons are cited for the failure of wages to balance the labor demand and labor supply equilibrium—minimum wages, unions, and the efficiency wage theory.

61 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Wages Above Equilibrium Lead to Greater Unemployment

62 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The labor market for workers with little experience and job skills is called the unskilled labor market. Suppose the government decided to establish a minimum wage rate (an hourly wage floor) for unskilled workers above the equilibrium wage. Minimum Wages and Unemployment

63 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. At the minimum wage, the quantity of labor supplied grows because more people are willing to work at a higher wage. However, the quantity of labor demanded falls because some employers would find it unprofitable to hire low-skilled workers at the higher wage.

64 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The gap that exists between the quantity of labor demanded and the quantity supplied represents a surplus of unskilled workers— unemployment. Since minimum wage earners, a majority of whom are 25 years or younger, are a small portion of the labor force, most economists believe the effect of the minimum wage on unemployment is small.

65 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. If, through the process of collective bargaining, union officials are able to raise wages, then unemployment will rise in the union sector. If the union wage increases above the equilibrium level, the quantity of union labor demanded will decrease, and the quantity of union labor supplied will increase, resulting in the unemployment of union workers. The Impact of Unions on the Unemployment Rate

66 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The union workers who still have their jobs will be better off, but some who are equally skilled will be unemployed and will either seek nonunion work or wait to be recalled in the union sector. Many believe that is why wages are approximately 15 percent higher in union jobs, even when nonunion workers have comparable skills.

67 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. On the other hand, even though wages in the union sector are typically higher than the market wage, the presence of unions does not necessarily lead to greater unemployment because workers can find jobs in the nonunion sector. Less than 10 percent of private sector jobs are unionized.

68 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. It is generally assumed that as productivity rises, wages rise, and workers can raise their productivity through investments in human capital like education and on-the- job training. Some economists, however, follow the efficiency wage model, which is based on the belief that higher wages lead to greater productivity. Efficiency Wage

69 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Under this model, employers pay their employees more than the equilibrium wage to be more efficient. Proponents of this theory suggest that it may lead to attracting the most productive workers, fewer job turnovers, and higher morale, which in turn can lead to lower hiring and training costs.

70 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Since the efficiency wage rate is greater than the equilibrium wage rate, the quantity of labor supplied is greater than the quantity of labor demanded, resulting in greater amounts of unemployment.

71 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Some have argued that the positive effects of the efficiency wage are unique to assembly line production and its high degree of worker interdependence. However, it is costly for firms to pay an efficiency wage. Consequently, firms must monitor their workers’ efforts.

72 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. If enough firms resort to paying the efficiency wage rate it leads to a surplus of workers who want jobs and cannot find them. This, like a binding minimum wage, leads to unemployment.

73 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Different firms offer different compensation packages (salary, fringe benefits, working conditions), and workers are sometimes unaware of these packages when they seek the “best” job available. It takes time and money to locate the best available opportunities. Also, not all job seekers are the same: They have different tastes and preferences about types of jobs and job locations. Sometimes it is difficult to get the information about particular jobs to the right job candidate. These search activities prolong the duration of unemployment. However, the search goes on because the job seeker hopes to find a better offer. Job Search

74 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The labor demand and supply curves are constantly shifting. That is, labor markets are constantly in flux— people losing jobs, leaving jobs, reentering jobs. In a growing and dynamic economy, jobs are constantly being destroyed and created, leading to temporary unemployment as workers search for the best jobs for their skills.

75 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Losing a job can lead to considerable hardships, and unemployment insurance is designed to partially offset the severity of the unemployment problem. That is, unemployment insurance allows unemployed workers to maintain some income and spending, reducing hardships and the severity of a recession. Unemployment insurance does not cover those who were fired or quit their jobs. To qualify, recipients must have worked a certain length of time and lost their jobs because the employer no longer needed their skills. The typical compensation is half salary for 26 weeks. Unemployment Insurance

76 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Although the program is intended to ease the pain of unemployment, it also leads to prolonged periods of unemployment, as job seekers stay unemployed for longer periods searching for new jobs. It has been estimated that the existence of unemployment compensation programs may raise overall unemployment rates by as much as 1 percent.

77 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Without unemployment insurance, a job seeker would be more likely to take the first job offered, even if the job did not match the job seeker’s preferences or skill levels. A longer job search might mean a better match, but it comes at the expense of lost production and greater amounts of tax dollars. Of course, that does not mean that unemployment insurance is necessarily a bad program. It still serves its desired goal of reducing income uncertainty. Workers that turn down unattractive jobs have an opportunity to find better jobs that may be better suited for their tastes and skills. In summary, most economists believe that eliminating unemployment insurance could reduce unemployment, but they disagree on whether economic well-being is reduced or enhanced by a change in the policy.

78 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Generally, new inventions are cost saving, and these cost savings usually generate higher incomes for producers and lower prices and better products for consumers— benefits that ultimately result in the growth of other industries. If the new equipment is a substitute for labor, it might displace workers. Does New Technology Lead to Greater Unemployment?

79 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. However, new capital equipment requires new workers to manufacture and repair the new equipment. The most famous example being the computer. The problem is that it is easy to see only the initial effect of technological advances (displaced workers) but difficult to recognize the implications of that invention throughout the whole economy over time.

80 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Some economists believe that some of the real wage differentials between skilled and unskilled workers in the last couple of decades are due to technical changes that are biased toward skilled workers. New machines, with highly sophisticated computerization, require highly skilled workers.

81 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Consequently, the new machines make these workers more productive and therefore they receive higher real wages. With an increase in demand for skilled labor, their real wages and employment are higher. Simultaneously, the demand is lower for workers without technical training in specialized machinery, and the demand falls.

82 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. As a result of the decrease in demand for unskilled workers, real wages and employment fall. Thus, skill-biased technical change tends to create even greater disparities between the wages of skilled and unskilled workers.

83 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Skill-Biased Technical Change and Wage Inequality

84 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inflation Just as full employment brings about one kind of economic security, an overall stable price level increases another form of economic security. Most prices in the U.S. economy tend to rise over time. The continuing rise in the overall price level is called inflation. 10.5

85 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Even when the level of prices is stable, some prices will be rising while others are falling. When inflation is present, the goods and services with rising prices will outweigh the goods and services with lower prices. Stable Price Level as a Desirable Goal

86 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Without stability in the price level, consumers and producers will experience more difficulty in coordinating their plans and decisions. When the overall price level is falling, it is called deflation. The average price level in the U.S. economy fell throughout the late nineteenth century.

87 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A reduction in the rate of inflation is called disinflation. In the United States, we saw disinflation from 1981–1986, 1991–1994, and 2001–2003. It is difficult and costly to bring the inflation rate down once it has become expected. Most economists believe that the inflation rates of the 1970s were finally brought under control by the 1980–1981 recession, when the unemployment rate reached 10.7 percent. 87

88 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Thus, most believe the best policy is to not let inflation get out of control in the first place—one of the primary jobs of the Federal Reserve System. In general, the only thing that can cause a sustained increase in the rate of inflation is a high rate of growth in money.

89 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inflation distorts the information that flows from price signals. To measure the changing purchasing power of the dollar we must construct a price index. A price index attempts to provide a measure of the prices paid for a certain bundle of goods and services over time. Measuring Inflation

90 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The consumer price index (CPI), measures the trend in the prices of certain goods and services purchased for consumption purposes. The typical CPI shopping basket is shown below. The GDP deflator measures the average level of prices of all final goods and services produced in the economy (i.e., in GDP). The Consumer Price Index and the GDP Deflator

91 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

92 92

93 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Literally thousands of goods and services are in our economy; attempting to include all of them in an index would be cumbersome and make the index expensive to compute, and it would take a long time to gather the necessary data. Hence, a “bundle” or “basket” of representative goods and services is selected by the index calculators (the Bureau of Labor Statistics of the U.S. Department of Labor for consumer and wholesale price indices; the Office of Business Economics of the Department of Commerce for the GDP deflator). How is a Price Index Created

94 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Suppose a consumer typically buys 24 loaves of bread and 12 gallons of milk in a year.

95 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part is the “base year.” Using the numbers from the table and the following formula, we can calculate a price index to measure the inflation rate.

96 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The year 2010 is designated as the base year, so its value is set equal to 100. That is, the price index for 2012 compared with 2010 is 125. Therefore, using the price index formula, we can say that prices are 25 percent higher in 2012 than they were in 2010, the base year.

97 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The producer price index—a measure of the cost of goods and services bought by firms. Because firms often pass on part of their costs to consumers, this measure is useful in predicting changes in the CPI. The Producer Price Index

98 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CPI and the GDP deflator move together but the CPI is more volatile. Both measures probably overstate the inflation rate. One important difference between them that can yield different results is that the GDP deflator measures the price of all goods and services that are produced domestically, while the CPI measures the goods and services bought by consumers. GDP Deflator Versus CPI

99 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 99

100 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

101

102 What is the historical record of changes in the overall U.S. price level? Consumer price index (CPI) is a measure of the trend in prices of a basket of consumable goods and services that serves to gauge inflation. The Price Level over the Years

103 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The problem with comparing prices today with prices in the past is that it focuses on the number of dollars it takes to buy something rather than the purchasing power of the dollar.

104 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Before we can determine the effects of inflation, we must distinguish between anticipated and unanticipated inflation. Anticipated inflation causes few problems. For the most part, people see it coming and prepare for it. 104

105 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Unanticipated inflation occurs when people don’t see it coming and have failed to prepare for it. Unanticipated inflation leads to arbitrary gains and losses as wealth and income are redistributed from one group to another. 105

106 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 106 If people prefer buying in bulk at discount stores, will the CPI accurately measure inflation? The success of discount stores has grown over the last few years, indicating that for some customers, the reduction in customer service often associated with these megastores does not offset the lower prices, introducing an upward bias into the index. REUTERS/MOLLY RILEY/LANDOV

107 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inflation brings about changes in peoples’ purchasing power, and these changes may be either desirable or undesirable. Your real income—your income adjusted to reflect changes in purchasing power—falls. Who Loses with Inflation?

108 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inflation lowers income in real terms for people on fixed-dollar incomes. Likewise, inflation can hurt creditors. if the lender does not correctly anticipate the higher rate of inflation, the borrower is paying back with dollars that have much less purchasing power than those dollars they borrowed in periods of lower inflation.

109 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. People whose incomes are tied to long-term contracts also sometimes lose out, at least temporarily, due to high inflation. For example, if inflation begins shortly after a labor union signs a three-year wage agreement, it may completely eat up the wage gains provided by the contract. If businesses agree to sell quantities of one thing for a fixed price for a given number of years, they can lose if inflation turns out to be higher than anticipated.

110 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Debtors pay back dollars worth less in purchasing power than those borrowed. Corporations that can quickly raise the prices on their goods may have revenue gains greater than their increases in wages and other costs, providing additional profits. If some people lose because of unanticipated inflation, others must gain.

111 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The uncertainty that inflation creates can also discourage investment and economic growth. When inflation rates are high, they also tend to vary considerably, which creates a lot of uncertainty. Moreover, inflation can raise one nation’s price level relative to price levels in other countries.

112 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. In turn, this shift can make financing the purchase of foreign goods difficult, or it can decrease the value of the national currency relative to that of other countries.

113 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A slow predictable rate of inflation makes predicting future price increases relatively easy. Consequently, setting interest rates will be an easier task and the redistribution effects of inflation will be minimized.

114 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. High and variable inflation rates make it almost impossible to set long-term contracts because prices and interest rates may be changing by the day, or even by the hour in the case of hyperinflation— extremely high rates of inflation for sustained periods of time. In its extreme form, inflation can lead to a complete erosion of faith in the value of the pieces of paper we commonly call money. Cost of High Inflation

115 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. In Germany, after both world wars, prices rose so fast that people in some cases finally refused to take paper money, insisting instead on payment in goods or metals, whose prices tend to move predictably with inflation. Unchecked inflation can feed on itself and may ultimately lead to hyperinflation of 300 percent or more per year. We saw these rapid rates of inflation in Argentina and Brazil in the early 1990s when the inflation rate topped 2,000 percent per year. 115

116 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 116 German woman using money as fuel in her wood burning stove. During the 1923–24 hyperinflation in Germany, it took less paper money to generate needed heat in the stove by burning the money than it did to use it to buy wood to burn.

117 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Most economists believe we can live quite well in an environment of low, steady inflation, but no economist believes we can prosper with high, variable inflation.

118 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. We often use the term purchasing power when we discuss how many goods and services a dollar can buy. In times of inflation, a dollar buys fewer goods and services. Thus, the higher the inflation rate, the greater the rate of decline in purchasing power. In periods of high and variable inflation, households and firms have a difficult time distinguishing between changes in the relative prices of individual goods and services and changes in the general price level. Unanticipated Inflation Distorts Price Signals

119 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Because of the difficulty in determining relative prices, inflation distorts the information that flows from price signals. Does the good have a higher price because it has become relatively more scarce, and therefore more valuable relative to other goods, or did the price rise along with the average of all other prices, because of inflation? The muddying of price information undermines good decision making. 119

120 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Whether inflation is perfectly anticipated or not, firms incur costs as a result of the need to change prices more frequently. These costs are called menu costs; they are the costs of changing posted prices. 120 Other Costs of Anticipated and Unanticipated Inflation

121 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Another problem with inflation is that, even when inflation is fully anticipated, some people will experience a cost from holding money. The shoe-leather cost of inflation is the cost of going to and from the bank to check on your assets. High rates of inflation erode the value of a currency, which means that people will want to hold less currency—perhaps going to the ATM once a week rather than twice a month. So, the cost is really the time and convenience sacrificed to keep less money on hand than you would if inflation were not a factor. The effects of shoe-leather costs of inflation, like those of menu costs, are modest in countries with low inflation rates but can be quite large in countries where inflation is substantial. 121

122 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The interest rate is usually reported as the nominal interest rate, which means it is not adjusted for inflation. We determine the real interest rate by taking the nominal rate of interest and subtracting the inflation rate: Inflation and Interest Rates Real interest rate = Nominal interest rate – Inflation rate

123 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. If people can correctly anticipate inflation, they will behave in a manner that will largely protect them against loss. If not, inflation will still redistribute income. To protect themselves, creditors will demand a rate of interest large enough to compensate for the deteriorating value of money.

124 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Failure to understand the difference between nominal and real interest rates is critical. In most economic decisions, it is the real rate of interest that matters because it is this rate that shows how much borrowers pay and lenders receive in terms of purchasing power—goods and services money can buy.

125 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Investors and lenders will do best when the real interest rates are high. When the nominal interest rate is high, the inflation rate is high; and when the nominal interest rate is low, the inflation rate is low. This is because when inflation is high, borrowers offer and lenders demand higher nominal interest rates to compensate for the falling value of money in the future.

126 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. When the inflation rate is low, borrowers offer and lenders demand lower nominal interest rates because the value of money (purchasing power) is falling less quickly. Hence, the tendency is for nominal interest rates and inflation rates to move together—high inflation rates mean high nominal interest rates, and low inflation rates mean low nominal interest rates.

127 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Usually, lenders are able to anticipate inflation with reasonable accuracy. If the inflation rate is anticipated accurately, new creditors will not lose nor will debtors gain from a change in the inflation rate. Do Creditors Always Lose During Inflation?

128 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Increasingly, groups try to protect themselves from inflation by means of cost- of-living clauses in contracts. Many long-term contracts between firms and unions include a cost of living allowance (COLA) that automatically increases when the consumer price index (CPI) increases. Protecting Ourselves from Inflation

129 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. With these clauses, laborers automatically get wage increases that reflect rising prices. The same is true of many pensioners, including those on Social Security. Personal income taxes likewise are now indexed (adjusted) for inflation.

130 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. However, some of the tax code is still not indexed for inflation. These factors affect the incentives to work, save, and invest. Also, adjustable mortgage rates adjust to market conditions, reducing the chance that there will be winners and losers with changes in the unanticipated inflation rate.

131 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Economic Fluctuations The aggregate amount of economic activity in the United States and most other nations has increased markedly over time, even on a per capita basis, indicating economic growth. Short-term fluctuations in the level of economic activity also occur. 10.6

132 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. These short-term fluctuations are sometimes called business cycles. Over a long period, the economic activity line slopes upward, indicating increasing real output. Over short periods, however, downward, as well as upward, output changes occur.

133 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Business cycles refer to the short- term ups and downs in economic activity, not to the long-term trend in output, which in modern times has been upward.

134 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Business Cycles and Economic Growth

135 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A business cycle has four phases: Expansion; Peak; Contraction; and Trough. The Phases of a Business Cycle

136 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The period of expansion is when output (real GDP) is rising significantly. During the expansion phase, unemployment is falling and both consumer and business confidence are high. Investment, and expenditures for expensive durable consumer goods rises.

137 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The peak is the point in time when the expansion comes to an end, when output is at the highest point in the cycle. The contraction is a period of falling real output and is usually accompanied by rising unemployment and declining business and consumer confidence.

138 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The contraction phase is measured from the peak to the trough—the point in time when output stops declining and business activity is at its lowest point in the cycle. Investment spending and expenditures on consumer durable goods fall sharply in a typical contraction.

139 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The contraction phase is also called recession, a period of significant decline in output and employment. Unemployment is relatively high at the trough, although the actual maximum amount of unemployment may not occur exactly at the trough.

140 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Often, unemployment remains fairly high well into the expansion phase. The expansion phase is measured from the trough to the peak.

141 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Four Phases of a Business Cycle

142 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Since the term business cycle does not have the regularity that the term cycle implies, economists often use the term economic fluctuation. In addition, economic fluctuations are almost impossible to predict. The contraction phase is one of recession, a decline in business activity. How Long Does the Business Cycle Last?

143 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A severe recession is called a depression. A prolonged expansion in economic activity is sometimes called a boom. The National Bureau of Economic Research (NBER) Business Cycle Dating Committee met in November of 2008 and determined that the economy peaked in December 2007, marking the end of a 73-month expansion and the beginning of an 18-month recession that ended in June of There is a delay before the NBER announces the beginning or end of a recession, because of the complexities involved in gathering and evaluating the data. So the official beginning and end dates of a recession are not known until many months later.

144 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

145 Business activity, whether measured by production or by the sale of goods, tends to be high in the two months before the winter holidays and somewhat lower in summertime, when many families are on vacation. Within individual industries, of course, seasonal fluctuations in output often are extremely pronounced, agriculture being the best example. Seasonal Fluctuations Affect Economic Activity

146 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Key economic statistics, such as unemployment rates, are seasonally adjusted, meaning the numbers are modified to account for normal seasonal fluctuations. Thus, seasonally adjusted unemployment rates in summer months are below actual unemployment rates, because employment is normally high in summertime due to the inflow of school-age workers into the labor force.

147 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Businesses, government agencies, and, to a lesser extent, consumers rely on economic forecasts to learn of forthcoming developments in the business cycle. If it looks as if the economy will continue in an expansionary phase, businesses may expand production to meet a perceived forthcoming need; if it looks as if contraction is coming, businesses may decide to be more cautious. Forecasting Cyclical Changes

148 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Using theoretical models, economists gather statistics on economic activity in the immediate past, including, for example, consumer expenditures, business inventories, the supply of money, governmental expenditures, tax revenues, and so on.

149 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Using past historical relationships between these factors and the overall level of economic activity (which form the basis of the economic theories), they formulate econometric models. Statistics from the immediate past are plugged into the model, and forecasts are made.

150 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The media also publish data on business cycle indicators that fall into three main categories: leading economic indicators, coincident economic indicators, and lagging economic indicators. The index of leading economic indicators are designed to predict activity in the U.S. economy six to nine months in the future and can be useful as short-term predictors of the economy. The stock market, measured by the S&P 500 index, is one of the leading economic indicators. For example, the stock market often turns downward before a recession and usually begins to improve before the economy recovers from a slump. Economic Indicators

151 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Another leading indicator is new consumer goods orders; often consumers reduce their spending on big- ticket items like homes and automobiles before a recession begins. Interest rates are also an important economic indicator because they have strong effects on consumer and business spending. Other leading economic indicators include the length of the average workweek, initial claims for unemployment, new building permits, new orders for plant and equipment, the extent of delayed deliveries, and the money supply (M2). The Department of Commerce combines all these into an index of leading indicators. If the index rises sharply for two or three months, it is likely (but not certain) that increases in the overall level of activity will follow 151

152 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. However, using leading economic indicators to predict future trends can be unreliable. For example, if the federal government responds with policies to combat the recession as soon as the leading economic indicators begin predicting it, then a recession that would have occurred may fail to materialize. On the other hand, a self-fulfilling prophecy may result if businesses respond with cutbacks in orders for plants and equipment as soon as the leading economic indicators begin predicting a recession.

153 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. In addition to leading economic indicators, there are coincident economic indicators, which help to predict peaks and troughs. In other words, they change with real GDP. For example, as real GDP increases we would expect an increase in total employment, personal income, industrial production, and sales. Coincident Economic Indicators

154 ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Lagging economic indicators follow economic activity. That is, they change after real GDP changes. For example, the duration of unemployment is a lagging economic indicator. As real GDP rises and the economy begins to recover, it may take many months before the average time unemployed workers remain unemployed falls. Other lagging indicators include interest rates, the unemployment rate, and the consumer price index. Lagging economic indicators


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