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Chapter 9 Business Cycles, Unemployment, and Inflation

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1 Chapter 9 Business Cycles, Unemployment, and Inflation
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2 Chapter Objectives The business cycle and its phases
Measuring unemployment and inflation The types and impacts of unemployment and inflation 9-2

3 The Business Cycle The long-run economic growth of the U.S. has from time to time, become unstable. This is commonly referred to as the business cycle, but fluctuation may be a better term The instability may result in great periods of rapid growth, or periods of degrowth or recession When in a growth phase, the business cycle will result in full employment and near-capacity output (GDP is increasing) When in recession, there is usually considerable unemployment and low output (GDP is decreasing)

4 The Business Cycle There are four phases of the business cycle
A peak when business activity reaches a temporary maximum with full employment and near-capacity output A recession is a decline in total output, income, employment and trade, sometimes lasting a year or more The trough is the bottom of the recession period Recovery is when output and employment are expanding toward full employment

5 Possible Causes of the Business Cycle
There are several suggested causes for macroeconomic instability as suggested by the business cycle Supply shocks may occur when major innovations are developed such as the internet these innovations have large effects on investment spending and consumption spending We have earlier discussed the role of demand and supply shock and the stickiness of price as factors which contribute to fluctuations in the economy Shocks to productivity such as unexpected increases or decreases

6 Possible Causes of the Business Cycle
One thing most economists agree on: the immediate cause of the large majority of cases is the unexpected changes, increases or decreases, in the level of total spending When total spending drops unexpectedly, firms cannot immediately lower prices (the stickiness factor) Firms find themselves selling fewer units because of the decreased spending With slower sales, firms cut back on production, leading to a decrease in GDP

7 Possible Causes of the Business Cycle
By contrast, when the level of spending unexpectedly rises, output, employment, and incomes will rise With sticky prices, the increased spending levels will mean larger consumer purchases In response to greater consumption, firms will raise output In order to raise output, firms will hire more workers and employment increases Eventually, in a boom economy, prices are probably going to increase because of the increased spending

8 The Business Cycle Durable and nondurable industries
Peak Peak Trend Peak Expansion Growth Level of Real Output Recession Expansion Trough Recession Trough Time Durable and nondurable industries affected differently 9-8

9 How is unemployment measured
Common problems which occur as a consequence of the business cycle is high unemployment and increased inflation Measurement of unemployment The labor force consists of all those who are working or are actively looking for work

10 How is unemployment measured
Measurement of unemployment Those who are “not in the labor force” are adults who are potential workers but who are not employed and not seeking work The category “under 16 and/or institutionalized includes the young and those in prison or mental hospitals Workers who are in the labor force and are actively looking for work represent the unemployed

11 How is unemployment measured
The unemployment is determined in this manner: Unemployment rate = unemployed/labor force X 100 Criticisms of how who is counted as unemployed Part-time employment; those working part-time but also those who wanted to work full time but could find a job and had to settle for part time By counting these workers, the unemployment rate is understated Workers who become discouraged and give up looking for work; they are not part of the unemployment sector and thus unemployment again is under-reported

12 Unemployment 2007 data Under 16 And/or Institutionalized
(71.8 Million) Not in Labor Force (78.7 Million) Total Population (303.6 Million) Employed (146.0 Million) Labor Force (153.1 Million) Unemployed (7.1 Million) Source: Bureau of Labor Statistics 9-12

13 Types of unemployment Types of Unemployment
Frictional where workers are between jobs from either voluntary resignation or from being fired There is always a percent if unemployed people who are frictionally unemployed Not a bad type of unemployment, it shows there is mobility as people change or seek jobs 9-13

14 Types of Unemployment Structural where workers can not respond to changes in technology or shifts in geographical requirements Workers may not have the training to enter the field of computer software Your factory may be relocated to Utah and you can’t leave your sick mother or you can’t afford the moving expense There is always a component of structural unemployment present in the unemployment rate

15 Unemployment The most important type of unemployment is cyclical
Cyclical unemployment is the direct result of the downward phase of the business cycle or the recession stage It is unemployment that is caused by a decline in total spending and is represented by the people who lose their jobs because of reduction in output Reached 25% during the Great Depression; today, unemployment is 9.8%

16 What is “Full Employment”?
Full employment does not mean zero unemployment When an economy has only frictional and structural unemployment, it is said to be in full employment Still have a small component of those frictionally or structurally unemployed Thus, there is no cyclical unemployment when an economy is in full employment At full employment, the economy is producing at its full or potential output

17 What is “Full Employment”?
The Natural Rate of Unemployment or NRU is the unemployment rate that is consistent with full employment Thus, the NRU measures only structural and frictional unemployment The NRU is achieved when the number of job seekers equals the number of job vacancies

18 Cost of Unemployment The basic cost of unemployment is the output which could have been achieved if there had been full employment It is the difference between the actual GDP as a consequence of a recession and the potential GDP without it This difference is called the GDP gap Actual output-potential output 9-18

19 Cost of Unemployment Okun’ Law determined the relationship between unemployment and the GDP gap For every 1% of unemployment above the NRU, a 2% negative gap in GDP output is created

20 The Unequal Burdens of Unemployment
Unemployment rates are lower for white-collar workers African-Americans have higher rates than whites Teenagers have the highest rates Black teenagers have the greatest unemployment

21 The Unequal Burdens of Unemployment
Less educated workers usually have higher rates The long-term (15 weeks or more) rates of unemployment have increase tremendously in the last year or two Some economists estimate that a more accurate estimate of unemployment may be as high as 20% Includes unemployed and seeking work as well as those who have just given up and are not counted as unemployed

22 Unemployment GDP gap (positive) Potential GDP GDP gap (negative)
The GDP Gap 12,000 11,000 10,000 9,000 8,000 7,000 6,000 5,000 GDP (billions of 1996 dollars) GDP gap (positive) Potential GDP GDP gap (negative) Actual GDP The Unemployment Rate 10 8 6 4 2 (percent of civilian Unemployment Labor force) Source: Congressional Budget Office & Bureau of Economic Analysis 9-22

23 Unemployment Unemployment Rates in Five Industrial Nations,1995-2005
Source: Bureau of Labor Statistics 9-23

24 Inflation Inflation may be defined as a rise in the general level of prices The main index to measure inflation is the Consumer price index (CPI) the CPI utilizes a “market basket” of about 300 consumer goods and services purchased by a typical urban consumer The contents of the CPI market basket differ from that of the market basket for determining real GDP

25 Inflation The GDP market basket included not only consumer goods, but capital goods, goods and services purchased by the government and by foreign countries The CPI is updated every 2 years

26 How to determine the CPI
The “rule of 70” allows for quick calculation of the time it takes the price level (i.e., inflation ) to double Divide 70 by the percentage rate of inflation and the result is the number of years for the price level to double If the inflation rate is 7 %, it will take about 10 years for prices to double Only works if the inflation rate is consistent over the 10 year period Deflation (decrease in price level) has occurred in past years In the 1930’s, the depression was a time of declining prices and wages CPI Price of the Most Recent Market Basket in the Particular Year Price estimate of the Market Basket in = x 100 9-26

27 Inflation Annual Inflation Rates in the United States, 1960-2007
Inflation Rate (percent) Source: Bureau of Labor Statistics 9-27

28 Inflation Inflation Rates in Five Industrial Nations, 1995-2005
Source: Bureau of Labor Statistics 9-28

29 Types of Inflation Causes of Inflation
“Demand pull” is the most common type of inflation Increases in the price level are caused an excess of total spending beyond the economy’s capacity to produce “to many dollars chasing too few goods” When inflation is rapid and sustained for a long period, the cause is usually an oversupply of money 9-29

30 Causes of Inflation If resources are already fully employed when prices begin to rise, firms cannot respond to excess demand by expanding output The excess demand then drives up the prices of the limited output

31 Causes of Inflation Cost-push inflation occurs on the supply side of the market With this type of inflation, the price level increases even though total spending was not excessive In fact, there were times when both output and employment were both declining

32 Causes of Inflation Cost-push inflation occurs when the cost of producing each rises This “per-unit” production figure is found by dividing the total input cost by the units of production Rising per-unit costs squeezes profits, thereby reducing the amount of output firms are willing to supply at the existing level The economy’s supply of goods and services then declines and is followed by a general rise in the level of prices Cost-push inflation is often referred to as a “Supply Shock”

33 Anticipated vs Unanticipated Inflation
The effects of inflation on consumers and business firms will differ depending upon whether the inflation was “anticipated” or “unanticipated” Unanticipated increases in prices limits the ability of the government to enact economic policy to counter the inflation

34 Anticipated vs Unanticipated Inflation
Unanticipated inflation is particularly harmful to consumers with fixed incomes If nominal income does not rise at the same rate of inflation, then loss in purchasing power will occur Real income = nominal income/price index

35 Inflation effects on debtors and creditors
When prices are rising, the debtors are the gainers and pay back the debts when the purchasing power is low due to inflation The creditors receive the same amount of money but in terms of goods and services, they receive less. When prices are falling, the creditors are the gainers and the debtors are the losers 9-35

36 Inflation effects on debtors and creditors
Savers will be hurt by unanticipated inflation, because interest rates may not cover the cost of inflation. Their savings will lose purchasing power Unanticipated inflation will increase the risks of investment by firms, and therefore slow the level of production activities Faced with uncertainty, business will not undertake capital investment or any other transactions involving long-term commitment

37 More effects of Inflation
Anticipated inflation The government has time to develop anti-inflationary policies some consumers such as union workers can adjust their nominal incomes through negotiating new wage contracts Lenders can establish interest rates which “build in” the rate of inflation Lenders may charge an “inflation premium” to adjust for the increase in inflation The nominal interest rate = the real interest rate plus the inflation premium (which is the expected rate of inflation)

38 Anticipated Inflation
Nominal Interest Rate Real Interest Rate Inflation Premium 11% 6% = + 5% Inflation Premium Nominal Interest Rate Real Interest Rate 9-38

39 The Stock Market Stock prices have only a limited impact on macroeconomic stability The market for stocks has increased tremendously in the last 20 or 30 years Increases in the value of stocks creates a wealth effect Also, increases in stock value cause companies to invest more Stock market bubbles do have an impact Stocks have been added to the index of Leading Indicators which is used to help predict the direction of the economy 9-39

40 Key Terms Okun’s law business cycle inflation peak
Consumer Price Index (CPI) demand-pull inflation cost-push inflation per-unit production costs nominal income real income anticipated inflation unanticipated inflation cost-of-living adjustments (COLAs) real interest rate nominal interest rate deflation hyperinflation business cycle peak recession trough expansion labor force unemployment rate discouraged workers frictional unemployment structural unemployment cyclical unemployment full-employment rate of unemployment natural rate of unemployment (NRU) potential output GDP gap 9-40

41 Next Chapter Preview… Basic Macroeconomic Relationships 9-41

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