1. Chapter 10 Unemployment, Inflation, and the Business Cycle

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-2 Learning Objectives List and explain the four types of unemployment. Outline the steps involved in deriving the measured rate of unemployment. Contrast anticipated with unanticipated inflation and relate those concepts to the nominal rate of interest. List the three potential causes of business fluctuations.

3. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-3 Macroeconomics Macroeconomics is the study of economy-wide phenomena such as unemployment, inflation, interest rates, and government stabilization policies.

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-4 Unemployment Unemployment is the inability of those who are in the labor force to find a job. The labor force consists of those 16 years of age and older who are either employed or are actively looking for employment.

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-5 Types of Unemployment No matter how one examines unemployment, it costs the economy. There are several reasons why individuals become unemployed. Economists categorize unemployment into four basic types: frictional, structural, cyclical, and seasonal.

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-6 Frictional Unemployment We live in a dynamic economy. Some people are fired or laid off and have to look for a job. Others just want to change occupations. All of the ins and outs in the labor market result in frictional unemployment, defined as the continuous flow of individuals from job to job and in and out of employment.

7. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-7 Structural Unemployment Structural changes in our economy cause some workers to become unemployed permanently or for very long periods, because they cannot find jobs that use their particular skills. This is called structural unemployment.

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-8 Cyclical Unemployment Cyclical unemployment happens as the business fluctuations cycle through good times and bad times. When overall economic activity slows down, there will be cyclical unemployment. One way to lessen cyclical unemployment is to reduce the intensity, duration, and frequency of the ups and downs of nationwide business activity.

9. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-9 Seasonal Unemployment Seasonal unemployment varies with seasons of the year in which the demand for particular jobs rises and falls. The official unemployment numbers released by the Bureau of Labor Statistics are typically “seasonally adjusted” to remove the effects of variations in seasonal unemployment.

10. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-10 Measuring the Unemployment Rate To determine the rate of unemployment, the government first adds up the employed and the unemployed, to obtain the measured labor force. Then it divides the unemployed by that total. For example, if the number of unemployed is 10 million and the number of employed is 140 million, then the labor force is 150 million, and the measured rate of unemployment is 0.067 or 6.7 percent.

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-11 The Discouraged Worker Phenomenon Critics of the published unemployment rate believe that it fails to reflect the true numbers of discouraged workers—who have dropped out of the labor force and are no longer looking for a job because they believe that the job market has little to offer them— and hidden unemployed—those working part time because they are unable to find full time jobs.

12. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-12 Labor Force Participation The labor force participation rate is defined as the proportion (percentage) of working-age individuals who are employed or seeking employment. Over the last 60 years, the labor force participation rate of females has risen and the labor force participation rate of males has fallen.

13. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-13 Inflation We define inflation as a sustained rise in the general price level of goods and services. The value of a dollar does not stay constant when there is inflation. The value of money is usually referred to in terms of its purchasing power.

14. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-14 Purchasing Power A dollar’s purchasing power is the amount of real goods and services that it can buy. Consequently, another way of defining inflation is as a decline in the purchasing power of money over time. The faster the rate of inflation, the greater the rate of decline in the purchasing power of money.

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-15 How We Measure the Rate of Inflation Government statisticians use price indexes to measure inflation. Two of these price indexes are: –The CPI or Consumer Price Index, and –The GDP Deflator.

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-16 Computing a Price Index A price index is defined as the cost of a market basket of goods and services today, expressed as a percentage of the cost of that identical market basket of goods and services in some starting year, known as the base year.

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-17 The Consumer Price Index (CPI) The CPI attempts to measure changes only in the level of prices of all goods and services purchased by all urban consumers. The Bureau of Labor Statistics (BLS) has the task of identifying a market basket of goods and services of the typical consumer. Today, the BLS uses as its base the period 1982–1984.

18. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-18 Flaws in Measuring the CPI The BLS has been unable to account for the way consumers substitute less expensive items for higher-priced items. Until recently, the BLS has been unable to consider quality changes as they occur. The CPI usually ignores successful new products until long after they are introduced.

19. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-19 The GDP Deflator The GDP deflator measures the changes in prices of all new goods and services produced in the economy. The basket on which it is based is allowed to change with people’s consumption and businesses’ investment patterns. Usually, the GDP deflator is used to create measures of real GDP.

20. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-20 Anticipated versus Unanticipated Inflation Anticipated inflation is the rate of inflation that is generally expected by individuals in the economy. Unanticipated inflation is inflation that comes as a surprise to individuals in the economy.

21. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-21 Anticipated versus Unanticipated Inflation (cont.) Some of the issues caused by inflation arise when it is unanticipated. In contrast, when inflation is anticipated, many people are able to protect themselves from disadvantageous contracts, for example.

22. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-22 How Inflation Hurts In most situations, unanticipated inflation benefits borrowers because the nominal interest rate they are being charged does not fully compensate for the inflation that actually occurred. Whenever inflation rates are underestimated for the life of a loan, creditors lose and debtors gain.

23. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-23 Protecting Against Inflation Banks attempt to protect themselves against inflation by raising nominal interest rates to reflect anticipated inflation. Adjustable-rate mortgages in fact do just that. Workers can protect themselves through cost-of-living adjustments (COLAs) in their labor contracts.

24. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-24 Inflation and Interest Rates The nominal rate of interest—market rate of interest—is equal to the real rate of interest plus an inflationary premium to take account of anticipated inflation. The inflationary premium covers the expected fall in the purchasing power of the dollars repaid by borrowers.

25. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-25 Business Fluctuations and Business Cycles Nationwide economic activity does not just go up at a steady pace every year. Business fluctuations used to be called business cycles, but that term no longer seems appropriate because cycle implies regular or automatic recurrence, and we normally don’t observe automatic recurrent fluctuations in general business and economic activity.

26. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-26 Expansions and Contractions The ups and downs in economy-wide economic activity are sometimes called business fluctuations. When business fluctuations are positive, they are called expansions—speedups in the pace of national economic activity. The opposite of an expansion is a contraction. The top of an expansion is usually called its peak, and the bottom of a contraction is usually called its trough.

27. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-27 Recessions and Depressions If the contractionary phase of business fluctuations becomes severe enough, we call it a recession. An extremely severe recession is called a depression. The Great Depression lasted throughout most of the 1930s. By 1932, 13 million people were unemployed. By 1933, actual output was at least 35 percent below the nation’s productive capacity.

28. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-28 A Typical Business Cycle In Figure 10-4, next, you see a typical business cycle. Business fluctuations occur around a growth trend in overall business activity. A straight upward-sloping line shows this growth trend. Starting out at a peak, the economy goes into a contraction. Then an expansion, moves up to its peak, and the sequence starts over again. That is where the term cycle comes from in business cycle.

29. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-29 Figure 10-4: The Typical Course of Business Fluctuations

30. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.10-30 Key Terms and Concepts anticipated inflation business fluctuations consumer price index cyclical unemployment discouraged workers expansions frictional unemployment inflation labor force participation rate nominal rate of interest purchasing power real rate of interest recession seasonal unemployment structural unemployment unanticipated inflation