Chapter 26 Lecture - Business Cycles, Unemployment, and Inflation

Business Cycles Business Cycle: the pattern of real GDP rising and falling. Recession (cookbook): real GDP declines for at least two consecutive quarters. Recession (official): “a recurring period of decline in total output, income, employment and trade, usually lasting six months to a year and marked by contractions in many sectors of the economy.” Recession (Contraction): two or more successive quarters of falling real GDP. Depression: a severe, prolonged economic contraction. Usually involves unemployment rising to greater than 10% for years.

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

Causes of Business Cycles Shocks and price stickiness Supply and productivity shocks Monetary shocks Financial bursts and bubbles Unexpected political events Common link Unexpected changes in spending http://www.nber.org/cycles/cyclesmain.html A National Bureau of Economic Research Panel picks peaks and troughs, often many months after the turning point. Forecasters have a good record of forecasting expansions because 4 out of 5 years since 1950 have been expansion years.

number in the Labor Force Unemployment The unemployment rate is the percentage of the labor force that is not working. The U.S. Labor Department defines the labor force as being equal to: All U.S. residents 16 years of age and over Who are not institutionalized Who are looking for work Rate of Unemployment = number unemployed number in the Labor Force Putting a number on the unemployment rate that can be considered full employment is a difficult process and will depend on factors such as the state of development of the economy and the method by which unemployment is calculated.

Interpreting the Unemployment Rate Discouraged Workers are workers who have looked for work in the past year, but who have stopped looking because they believe no one will offer them a job. Underemployment is the employment of workers in jobs that do not utilize their productive skills.

Types of Unemployment Seasonal Unemployment: A product of regular, recurring changes in the hiring needs of certain industries on a monthly or seasonal basis. For example, retail sales are higher during the holiday season therefore unemployment in this industry goes down during the months of November and December. Frictional Unemployment Usually short term, occurs because workers and employers have to find one another. College graduates seeking employment are a good example of frictional unemployment.

Types of Unemployment Structural Unemployment Reflects an imperfect match-up of employee skills and the skill requirements of the available jobs or a permanent reduction in demand for an industry’s output. Advancements in technology have resulted in consistent declines in employment in the agriculture, forestry and fishing industries. Cyclical Unemployment A product of business cycle fluctuations. As a recession occurs, cyclical unemployment increases, and as growth occurs, cyclical unemployment decreases. .

Unemployment and Its Costs Natural Rate of Unemployment The level of unemployment that results when the rate of unemployment is normal, considering both frictional and structural factors. Also called the NAIRU (Nonaccelerating Inflation Rate of Unemployment) Potential Real GDP The level of output produced when nonlabor resources are fully utilized and unemployment is at its natural rate. GDP gap = potential real GDP – actual GDP

Unemployment and Potential Output To determine the effect changes in the unemployment rate will have on output, we use Okun's rule of thumb. The rule states that a 1 percentage point change in unemployment will cause output to change in the opposite direction by 2 percent.

GDP GAP

http://www. reliableplant. com/article. aspx http://www.reliableplant.com/article.aspx?articleid=16398&pagetitle=Chart%3A+Unemployment+rates+by+various+demographics

The gap in unemployment rates between those with a bachelor’s degree and others is wider today than in 1967. Percent unemployed Note: 25 to 64 years for 1967 to 1997; 25 years or older for 2006. Sources: Bureau of Labor Statistics, March Current Population Survey; and Wayne J. Howe, Monthly Labor Review (Jan. 1988). © 2006 POPULATION REFERENCE BUREAU

http://www.bls.gov/opub/working/page3b.htm

Three Key Price Indexes Inflation - Rise in the General Level of Prices Three Key Price Indexes Consumer Price Index (CPI) measures the impact of price changes on the cost of the typical bundle of goods and services purchased by households. Producer Price Index (PPI) A measure of the average prices received by producers for raw materials, intermediate, and final goods. The PPI used to be called the Wholesale Price Index (WPI). GDP Deflator (GDP Price Index or GDPPI) Is a broader price index than the CPI. It is designed to measure the change in the average price of all the goods and services included in GDP.

Price Indexes The value of a price index in any particular year indicates how prices have changed relative to a base year. The base year is the year against which all other years are compared. The index is 100  the percent change in prices from the base year. This type of index suffers from substitution bias as some buyers will change the mix of goods that they buy in response to price changes.

CPI = x Consumer Price Index Consumer price index (CPI) Market basket 300 goods and services Typical urban consumer 2 year updates CPI Price of the Most Recent Market Basket in the Particular Year Price estimate of the Market Basket in 1982-1984 = x 100 The next slides show how a CPI is calculated.

In order to properly measure the rate of inflation or deflation it is necessary establish a base year from which to make a comparison. Once the base is established, future (or past) price level changes can then be compared to this base.   The easiest way see this is to look at how the consumer price index or CPI is calculated. The formula for CPI is: CPI =  P1Q0 x 100  P0Q0 P0 is the price of the good in time period 0. Q0 is the quantity of the good in time period 0. P1 is the price of the good in time period 1. Suppose your were given a shopping list of a number of different items (or a basket of items) and told to find out how much it would cost to purchase this basket at a given point in time. In time period 0 you purchase a market basket which includes: 2 haircuts at 2.50 per haircut = 5.00 4 shirts at 10.00 per shirt = 40.00 10 apples at .50 per apple = 5.00 ______________________________________________ Total cost = 50.00

2 haircuts at 3.50 per haircut = 7.00   One year late (time period 1) you go out and purchase the same market basket. Time period 1 2 haircuts at 3.50 per haircut = 7.00 4 shirts at 11.25 per shirt = 45.00 10 apples at .40 per apple = 4.00 __________________________________________ Total cost = 56.00 As shown, the market basket which cost 50.00 in time period 0 costs 56.00 in time period 1. It is important to note that the index looks at the price of a market basket of goods, not just one good's price. In general form, to calculate the CPI in any given year, other than the base year which is always equal to 100, the following formula is used:   CPI = Cost of Market Basket in given year X 100. Cost of Market Basket in base year Using a little bit of algebra,   56.00 X 100 = 1.12 X 100 = 112 50.00 1 Since the base is 100, the index, 112, can be interpreted as what costs 100 in time period 0 will cost 112 in time period 1.

BLS Home Page for CPI etc. Over time, the price level can go up or down. The most common occurrence is INFLATION which is defined as a rise in the price level. There have been, however, periods in which the overall price level has declined. This phenomena is referred to as DEFLATION. What is disinflation? BLS Home Page for CPI etc. http://stats.bls.gov

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

Price Changes Over Time To Print this Chart: When Printer dialog box appears be sure to switch to Landscape mode           Price Changes Over Time http://www.inflationdata.com/inflation/Inflation_Rate/HistoricalInflation.aspx

Types of Inflation Demand-pull inflation: increases in aggregate demand outpace increases in aggregate supply. Cost-push inflation: increases in production costs cause firms to raise prices. Hyperinflation: extremely high rate of inflation.

Problems with Inflation Redistributive Effects Nominal and real income Growth in nominal income vs. inflation rate Anticipated vs. unanticipated inflation Who is hurt by inflation? Fixed-income receivers Savers Creditors Who is unaffected or not hurt by inflation? Flexible-income receivers Cost-of-living adjustments (COLAs) Debtors

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

The Stock Market Stock prices and macro instability The market for stocks Volatile stock prices Wealth effect Investment effect Little impact on macroeconomy Stock market bubbles do have an impact Index of Leading Indicators

Economic Indicators Leading Indicators Coincident Indicators A variable that fairly consistently changes before real GDP changes Coincident Indicators A variable that fairly consistently changes at the same time as real GDP changes Lagging Indicators A variable that fairly consistently changes after real GDP changes www.conference-board.org

Indicators of Business Cycle Leading Indicators New Building Permits Manufacturers’ New Orders Money Supply Average Work Week New plant and equipment orders Interest Rate Spread Delivery Times Unemployment Claims Consumer Expectations Stock Prices

Indicators of Business Cycle Co-incident Indicators Personal income Payroll employment Industrial production Manufacturing and trade sales

Indicators of Business Cycle Lagging Indicators Inventories to sales ratio Labor cost per unit of output Inflation rate for services Unemployment duration Outstanding commercial loans Prime interest rate Consumer credit to personal income ratio

Recent Unemployment Rates Great Depression Year U.S. Unemployment Rate 1929 3.2% 1930 8.7% 1931 15.9% 1932 23.6% 1933 24.9%  1939 17.2% http://www.bls.gov/eag/eag.us.htm http://www.google.com/publicdata?ds=usunemployment&met=unemployment_rate&tdim=true&q=chart+us+unemployment+rate http://dallasfed.org/data/usdata.html#usshow