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CHAPTER 10
THE BUSINESS CYCLE
WHAT IS THIS CHAPTER ALL ABOUT?
This chapter focuses on the nature of the business cycle and the problems of unemployment and
inflation that accompany it. The principal goal of the chapter is to develop an understanding of
why the business cycle is a problem.
As the first chapter in the macroeconomics section of the text, a number of new concepts and
ideas related to macro failures and macro policies are introduced.
The goal of this chapter is to help students develop some understanding for the three basic
questions that follow:
1.
What are business cycles?
2.
What damage does unemployment cause?
3.
Who is hurt by inflation?
NEW TO THIS EDITION
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
New headline on the 2001 recession
New Headline on the social costs of unemployment
New Headline on college tuition hikes
Two new Questions for Discussion
Updated Problems
Living Econ on “How Do High Prices Affect Me?”
LECTURE LAUNCHERS
Where should you start?
1.
Begin by discussing the Headline titled ‘The Crash of 1929” on page 226. Follow this
with a discussion of Table 10.1.
Note that during the “Great Depression” the unemployment rate peaked at nearly
Chapter 10 – The Business Cycle – Page 198
25 percent. How many students know someone who lived through the Great
Depression? (The student’s great-great grandparents.) Then compare that number
to the peak unemployment rate of 6.5 percent during the most recent recession.
Finally, explain how economics changed because of the Great Depression, i.e.,
governments began taking a more active role in dictating economic outcomes.
2.
Define what it means to have a recession.
This can be accomplished by showing the students the definition on page 231. Follow
with a discussion of the Headline: Economy Contracts in 3rd Quarter.
3.
Another idea is to bring in a recent article about economic growth or downturns.
Have your students log into www.bea.gov/bea/glance.htm to find the most recent data
on GDP.
4.
A picture of the impact of business cycles on the U.S. economy’s growth rate can be
found in page Figure 10.2. Show this to your students.
This graph is a good visual representation of US business cycles.
5.
Ask your students to describe what it means to be unemployed.
Most will respond to be unemployed means you don’t have a job. Ask whether that
means that stay-at-home moms are unemployed? Are infants unemployed? Are
retired people unemployed? Use these discussions to lead into a definition of the
unemployment rate and the different kinds of unemployment starting.
6.
Ask the students what happened to the price of gas in the late 1990s and early 2000s.
Does this mean we had inflation?
During this time period, the price of gasoline increased dramatically. Even so, the
increase in price of one item does not indicate inflation took place. Use this discussion
to introduce the concept of inflation. The pains of rapid inflation can be discussed using
the Headline titled Hyperinflation.
7.
Ask students whether the government’s number one goal should be low unemployment.
This question allows you to discuss the trade-off between unemployment and inflation
and allows you to introduce the concept of full employment.
COMMON STUDENT ERRORS
Many students make these common errors. This same list is included in the student study
guide. The first statement in each “common error” below is incorrect. Each incorrect statement
is followed by a corrected version and an explanation.
1.
The government should eliminate unemployment. WRONG!
The government must lower unemployment at the same time that it accomplishes other
goals. RIGHT!
Chapter 10 – The Business Cycle – Page 199
Under the Full Employment and Balanced Growth Act of 1978, the government sets an
unemployment goal for itself, but this goal is well short of a zero unemployment rate.
As the economy approaches full employment, it begins to experience inflationary
pressure. At this point, there is a trade off between increases in employment and stable
prices. In this chapter, Dr. Schiller also shows that it would be very difficult, and even
undesirable, to eliminate frictional or seasonal unemployment.
2.
A rise in the unemployment rate of 0.1 or 0.2 percent for a month is bad. WRONG!
Monthly changes in the unemployment rate may not have any significant economic
implications. RIGHT!
Small changes in the unemployment rate tell us nothing about what is happening to
disguised unemployment (people who seem to be working but are not), discouraged
workers (people who are no longer looking), or changes in the labor force; and large
changes in seasonal or frictional unemployment are not necessarily bad and could not
be easily remedied even if they were. Be careful in interpreting short run changes in
the unemployment rate.
3.
When the price of a product rises, there is inflation. WRONG!
When an average of prices rises, there is inflation. RIGHT!
The price of a single product may rise while an average of prices of all products falls.
Such adjustment in relative prices is essential to the most efficient distribution of goods
and services through the market. When the average of all prices is rising, however,
distribution may not be efficient and redistributions of income may occur.
4.
As long as price increases do not exceed the inflation rate, they do not contribute to
inflation. WRONG!
Every price increase contributes to a rise in the inflation rate. RIGHT!
Since the inflation rate is an average of all price increases, the increase in any price by
any amount raises the average. Firms that buy commodities from other firms that
raise prices will in turn pass the increase on to their own customers; an increased price
may have indirect effects in raising the inflation rate.
5. If the economic growth rate is less than it was in the last quarter, this indicates a recession.
WRONG!
As long as the economic growth rate is positive, the economy is not is a recession. RIGHT!
The economic growth rate is measured by the percentage change in the real GDP. A
recession is defined to occur whenever that percentage change is negative for two
consecutive quarters. As long as the economic growth rate is positive, the economy is not
defined to be in a recession even if the growth rate is less than in the previous quarter.
Chapter 10 – The Business Cycle – Page 200
HEADLINES
There are six Headline boxes in this chapter dealing with various aspects of business cycles.
Their titles and the concepts they illustrate are:
"Market in Panic as Stocks Are Dumped in 12,894,600 Share Day: Bankers
Halt It" (The Crash of 1929),
An excerpt from a 1929 newspaper article captures the panic associated with the crash of
Wall Street in 1929.
“Economy contracts in 3rd quarter” (Declining Output)
Real GDP declined in the third quarter of 2001, signaling the start of the first recession
since 1990-1991. The decline was 0.4 percent, a stark contrast with 1999 and 2000 when
the economy grew at 4.1 percent rate, but not as bad as the 3.2 percent drop in 19901991.
"Depression Slams World Economies" (Worldwide Losses),
International comparison of world economies during the Great Depression. Other
countries also experienced severe recessions.
“How unemployment affects the family” (Social costs)
The chart shows how unemployment increases family stress, postpones medical care,
cuts back on food spending, reduces spending for children, increases work by other
family members, interrupts education, cancels phone service and ends child or elder
care.
"Inflation and the Weimar Republic" (Hyperinflation),
A look at the extreme inflation experienced in Germany in the early 1900's. The result
was economic disruption, unemployment and lack of stability.
“Tuition is up 11.5% at community colleges” (Price Effects)
Tuition increased by 11.5% in 2003 at US community colleges, ranging from a 60 percent
increase in California to no increase in Maine and West Virginia. Even so, average
tuition, about $1,560 annually, remains the lowest in higher education.
ANNOTATED CONTENTS IN DETAIL
I.
Headline: "Market in Panic as Stocks Are Dumped in 12,894,600 Share Day;
Bankers Halt It." (The Crash of 1929) - An excerpt from a 1929 newspaper article
captures the panic associated with the crash of Wall Street in 1929.
A.
Macroeconomics
Definition: Macroeconomics - The study of aggregate economic behavior,
of the economy as a whole.
B.
Business Cycle
Definition: Business Cycle - Alternating periods of economic growth and
contraction.
Note: Figure 10.1 demonstrates the concept of business cycles.
Chapter 10 – The Business Cycle – Page 201
II.
Assessing Macro Performance
A.
The three basic measures of macro performance are:
1.
Output (GDP) growth
2.
Unemployment
3.
Inflation
B.
GDP growth
1.
An economy’s potential output is reflected in its production possibilities
curve.
2.
Definition: Production Possibilities Curve – The alternative
combinations of goods and services that could be produced
in a given time period with all available resources and
technology.
3. If we are producing inside the production possibilities curve, some resources
are unnecessarily idle.
4.
Headline:
“Economy contracts in 3rd quarter” (Declining
Output)
Real GDP declined in the third quarter of 2001, signaling the start of the
first recession since 1990-1991. The decline was 0.4 percent, a stark
contrast with 1999 and 2000 when the economy grew at 4.1 percent rate,
but not as bad as the 3.2 percent drop in 1990-1991.
5.
The economy must keep expanding if it is to stay “healthy”.
C.
Business Cycles
1.
The central concern in macroeconomics is that the rate of output won’t
always keep up with ever expanding production possibilities.
2.
During an economic expansion, total output grows rapidly. A peak is
reached and output starts to drop. Once a trough is reached, the economy
prospers again.
D.
Real GDP
1.
The physical volume of output is virtually impossible to measure, so we
measure the volume of output by its market value.
2.
To avoid false readings, we adjust our measure of output for changing
price levels using real GDP.
3.
Definition: Read GDP - The inflation - adjusted value of GDP; the
value of output measured in constant prices.
4.
Real GDP doesn’t increase in consistent, smooth increments, but in a
pattern of steps, stumbles and setbacks (Figure 10.2)
E.
Erratic Growth
1.
Real GDP doesn’t increase in consistent, smooth increments but in a
pattern of steps, stumbles, and setbacks
2.
The Great Depression
a.
Steady decline in U.S. Output.
b.
Real GDP fell 30% 1929-1933.
c.
Economy started to grow again in 1934.
d.
Total output declined again 1936-1937.
e.
Real GDP in 1939 virtually the same as in 1929.
Chapter 10 – The Business Cycle – Page 202
3.
4.
5.
f.
Per capita GDP lower in 1939 than in 1929.
Headline: "Depression Slams World Economies" (Worldwide
Losses) - International comparison of world economies during the Great
Depression. Other countries also experienced severe recessions.
World War II
a.
Greatly increased demand for goods and services.
b.
Marked the end of the Great Depression.
c.
Output grew 19% in 1942.
d.
Full employment.
Recent Recessions (Table 10.1)
a.
Recession
Definition: Recession - A decline in total output (real GDP)
for two or more consecutive quarters.
b.
Post-war recession
i.
Lasted 8 months.
ii.
Unemployment rate 4.3%.
iii.
1981-1982 recession
a.
Lasted 16 months.
b.
Unemployment rate 10.8%.
c.
Highest unemployment rate since 1930's.
c.
1990-1991 recession
i.
Very brief: 8 months.
ii.
Continued expansion through 1998.
III. Unemployment
A.
B.
The labor force (Figure 10.3)
Definition: Labor Force - All persons over age sixteen who are either
working for pay or actively seeking paid employment.
Unemployment Rate (Figure 10.4)
1.
Definition: Unemployment rate – The proportion of the labor force
that is unemployed.
2.
Formula:
Unemployment rate 
number of unemployed people
size of the labor force
3.
Unemployment
Definition: The inability of labor-force participants to find jobs.
4. Headline: “How unemployment affects the family” (Social costs)
The chart shows how unemployment increases family stress, postpones
medical care, cuts back on food spending, reduces spending for children,
increases work by other family members, interrupts education, cancels phone
service and ends child or elder care.
C.
The Full Employment Goal - not "zero" unemployment.
1.
Seasonal unemployment - Caused by seasonal changes.
Example:
School is out in summer and teens look for summer jobs.
2.
Frictional unemployment - Brief periods of unemployment associated
with job search.
Example:
Students entering work force after graduation with
marketable skills, workers in-between jobs.
Chapter 10 – The Business Cycle – Page 203
3.
4.
5.
IV.
Structural unemployment - Results from mismatch between skills of
labor force participants and skills needed by employers.
Examples: Layoffs secondary to defense cutbacks make it hard for
displaced workers to find jobs in non-defense industry.
Cyclical unemployment - Not enough jobs to go around due to
downturns in the business cycle.
Example:
The Great Depression
The Policy Goal
a.
Avoid as much cyclical and structural unemployment as possible.
b.
Try to achieve full employment
c.
Full employment
Definition: Full employment - The lowest rate of
unemployment comparable with price stability;
variously estimated at between 4 and 6 percent
unemployment.
Inflation
A.
1.
2.
As an economy reaches full employment the biggest fear is inflation.
Headline: "Inflation and the Weimer Republic"
(Hyperinflation) A look at the extreme inflation experienced in
Germany in the early 1900's. The result was economic disruption,
unemployment, and lack of stability.
B.
Relative vs. Average Prices
1.
Inflation
Definition: Inflation - An increase in the average level of prices and
services, not a change in any specific price.
2.
Deflation
Definition: Deflation - A decrease in the average level of prices of
goods and services.
3.
Relative price
Definition: Relative Price - The price of one good in comparison
with the price of other goods.
4.
Relative changes can occur in period of stable average prices.
5.
Changes in relative prices are market signals that help reallocate
resources in the economy.
C.
Redistributions
1.
Although inflation makes some people worse off, it makes other people
better off.
2.
Inflation acts just like a tax, taking income or wealth from some people
and giving it to others.
3.
Price effects
a.
Nominal income
Definition: Nominal Income - The amount of money income
received in a given time period, measured in
current dollars.
b.
Real income
Definition: Income in constant dollars; nominal income
adjusted for inflation.
Chapter 10 – The Business Cycle – Page 204
c.
4.
5.
6.
“Tuition is up 11.5% at community colleges” (Price
Effects)
Tuition increased by 11.5% in 2003 at US community colleges,
ranging from a 60 percent increase in California to no increase in
Maine and West Virginia. Even so, average tuition, about $1,560
annually, remains the lowest in higher education.
d.
Not all prices rise at same rate during inflation (Table 10.2).
e.
Not everyone suffers equally from inflation.
Income effects
a.
What looks like a price to a buyer is income to the seller.
b.
If prices rise, so do incomes (Figure 10.5).
Wealth effects
a.
Wage and price indices, over time. (Table 10.3)
b.
Redistribution (Table 10.4)
Robin Hood? - Inflation redistributes income through these effects:
a.
Price effects - People who prefer goods and services that
increase in price least quickly end up with larger share of real
income.
b.
Income effects - People whose nominal incomes rise faster than
inflation end up with larger share of total income.
c.
Wealth effects - People who own assets that increase in real
value end up better off.
d.
Inflation acts just like a tax taking income or wealth from one
group and giving it to another.
D.
Uncertainty
1.
Economic decisions are increasingly difficult, when inflation is present.
2.
Changing price levels affect production decisions.
a.
Postponing construction.
b.
Not finishing new construction.
3.
Uncertainty can induce people to buy more goods and services before
price increases occur?
E.
Measuring inflation
1.
Consumer Price Index (CPI)
Definition: Consumer Price Index (CPI) - A measure (index) of
changes in the average price of consumer goods and
services.
b.
Inflation rate
Definition: Inflation Rate - The annual rate of increase in the
average price level.
2.
Bureau of Labor Statistics - tells us what is happening to consumer prices
by updating the CPI monthly.
F.
The Price Stability Goal
1.
Price Stability
Definition: Price Stability - The absence of significant changes in the
average price level, officially defined as a rate of inflation of
less than 3%.
2.
The policy goal
Chapter 10 – The Business Cycle – Page 205
a.
3.
4.
The Full Employment and Balanced Growth Act (1978) set a gold
of holding the rate of inflation under 3%.
b.
Why 3%?
i.
Zero percent inflation might harm the goal of full
employment.
ii.
Need for allowance for price changes cue to quality
improvements.
Quality Improvements
a.
The CPI is not a perfect measure of inflation.
b.
Over time, the goods contained in the CPI shopping basket
change. Old products become better as a result of quality
improvements.
c.
Examples: A 1955 television does not compare in quality to a
2000 television. Also, today’s automobiles cost more that Henry
Fords model T, but part of that price is reflected in the higher
quality.
New Products
a.
The market basket used to measure the CPI changes.
b.
Products like computers did not exist in the 1972-73 market
basket. DVD players did not exist in the 1987 CPI market basket.
IN-CLASS DEBATE, EXTENDING THE DEBATE, AND
DEBATE PROJECTS
In-class Debate
What’s worse: unemployment or inflation?
This chapter reviewed the costs of unemployment and inflation. Clearly, the preferred policy
goal is lower unemployment and lower inflation. But sometimes policymakers need to make
choices. Make certain that you have identified:
All the costs of unemployment. They are:
All the costs of inflation. They are:
Which is worse:


a 1 percent increase in the unemployment rate, or
a 1 percent increase in the inflation rate.
Weigh the costs of each: which is more harmful?
Chapter 10 – The Business Cycle – Page 206
Teaching notes
After students have answered individually, post signs on walls of the room labeled with each
choice (unemployment worse; inflation worse) Ask students to stand up and move to the part of
the room representing their position. Call on individual students to explain their position.
Announce that students may shift position if they change their minds based on student
comments.
Ask students to pair with someone who has the same position. Together they might write a
paragraph explaining their position.
Follow with a cooperative controversy. Format: Pairs combine into groups of four with one pair
on each side of the debate. One pair reads their reasons while the other side listens. Then
reverse so that the other pair reads their reasons. Group of four selects strongest argument on
each side.
Or, follow with an individual writing assignment.
Extending the Debate
What is full employment?
Economists disagree about what is full employment (see page 236)—and the best policies to
achieve full employment. For two opposing points-of-view see position papers from the liberal
Economic Policy Institute at:
http://www.epinet.org/content.cfm/workingpapers_full-employment
and the conservative Heritage Foundation at:
http://www.heritage.org/Research/Budget/BG1506.cfm
Should the US aim to achieve a low unemployment target? List the arguments on each side of
this debate. What are the strongest two arguments on each side?
What policies are needed to achieve this target? Describe the policies recommended by each
side.
Teaching notes
Use information gathered by students out of class to conduct an in-class cooperative
controversy. Or, use the information for individually-written essays on the topic.
Format: Organize students into groups of two. (Use instructor assignment or random
assignment so that friends don’t work together.) One half of the groups take the pro side; the
other half takes the con side. Each pair lists the strongest three arguments for their position.
Then pairs combine into groups of four with one pair on each side of the debate. One pair reads
Chapter 10 – The Business Cycle – Page 207
their reasons while the other side listens. Then reverse so that the other pair reads their reasons.
Group of four selects strongest argument on each side and, if appropriate, reaches consensus on
final position.
Debate project
For related debate material see “Economic Growth” in Chapter 1.
ANSWERS TO QUESTIONS FOR DISCUSSION, WEB
ACTIVITIES AND PROBLEMS
QUESTIONS FOR DISCUSSION
1.
Microsoft sells operating systems, applications software, and technical services. How
would you compute changes in the volume of output from one year to the next? How
would price changes affect your computations?
Microsoft should measure the volume of its output by it market value, not it’s
physical quantity. The problem that Microsoft has with measuring changes in
the volume of output from one year to the next is the same problem we have in
measuring aggregate output. As a result, the company should calculate a figure
like real GDP.
Product price changes will, however, distort this number. Increases in prices
will make nominal GMP increase, even if physical output does not increase.
Microsoft needs to adjust GMP for changes in the market price of its products by
calculating real GMP. If it does not do so, and prices rise or fall, the company
will have a false reading of its physical volume.
2.
According to the Headline on p. 228, when did the U.S. economy go into a recession?
According to the Headline, the U.S. economy entered a recession during the
July-to-September quarter, when GDP fell by 0.4 percent on an annual basis.
However, as the generally-accepted definition of a recession is two consecutive
quarters of GDP contracting, it was too early to say that the economy was in a
recession.
3.
Could we ever achieve an unemployment rate below "full" employment? What problems
might we encounter if it did?
Yes, but as labor becomes relatively more scarce, workers are able to command
wage increases that could result in product prices increasing, i.e., the labor
shortage results in inflation.
4.
Have you ever had difficulty finding a job? Why didn't you get one right away? What
kind of unemployment did you experience?
Answers will vary, but should reflect structural, cyclical, and frictional reasons.
5.
Why might inflation accelerate as the unemployment rate declines?
Chapter 10 – The Business Cycle – Page 208
As the unemployment rate declines, qualified workers become harder to find.
As a result, employers often must pay premiums to workers to attract them into
the labor force or away from current employers. The result is inflationary
6.
During the period shown in Table 10.4, what happened to
(a) the nominal price of gold, and
(b) the real price of gold during the period shown?
a) According to the information provided in the table, the nominal price of gold
declined by 29 percent.
b) Since price of gold fell by 29 percent it is 71 percent of its original value. At
the same time, because the average price of goods, i.e., the inflation rate, rose by
32 percent, they are 132 percent of their original values. The real price of gold
is $71/1.32 = $53.78. Thus, the price of gold is approximately 54 percent of its
original value or a real decline of 46 percent.
7.
According to Table 10.2, who was most adversely affected by price changes in 2002?
Consumers who a) eat a bacon and egg breakfast, or b) just have coffee?
People who eat bacon and egg breakfast found that the price of bacon and eggs
both increased substantially (7.1% and 9.3%, respectively), while people who
just have coffee for breakfast found the price of coffee decreased (by 4.1%).
Ceteris paribus, those who eat a bacon and egg breakfast are adversely affected
by the price changes while those who have just coffee actually experience an
improvement in their standard of living.
8.
Which of the following people would we expect to be hurt by an increase in the rate of
inflation from 3 percent to 6 percent?
a.
A homeowner with a $50,000 fixed-rate mortgage on his home.
Whatever this person’s nominal mortgage (interest) rate was, the real
interest rate will decline by 3 percentage points. Ceteris paribus,
borrowers benefit from inflation.
b.
A retired person who receives a monthly pension of $500 from her former
employer.
This person’s purchasing power of the $500 fixed income will decline,
thus, this person is hurt by inflation.
c.
An automobile worker with a cost-of-living provision in his employment contract.
Assuming that the cost-of-living provision is based on this rate of
inflation and results in a 6 percent increase in salary, this person’s
purchasing power will not change. This person will not be hurt or
benefited by inflation.
d.
A wealthy individual who owns corporate bonds that pays her an interest rate of
8% per year.
Interest rates generally move in the same direction as inflation because
nominal interest rates include an inflation component. The values of
bonds move in the opposite direction of the movement in interest rates.
As a result, the value of the bonds declines as inflation increases and this
person is harmed by inflation. In addition, this individual receives a
fixed income from this bond. This purchasing power of this fixed income
is diminished by inflation.
9.
Would it be advantageous to borrow money if you expected prices to rise? Why, or why
not? Provide numerical example.
Chapter 10 – The Business Cycle – Page 209
The simple answer is that it is generally advantageous to borrow under
these circumstances if you can lock in a fixed rate and buy whatever it is
you are buying before prices rise. You gain first by buying at the preinflation price, and second you are repaying the loan with deflated
dollars.
A more complex answer depends upon whether financial markets
anticipate inflation correctly. If they do, then the inflation premium is
already included in the interest rate and there is no advantage in
borrowing money. If the financial markets are incorrect but you guess
correctly, i.e., you expect higher inflation than do the financial market,
then yes, because as prices (and incomes) rise, the real cost of the
borrowed money will decline. For example, assume that you borrow
$100 at 5 percent interest rate. In one year, you must repay $105. If
prices rise by 10 percent during that year, the real value of the $105 you
repay will only be approximately $95. You will have borrowed $100
worth of purchasing power for $95 worth of purchasing power.
10.
Why did the Great Depression last so long? What happened to all the jobs?
The length and depth of the Great Depression were due to the complete
lack of confidence created by events such as the stock market crash and
the closing of banks. In such a situation, consumers were unwilling to
spend what little they had and businesses did not have the confidence to
invest. In addition, monetary and fiscal policies at the time were not
designed correctly to provide a stimulus to the economy. Monetary
policy called for an increase in the reserve requirement (contractionary)
and fiscal policy was only slightly expansionary. The absence of any
significant government spending to take up the slack until the buildup
for World War II let the Great Depression continue so long. As a result,
many people were laid off resulting in one some of the highest
unemployment in U.S. history.
WEB ACTIVITIES
1.
Log on to www.whitehouse.gov/fsbr/esbr.html. List three of the leading economic
indicators and explain what they suggest about the current U.S. business cycle, i.e., are
we currently in a period of economic expansion or recession? Your answer should
include a discussion of the general trend in the indicators you have chosen and what this
trend suggests about the current business cycle.
Your answer to this question will depend on the time period in which you answer this
question is answered and which indicators you choose. The general categories of
indicators are production, employment, income, international trade and finance,
money supply, output, prices and transportation.
2.
Log on to www.census.gov and click on the latest economic indicators (under subjects
index "E"). Choose three economic indicators to examine (different indicators than
described in question 1). Explain what the trends in these indicators suggest about the
current U.S. business cycle.
Chapter 10 – The Business Cycle – Page 210
Your answer to this question will depend on the time period in which you answer this
question is answered and which indicators you choose. On this site, there are
indicators such as monthly wholesale trade, manufacturers’ shipments, construction
spending, new home sales, and more.
3.
Log on to www.whitehouse.gov/fsbr/esbr.html, link into output then click on the chart
for Gross Domestic Product. What has been the trend in real GDP? What does this data
suggest about the current business cycle? i.e., are we in a period of economic growth or
decline?
Your answer to this question will depend on the time period in which you answer this
question.
PROBLEMS
1.
How much more output will the average American have next year if the $11 trillion U.S.
economy grows by:
a.
2 percent?
b.
5 percent?
c.
-1.0 percent?
(Assume a population of 290 million):
a) $759
b) $1897
c) - $379
To calculate the change in GDP per capita, multiply the GDP by the percent
change and divide by the population.
2.
Suppose the following data describe a nation’s population
Year 1
Population
200 million
Labor Force 120 million
Unemployed 7.2 million
a.
b.
c.
Year 2
203 million
125 million
7.5 million
What is the unemployment rate in each year?
How has the number of unemployed changed from Year 1 to Year 2?
How is the apparent discrepancy between (a) and (b) explained?
a.
b.
c.
The unemployment rate is calculated as the number of unemployed
divided by the labor force. Using this formula, the unemployment rate
in year 1 is 7.2 million/120 million = 0.06 or 6 percent. The
unemployment rate in year 2 is 7.5/125 million = 0.06 percent or 6
percent.
The number of unemployed increases by .3 million or 300,000 workers.
The unemployment rate is determined by both the number of
unemployed and the size of the labor force. Even though the number of
people who were counted as unemployed increased by 300,000, the size
Chapter 10 – The Business Cycle – Page 211
of the labor force also increased by the same proportion, resulting in no
change in the unemployment rate.
3.
If the average worker produces $70,000 of GDP, by how much will GDP increase if there
are 140 million labor force participants and the unemployment rate drops from 5.2 to 4.5
percent?
If the labor force consists of 140 million participants, and there is a drop
of the unemployment rate from 5.2 (140 million x 0.052 = 7,280,000
unemployed) to 4.5 (140 million x .045 = 6,300,000 unemployed), there
will be an additional 980,000 people employed. If each person produces
$70,000 in additional GDP, then GDP will increase by $68.6 billion.
4.
What would the real value be in ten years of $500 you hid under your mattress if the
inflation rate is:
a.
4 percent.
b.
8 percent.
To answer this question, one simply needs to calculate the compounded impact
of the annual inflation and divide the $500 by that number.
5.
(a)
$500 after 10 years of 4% inflation is determined by dividing the $500
by 1.48, which is 1.04n and n is 10. The value after 10 years is
approximately $338.
(b)
$500 after 10 years of 8% inflation is, by the same formula,
approximately $232.
According to the data below,
a.
How did nominal wages change between 1990 and 1992?
b.
How did real wages change between 1990 and 1992?
c.
How did nominal wages change between 1990 and 1999?
d.
How did real wages change between 1990 and 1999?
Compute percentage changes for each answer
1990 1992 1999
Average Weekly Wage $345 $364 $457
CPI
131
140
167
a.
b.
c.
Nominal wages, the stated dollar wage for the given time period
increased from $345 to $364, a change of 5.5% . This is calculated as
($364-$345)/$345= 0.055 or 5.5%.
To calculate real wages, it is necessary to adjust for inflation using the
CPI numbers provided. Note: a CPI of 131 indicates prices are 1.31 times
larger than in the base period. Real wages in 1990 were $345/1.31=
$263.36. Real wages in 1992 were $364/1.40=$260. Thus, real wages
declined between 1990 and 1992. This is a 1.28 percent decline in real
wages (($263.36-$260)/$263.36))
Nominal wages increased from $345 to $457, a 32.5 percent increase.
Chapter 10 – The Business Cycle – Page 212
d.
6.
As stated in part b, real wages in 1990 were $263.36. Using the same
method of calculation, real wages in 1999 were $273.65. Thus, real
wages increased by $10.29 per week, a 3.9 percent increase.
Suppose that you will have an annual nominal income of $40,000 for the next five years,
without any increases. However, the inflation rate is 5 percent.
a.
Find the real value of your $40,000 salary for each of the next 5 years.
b.
Suppose your boss agrees to raise your $40,000 salary by 5 percent for each of
the next five years. Given the 5 percent inflation rate for each of those five years,
what is the real value of your salary for each year?
Given an annual inflation rate of 5% for each of the next five years, the price
index for year 1 will be 100, for year 2: 105, for year 3: 110.25, for year 4:
115.76, for year 5: 121.55.
7.
(a)
Real income year 2, = $40,000/ 1.05 = $38,095
Year 3, $40,000/1.1025 = $36,281
Year 4, $40,000/1.1576 = $34,554
Year 5, $40,000/1.2155 = $32,908
(b)
$40,000 is the real value of the salary each year, as the 5% annual raise
is offset by the 5% annual rate of inflation.
The following table lists the prices of a small market basket purchased in both 2000 and
2004. Assuming that this basket of goods is representative of all goods and services
a.
Compute the cost of the market basket in 2000.
b.
Compute the cost of the market basket in 2004.
c.
By how much has the average price level risen between 2000 and 2004?
d.
The average household’s nominal income increased from $45,000 to $50,000
between 2000 and 2004. What happened to its real income?
Item
Coffee
Tuition
Pizza
VCR Rental
Vacation
Quantity
20 pounds
1 year
100 pizzas
75 days
2 weeks
Price (per unit
2000
2004
$
3 $
4
$4,000 $7,000
$
8 $
10
$ 15 $
10
$ 300 $ 500
(a), (b) The market basket's total cost is as follows
2000
Coffee
Tuition
Pizza
VCR Rental
Vacation
TOTAL
2004
$ 60
4,000
800
1,125
600
$6,585
Chapter 10 – The Business Cycle – Page 213
$ 80
7,000
1,000
750
1,000
$9,830
(c)
The average price level rose by 49.28% between 2000 and 2004. This was
calculated by dividing 2004 cost by 2000 cost. Looked at another way, the
average price level for 2004 is 149.28% of its 2000 level.
(d)
Using the index 149.28 and dividing the $50,000 salary by it, we get a real
income of $33,494 for 2005. The real income of this average household
decreased by approximately $11,500 (25%) in this period--it fell because the
nominal wage grew more slowly than the price level.
Chapter 10 – The Business Cycle – Page 214
MEDIA EXERCISE
Chapter 10
The Business Cycle
Name: ______________________
Section: _____________________
Grade: ______________________
Find an article about the inflation rate. Use the article you have found to fulfill the following
instructions and questions.
1. Mount a copy (do not cut up newspapers or magazines) of the article on a letter-sized page or
print an article from an Internet news agency such as www.cnn.com, www.msnbc.com,
www.abc.com, www.nytimes.com, etc.
2. Use an arrow to indicate in the article which of the three indicators is being used (CPI, PPI,
GDP deflator, or other price index).
3. Underline a single statement in the article (not more than a sentence) that indicates whether
the unemployment rate is rising, remaining the same, or decreasing. There should be an
index for previous months or years.
4. Circle a statement (not more than a sentence) in the article about the media’s, market’s, or
government’s interpretation of the numbers. (The statement should help with number 6
below.)
5. Collect the most recent 12 months of data on the inflation index (annual rate) and graph it
using these axes: Percentage change on the horizontal axis and month on the vertical axis.
Data is most readily available in your library from the Survey of Current Business by the U.S.
Department of Commerce, the Economic Indicators Supplement, The Economic Report of
the President, the Employment and Earnings Report, The Consumer Price Index Report
(last three by the Bureau of Labor Statistics). This information is also available at
www.whitehouse.gov. Write down the source of your data:
Source: __________________date: __________________page: _______________
6. On the basis of this data, do you agree with the interpretation that you circled for number 4
above? Explain your answer on the back of this page.
7. In the remaining space below your article, indicate the source (name of newspaper,
magazine or web site), title (newspaper headline, magazine article, or web article title), date,
and page for the article you have chosen. Use this format:
8. Source:
Date:
Page:
Headline:
If this information also appears in the article itself, circle each item.
9. Neatness counts.
Chapter 10 – The Business Cycle – Page 215
Professor’s Note
Learning Objective for Media Exercise
To familiarize students with the sources of information on inflation, get them to verify and judge
information on inflation that is provided by the media, and raise the level of their critical
thinking about professional interpretation of the data.
Suggestions for Correcting Media Exercise
1. A teacher aiming at the highest cognitive level for the students should correct the short
statement in number 6 about agreeing or disagreeing with the government analysis of
inflation information.
2. A glance can verify whether the students have done the work to find and graph the data.
Likely Student Mistakes and Lecture Opportunities
The problems of finding data and revisions of data are similar to those for finding the
unemployment data in the Chapter six exercise. The Chapter six comments on lecture
opportunities and likely student mistakes also apply here.
SUPPLEMENTARY RESOURCES
Frumkin, Norman: Guide to Economic Indicators, M.E. Sharpe, Armonk, NY, 2000.
Helpful guide to macroeconomic data.
Schneider, Friedrich and Dominik H. Enste, “Shadow Economies: Size, Causes and
Consequences,” Journal of Economic Literature, March 2000. Technical
discussion of the underground economy around the world.
Baker, Dean: Getting Prices Right: The Debate over the Consumer Price Index. M.E.
Sharpe, Armonk, NY, 1997. Accessible discussion of problems with the CPI.
Includes Boskin Commission report and a critique of those conclusions.
Symposium on “Measuring the CPI” Journal of Economic Perspectives, Winter 1998, pp.
1-78.
Blegger, John, and Steven Hangen: “BLS Introduces New Range of Alternative
Unemployment Measures”, Monthly Labor Review, October 1995. Discusses six
alternative measures of unemployment.
Costillo, Monica. “Persons Outside The Labor Force Who want a Job:, Monthly Labor
Review, July 1998, pp. 24 – 42. Characteristics of the “hidden unemployed” are
analyzed.
Mishel, Lawrence, and Jared Bernstein: The State of Working America. Cornell
University Press. Yearly account of employment, unemployment and pay in the
US.
Chapter 10 – The Business Cycle – Page 216
Schor, Juliet: The Overworked American: The Unexpected Decline of Leisure, Basic
Books, New York, 1991. Shows (accessible to students) how groups are working
more and provides more detailed data on higher married women’s participation
rates (p. 25), higher teenage labor-force participation rates (p. 26), and lower
male labor-force participation rates (p. 28).
Symposium on “The Natural Rate of Unemployment,” Journal of Economic
Perspectives, Winter 1997. Six articles by leading economists on the natural rate
hypothesis.
Chapter 10 – The Business Cycle – Page 217