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Chapter 9
Business
Cycles,
Unemployment,
and Inflation
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• The business cycle and its
phases
• Measuring unemployment and
inflation
• The types and impacts of
unemployment and inflation
9-2
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)
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
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
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
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
The Business Cycle
Peak
Level of Real Output
Peak
Peak
Trough
Trough
Time
Durable and nondurable industries
affected differently
9-8
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
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
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
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
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
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
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%
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
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
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
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
The Unequal Burdens of Unemployment
• Unemployment rates are lower for whitecollar workers
• African-Americans have higher rates than
whites
• Teenagers have the highest rates
– Black teenagers have the greatest
unemployment
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
GDP (billions of 1996 dollars)
Unemployment
12,000
12,000
The GDP Gap
11,000
11,000
GDP gap
(positive)
10,000
10,000
9,000
9,000
Potential GDP
8,000
8,000
GDP gap
(negative)
7,000
7,000
6,000
6,000
Actual GDP
5,000
5,000
1985
1987
Unemployment
(percent of civilian
Labor force)
1985
1987
1989
1989
1991
1991
1993
1993
1995
1995
1997
1997
1999
1999
2001
2001
2003
2003
2005
2005
10 10
8
8
6
6
4
4
2
2
0
0
1985
The Unemployment Rate
1985 1987 1987
1989
1989
1991 1991
19931993
1995
1995
1997
1997
1999
1999
2001
2001
Source: Congressional Budget Office & Bureau of Economic Analysis
2003
2003
2005
2005
9-22
Unemployment
Unemployment Rates in Five Industrial
Nations,1995-2005
Source: Bureau of Labor Statistics
9-23
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
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
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 1982-1984
x
100
9-26
Inflation
Annual Inflation Rates in the United States,
1960-2007
Inflation Rate (percent)
15
10
5
0
1960
1970
1980
1990
Source: Bureau of Labor Statistics
2000
9-27
Inflation
Inflation Rates in Five Industrial Nations,
1995-2005
Source: Bureau of Labor Statistics
9-28
Causes of Inflation
• Types 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
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
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
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”
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
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
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
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
More effects of Inflation
• Anticipated inflation
– The government has time to develop antiinflationary 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)
Anticipated Inflation
–Nominal Interest Rate
–Real Interest Rate
–Inflation Premium
6%
11%
=
+
5%
Nominal
Interest
Rate
Inflation
Premium
Real
Interest
Rate
9-38
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
Key Terms
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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
•
•
•
•
•
•
•
•
•
•
•
•
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•
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Okun’s law
inflation
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
9-40
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Basic
Macroeconomic
Relationships
9-41