Download Chapter 10

Chapter 10
Economic Fluctuations,
Unemployment, and Inflation
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-1
Objectives
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Examine the business cycle
Consider various business cycle theories
Show how economic forecasting is done
Measure the GDP gap
Learn how the unemployment rate is computed
Look at the types of unemployment
Construct a consumer price index
Consider the theories of inflation
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-2
GDP in 1996 dollars, 1958-2002
Shaded areas indicate recessions
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-3
Recessions Since 1945
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-4
Hypothetical Business Cycles
Peak
Peak
Peak
Prosperity
Trough
Trough
2005
2010
2015
Year
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10-5
Business Cycle Theories
• Endogenous theories
–
–
–
–
–
Innovation theory
Psychological theory
Inventory cycle theory
Monetary theory
Underconsumption theory
• Exogenous theories
– Sunspot theory
– War theory
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10-6
Business Cycle Forecasting
• The Ten Leading Economic Indicators
– 1. Average workweek of production workers in
manufacturing
– 2. Average initial weekly claims for state
unemployment insurance
– 3. New orders for consumer goods and materials
– 4. Vendors performance (companies receiving
slower deliveries from suppliers)
– 5. New orders for capital goods
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-7
Business Cycle Forecasting
(Continued)
• The Ten Leading Economic Indicators
–
–
–
–
6. New building permits issued
7. Index of stock prices
8. Money supply
9. Spread between rates on 10-year Treasury
bonds and Federal funds
– 10. Index of consumer expectations
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-8
Unemployment
• The problem
– One of the most devastating experiences a person
can have is to be out of work for a prolonged period
– Discouraged workers are those who have given up
looking for work and have simply dropped out of
the labor force
• The Bureau of Labor Statistics does not count discouraged
workers as part of the labor force
• There were over 5 million Americans classified as
discouraged in 2002 and 2002
• Had they been counted the unemployment would have been
almost double
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-9
Unemployment
(Continued)
• The liberal criticism
– A person who worked one day last month is
counted as employed
– Someone who works part-time but who
wants to work full-time is counted as
employed
– The true unemployment rate is higher than
the official rate
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-10
Unemployment
(Continued)
• The conservative criticism
– Some just go through the motions of looking
for work to remain eligible for benefits and
are not really looking for work
– Huge numbers of Americans – as well as
illegal immigrants are working in the
underground economy
• These people are employed off the books, do not
report their income, and are not counted as
employed by the bureau of labor statistics
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-11
Unemployment
(Continued)
• The conservative criticism
– The percentage of married women in the labor force
has risen from 25 percent in the late 1940s to about
65 percent today (this raises the unemployment rate
in three ways)
• Married women who are reentering the labor force will
have to find jobs
• Because their husbands are employed they can shop
around for a while
• Their husbands, if unemployed, can also shop around for a
while if their wives are working
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-12
Unemployment
(Continued)
• The conservative criticism
– The true unemployment rate is lower than
the official rate
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10-13
How Is the Unemployment
Rate Computed?
Number of Unemployed
UR = -----------------------------------------Labor Force
Number employed
+ Number unemployed
= Labor Force
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-14
How Is the Unemployment
Rate Computed?
Number of Unemployed
UR = ------------------------------------------ Number employed
Labor Force
+ Number unemployed
= Labor Force
2000 Number unemployed = 5,655,000
+ Number employed = 135,208,000
Labor Force = 140,863,000
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-15
How Is the Unemployment
Rate Computed?
Number of Unemployed
UR = -----------------------------------------Labor Force
5,655,000
UR = --------------------------------------140,863,000
Number employed
+ Number unemployed
= Labor Force
2000 Number unemployed = 5,655,000
+ Number employed = 135,208,000
Labor Force = 140,863,000
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-16
How Is the Unemployment
Rate Computed?
Number of Unemployed
UR = ------------------------------------------ Number employed
Labor Force
+ Number unemployed
5,655,000
UR = --------------------------------------= Labor Force
140,863,000
2000 Number unemployed = 5,655,000
+ Number employed = 135,208,000
UR = .0401453 = 4.0 %
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Labor Force = 140,863,000
10-17
Unemployment Rates for
Blacks
• Historically, the unemployment rate for
blacks has been double that of whites
– During recessions the black unemployment
rate is rarely below 10 percent
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-18
The Unemployment Rate, 1948-2000
Economic Report of the President, 2001; Economic Indicators, May 2003
Unemployment went up between 1969 and 1982 and went down after that
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10-19
Types of Unemployment
• Frictional unemployment
• Structural unemployment
• Cyclical unemployment
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10-20
Frictional Unemployment
• The frictionally unemployed are people
who are between jobs or just entering or
reentering the labor market
– Usually weeks or months pass before
positions are filled
– At any given time, about 2 or 3 percent of
the labor force is frictionally unemployed
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10-21
Structural Unemployment
• A person who is out of work for a relatively long
period of time, say, a couple of years, is
structurally unemployed. Some examples are
– Steelworkers and coal miners who are out of work
because the local steel plant and coal mine have
closed
– Clerical workers, typists, and inventory control
clerks who have been made obsolete by a computer
system
– People who are functionally illiterate are virtually
shut out of the labor force
• One in five adult Americans is functionally illiterate
• Our educational system turns out 1 million more functional
illiterates every year
– About 2 to 3 percent of our labor force is always
structurally unemployed
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-22
Cyclical Unemployment
• Cyclical unemployment is anything above
the sum of frictional and structural
unemployment
– Caused by the ups and downs in our
economy known as the business cycle
• Fluctuations in our unemployment rate
are due to cyclical unemployment
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-23
Natural Unemployment Rate
Most economists estimate the natural unemployment rate to be 5 or
6 percent. If we take a 5 percent unemployment rate as our working
definition of full employment, anything above 5 percent would be
cyclical unemployment
Frictional
2.5%
(Natural)
+ Structural
2.5%
(Natural)
+ Cyclical
Unemployment Rate
5.0%
(Full unemployment)
1.7%
(Not natural)
6.7%
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-24
Natural Unemployment Rate
As the unemployment rate falls, and it becomes
increasingly difficult to find employees,
employers will bid up wage rates, pushing up
the rate of inflation
Once the unemployment rate falls below its
natural rate, then inflationary wage pressure
emerges
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-25
Inflation
• Defining inflation
– Generally, we consider inflation a sustained rise in
the average price level over a period of years
• When the overall price level is rising, the prices of some
goods and services are going down, i.e., TV prices in the
1970s and the 1980s, the price of VCRs, and more recently
the price of cellular phones
– U.S. inflation has been persistent since World War II
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-26
The Consumer Price Index
(CPI)
• The CPI, which measures changes in our
cost of living, is reported near the middle
of every month by the Bureau of Labor
Statistics
– The CPI is based on what it cost an average
family to live
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-27
Finding Percentage Change in
the Price Level
Year
CPI
1972
125.3
1982
289.1
By what percentage did the cost of
living rise?
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-28
Finding Percentage Change in
the Price Level
Year
CPI
1972
125.3
1982
289.1
By what percentage did the cost of
living rise?
Change
Percentage change = ---------------------------- X 100
Original Number
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-29
Finding Percentage Change in
the Price Level
Year
CPI
1972
125.3
1982
289.1
Original Number
By what percentage did the cost of
living rise?
Change = 163.8
Change
Percentage change = ---------------------------- X 100
Original Number
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-30
Finding Percentage Change in
the Price Level
Year
CPI
1972
125.3
1982
289.1
Original Number
By what percentage did the cost of
living rise?
Change = 163.8
Change
Percentage change = ---------------------------- X 100
Original Number
163.8
Percentage change = ---------------------------X 100
125.3
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
10-31
Finding Percentage Change in
the Price Level
Year
CPI
1972
125.3
1982
289.1
Original Number
By what percentage did the cost of
living rise?
Change = 163.8
Change
Percentage change = ---------------------------- X 100
Original Number
163.8
Percentage change = ---------------------------- X 100
125.3
Percentage change = 1.307 X 100
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-32
Finding Percentage Change in
the Price Level
Year
CPI
1972
125.3
1982
289.1
Original Number
By what percentage did the cost of
living rise?
Change = 163.8
Change
Percentage change = ---------------------------- X 100
Original Number
163.8
Percentage change = ---------------------------- X 100
125.3
Percentage change = 1.307 X 100
Percentage change = 130.7
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10-33
A Magic Number
The number 100 is magic! It lends itself to calculating
percentage changes. Suppose we want to find out by what
percentage prices have risen since the base year?
The base year is set at 100.
If the CPI today is 136.4, by what percentage did prices rise
since the base year?
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-34
A Magic Number
The number 100 is magic! It lends itself to calculating
percentage changes.Suppose we want to find out by what
percentage prices have risen since the base year?
The base year is set at 100.
If the CPI today is 136.4, by what percentage did prices rise
since the base year?
136.4 – 100 = 36.4%
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-35
Annual Percentage Change in the Consumer Price Index, 1946-2002
Economic Report of the President, 2002
Since World War II we have had two periods of price stability-from
1952 through 1965 and from 1991 to the present
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10-36
Inflation Seems Inevitable
• It appears that it takes a
recession to deflate “inflation”
• Sir Frederick Keith-Ross (1957)
– “Inflation is like sin; every
government denounces it and
every government practices it”
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-37
Deflation
• Deflation is a decline in the general level
of prices for a period of years
– This is the OPPOSITE of inflation
– This last occurred between 1929 -33
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10-38
Deflation
• Deflation is a decline in the general level
of prices for a period of years
– This is the opposite of inflation
– This last occurred between 1929 -33
Year
CPI
1929
17.1
1930
16.7
1931
15.2
1932
13.7
1933
13.0
1934
13.4
General price levels are
declining when the CPI is
decreasing
General price levels are rising
when the CPI is increasing
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-39
Deflation
• Deflation is a decline in the general level
of prices for a period of years
– This is the opposite of inflation
– This last occurred between 1929 -33
Year
CPI
1929
17.1
1930
16.7
1931
15.2
1932
13.7
1933
13.0
1934
13.4
General price levels are
declining when the CPI is
decreasing
General price levels are rising
when the CPI is increasing
Business owners dislike
inflation but they hate
deflation a lot more
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10-40
Disinflation
• Disinflation occurs when the RATE OF
INFLATION declines
Year CPI
Inflation Rate
1980
82.4
13.5%
1981
90.9
10.3%
1982
96.5
6.2%
1983
99.6
3.2%
1984
103.9
4.3%
1981 -83 the rate of inflation
declined . . . but prices
continued to increase . . .
just at a lower rate!
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-41
Consumer Price Index (CPI)
The most important measure of inflation is the Consumer
Price Index (CPI)
Cost of livingcy
CPI = --------------------------------- X 100
Cost of livingby
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10-42
Anticipated and Unanticipated
Inflation: Who Is Hurt by
Inflation and Who Is Helped?
• Debtors benefit from unanticipated
inflation
– They get to repay their loan in dollars that
are worth less than the dollars they
borrowed
– The biggest debtor and gainer from
unanticipated inflation has been the U.S.
government
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10-43
Anticipated and Unanticipated
Inflation: Who Is Hurt by
Inflation and Who Is Helped?
• Creditors, the people who lend out money, are
hurt by unanticipated inflation
– The ultimate creditors, or lenders, are the people
who put their money in banks, life insurance, or any
other financial instrument paying a fixed rate of
interest
• People who live on fixed incomes, particular
retired people who depend on pensions (except
Social Security) and those who hold long-term
bonds, are hurt by unanticipated inflation
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10-44
Anticipated and Unanticipated
Inflation: Who Is Hurt by
Inflation and Who Is Helped?
• When inflation is fully anticipated,
theoretically, there are no winners and
losers
– Creditors have learned to charge enough
interest to take into account, or anticipate,
the rate of inflation over the course of the
loan
• This is tacked onto the regular interest rate that
the lender would charge had no inflation been
expected
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10-45
The Real Rate of Interest
• The real rate of interest is the rate that
would be charged without inflation
Expected Rate of inflation
+ Real Rate of Interest
Nominal Rate of Interest <-------what we pay
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10-46
The Real Rate of Interest
• The real rate of interest is the rate that
would be charged without inflation
Expected Rate of inflation
+ Real Rate of Interest
Nominal Rate of Interest
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6%
5%
11%
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The Real Rate of Interest
• The real rate of interest is the rate that
would be charged without inflation
Expected Rate of inflation
+ Real Rate of Interest
Nominal Rate of Interest
6%
5%
11%
If the nominal interest rate accurately reflects the inflation,
then the inflation has been fully anticipated and no one wins
or loses, except the people who borrow money at the higher
nominal rate of interest
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10-48
The Real Rate of Interest
• The real rate of interest is the rate that
would be charged without inflation
Expected Rate of inflation
+ Real Rate of Interest
Nominal Rate of Interest
6%
5%
11%
But if the rate of inflation keeps growing – even if it is
correctly anticipated – our economy will be in big trouble
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-49
Consumer Price Index
1915 – 2002 (1967=100)
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10-50
Theories of the Causes of
Inflation
• Demand-Pull Inflation
• Cost-Push inflation
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10-51
Demand-Pull Inflation
• When there is excessive demand for
goods and services, we have demand-pull
inflation
– This occurs when people are willing and able
to buy more output than our economy can
produce because our economy is already
operating at full capacity
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10-52
Demand-Pull Inflation
• Demand-pull inflation is often summed
up as “too many dollars chasing too few
goods”
– Just where did all of this money come
from”? Milton Friedman, a Nobel laureate
in economics, suspects the seven governors of
the Federal Reserve System, which controls
the rate of growth of the money supply
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10-53
Cost-Push Inflation
• There are three variants of cost-push
inflation
– The wage-price spiral
– Profit-push inflation
– Supply-side cost shocks
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10-54
Cost-Push Inflation
• The wage-price spiral
– Wages constitute nearly two-thirds of the
cost of doing business
– Whenever workers receive a significant wage
increase, this increase is passed along to
consumers in the form of higher prices
– Higher prices raise everyone’s cost of living,
engendering further wage increases
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10-55
Cost-Push Inflation
• Profit-push inflation
– Because just a handful of firms dominate
many industries, they have the power to
administer prices rather than accept the
dictates of the market forces of supply and
demand
– To the degree that they are able, these firms
will respond to any rise in cost by passing
them on to their customers
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10-56
Cost-Push Inflation
• Supply-side cost shocks
– Finally, we have supply-side shocks, most
prominently the oil price shocks of 1973-74
and 1979
• OPEC nations raised the price of oil
• When the price of oil rises, the cost of making
many other things rise as well
– Cost increases are quickly translated into
price increases
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10-57
Inflation as a Psychological
Process
• If people believe prices will rise, they will
act in a way that keeps them rising
• To break the back of inflationary
psychology is to bring down the rate of
inflation for a sufficiently long period of
time for people to actually expect price
stability to continue
• This has happened in the recent past only
after successive recessions have wrung
inflation out of the economy
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10-58
Creeping Inflation and
Hyperinflation
• Inflation is a relative term
– Creeping inflation in one country would be
hyperinflation in another
• But once we cross the line between creeping
inflation and hyperinflation – which keeps
shifting- we run into trouble
– It becomes increasingly difficult to conduct normal
economic affairs
– Prices are raised constantly
– It becomes impossible to enter into long-term
contracts
– No one is sure what the government might do
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10-59
Conclusion
• One thing the economy has rarely been able to attain
simultaneously is a low unemployment rate and stable prices
The Misery Index, 1948-2002
Economic Report of the President, 2002
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10-60