Download Chapter No. 4 - College of Business Administration @ Kuwait

26
Business Cycles, Unemployment, and
Inflation
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
The Business Cycle
• Introduction: This chapter looks at trends of real GDP
growth and the macroeconomic problems of the
business cycle, unemployment and inflation.
• Learning objectives – After reading this chapter, students
should be able to:
• Describe the business cycle and its primary phases.
• Illustrate how unemployment and inflation are measured.
• Explain the types of unemployment and inflation and their
various impacts.
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The Business Cycle
• Overview of the Business Cycle
• Historical record:
• 1. The United States’ impressive long-run economic growth
has been interrupted by periods of instability.
• 2. Uneven growth has been the pattern, with inflation often
accompanying rapid growth, and declines in employment
and output during periods of recession and depression (see
Figure 26.1 and Table 26.1).
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The Business Cycle
U.S. Recessions since 1950
Period
Duration,
Months
Depth
(Decline in Real
Output)
1953-54
10
-2.6%
1957-58
8
-3.7
1960-61
10
-1.1
1969-70
11
-0.2
1973-75
16
-3.2
1980
6
-2.2
1981-82
16
-2.9
1990-91
8
-1.4
2001
8
-0.4
2007-09
18
-3.7
Source: National Bureau of Economic Research, http://www.nber.org and Minneapolis Federal Reserve
Bank, http://www.minneapolisfed.org Output data are in 2000 dollars
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The Business Cycle
• Four phases of the business cycle are identified over a
several-year period. (See Figure 26.1)
• 1. A peak is when business activity reaches a temporary
maximum with full employment and near-capacity output.
• 2. A recession is a decline in total output, income,
employment, and trade lasting six months or more.
• 3. The trough is the bottom of the recession period.
• 4. Recovery is when output and employment are expanding
toward full-employment level.
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The Business Cycle
Peak
Level of real output
Peak
Peak
Trough
Trough
Time
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Causation: A First Glance
• There are several theories about causation.
• 1. Major innovations may trigger new investment and/or
consumption spending.
• 2. Changes in productivity may be a related cause.
• 3. Monetary factors
• 4. Political events
• 5. Financial Stability
• 6. Most agree that the level of aggregate spending is
important, especially changes on capital goods and
consumer durables.
• Cyclical fluctuations: Durable goods output is more volatile
than non-durables and services because spending on latter
usually can not be postponed.
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Unemployment
• Unemployment (One Result of Economic Downturns)
• Measuring unemployment (see Figure 26.2 for 2009):
• 1. The population is divided into three groups:
• those under age 16 or institutionalized,
• those “not in labor force,”
• the labor force that includes those age 16 and over who are willing
and able to work, and actively seeking work (demonstrated job
search activity within the last four weeks).
• 2. The unemployment rate is defined as the percentage of
the labor force that is not employed. (Note: Emphasize not
the percentage of the population.)
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Unemployment
Total
population
(307.3
million)
Under 16
and/or
Institutionalized
(71.4 million)
Unemployment rate =
# of unemployed
X 100
labor force
Not in
labor
force
(81.7 million)
Unemployment rate =
Employed
(139.9 million)
14,265,000
X 100 = 9.3%
154,142,000
Labor
force
(154.2
million)
Unemployed
(14.3 million)
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Unemployment
• 3. The unemployment rate is calculated by random survey of
60,000 households nationwide. (Note: Households are in
survey for four months, out for eight, back in for four, and
then out for good; interviewers use the phone or home visits
using laptops.) Two factors cause the official unemployment
rate to understate actual unemployment.
• a. Part-time workers are counted as “employed.”
• b. “Discouraged workers” who want a job, but are not
actively seeking one, are not counted as being in the labor
force, so they are not part of unemployment statistic.
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Types of Unemployment
• Types of unemployment:
• 1. Frictional unemployment: consists of those searching
for jobs or waiting to take jobs soon; it is regarded as
somewhat desirable, because it indicates that there is
mobility as people change or seek jobs.
• 2. Structural unemployment: due to changes in the
structure of demand for labor; e.g., when certain skills
become obsolete or geographic distribution of jobs changes.
• 3. Cyclical unemployment: is caused by the recession
phase of the business cycle.
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Types of Unemployment
• As firms respond to insufficient demand for their goods and services,
output and employment are reduced.
• Extreme unemployment during the Great Depression (25 percent in
1933) was cyclical unemployment.
• 4. It is sometimes not clear which type describes a person’s
unemployment circumstances.
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Definition of Full Employment
• Definition of “Full Employment”
• Full employment does not mean zero unemployment.
• The full-employment unemployment rate is equal to the total
frictional and structural unemployment.
• The full-employment rate of unemployment is also referred
to as the natural rate of unemployment.
• The natural rate is achieved when labor markets are in
balance; the number of job seekers equals the number of
job vacancies.
• The natural rate of unemployment is not fixed but depends
on the demographic makeup of the labor force and the laws
and customs of the nations.
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Economic Cost of Unemployment
• Recently the natural rate has dropped from 6% to 4 to 5%
as demographic factors, job search methods, and public
policies change.
• Economic cost of unemployment:
• GDP gap and Okun’s Law: GDP gap is the difference
between potential and actual GDP. (See Figure 26.3)
Economist Arthur Okun quantified the relationship between
unemployment and GDP as follows: For every 1 percent of
unemployment above the natural rate, a negative GDP gap
of about 2 percent occurs. This is known as “Okun’s law.”
• Unequal burdens of unemployment exist. (See Table 26.2)
• Rates are lower for white-collar workers.
• Teenagers have the highest rates.
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• African-Americans have higher rates than whites.
• Rates for males and females are historically comparable, though
during the Great Recession females had a significantly lower rate.
• Less educated workers, on average, have higher unemployment
rates than workers with more education.
• “Long-term” (15 weeks or more) unemployment rate is much lower
than the overall rate, although it has nearly tripled from 1.5% in 2007
to 4.7% in 2009 due to the Great Recession.
• Noneconomic costs include loss of self-respect and social
and political unrest.
• International comparisons. (See Global Perspective 26.1)
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Unequal Burdens
Unemployment Rates by Demographic Group: Full Employment Year (2007) and Recession Year (2009)*
Unemployment Rate
Demographic Group
Overall
Occupation:
Managerial and professional
Construction and extraction
Age:
16-19
African American, 16-19
White, 16-19
Male, 20+
Female, 20+
Race and ethnicity:
African American
Hispanic
White
Gender:
Women
Men
**
Education:
Less than high school diploma
High school diploma only
College degree or more
Duration:
15 or more weeks
LO3
2007
2009
4.6%
9.3%
2.1
4.6
7.6
19.7
15.7
24.3
29.4
39.5
13.9
21.8
4.1
9.6
4.0
7.5
8.3
14.8
5.6
12.1
4.1
8.5
4.5
8.1
4.7
10.3
7.1
14.6
4.4
9.7
2.0
4.6
1.5
4.7
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Global Perspective
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Economic Cost of Unemployment
Economic Cost of Unemployment
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Economic Cost of Unemployment
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Inflation
• Inflation: Defined and Measured
• Definition: Inflation is a rising general level of prices (not all
prices rise at the same rate, and some may fall).
• The main index used to measure inflation is the Consumer
Price Index (CPI). To measure inflation, subtract last year’s
price index from this year’s price index and divide by last
year’s index; then multiply by 100 to express as a
percentage.
• “Rule of 70” permits quick calculation of the time it takes the
price level to double: Divide 70 by the percentage rate of
inflation and the result is the approximate number of years
for the price level to double. If the inflation rate is 7 percent,
then it will take about ten years for prices to double. (Note:
You can also use this rule to calculate how long it takes
savings to double at a given compounded interest rate.)
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Inflation
• Facts of inflation:
• In the past, deflation has been as much a problem as
inflation. For example, between 2008 and 2009, the CPI
decreased by.4%. The prospect of deflation has been a
concern of economic policymakers.
• All industrial nations have experienced the problem (see
Global Perspective 26.2).
• Some nations experience astronomical rates of inflation
(Zimbabwe’s was 14.9 billion percent in 2008 before doing
away with their existing currency).
• The inside covers of the text contain historical rates for the
U.S.
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Inflation
Inflation Rates in Five Industrial Nations
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Inflation
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Inflation
• Causes and theories of inflation:
• Demand-pull inflation: Spending increases faster than
production. It is often described as “too much spending
chasing too few goods.”
• CONSIDER THIS … Clipping Coins
• Princes would clip coins, paying peasants with the clipped coins and
using the clippings to mint new coins.
• Clipping was essentially a tax on the population as the increased
money supply caused inflation and reduced the purchasing power of
each coin.
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Inflation
• Cost-push or supply-side inflation: Prices rise because
of rise in per-unit production costs (Unit cost = total input
cost/units of output).
• Output and employment decline while the price level is
rising.
• Supply shocks have been the major source of cost-push
inflation. These typically occur with dramatic increases in
the price of raw materials or energy.
• Complexities: It is difficult to distinguish between
demand-pull and cost-push causes of
inflation, although cost-push will die out in a recession if
spending does not also rise.
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Inflation
• Core Inflation
• Food and energy prices are very volatile due to changes in
supply and demand which are usually temporary changes.
• To prevent a misinterpretation of the changes in the CPI that
might be due to temporary changes in supply and demand,
economists use core inflation.
• Core inflation doesn’t include food and energy goods.
• If core inflation is low and stable, current policy may not
need to be changed even if the CPI is rising.
• Economists will be greatly concerned if core inflation
increases.
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Inflation
• Redistributive effects of inflation:
• The price index is used to deflate nominal income into real
income. Inflation may reduce the real income of individuals
in the economy, but won’t necessarily reduce real income
for the economy as a whole (someone receives the higher
prices that people are paying).
• Unanticipated inflation has stronger impacts; those
expecting inflation may be able to adjust their work or
spending activities to avoid or lessen the effects.
• Fixed-income groups will be hurt because their real income
suffers. Their nominal income does not rise with prices.
• Savers will be hurt by unanticipated inflation, because
interest rate returns may not cover the cost of inflation.
Their savings will lose purchasing power.
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Inflation
• Debtors (borrowers) can be helped and lenders hurt by
unanticipated inflation. Interest payments may be less than
the inflation rate, so borrowers receive “dear” money and
are paying back “cheap” dollars that have less purchasing
power for the lender.
• If inflation is anticipated, the effects of inflation may be less
severe, since wage and pension contracts may have
inflation clauses built in, and interest rates will be high
enough to cover the cost of inflation to savers and lenders.
• “Inflation premium” is amount that interest rate is raised to
cover effects of anticipated inflation.
• “Real interest rate” is defined as nominal rate minus inflation
premium. (See Figure 26.5)
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Inflation
• Final points
• Unexpected deflation, a decline in price level, will have the
opposite effect of unexpected inflation.
• Many families are simultaneously helped and hurt by
inflation because they are both borrowers and earners and
savers.
• Effects of inflation are arbitrary, regardless of society’s
goals.
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Anticipated Inflation
6%
11%
=
+
5%
Nominal
Interest
Rate
LO3
Inflation
Premium
Real
Interest
Rate
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Inflation
• Output Effects of Inflation
• Cost-push inflation, where resource prices rise
unexpectedly, could cause both output and employment to
decline. Real income falls.
• Mild inflation (<3%) has uncertain effects. It may be a
healthy by-product of a prosperous economy, or it may have
an undesirable impact on real income.
• Danger of creeping inflation turning into hyperinflation,
which can cause speculation, reckless spending, and more
inflation (see examples in text of Japan following World War
II, and Germany following World War I).
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Last word
• LAST WORD: The Stock Market and The Economy:
How, if at all, do changes in stock prices relate to
macroeconomic stability?
• Do changes in stock prices and stock market wealth cause
instability? The answer is yes, but usually the effect is
weak.
• There is a wealth effect: Consumer spending rises as asset
values rise and vice versa if stock prices decline
substantially.
• Also, there is an investment effect: Rising share prices lead
to more capital goods investment and the reverse in true for
falling share prices.
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Last word
• Stock market “bubbles” can hurt the economy by
encouraging reckless speculation with borrowed funds or
savings needed for other purposes. A “crash” can cause
unwarranted pessimism about the underlying economy.
• A related question concerns forecasting value of stock
market averages. Stock price averages are included as one
of ten “Leading Indicators” used to forecast the future
direction of the economy. (See Last Word, Chapter 30).
However, by themselves, stock values are not a reliable
predictor of economic conditions.
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