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Survey of ECON Chapter 11 © AP PHOTO Robert L. Sexton Introduction to Macroeconomics: Unemployment, Inflation, and Economic Fluctuations 1 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 11 Sections – Macroeconomic Goals – Employment and Unemployment – Types of Unemployment – Reasons for Unemployment – Inflation – Economic Fluctuations 2 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Macroeconomic Goals 3 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 1 SECTION 1 QUESTIONS 4 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Macroeconomic Goals 5 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Three Major Macroeconomic Goals REAL GROSS DOMESTIC PRODUCT (RGDP) the total value of all final goods and services produced in a given period, such as a year or a quarter, adjusted for inflation • The term real gross domestic product (RGDP) is used to measure output or production. • The term real is used to indicate that the output is adjusted for the general increase in prices over time. 6 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Acknowledging Our Goals: The Employment Act of 1946 • The Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978 (the Humphrey– Hawkins Act) committed the U.S. government to pursuing unemployment policies that were also consistent with price stability. • It first acknowledged formally primary macroeconomic goals. 7 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 1 8 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Employment and Unemployment 9 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 2 SECTION 2 QUESTIONS 10 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Consequences of High Unemployment • The news of lower unemployment usually sends stock prices higher; and the news of higher unemployment usually sends stock prices lower. • Politicians are also concerned about the unemployment figures because elections often hinge precariously on whether unemployment has been rising or falling. 11 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Consequences of High Unemployment • A loss of a job can mean financial insecurity and a great deal of anxiety. • High rates of unemployment in a society can increase tensions and despair. – Society loses potential output of goods when some of its productive resources—human or nonhuman—remain idle, and potential consumption is reduced. 12 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Consequences of High Unemployment 13 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © Masterfile • Thus a loss in efficiency occurs when people willing to work and equipment able to produce remain idle. • Other things being equal, relatively high rates of unemployment are viewed almost universally as undesirable. What is the Unemployment Rate? • When discussing unemployment, economists and politicians refer to the unemployment rate. • To calculate the unemployment rate, you must first understand another important concept—the labor force. • It includes the number of people over the age of 16 who are available for employment. 14 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. What is the Unemployment Rate? • The civilian labor force figure excludes people in the armed services and those in prisons or mental hospitals. • Other people regarded as outside the labor force include homemakers, retirees, and full-time students. • This is because they are not considered currently available for employment. 15 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SOURCE: Bureau of Labor Statistics, Current Population Survey, Employment Situation Summary Table A. Washington D.C., March 5, 2010. Available at http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010). Exhibit 11.1: The U.S. Labor Force, 2010 16 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. What is the Unemployment Rate? • To calculate the unemployment rate, we simply divide the number of unemployed by the number in the civilian labor force: 17 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. What is the Unemployment Rate? • In August 2009, the number of civilians unemployed in the United States was 14.46 million, and the civilian labor force totaled 154.5 million. • Thus the unemployment rate in August 2009 was 9.4 percent. 18 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Worst Case of U.S. Unemployment • By far, the worst employment downturn in U.S. history occurred during the Great Depression, which began in late 1929 and continued until 1941. – Unemployment rose from only 3.2 percent of the labor force in 1929 to more than 20 percent in the early 1930s, and double-digit unemployment persisted through 1941. 19 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Worst Case of U.S. Unemployment • Some economists would argue that modern macroeconomics, with its emphasis on the determinants of unemployment and its elimination, truly began in the 1930s. 20 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Variations in the Unemployment Rate • Unemployment since 1960 ranged from a low of 3.5 percent in 1969 to a high of 10.8 percent in 1982. • The financial crisis of 2008 led to unemployment rates of 9.4 percent by mid-2009. • Before 1960, variations in unemployment were more pronounced. 21 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SOURCE: Bureau of Labor Statistics, CPS Tables, Annual Averages—Household Data, Employment status of the civilian noninstitutional population, 1940s to date. Washington, D.C. Available at http://www.bls.gov/cps/tables.htm#empstat (accessed March 25, 2010). Exhibit 11.2: U.S. Unemployment Rates, 1960–2009 22 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Are Unemployment Statistics Accurate Reflections of the Labor Market? DISCOURAGED WORKER an individual who has left the labor force because he or she could not find a job • Individuals who have not actively sought work for four weeks are not counted as unemployed; instead, they fall out of the labor force. 23 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Are Unemployment Statistics Accurate Reflections of the Labor Market? • People looking for full-time work who grudgingly settle for part-time jobs are counted as “fully” employed, even though they are only “partly” employed. • At least partially balancing these two biases in government employment statistics, however, is the number of people who are over-employed—that is, working overtime or at more than one job. 24 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Are Unemployment Statistics Accurate Reflections of the Labor Market? • A number of jobs in the underground economy (e.g., drug dealing, prostitution, gambling, and so on) are not reported. • In addition, many people may claim they are seeking work when, in fact, they may just be going through the motions so they can continue to collect unemployment compensation or receive other government benefits. 25 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Who are the Unemployed? • Unemployment usually varies greatly across different segments of the population and over time. • According to the Bureau of Labor Statistics, the unemployment rate across the sexes and races among college graduates is significantly lower than for those who do not complete high school. 26 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Education as a Factor in Unemployment • College graduates have lower unemployment rates than people who have some college education but did not complete their bachelor’s degrees (3.6 percent). • The incidence of unemployment varies widely among the population. 27 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Age, Sex, and Race as Factors in Unemployment • Unemployment tends to be greater among the very young, among blacks and other minorities, and among workers with few skills. • The unemployment rate for adult females tends to be higher than that for adult males. 28 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Age, Sex, and Race as Factors in Unemployment • Considering the great variations in unemployment for different groups in the population, we calculate separate unemployment rates for groups classified by sex, age, race, family status, and type of occupation. • Some would regard teenage unemployment a lesser evil than unemployment among adults, because most teenagers have parents or guardians on whom they can rely for subsistence. 29 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SOURCE: Bureau of Labor Statistics, Current Population Survey, Employment Situation Summary Table A. Washington, D.C., March 5, 2010. Available at http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010). Exhibit 11.3: Unemployment in the United States by Age, Sex, and Race 30 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Categories of Unemployed Workers • According to the Bureau of Labor Statistics, the four main categories of unemployed workers are JOB LOSER an individual who has been temporarily laid off or fired JOB LEAVER a person who quits his or her job 31 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Categories of Unemployed Workers REENTRANT an individual who worked before and is now reentering the labor force NEW ENTRANT an individual who has not held a job before but is now seeking employment • It is a common misconception that most workers are unemployed because they have lost their jobs. 32 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SOURCE: Bureau of Labor Statistics, Current Population Survey, Employment Situation Summary Table A. Washington, D.C., March 5, 2010. Available at http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010). Exhibit 11.4: Reasons for Unemployment 33 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. How Much Unemployment? • Even though unemployment is painful to those who have no source of income, reducing unemployment is not costless. • In the short run, a reduction in unemployment may come at the expense of a higher rate of inflation, especially if the economy is close to full capacity, where resources are almost fully employed. 34 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. How Much Unemployment? • Trying to match employees with jobs can quickly lead to significant inefficiencies because of mismatches between a worker’s skill level and the level of skill required for a job. • That is, the skills of the employee may be higher than those necessary for the job, resulting in what economists call underemployment. • Another source of inefficiencies is placing employees in jobs beyond their abilities. 35 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. How Long are People Usually Unemployed? • The duration of unemployment is equally as important as the amount of unemployment. • It is useful to look at the average duration of unemployment to discover what percentage of the labor force is unemployed longer than a certain period, say 15 weeks. 36 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. How Long are People Usually Unemployed? • The duration of unemployment tends to be greater when the amount of unemployment is high and smaller when the amount of unemployment is low. • The loss of output resulting from unemployment for any duration is permanent; it is not made up when unemployment starts falling again. 37 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SOURCE: Bureau of Labor Statistics, Current Population Survey, Employment Situation Summary Table A. Washington, D.C., March 5, 2010. Available at http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010). Exhibit 11.5: Duration of Unemployment 38 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Labor Force Participation Rate • The percentage of the population that is in the labor force is what economists call the labor force participation rate. • Over the last several decades, the number of women working shifted dramatically, reflecting the changing role of women in the workforce. • Today the labor force participation rate for men has fallen to roughly 71 percent, as many men stay in school longer and opt to retire earlier. 39 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SOURCE: Bureau of Labor Statistics, Current Population Survey, Table A-1. Employment status of the civilian population by sex and age. Washington, D.C., March 5, 2010. Available at http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010). Exhibit 11.6: Labor Force Participation Rates for Men and Women 40 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 2 41 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Types of Unemployment 42 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 3 SECTION 3 QUESTIONS 43 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Frictional Unemployment • Frictional unemployment is the temporary unemployment that results from the search time that occurs when people are searching for suitable jobs and firms are looking for suitable workers. • People seeking work do not usually take the first job offered to them. 44 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Frictional Unemployment • Likewise, firms do not usually take the first person they interview. • People and firms engage in a search to match up skills and interests. • While the unemployed are looking, they are frictionally unemployed. 45 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Frictional Unemployment • Whether the unemployment is due to having been fired or from having voluntarily quit, frictional unemployment is short term and results from normal turnover in the labor market, as when people change from one job to another. 46 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Frictional Unemployment • Some unemployment occurs because certain types of jobs are seasonal in nature, called seasonal unemployment. • Occupations that experience either sharp seasonal shifts in demand or are subject to changing weather conditions may lead to seasonal unemployment—such as in agriculture where employment increases during harvest season. 47 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Frictional Unemployment • Since this type of unemployment can make the unemployment rate higher in the offseason and lower during the in-season, the Bureau of Labor Statistics (BLS) publishes a seasonally adjusted unemployment rate as well. • These figures are more accurate because they take into account the effects of seasonal unemployment. 48 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Should We Worry about Frictional Unemployment? • Geographic and occupational mobility are considered good for the economy because they generally lead human resources to go from activities of relatively low productivity or value to areas of higher productivity, increasing output in society as well as the wage income of the mover. 49 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Should We Worry about Frictional Unemployment? • Frictional unemployment involving searches by firms and workers to find more suitable match-ups is obviously beneficial to the economy. • Although the amount of frictional unemployment varies somewhat over time, it is unusual for it to be much less than 2 percent of the labor force. 50 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Should We Worry about Frictional Unemployment? • Actually, frictional unemployment tends to be somewhat greater in periods of low unemployment, when job opportunities are plentiful. • This high level of job opportunity stimulates mobility, which, in turn, creates some frictional unemployment. 51 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Structural Unemployment • Like frictional unemployment, structural unemployment is related to occupational movement or mobility—in this case, to a lack of mobility. • It occurs when workers lack the necessary skills for jobs that are available or have particular skills that are no longer in demand. 52 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Structural Unemployment • The quantity of unemployed workers conceivably could equal the number of job vacancies, with the unemployment persisting because the unemployed lack the appropriate skills. • Given the existence of structural unemployment, it is wise to look at both unemployment and job vacancy statistics in assessing labor market conditions. 53 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Structural Unemployment • Structural unemployment, like frictional unemployment, reflects the dynamic dimension of a changing economy. • Over time, new jobs open up that require new skills, while old jobs that required different skills disappear. • Government-subsidized retraining programs are a popular means of reducing structural unemployment for this reason. 54 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Structural Unemployment • Another reason for structural unemployment is that low-skilled workers are frequently unable to find desirable long-term employment. • Since they acquired no new skill from the old job, they may not find a long-term secure job. • That is, structural workers cannot be said to be “in-between jobs” like those who are frictionally unemployed. 55 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Structural Unemployment • Structural unemployment is more long term and serious than frictional unemployment because these workers do not have marketable skills. • The dimensions involved are debatable, due to the difficulty in precisely defining the term in an operational sense. 56 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Some Unemployment Is Unavoidable • Frictional and structural unemployment are simply unavoidable in a vibrant economy. • To a certain extent, both can be viewed as phenomena resulting from imperfections in the labor market. 57 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Some Unemployment Is Unavoidable • It takes time for suppliers of labor to find the demanders of labor services, and it takes time and money for labor resources to acquire the necessary skills. • Bringing together demanders and suppliers of labor services does not occur instantaneously, because information and job searches are expensive. 58 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cyclical Unemployment • In years of relatively high unemployment, some joblessness may result from shortterm cyclical fluctuations in the economy, called cyclical unemployment. • An unemployment rate that is greater than normal, such as during recession, is due to cyclical unemployment. • Most attempts to solve the cyclical unemployment problem emphasized increasing aggregate demand to counter recession. 59 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Cost of Cyclical Unemployment • When the unemployment rate is high, numerous economic and social hardships result. • Economic costs are the forgone output when the economy is not producing at its potential level. 60 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Cost of Cyclical Unemployment • According to Okun’s Law (really, a rule of thumb), a 1 percent increase in cyclical unemployment reduces output by 2 percentage points. • The costs are particularly high for those groups with the least skills—the poorly educated and teenagers with little work experience. 61 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Natural Rate of Unemployment • Over the period in which annual unemployment data are available, the median, or “typical,” annual unemployment rate has been at or slightly above 5 percent. • Some economists call this typical unemployment rate the natural rate of unemployment. 62 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Natural Rate of Unemployment • Abnormally high unemployment exists when unemployment rises well over 5 percent, and abnormally low unemployment exists when it falls below 5 percent. • The natural rate of unemployment of approximately 5 percent roughly equals the sum of frictional and structural unemployment when they are at their maximums. 63 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Natural Rate of Unemployment • Thus, unemployment rates below the natural rate reflect the existence of below-average levels of frictional and structural unemployment. • Unemployment rates above the natural level show the existence of cyclical unemployment. • In short, the natural rate of unemployment is the unemployment rate when the economy is experiencing neither a recession nor a boom. 64 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Natural Rate of Unemployment • The natural rate of unemployment is also called the full employment rate of unemployment. • It can change over time as technological, demographic, institutional, and other conditions vary. • Baby boomers, Internet and improvements in job placement, and new work requirements of welfare laws. 65 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Full Employment and Potential Output • When all the resources of an economy— labor, land, and capital—are fully employed, the economy is said to be producing its potential output. • This means that the economy is providing employment for all who are willing and able to work with no cyclical unemployment. 66 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Full Employment and Potential Output • It also means that capital and land are fully employed. – At the natural rate of unemployment, all resources are fully employed, the economy is producing its potential output, and no cyclical unemployment is present. • This, however, does not mean that the economy will be producing at its potential output of resources. 67 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Full Employment and Potential Output • For example, when the economy is experiencing cyclical unemployment, the unemployment rate is greater than the natural rate. • It is also possible for the economy to temporarily exceed the natural rate as workers put in overtime or moonlight by taking on extra employment. 68 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 3 69 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Reasons for Unemployment 70 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 4 SECTION 4 QUESTIONS 71 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Why Does Unemployment Exist? • In many markets, prices adjust to the market equilibrium price and quantity, and no prolonged periods of shortage or surplus occur. • However, in labor markets, obstacles prevent wages from adjusting and balancing the quantity of labor supplied and the quantity of labor demanded. 72 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Why Does Unemployment Exist? • The market equilibrium wage equates the quantity of labor demanded with the quantity of labor supplied. • When the quantity of labor supplied is greater than the quantity of labor demanded, an excess quantity of labor supplied—unemployment—exists. 73 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Why Does Unemployment Exist? • More people want to work at the going (nonequilibrium) wage than employers want to hire, and those who are not able to find work are “unemployed.” • Three reasons are cited for the failure of wages to balance the labor demand and labor supply equilibrium—minimum wages, unions, and the efficiency wage theory. 74 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 11.7: Wages above Equilibrium Lead to Greater Unemployment 75 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Minimum Wages and Unemployment • The labor market for workers with little experience and job skills is called the unskilled labor market. • Suppose the government decided to establish a minimum wage rate (an hourly wage floor) for unskilled workers above the equilibrium wage. 76 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Minimum Wages and Unemployment • At the minimum wage, the quantity of labor supplied grows because more people are willing to work at a higher wage. • However, the quantity of labor demanded falls because some employers would find it unprofitable to hire low-skilled workers at the higher wage. 77 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Minimum Wages and Unemployment • The gap that exists between the quantity of labor demanded and the quantity supplied represents a surplus of unskilled workers—unemployment. • Because minimum wage earners, a majority of whom are 25 years or younger, are a small portion of the labor force, most economists believe the effect of minimum wage on unemployment is small. 78 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Impact of Unions on the Unemployment Rate • If, through the process of collective bargaining, union officials are able to raise wages, then unemployment will rise in the union sector. • If the union wage increases above the equilibrium level, the quantity of union labor demanded will decrease, and the quantity of union labor supplied will increase, resulting in the unemployment of union workers. 79 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Impact of Unions on the Unemployment Rate • The union workers who still have their jobs will be better off, but some who are equally skilled will be unemployed and will either seek nonunion work or wait to be recalled in the union sector. • Many believe that is why wages are approximately 15 percent higher in union jobs, even when nonunion workers have comparable skills. 80 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Impact of Unions on the Unemployment Rate • On the other hand, even though wages in the union sector are typically higher than the market wage, the presence of unions does not necessarily lead to greater unemployment because workers can find jobs in the nonunion sector. • Less than 10 percent of private sector jobs are unionized. 81 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Efficiency Wage • It is generally assumed that as productivity rises, wages rise, and workers can raise their productivity through investments in human capital such as education and on-the-job training. • Some economists, however, follow the efficiency wage model, which is based on the belief that higher wages lead to greater productivity. 82 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Efficiency Wage • Under this model, employers pay their employees more than the equilibrium wage to be more efficient. • Proponents of this theory suggest that it may lead to attracting the most productive workers, fewer job turnovers, and higher morale, which in turn can lead to lower hiring and training costs. 83 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Efficiency Wage • Since the efficiency wage rate is greater than the equilibrium wage rate, the quantity of labor supplied is greater than the quantity of labor demanded, resulting in greater amounts of unemployment. 84 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Efficiency Wage • Some have argued that the positive effects of the efficiency wage are unique to assembly line production and its high degree of worker interdependence. • However, it is costly for firms to pay an efficiency wage. • Consequently, firms must monitor their workers’ efforts. 85 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Efficiency Wage • If enough firms resort to paying the efficiency wage rate, then the average real wage rate will be greater than the equilibrium wage. • Thus, this equilibrium will lead to unemployment. 86 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Job Search • Because of frictional unemployment, some unemployment would exist even if labor supply and labor demand were balanced. • It takes time and money to locate the best available opportunities. • Simultaneously, differences exist in job seekers’ tastes and preferences about types of jobs and job locations. 87 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Job Search • Sometimes, getting information about particular jobs suitable for the right job candidate is difficult. • These search activities prolong the duration of unemployment. • However, the search goes on because the job seeker hopes to find a better offer. 88 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Job Search • The labor demand and supply curves are constantly shifting. – That is, labor markets are constantly in flux as people lose jobs, leave jobs, and reenter jobs. • In a growing and dynamic economy, jobs are constantly being destroyed and created, leading to temporary unemployment as workers search for the best jobs for their skills. 89 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Unemployment Insurance • Unemployment insurance does not cover those who were fired or quit their jobs. • To qualify, recipients must have worked a certain length of time and lost their jobs because the employer no longer needed their skills. • The typical compensation is half salary for 26 weeks. 90 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Unemployment Insurance • Although the program is intended to ease the pain of unemployment, it also leads to prolonged periods of unemployment, as job seekers stay unemployed for longer periods searching for new jobs. • It has been estimated that the existence of unemployment compensation programs may raise overall unemployment rates by as much as 1 percent. 91 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Unemployment Insurance • Without unemployment insurance, a job seeker would be more likely to take the first job offered, even if the job did not match the job seeker’s preferences or skill levels. • A longer job search might mean a better match, but it comes at the expense of lost production and greater amounts of tax dollars. 92 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Does New Technology Lead to Greater Unemployment? • Generally, new inventions are cost saving, and these cost savings usually generate higher incomes for producers and lower prices and better products for consumers—benefits that ultimately result in the growth of other industries. • If the new equipment is a substitute for labor, it might displace workers. 93 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Does New Technology Lead to Greater Unemployment? • However, new capital equipment requires new workers to manufacture and repair the new equipment. – The most famous example being the computer. • The problem is that it is easy to see only the initial effect of technological advances (displaced workers) but difficult to recognize the implications of that invention throughout the whole economy over time. 94 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Does New Technology Lead to Greater Unemployment? • Some economists believe that some of the real wage differentials between skilled and unskilled workers in the last couple of decades are due to technical changes that are biased toward skilled workers. • New machines, with highly sophisticated computerization, require highly skilled workers. 95 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Does New Technology Lead to Greater Unemployment? • Consequently, the new machines make these workers more productive and they therefore receive higher real wages. – With an increase in demand for skilled labor, their real wages and employment are higher. – Simultaneously, the demand is lower for workers without technical training in specialized machinery, and the demand falls. 96 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Does New Technology Lead to Greater Unemployment? • As a result of the decrease in demand for unskilled workers, real wages and employment fall. • Thus, skill-biased technical change tends to create even greater disparities between the wages of skilled and unskilled workers. 97 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 11.8: Skill-Biased Technical Change and Wage Inequality 98 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 4 99 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inflation 100 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 5 SECTION 5 QUESTIONS 101 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inflation PRICE LEVEL the average level of prices in the economy • Most prices in the U.S. economy tend to rise over time. INFLATION a rise in the overall price level, which decreases the purchasing power of money 102 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Stable Price Level as a Desirable Goal • Even when the level of prices is stable, some prices will be rising while others are falling. • When inflation is present, the goods and services with rising prices will outweigh the goods and services with lower prices. 103 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Stable Price Level as a Desirable Goal • Without stability in the price level, consumers and producers will experience more difficulty in coordinating their plans and decisions. • When the overall price level is falling, it is called deflation. • The average price level in the U.S. economy fell throughout the late nineteenth century. 104 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Stable Price Level as a Desirable Goal • In general, the only thing that can cause a sustained increase in the rate of inflation is a high rate of growth in money. 105 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Measuring Inflation • Inflation distorts the information that flows from price signals. • To measure the changing purchasing power of the dollar, we must construct a price index. • A price index attempts to provide a measure of the prices paid for a certain bundle of goods and services over time. 106 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Consumer Price Index and the GDP Deflator CONSUMER PRICE INDEX (CPI) a measure of the cost of a market basket that represents the consumption of a typical household • The typical CPI shopping basket is shown in Exhibit 11.9. GDP DEFLATOR a price index that helps measure the average price level of all final consumer goods and services produced 107 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SOURCE: Bureau of Labor Statistics, Consumer Price Index - February 2010, Table 1. Consumer Price Index for All Urban Consumers. Washington, D.C., March 18, 2010. Available at http://www.bls.gov/news.release/cpi.t01. htm (accessed March 25, 2010). Exhibit 11.9: The Typical CPI Shopping Basket of Goods and Services 108 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. How is a Price Index Created? • Literally thousands of goods and services are in our economy; attempting to include all of them in an index would be cumbersome and make the index expensive to compute, and it would take a long time to gather the necessary data. • Hence, a “bundle” or “basket” of representative goods and services is selected by the index calculators (the Bureau of Labor Statistics of the U.S. Department of Labor for consumer and wholesale price indices; the Office of Business Economics of the Department of Commerce for the GDP deflator). 109 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Calculating a Simple Price Index • Suppose a consumer typically buys 24 loaves of bread and 12 gallons of milk in a year. 110 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Calculating a Simple Price Index • Using the numbers from the table and the following formula, we can calculate a price index to measure the inflation rate. 111 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Calculating a Simple Price Index • The year 2010 is designated as the base year, so its value is set equal to 100. • That is, the price index for 2012 compared with 2010 is 125. • Therefore, using the price index formula, we can say that prices are 25 percent higher in 2012 than they were in 2010, the base year. 112 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SOURCES:Bureau of Labor Statistics, Consumer Price Index, Table Containing History of CPI-U U.S. All Items Indexes and Annual Percent Changes From 1913 to Present. Washington, D.C., March 18, 2010. Available at ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt (accessed March 25, 2010). Bureau of Economic Analysis, National Economic Accounts, Current-dollar and “real” GDP. Washington, D.C., February 26, 2010. Available at http://bea.gov/national/index.htm#gdp (accessed March 25, 2010). Exhibit 11.10: The CPI and the GDP Deflator 113 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Price Level over the Years • What is the historical record of changes in the overall U.S. price level? • The problem with comparing prices today with prices in the past is that it focuses on the number of dollars it takes to buy something, rather than the purchasing power of the dollar. 114 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SOURCE: Bureau of Labor Statistics, Consumer Price Index, Table Containing History of CPI-U U.S. All Items Indexes and Annual Percent Changes From 1913 to Present. Washington, D.C., March 18, 2010. Available at ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt (accessed March 25, 2010). Exhibit 11.11: The Inflation in the United States, 1913–2009 115 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Who Loses with Inflation? • Inflation brings about changes in peoples’ purchasing power, and these changes may be either desirable or undesirable. • Your real income—your income adjusted to reflect changes in purchasing power— falls. 116 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Who Loses with Inflation? • Inflation lowers income in real terms for people on fixed-dollar incomes. • Likewise, inflation can hurt creditors. – If the lender does not correctly anticipate the higher rate of inflation, the borrower is paying back with dollars that have much less purchasing power than those dollars they borrowed in periods of lower inflation. 117 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Who Loses with Inflation? • People whose incomes are tied to long-term contracts also sometimes lose out, at least temporarily, due to high inflation. • If inflation begins shortly after a labor union signs a three-year wage agreement, it may completely eat up the wage gains provided by the contract. • Businesses that agree to sell quantities of one thing, for a fixed price for a given number of years. 118 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Who Loses with Inflation? • Debtors pay back dollars worth less in purchasing power than those borrowed. • Corporations that can quickly raise the prices on their goods may have revenue gains greater than their increases in costs, providing additional profits. 119 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Who Loses with Inflation? • Wage earners sometimes lose from inflation because wages may rise at a slower rate than the price level. • The redistributional impact of inflation is not the result of conscious public policy; it just happens. 120 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Who Loses with Inflation? • The uncertainty that inflation creates can also discourage investment and economic growth. • When inflation rates are high, they also tend to vary considerably, which creates a lot of uncertainty. • Moreover, inflation can raise one nation’s price level relative to price levels in other countries. 121 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Who Loses with Inflation? • In turn, this shift can make financing the purchase of foreign goods difficult, or it can decrease the value of the national currency relative to that of other countries. 122 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. • A slow predictable rate of inflation makes predicting future price increases relatively easy. • Consequently, setting interest rates will be an easier task and the redistribution effects of inflation will be minimized. 123 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PHOTO ILLUSTRATION BY CENAGE / © JULIA ROBERTSON/GETTY IMAGES Costs of High Inflation Costs of High Inflation • High and variable inflation rates make it almost impossible to set long-term contracts because prices and interest rates may be changing by the day, or even by the hour in the case of hyperinflation—extremely high rates of inflation for sustained periods of time. 124 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Costs of High Inflation • In its extreme form, inflation can lead to a complete erosion of faith in the value of the pieces of paper we commonly call money. • Unchecked inflation can feed on itself and may ultimately lead to hyperinflation of 300 percent or more per year. 125 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Costs of High Inflation • Most economists believe we can live quite well in an environment of low, steady inflation, but no economist believes we can prosper with high, variable inflation. 126 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Other Costs of Inflation • This includes the cost incurred by firms as a result of being forced to change prices more frequently. • These costs are called menu costs; they are the costs of changing posted prices. 127 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Other Costs of Inflation • The shoe-leather cost of inflation is the cost of going to and from the bank to check on your assets (so often that you wear out the leather on your shoes). • Specifically, high rates of inflation erode the value of a currency, which means that people will want to hold less currency. 128 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Other Costs of Inflation • That is, the higher inflation rates lead to higher nominal interest rates, which may induce more individuals to put money in the bank rather than allowing it to depreciate in their pockets. • The effects of shoe-leather costs of inflation are modest in countries with low inflation rates but can be quite large in countries with high inflation. 129 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Do Creditors Always Lose during Inflation? • Usually, lenders are able to anticipate inflation with reasonable accuracy. • If the inflation rate is anticipated accurately, new creditors will not lose nor will debtors gain from a change in the inflation rate. 130 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Do Creditors Always Lose during Inflation? • However, nominal interest rates and real interest rates do not always run together. • For example, in periods of high unexpected inflation, the nominal interest rates can be high when the real interest rates are low or even negative. 131 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Protecting Ourselves from Inflation • Increasingly, groups try to protect themselves from inflation by means of cost-of-living clauses in contracts. • Many long-term contracts between firms and unions include a cost of living allowance (COLA) that automatically increases when the consumer price index (CPI) increases. 132 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Protecting Ourselves from Inflation • With these clauses, laborers automatically get wage increases that reflect rising prices. • The same is true of many pensioners, including those on Social Security. • Personal income taxes also are now indexed (adjusted) for inflation. 133 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Protecting Ourselves from Inflation • However, some of the tax code is still not indexed for inflation. – These factors affect the incentives to work, save, and invest. • Some argue for indexing everything, meaning that all contractual arrangements would be adjusted frequently to take account of changing prices. 134 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Protecting Ourselves from Inflation • Such an arrangement might reduce the impact of inflation, but it would also entail additional contracting costs (and not every good—most notably, currency—can be indexed). 135 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Protecting Ourselves from Inflation • An alternative approach has been to try to stop inflation through various policies relating to the amount of government spending, tax rates, and the amount of money created. • Wage and price controls—legislation limiting wage and price increases—offer still another approach to the inflation problem. 136 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 5 137 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Economic Fluctuations 138 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 6 SECTION 6 QUESTIONS 139 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Economic Fluctuations • The aggregate amount of economic activity in the United States and most other nations has increased markedly over time, even on a per capita basis, indicating economic growth. • Short-term fluctuations in the level of economic activity also occur. 140 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Short-Term Fluctuations in Economic Growth • These short-term fluctuations are sometimes called business cycles. • Over a long period, the economic activity line slopes upward, indicating increasing real output. • Over short periods, however, downward, as well as upward, output changes occur. 141 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Short-Term Fluctuations in Economic Growth • Business cycles refer to the short- term ups and downs in economic activity, not to the long-term trend in output, which in modern times has been upward. 142 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 11.12: Business Cycles and Economic Growth 143 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Phases of a Business Cycle • A business cycle has four phases: – Expansion – Peak – Contraction – Trough 144 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Phases of a Business Cycle • The period of expansion is when output (real GDP) is rising significantly. – During the expansion phase, unemployment is falling and both consumer and business confidence are high. – Investment and expenditures for expensive durable consumer goods rises. 145 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Phases of a Business Cycle • The peak is the point in time when the expansion comes to an end, when output is at the highest point in the cycle. • The contraction is a period of falling real output and is usually accompanied by rising unemployment and declining business and consumer confidence. 146 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Phases of a Business Cycle • The contraction phase is measured from the peak to the trough—the point in time when output stops declining and business activity is at its lowest point in the cycle. – Investment spending and expenditures on consumer durable goods fall sharply in a typical contraction. 147 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Phases of a Business Cycle • The contraction phase is also called recession, a period of significant decline in output and employment. • Unemployment is relatively high at the trough, although the actual maximum amount of unemployment may not occur exactly at the trough. 148 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Phases of a Business Cycle • Often, unemployment remains fairly high well into the expansion phase. • The expansion phase is measured from the trough to the peak. 149 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 11.13: Four Phases of a Business Cycle 150 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. How Long Does a Business Cycle Last? • Since the term business cycle does not have the regularity that the term cycle implies, economists often use the term economic fluctuation. • In addition, economic fluctuations are almost impossible to predict. • The contraction phase is one of recession, a decline in business activity. 151 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. How Long Does a Business Cycle Last? • A severe recession is called a depression. • A prolonged expansion in economic activity is sometimes called a boom. – The National Bureau of Economic Research (NBER) Business Cycle Dating Committee determined that a recession began in March 2001, ending an expansion beginning March 1991, due to the September 11, 2001 attack. 152 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 11.14: A Historical Record of U.S. Recessions, 1920–2009 SOURCES: National Bureau of Economic Research, Inc., Business Cycle Expansions and Contractions, U.S. Department of Commerce. Washington, D.C., December 1, 2008. Available at http://www.nber.org/cycles.html (accessed March 18, 2010). 153 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Seasonal Fluctuations Affect Economic Activity • Business activity, whether measured by production or by the sale of goods, tends to be high in the two months before the winter holidays and somewhat lower in the summer, when many families are on vacation. • Within individual industries, of course, seasonal fluctuations in output often are extremely pronounced, agriculture being the best example. 154 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Seasonal Fluctuations Affect Economic Activity • Key economic statistics, such as unemployment rates, are seasonally adjusted, meaning the numbers are modified to account for normal seasonal fluctuations. • Thus, seasonally adjusted unemployment rates in summer months are below actual unemployment rates, because employment is normally high in summertime due to the inflow of school-age workers into the labor 155 force. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Forecasting Cyclical Changes • Businesses, government agencies, and, to a lesser extent, consumers rely on economic forecasts to learn of forthcoming developments in the business cycle. – If it looks as if the economy will continue in an expansionary phase, businesses may expand production to meet a perceived forthcoming need; if it looks as if contraction is coming, businesses may decide to be more cautious. 156 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Forecasting Models • Using theoretical models, economists gather statistics on economic activity in the immediate past, including, for example, consumer expenditures, business inventories, the supply of money, governmental expenditures, tax revenues, and so on. 157 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Forecasting Models • Using past historical relationships between these factors and the overall level of economic activity (which form the basis of the economic theories), they formulate econometric models. • Statistics from the immediate past are plugged into the model, and forecasts are made. 158 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Leading Economic Indicators • One less sophisticated but useful forecasting tool is watching trends in leading economic indicators. – Some types of economic activity change before the economy as a whole changes. – About a dozen such leading indicators exist, including the lengths of the average workweek, the size of the nation’s money supply, prices of common stocks, the number of new businesses formed, and new orders for plants and equipment. 159 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Leading Economic Indicators • The Department of Commerce combines all these into an index of leading indicators. – If the index rises sharply for two or three months, it is likely, but uncertain, that increases in the overall level of activity will follow. • Although the composite index of leading economic indicators has never failed to give some warning, the lead time has varied widely. 160 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Leading Economic Indicators • This variance in lead time can cause particular policy problems. • Specifically, the use of leading economic indicators to predict future trends can make policy decisions less accurate. 161 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Leading Economic Indicators • If the federal government responds with policies to combat the recession as soon as the leading economic indicators begin predicting a recession, then the recession that would have occurred may fail to materialize. 162 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Leading Economic Indicators • On the other hand, a self-fulfilling prophecy may result if businesses respond with cutbacks in orders for plants and equipment as soon as the leading economic indicators begin predicting a recession. • The economic indicators do provide a warning of a likely downturn, but they do not provide accurate information on the depth or duration of the downturn. 163 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Section 6 164 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.