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Chapter 10 The Business Cycle Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Macroeconomics • Macroeconomics is the study of aggregate economic behavior, of the economy as a whole. • A basic purpose of macroeconomic theory is to explain the business cycle. • Macro policy tries to control the business cycle. 10-2 Assessing Macro Performance • There are three basic measures of macro performance: – Output (GDP) growth. – Unemployment. – Inflation. 10-3 GDP • GDP is the total value of output (goods and services) produced in an economy during a given time period. 10-4 GDP Growth • An economy’s potential output is reflected in its production possibilities curve (PPC): – Production possibilities – the alternative combinations of goods and services that could be produced in a given time period with all available resources and technology. • When there is GDP growth, the PPC shifts outward. 10-5 The Business Cycle • The business cycle is the alternating periods of economic growth and contraction experienced by the economy. • It shows the rise and fall of the economy over time. 10-6 Figure 10.1 10-7 Real GDP • Business cycles are measured by changes in real GDP: – Nominal GDP is measured in current prices. – Real GDP is the inflation-adjusted value of GDP, the value of output measured in constant prices. 10-8 Figure 10.2 10-9 The Great Depression • This was the most prolonged departure from our long-term growth path. • Real GDP fell 30 percent from 1929 to 1933. • The economy grew moderately from 1934 to 1936. • Another decline occurred in 1936–1937. 10-10 The Great Depression • Real GDP in 1939 was virtually the same as in 1929. • GDP per capita was lower in 1939 than in 1929, meaning that Americans had a lower standard of living in 1939 than they did 10 years earlier. 10-11 Recession • A recession is a decline in total output (real GDP) for two or more consecutive quarters. • It is a slump or downturn in the economy. 10-12 Recent Recessions • 1981–1982: Lasted 16 months, with an unemployment rate of 10.8 percent, the highest since the 1930s. • 1990–1991: A brief 8-month recession. • 2001: Another 8-month recession. • 2008–2009: Failures in financial and real estate markets led to a significant decline in real GDP and 10 percent unemployment. 10-13 Unemployment • Unemployment is the inability of labor force participants to find jobs. • When output declines, jobs are eliminated. 10-14 The Labor Force • The labor force consists of everyone over the age of 16 who is actually working, plus all those who are not working but are actively seeking employment. • This includes about half of the total population. 10-15 Figure 10.3 10-16 The Unemployment Rate • The unemployment rate is the proportion of the labor force that is unemployed: Unemployment rate = Number of unemployed Number in labor force 10-17 Figure 10.4 10-18 The Policy Goal • The goal is to avoid as much cyclical unemployment as possible. • To try to achieve full employment. • Full employment is the lowest rate of unemployment compatible with price stability: – It is estimated to be between 4 and 6 percent. 10-19 Inflation • The biggest fear as an economy reaches full employment is inflation. • As an economy reaches its production possibilities, prices will begin to rise as: – Demand for goods outstrip supply. – Costs of production rise. 10-20 Relative versus Average Prices • The relative price is the price of one good in comparison with the price of other goods. • It is possible for individual prices to rise or fall continuously without changing the average price level. 10-21 Relative versus Average Prices • Relative changes can occur in a period of stable average prices. • Changes in relative prices are market signals that help reallocate resources in the economy. • In a general inflation – when all prices are rising – prices do not help to reallocate resources. 10-22 Figure 10.5 10-23 Measuring Inflation • Consumer Price Index (CPI) – a measure of changes in the average price of consumer goods and services. • Inflation rate – the annual rate of increase in CPI. 10-24 Measuring Inflation • CPI relates current prices to prices that existed in 1982–1984, when CPI was set to 100. • A current CPI of 230 in 2013 means that it takes $230 to buy what $100 could buy in 1983. 10-25 Price Stability and Policy Goal • Price stability is the absence of significant changes in the average price level. • The Full Employment and Balanced Growth Act of 1978 establishes a goal for economic policy to hold the rate of inflation at under 3 percent. 10-26 The Policy Goal • Congress weighs the tradeoff between inflation and full employment. • Zero percent inflation might harm the goal of full employment. • Three percent inflation was determined to be a safe target. 10-27