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Business Cycles Business cycles are irregular, non-periodic fluctuations in aggregate economic activity. Life is good, and then it's bad. It's a roller coaster ride. - Although we use the term 'cycle', we don't know how long an expansion or a contraction will last. The economy might expand for a year or it might expand for a decade before it declines A. Expansionary good times are almost always good. But there is a bad side. The good side: The economy is growing, more goods are produced, living standards rise, businesses are profitable, and scarcity problems are lessened. The bad side: Inflation and inefficiency. Inflation tends to worsen when the economy expands too rapidly because there is too much money in circulation. Inefficiency is likely during an expansion. With the entire economy expanding, and everyone becoming better off, the incentive to be efficient is reduced. We aren’t so concerned with how we utilize our factors of production when they seem to be in abundance. Expansionary good times mean more production and rising living standards, but also inflation and inefficiency problems B. Contractionary bad times give us the most problems. First: Real GDP declines during a contraction. Second: Unemployment increases. Third: The incomes of employed resources also tend to fall, or at least not rise as much as in an expansion. Fourth: Business profits decline and bankruptcies increase. Fifth: Social problems, including crime, poverty, and alcoholism, worsen. If prolonged, can become a recession or, if even longer, a depression But contractions have some good: Inflation remains low or declines (deflation). Some resources are more efficiently allocated. Since the 1930s Great Depression, when the modern study of economics was prompted, economists have sought indicators of business cycles. Some indicators are: Real GDP, the unemployment rate, and the inflation rate are useful measures, but they measure only specific aspects of the economy. These may not be the best indicators of overall business cycle activity. Economists have identified three sets of indicators to track business cycles: 1. Leading economic indicators indicate business-cycle activity 3 or 12 months ahead. If leading indicators decline now, then the economy is likely to decline in 3 to 12 months. Leading indicators are eleven statistics that precede changes in the economy. Three notable leading indicators are stock market prices, the money supply, and consumer confidence. 2. Coincident economic indicators move along with the aggregate economy. They mark the business cycle. The four coincident indicators are measures of production (GDP), employment, income, and sales. The Composite Index of Coincident Indicators combines all four. Changes in this index mark business cycle peaks and troughs. 3. Lagging economic indicators lag the turning points of business cycles by 3 to 12 months. Lagging indicators 'seal the deal' by certifying that a contraction or an expansion is over. The next turning point (business cycle) usually doesn't begin until lagging indicators confirm that the last one has happened. Seven statistics are used as lagging indicators, including in the inflation rate, consumer debt, and the prime interest rate. Major Economic Indicators: I. Gross domestic product (GDP) A. The total market value of all the final goods and services produced within an economic unit (country, state) within a period of time (normally a year) B. Includes all productive marketed activities - normal production of goods and services that are sold in regular markets C. Excludes non-productive market activities - Stock market sales - Sale of used products D. Includes estimates of some, but excludes other productive non-marketed activities - Housework (not included) - illegal activity (not included) - Owner occupied housing (included) - “in-kind” payments (included) Calculating GDP Two approaches to calculating GDP 1. Expenditure approach a. GDP equals Personal Consumption plus Business Investment plus Government Spending plus Net Exports 2. Income approach a. GDP equals Rent plus Wages plus Interest plus Profits plus Depreciation plus Indirect Business Taxes plus miscellaneous b. GDP = R + W + I + P + Acc. Dep. + Ind. Bus. Taxes + Misc. Nominal vs Real GDP If GDP increases from one year to the next, it could be the result of an increase in production or an increase in prices (inflation). To factor OUT inflation, REAL GDP is calculated. Real GDP is a calculation that uses constant prices (or, the prices from the comparative year). When GDP is calculated using current year dollars, it is called nominal GDP. II. Unemployment rate = the percentage of the Labor Force who is out of work Unemployment rate = 100 (# of people in the labor force seeking work / # of people in labor force) Labor Force = 16 yr.-olds and up who are employed or unemployed and looking for work The Three Types of Unemployment Economists break unemployment down into three distinct varieties - Structural, Frictional, and Cyclical. Below we will examine each type of unemployment to see how they differ. 1. Structural Unemployment: - Structural unemployment is unemployment that comes from there being an absence of demand for the workers that are available because their skills do not match available jobs. There are two major reasons that cause an absence of demand for workers in a particular industry: 1. Changes in Technology: As personal computers replaced typewriters, typewriter factories shut down. Workers in typewriter factories became unemployed and had to find other industries to be employed in. 2. Changes in Tastes: If bagpipes become unpopular, bagpipe companies will go bankrupt and their workers will be unemployed. 2. Frictional Unemployment: -Frictional unemployment is unemployment that comes from people moving between jobs, careers, and locations. Sources of frictional unemployment include the following: 1. People entering the workforce from school. 2. People re-entering the workforce after raising children. 3. People changing employers due to quitting or being fired (for reasons beyond structural ones). 4. People changing careers due to changing interests. 5. People moving to a new city (for non-structural reasons) and being unemployed when they arrive. 3. Cyclical Unemployment: - Cyclical unemployment occurs when the unemployment rate moves in the opposite direction as the GDP growth rate. So when GDP growth is small (or negative) unemployment is high. This unemployment reflects a contracting business cycle. Getting laid off due to a recession is the classic case of cyclical unemployment. This is why the unemployment rate is a key economic indicator. What About Seasonal Unemployment?: Seasonal unemployment is unemployment due to changes in the season - such as a lack of demand for department store Santa Clauses in January. Seasonal unemployment is a form of structural unemployment, as the structure of the economy changes from month to month. III. INFLATION - inflation is defined as a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in the money supply (because of available currency and credit beyond the proportion of available goods and services.) Calculating Inflation The calculation of inflation relies on the Consumer Price Index (CPI) - Each month, the BLS surveys prices for a “market basket” of goods and services in order to create an economic “snapshot” of the average consumer’s spending, which is quantified as the CPI. Because the CPI looks at expenditures in these fixed categories, this index is a valuable tool for comparing the current prices of goods and services to costs last month or one year ago. - the CPI is compiled by the Bureau of Labor Statistics monthly and is based upon a 1984 base of 100. An Index of 185 indicates 85% inflation since 1984 (actually the average of 1982-1984). Since this is an index it only tells you the total inflation since the base year. inflation = CPI2-CPI1 * 100 CPI1 Causes of Inflation A. Cost-push Inflation Cost-push Inflation occurs when a firm passes on an increase in production costs to the consumer. The inflationary effect of increased costs can be the result of: Increased wages, leading to 1. a wage-price spiral, which occurs when price increases spark off a series of wage demands which lead to further price increases and so on; 2. a wage-wage spiral, which occurs when one group of workers receive a wage increase which sparks off a series of wage demands from other workers. Increased import prices which can be the result of: 1. a rise in world prices for imported raw materials; Increased indirect taxation B. Demand-pull Inflation Demand-pull inflation occurs when there is 'too much money chasing too few goods' because the demand for current output exceeds supply. Remedies for Inflation Cost-push Remedies Introduce a prices and incomes policy to free price and wage increases. Reduce indirect taxation. Demand-pull Remedies Reduce government spending. Increase income tax to reduce consumer spending. Reduce peoples' ability to borrow money by increasing interest rates and tightening credit regulations. Control the supply of money. Effects of Inflation Advantages of Inflation Not everyone suffers from inflation. Some parts of society actually benefit: The government finds that people earn more and so pay more income tax. Firms are able to increase prices and profits before they pay out higher wages. Debtors (homeowners, businesses, government) are helped by high inflation because they pay back with dollars worth less than those borrowed. Both income and resource allocations are affected by inflation as the market tries to adjust to the loss in value caused by inflation. 1. High gas prices in the 1970's caused a switch to small cars and many people bought wood stoves. 2. Low gas prices in the 1990's made RV's less expensive to run. Disadvantages of Inflation People on fixed incomes are unable to buy so many goods. (COLAs) Creditors (savers) lose because the loan will have reduced purchasing power when it is repaid. US goods may become more expensive than foreign-made products so the balance of payments suffers. Industrial disputes may occur if workers are unable to secure wage increases to restore their standard of living.