Chapter 6 Business Cycles, Unemployment, & Inflation ECON 201 Chapter 6 Business Cycles, Unemployment, & Inflation

The Business Cycle The U.S. has experienced economic instability associated with business cycles. Business Cycles – alternating rises and declines in the level of economic activity, sometime over several years.

Business Cycle – 4 phases A peak is when business activity reaches a temporary maximum with full employment and near-capacity output. A recession is a decline in total output, income, employment, and trade lasting six months or more. The trough is the bottom of the recession period. Recovery is when output and employment are expanding toward full employment level.

Business Cycles Economic growth is interrupted by the periods of economic instability associated with business cycles. Two main phases of business cycles are recessions (declines) and expansions (increases) with turning points called peaks and troughs. Business cycles are recurring increases and decreases in the level of economic activity over periods of time. Economic growth is interrupted by the periods of economic instability associated with business cycles. Business cycles are recurring increases and decreases in the level of economic activity over periods of time. Two main phases of business cycles are recessions (declines) and expansions (increases) with turning points called peaks and troughs. A Recession is a period of declining real GDP, accompanied by lower income and higher unemployment. A Recession is a period of declining real GDP, accompanied by lower income and higher unemployment. LO: 6-1

Causes of Business Cycles Economic fluctuations are driven by demand shocks and supply shocks, such as unexpected changes in technology, productivity, or spending by consumers, businesses, and the government. Firms cannot deal with shocks on their own because of sticky prices, prices that are slow to respond to changes in demand and supply. What causes business cycles? Economic fluctuations are driven by demand shocks and supply shocks, such as unexpected changes in technology, productivity, or spending by consumers, businesses, and the government. Demand shocks are defined as unexpected changes in the demand for goods and services. Supply shocks are defined as unexpected changes in the supply of goods and services. Firms cannot deal with shocks on their own because of sticky prices, prices that are slow to respond to changes in demand and supply. Demand shocks are unexpected changes in the demand for goods and services. Supply shocks are unexpected changes in the supply of goods and services. LO: 6-1

Theories about Causation Major innovations may trigger new investment and/or consumption spending. Changes in productivity may be a related cause. Central banks adjusting the money supply Unexpected political events, wars, things like 9/11

Theories about Causation Most economists agree that the immediate cause of large scale cyclical changes is the expected change in the level of total spending So the level of aggregate spending is important, especially changes on capital goods and consumer durables.

Durable & Non-Durable Goods Consumer Durables are affected most by the business cycle. Examples: Capital Goods (housing, commercial buildings, heavy equipment) Consumer Durables (automobiles, refrigerators, computers)

The twin problems that arise from the business cycle are: Unemployment Inflation

Unemployment - 3 Groups Under age 16 or institutionalized “Not in labor force” Labor Force - 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).

Unemployment Rate The percentage of the labor force that is not employed (not the percentage of the population). Measured by the U.S. Bureau of Labor Statistics (BLS). Unemployment Rate Unemployed Labor Force = x 100

Labor Force, Employment, and Unemployment in 2007 Under 16 And/or Institutionalized (71.8 Million) Unemployment rate: (7.1 mil./153.1 mil.) x 100% = 4.6% Not in Labor Force (78.7 Million) Total Population (303.6 Million) Employed (146.0 Million) Consider the data for the U.S. in 2007. Total population was 303.6 million. 71.8 million were under 16 or institutionalized, and 78.7 million were not in the labor force (not working or looking for a job). The remaining 153.1 million constituted the labor force, out of which 146 million were employed and 7.1 were unemployed and actively looking for work. Thus, unemployment rate was 7.1 million divided by 153.1 million, which is 4.6 percent. Labor Force (153.1 Million) Unemployed (7.1 Million) LO: 6-2

Unemployment Rate Calculated by random survey of 60,000 households nationwide. (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)

Unemployment Rate Underestimated Two Factors: 1. Part‑time workers are counted as “employed.” 2. “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.

Three Types of Unemployment Frictional Structural Cyclical

Types of Unemployment 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.

Types of Unemployment 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. Examples : Glass blowers were replaced by bottle-making machines. Oil-field workers were displaced when oil demand fell in 1980s. Foreign competition has led to downsizing in U.S. industry and loss of jobs.

Types of Unemployment Cyclical Unemployment - caused by the recession phase of the business cycle. 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.

Three Types of Unemployment Structural Unemployment Unemployment that occurs due to mismatch between available jobs and the skills or locations of those unemployed. Frictional Unemployment People searching for jobs or waiting to take jobs in the near future. search unemployment wait unemployment Cyclical Unemployment Unemployment associated with recessionary phase of the business cycle. There are three main types of unemployment. Frictional Unemployment includes people searching for jobs or waiting to take jobs in the near future; it is subdivided into search unemployment and wait unemployment. Structural Unemployment occurs due to a mismatch between available jobs and the skills or locations of those unemployed. Cyclical Unemployment is associated with a recessionary phase of the business cycle. LO: 6-3

Full Employment Does not mean zero unemployment – something less that 100% employment of the Labor Force. The full‑employment unemployment rate = total frictional and structural unemployment. The full‑employment rate of unemployment is also referred to as the Natural Rate of Unemployment (NRU).

Economic Costs of Unemployment Forgone output is the basic economic cost of unemployment. If actual GDP is above or below potential GDP, the result is a GDP gap. When actual GDP is less than potential GDP, there is a negative GDP gap accompanied by a higher unemployment rate and foregone income. What are the economic costs of unemployment? The basic economic cost is forgone output. If actual GDP is above or below potential GDP, the result is a GDP gap. A GDP gap is the difference between actual GDP and potential GDP. When actual GDP is less than potential GDP, there is a negative GDP gap accompanied by a higher unemployment rate and foregone income. GDP gap = actual GDP – potential GDP LO: 6-3

Economic Cost of Unemployment: GDP gap and: GDP gap is the difference between potential and actual GDP. GDP Gap Actual GDP Potential GDP = -

Unequal Burdens of Unemployment Exist Rates are lower for white‑collar workers. Teenagers have the highest rates. Race and Ethnicity. Rates for males and females are comparable, though females had a lower rate in 2002. Less educated workers, on average, have higher unemployment rates than workers with more education.

Inflation Defined: 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 (also measured by the BLS).

Measuring Inflation CPI = x 100 The main measure of inflation in the U.S. is the consumer price index (CPI). The CPI includes some 300 products. The composition of the market basket is updated every two years. CPI Price of the Most Recent Market Basket in the Particular Year Price of the Same Market Basket in 1982-1984 = x 100 The main measure of inflation in the U.S. is the consumer price index (CPI), an index that compares the price of a market basket of goods and services in one period with the price of the same (or highly similar) market basket in a base period, currently 1982-1984. It is computed as the ratio of the price of the most recent market basket in the particular year to the price of the same market basket in 1982-1984, times 100. The CPI includes some 300 products, and the composition of the market basket is updated every two years. Consumer price index (CPI) is an index that compares the price of a market basket of goods and services in one period with the price of the same (or highly similar) market basket in a base period, currently 1982-1984. LO: 6-2

Consumer Price Index (also measured by the BLS) CPI Price of the Most Recent Market Basket in the Particular Year Price of the Same Market Basket in 1982-1984 = x 100

Two Types of Inflation Demand-Pull Cost-Push

Causes and Theories of 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.

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.”

Redistribution Effects of Inflation Inflation redistributes real income from some people to others.

Nominal & Real Income Nominal Income - # of dollars received as wages, rent, interest, or profits. Real Income – measure of the amount of goods and services nominal income can buy (the purchasing power of nominal income, or income adjusted for inflation). Real income = nominal income / price index (in hundredths)

Who is Hurt by Inflation? Fixed-Income Receivers Savers Creditors Who is Unaffected or Hurt by Inflation? Flexible-Income Receivers Cost-of-Living Adjustments (COLAs) Debtors

Redistributive Effects of Inflation 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.

Anticipated Inflation is Reflected in Interest Rates Nominal Interest Rate Real Interest Rate Inflation Premium 11% 6% = + 5% Inflation Premium Anticipated inflation is reflected in interest rates: nominal interest rate is equal to the sum of real interest rate and inflation premium. The higher the anticipated inflation, the higher the nominal interest rate. Nominal Interest Rate Real Interest Rate LO: 6-3

Redistribution Effects of Inflation Inflation redistributes real income from some people to others: Fixed-income receivers, savers and creditors, are hurt by unanticipated inflation. Flexible-income receivers are either unaffected or helped by inflation. As inflation reduces the value of the dollar, debtors (or borrowers) are helped by inflation. To analyze redistribution effects of inflation, let us define nominal and real income. Nominal income is the number of dollars received as wages, rent, interest, and profits. Real income is the purchasing power of nominal income, that is, a measure of the amount of goods and services nominal income can buy. Inflation redistributes real income from some people to others: Fixed-income receivers, savers and creditors, are hurt by unanticipated inflation; Flexible-income receivers are either unaffected or helped by inflation; As inflation reduces the value of the dollar, debtors (or borrowers) are helped by inflation. Nominal income is the number of dollars received as wages, rent, interest, and profits. Real income is the purchasing power of nominal income, that is, a measure of the amount of goods and services nominal income can buy. LO: 6-3

Inflation affecting output? As costs rise, demand falls for goods and services, so firms produce less, and unemployment goes up. Deflation – the general decline in the level of prices in the economy… very, very bad!!! Hyperinflation – extraordinarily rapid inflation. Normal economic relationships are messed up … consumers don’t know what to pay, firms don’t know what to charge…

Inflation and Output Inflation may affect a nation’s level of real output and real income. The direction and significance of this effect on output depends on the type of inflation and its severity. Cost-push inflation reduces real output. Demand-pull inflation causing mild inflation may reduce real output, according to some economists, but it can increase real output and lead to economic growth according to others. Inflation may affect a nation’s level of real output and real income. The direction and significance of this effect on output depends on the type of inflation and its severity. Cost-push inflation reduces real output. Demand-pull inflation causing mild inflation may reduce real output, according to some economists, but it can increase real output and lead to economic growth according to others. LO: 6-3

End Chapter 6