Economic Fluctuations, Unemployment, and Inflation Chapter 10 Economic Fluctuations, Unemployment, and Inflation 10-1 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives Examine the business cycle Consider various business cycle theories Show how economic forecasting is done Measure the GDP gap Learn how the unemployment rate is computed Look at the types of unemployment Construct a consumer price index Consider the theories of inflation 10-2 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

GDP in 1996 dollars, 1958-2002 Shaded areas indicate recessions 10-3 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Recessions Since 1945 10-4 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Business Cycles 10-5 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Cycle Theories Endogenous theories Innovation theory Psychological theory Inventory cycle theory Monetary theory Underconsumption theory Exogenous theories Sunspot theory War theory 10-6 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Cycle Forecasting The Ten Leading Economic Indicators 1. Average workweek of production workers in manufacturing 2. Average initial weekly claims for state unemployment insurance 3. New orders for consumer goods and materials 4. Vendors performance (companies receiving slower deliveries from suppliers) 5. New orders for capital goods 10-7 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Cycle Forecasting (Continued) The Ten Leading Economic Indicators 6. New building permits issued 7. Index of stock prices 8. Money supply 9. Spread between rates on 10-year Treasury bonds and Federal funds 10. Index of consumer expectations 10-8 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment The problem One of the most devastating experiences a person can have is to be out of work for a prolonged period Discouraged workers are those who have given up looking for work and have simply dropped out of the labor force The Bureau of Labor Statistics does not count discouraged workers as part of the labor force There were over 5 million Americans classified as discouraged in 2002 and 2002 Had they been counted the unemployment would have been almost double 10-9 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment (Continued) The liberal criticism A person who worked one day last month is counted as employed Someone who works part-time but who wants to work full-time is counted as employed The true unemployment rate is higher than the official rate 10-10 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment (Continued) The conservative criticism Some just go through the motions of looking for work to remain eligible for benefits and are not really looking for work Huge numbers of Americans – as well as illegal immigrants are working in the underground economy These people are employed off the books, do not report their income, and are not counted as employed by the bureau of labor statistics 10-11 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment (Continued) The conservative criticism The percentage of married women in the labor force has risen from 25 percent in the late 1940s to about 65 percent today (this raises the unemployment rate in three ways) Married women who are reentering the labor force will have to find jobs Because their husbands are employed they can shop around for a while Their husbands, if unemployed, can also shop around for a while if their wives are working 10-12 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment (Continued) The conservative criticism The true unemployment rate is lower than the official rate 10-13 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

How Is the Unemployment Rate Computed? Number of Unemployed UR = ------------------------------------------ Number employed + Number unemployed = Labor Force Labor Force 10-14 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

How Is the Unemployment Rate Computed? Number of Unemployed UR = ------------------------------------------ Number employed + Number unemployed = Labor Force 2000 Number unemployed = 5,655,000 + Number employed = 135,208,000 Labor Force = 140,863,000 Labor Force 10-15 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

How Is the Unemployment Rate Computed? Number of Unemployed UR = ------------------------------------------ Number employed + Number unemployed = Labor Force 2000 Number unemployed = 5,655,000 + Number employed = 135,208,000 Labor Force = 140,863,000 Labor Force 5,655,000 UR = --------------------------------------- 140,863,000 10-16 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

How Is the Unemployment Rate Computed? Number of Unemployed UR = ------------------------------------------ Number employed + Number unemployed = Labor Force 2000 Number unemployed = 5,655,000 + Number employed = 135,208,000 Labor Force = 140,863,000 Labor Force 5,655,000 UR = --------------------------------------- 140,863,000 UR = .0401453 = 4.0 % 10-17 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment Rates for Blacks Historically, the unemployment rate for blacks has been double that of whites During recessions the black unemployment rate is rarely below 10 percent 10-18 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Unemployment Rate, 1948-2000 Economic Report of the President, 2001; Economic Indicators, May 2003 Unemployment went up between 1969 and 1982 and went down after that 10-19 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Types of Unemployment Frictional unemployment Structural unemployment Cyclical unemployment 10-20 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Frictional Unemployment The frictionally unemployed are people who are between jobs or just entering or reentering the labor market Usually weeks or months pass before positions are filled At any given time, about 2 or 3 percent of the labor force is frictionally unemployed 10-21 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Structural Unemployment A person who is out of work for a relatively long period of time, say, a couple of years, is structurally unemployed. Some examples are Steelworkers and coal miners who are out of work because the local steel plant and coal mine have closed Clerical workers, typists, and inventory control clerks who have been made obsolete by a computer system People who are functionally illiterate are virtually shut out of the labor force One in five adult Americans is functionally illiterate Our educational system turns out 1 million more functional illiterates every year About 2 to 3 percent of our labor force is always structurally unemployed 10-22 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Cyclical Unemployment Cyclical unemployment is anything above the sum of frictional and structural unemployment Caused by the ups and downs in our economy known as the business cycle Fluctuations in our unemployment rate are due to cyclical unemployment 10-23 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Natural Unemployment Rate Most economists estimate the natural unemployment rate to be 5 or 6 percent. If we take a 5 percent unemployment rate as our working definition of full employment, anything above 5 percent would be cyclical unemployment Frictional 2.5% (Natural) Structural 2.5% (Natural) 5.0% (Full unemployment) Cyclical 1.7% (Not natural) Unemployment Rate 6.7% + + 10-24 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Natural Unemployment Rate As the unemployment rate falls, and it becomes increasingly difficult to find employees, employers will bid up wage rates, pushing up the rate of inflation Once the unemployment rate falls below its natural rate, then inflationary wage pressure emerges 10-25 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Inflation Defining inflation Generally, we consider inflation a sustained rise in the average price level over a period of years When the overall price level is rising, the prices of some goods and services are going down, i.e., TV prices in the 1970s and the 1980s, the price of VCRs, and more recently the price of cellular phones U.S. inflation has been persistent since World War II 10-26 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Consumer Price Index (CPI) The CPI, which measures changes in our cost of living, is reported near the middle of every month by the Bureau of Labor Statistics The CPI is based on what it cost an average family to live 10-27 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Finding Percentage Change in the Price Level Year CPI 1972 125.3 1982 289.1 By what percentage did the cost of living rise? 10-28 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Finding Percentage Change in the Price Level Year CPI 1972 125.3 1982 289.1 By what percentage did the cost of living rise? Change Percentage change = ---------------------------- X 100 Original Number 10-29 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Finding Percentage Change in the Price Level Original Number Year CPI 1972 125.3 1982 289.1 By what percentage did the cost of living rise? Change = 163.8 Change Percentage change = ---------------------------- X 100 Original Number 10-30 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Finding Percentage Change in the Price Level Original Number Year CPI 1972 125.3 1982 289.1 By what percentage did the cost of living rise? Change = 163.8 Change Percentage change = ---------------------------- X 100 Original Number 163.8 Percentage change = ---------------------------- X 100 125.3 10-31 Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved.

Finding Percentage Change in the Price Level Original Number Year CPI 1972 125.3 1982 289.1 By what percentage did the cost of living rise? Change = 163.8 Change Percentage change = ---------------------------- X 100 Original Number 163.8 Percentage change = ---------------------------- X 100 125.3 Percentage change = 1.307 X 100 10-32 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Finding Percentage Change in the Price Level Original Number Year CPI 1972 125.3 1982 289.1 By what percentage did the cost of living rise? Change = 163.8 Change Percentage change = ---------------------------- X 100 Original Number 163.8 Percentage change = ---------------------------- X 100 125.3 Percentage change = 1.307 X 100 Percentage change = 130.7 10-33 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

A Magic Number The number 100 is magic! It lends itself to calculating percentage changes. Suppose we want to find out by what percentage prices have risen since the base year? The base year is set at 100. If the CPI today is 136.4, by what percentage did prices rise since the base year? 10-34 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

A Magic Number The number 100 is magic! It lends itself to calculating percentage changes.Suppose we want to find out by what percentage prices have risen since the base year? The base year is set at 100. If the CPI today is 136.4, by what percentage did prices rise since the base year? 136.4 – 100 = 36.4% 10-35 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Annual Percentage Change in the Consumer Price Index, 1946-2002 Economic Report of the President, 2002 Since World War II we have had two periods of price stability-from 1952 through 1965 and from 1991 to the present 10-36 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Inflation Seems Inevitable It appears that it takes a recession to deflate “inflation” Sir Frederick Keith-Ross (1957) “Inflation is like sin; every government denounces it and every government practices it” 10-37 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Deflation Deflation is a decline in the general level of prices for a period of years This is the OPPOSITE of inflation This last occurred between 1929 -33 10-38 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Deflation Deflation is a decline in the general level of prices for a period of years This is the opposite of inflation This last occurred between 1929 -33 Year CPI 1929 17.1 1930 16.7 1931 15.2 1932 13.7 1933 13.0 1934 13.4 General price levels are declining when the CPI is decreasing General price levels are rising when the CPI is increasing 10-39 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Deflation Deflation is a decline in the general level of prices for a period of years This is the opposite of inflation This last occurred between 1929 -33 General price levels are declining when the CPI is decreasing General price levels are rising when the CPI is increasing Business owners dislike inflation but they hate deflation a lot more Year CPI 1929 17.1 1930 16.7 1931 15.2 1932 13.7 1933 13.0 1934 13.4 10-40 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Disinflation Disinflation occurs when the RATE OF INFLATION declines Year CPI Inflation Rate 1980 82.4 13.5% 1981 90.9 10.3% 1982 96.5 6.2% 1983 99.6 3.2% 1984 103.9 4.3% 1981 -83 the rate of inflation declined . . . but prices continued to increase . . . just at a lower rate! 10-41 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Price Index (CPI) The most important measure of inflation is the Consumer Price Index (CPI) Cost of livingcy CPI = --------------------------------- X 100 Cost of livingby 10-42 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Anticipated and Unanticipated Inflation: Who Is Hurt by Inflation and Who Is Helped? Debtors benefit from unanticipated inflation They get to repay their loan in dollars that are worth less than the dollars they borrowed The biggest debtor and gainer from unanticipated inflation has been the U.S. government 10-43 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Anticipated and Unanticipated Inflation: Who Is Hurt by Inflation and Who Is Helped? Creditors, the people who lend out money, are hurt by unanticipated inflation The ultimate creditors, or lenders, are the people who put their money in banks, life insurance, or any other financial instrument paying a fixed rate of interest People who live on fixed incomes, particular retired people who depend on pensions (except Social Security) and those who hold long-term bonds, are hurt by unanticipated inflation 10-44 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Anticipated and Unanticipated Inflation: Who Is Hurt by Inflation and Who Is Helped? When inflation is fully anticipated, theoretically, there are no winners and losers Creditors have learned to charge enough interest to take into account, or anticipate, the rate of inflation over the course of the loan This is tacked onto the regular interest rate that the lender would charge had no inflation been expected 10-45 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Real Rate of Interest The real rate of interest is the rate that would be charged without inflation Expected Rate of inflation + Real Rate of Interest Nominal Rate of Interest <-------what we pay 10-46 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Real Rate of Interest The real rate of interest is the rate that would be charged without inflation Expected Rate of inflation 6% + Real Rate of Interest 5% Nominal Rate of Interest 11% 10-47 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Real Rate of Interest The real rate of interest is the rate that would be charged without inflation Expected Rate of inflation 6% + Real Rate of Interest 5% Nominal Rate of Interest 11% If the nominal interest rate accurately reflects the inflation, then the inflation has been fully anticipated and no one wins or loses, except the people who borrow money at the higher nominal rate of interest 10-48 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Real Rate of Interest The real rate of interest is the rate that would be charged without inflation Expected Rate of inflation 6% + Real Rate of Interest 5% Nominal Rate of Interest 11% But if the rate of inflation keeps growing – even if it is correctly anticipated – our economy will be in big trouble 10-49 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Price Index 1915 – 2002 (1967=100) 10-50 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Theories of the Causes of Inflation Demand-Pull Inflation Cost-Push inflation 10-51 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Demand-Pull Inflation When there is excessive demand for goods and services, we have demand-pull inflation This occurs when people are willing and able to buy more output than our economy can produce because our economy is already operating at full capacity 10-52 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Demand-Pull Inflation Demand-pull inflation is often summed up as “too many dollars chasing too few goods” Just where did all of this money come from”? Milton Friedman, a Nobel laureate in economics, suspects the seven governors of the Federal Reserve System, which controls the rate of growth of the money supply 10-53 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost-Push Inflation There are three variants of cost-push inflation The wage-price spiral Profit-push inflation Supply-side cost shocks 10-54 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost-Push Inflation The wage-price spiral Wages constitute nearly two-thirds of the cost of doing business Whenever workers receive a significant wage increase, this increase is passed along to consumers in the form of higher prices Higher prices raise everyone’s cost of living, engendering further wage increases 10-55 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost-Push Inflation Profit-push inflation Because just a handful of firms dominate many industries, they have the power to administer prices rather than accept the dictates of the market forces of supply and demand To the degree that they are able, these firms will respond to any rise in cost by passing them on to their customers 10-56 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost-Push Inflation Supply-side cost shocks Finally, we have supply-side shocks, most prominently the oil price shocks of 1973-74 and 1979 OPEC nations raised the price of oil When the price of oil rises, the cost of making many other things rise as well Cost increases are quickly translated into price increases 10-57 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Inflation as a Psychological Process If people believe prices will rise, they will act in a way that keeps them rising To break the back of inflationary psychology is to bring down the rate of inflation for a sufficiently long period of time for people to actually expect price stability to continue This has happened in the recent past only after successive recessions have wrung inflation out of the economy 10-58 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Creeping Inflation and Hyperinflation Inflation is a relative term Creeping inflation in one country would be hyperinflation in another But once we cross the line between creeping inflation and hyperinflation – which keeps shifting- we run into trouble It becomes increasingly difficult to conduct normal economic affairs Prices are raised constantly It becomes impossible to enter into long-term contracts No one is sure what the government might do 10-59 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic Report of the President, 2002 Conclusion One thing the economy has rarely been able to attain simultaneously is a low unemployment rate and stable prices The Misery Index, 1948-2002 Economic Report of the President, 2002 10-60 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.