Economic Fluctuations, Unemployment, and Inflation Chapter 8 Economic Fluctuations, Unemployment, and Inflation

1. Swings in the Economic Pendulum

A Hypothetical Business Cycle The phases of the business cycle are: Expansion, Peak (or boom), Contraction, and, Recessionary trough. The duration of business cycles is irregular and the magnitude of the swings in economic activity varies. 1960 1965 1970 1975 1980 Long-run Growth Rate (approx.. 3%) 1985 1990 1995 Year 2000 2 -4 4 6 8 -2 Annual Rate of Growth in Real GDP Source: Economic Report of the President, various issues.

The Business Cycle Real GDP Time Real GDP Business Peak Trend line Business Peak Recessionary Trough Expansion Contraction Recessionary Trough In the past, ups and downs have often characterized aggregate business activity. Despite these fluctuations, there has been an upward trend in real GDP in the United States and other industrial nations.

2. Economic Fluctuations and the Labor Market

Economic Fluctuations and the Labor Market The noninstitutional civilian adult population is grouped into two broad categories: Persons not in the labor force, and, persons in the labor force. Labor Force Participation Rate = # in the Labor Force Civilian Population (16+) Employed + Unemployed Recall the Labor Force = In order to be classified as unemployed, one must either be on layoff or actively seeking work. Rate of Unemployment = # Unemployed # in the Labor Force Employed + Unemployed Recall the Labor Force =

U.S. Population, Employment, and Unemployment: 1998 205.2 Million Civilian population 16 and over 137.7 Million 67.5 Million Not in the Labor Force Household workers Students Retirees Disabled Civilian Labor Force 6.2 Million Employed Employees Self-employed workers Unemployed New entrants Reentrants Lost last job Quit last job Laid off 131.5 Million Rate of Labor Force Participation = Civilian Labor Force Civilian Population (16+) = 67.1% Employment / Population Ratio = Number Employed Civilian Population (16+) = 64.1% Rate of Unemployment = Number Unemployed Civilian Labor Force = 4.5%

U.S. Labor Force Participation of Men and Women: 1998 20 40 60 80 Labor Force Participation Rate 100 Source: Monthly Labor Review April 1999.. 87.0 83.3 77.9 76.8 60.4 46.3 37.7 32.7 1948 1960 1975 1998 1948 1960 1975 1998 Men Women As the chart illustrates, the labor force participation rate for women has been steadily increasing for several decades. The rate for men has been declining during the same period.

Composition of the Unemployed by Reason Job Leavers (11.8%) New Entrants (8.4%) Dismissed from Previous Jobs (31.5%) Reentrants (34.3%) There are various reasons why persons were unemployed in 1998. Only one third (31.5 %) of the unemployed were terminated from their previous jobs. On Layoff (13.9%) More than two fifths (42.7 %) of the unemployed were either new entrants or reentrants into the labor force. Source: Monthly Labor Review, April 1999.

3. Three Types of Unemployment

Three Types of Unemployment Frictional Unemployment: Caused by imperfect information in a world of dynamic change. Occurs because: employers are not fully aware of all available workers and their job qualifications, and, available workers are not fully aware of the jobs being offered by employers. Structural Unemployment: Reflects an imperfect match-up of employee skills and the skill requirements of the available jobs. Also reflects structural and demographic characteristics of the labor market. Cyclical Unemployment: Reflects business cycle conditions When there is a general downturn in business activity, cyclical unemployment increases.

4. Employment Fluctuations -- The Historical Record

Unemployment and Output Are Closely Linked Over the Business Cycle 1960 1965 1970 1975 1980 1985 1990 1995 2 4 6 8 10 2000 % of Labor Force Unemployed Sources: Economic Report of the President, 1998; & Robert J. Gordon, Macroeconomics (Boston: Little Brown, 1990). Actual rate of unemployment Natural rate of unemployment Here we illustrate the rate of unemployment during the 1960-1998 period. As expected, unemployment rose rapidly during each of the six recessions (the shaded years indicate periods of recession). In contrast, soon after each recession ended, the unemployment rate began to decline as the economy moved into an expansionary phase of the business cycle. Note that the actual rate of unemployment was greater than the natural rate during and immediately following the recession.

The Concept of Full Employment Full Employment: The level of employment that results when the rate of unemployment is normal, considering both frictional and structural factors. The concept of full employment is closely related to concept of the natural rate of unemployment. Natural Rate of Unemployment: The level of unemployment that reflects “job shopping” in an economy filled with imperfect information and dynamic change.

The Concept of Full Employment The natural rate of unemployment is neither a temporary high nor a temporary low; it is a rate that is both achievable and sustainable into the future. It is the rate of unemployment accompanying the economy’s "maximum sustainable rate of output.” The natural rate of unemployment is influenced by both demographic factors (e. g. youthful workers as a share of the labor force) and public policy (e. g. generous unemployment benefits). The actual rate rises above the natural rate during a recession and falls below the natural rate during an economic boom.

5. Unemployment and Measurement Problems

Unemployment and Measurement Problems The definition of unemployed involves some subjectivity. Some economists argue that the employment/population ratio -- the number employed divided by population 16 years old and over -- is a better indicator of job availability than the unemployment rate.

Questions for Thought: 1. Classify each of the following as employed, unemployed, or not in the labor force: a. Brown is not working; she applied for a job at Wal-Mart last week and is awaiting the result of her application. b. Smith is vacationing in Florida during a layoff at a GM plant due to a model changeover, but he expects to be recalled in a couple of weeks. c. Green was laid off as a carpenter when a construction project is completed. He is looking for work but has not found anything except an $8 per hr job, which he turned down. d. West works 50 to 60 hours per week as a homemaker for her family of nine. e. Carson, a 17-year-old, works six hours per week as a route person for the local newspaper. f. Johnson has worked three hours in the mornings at a clinic and for the last two weeks and spent the afternoons looking for a full-time job. 2. What is full employment? How are full employment and the natural rate of unemployment related? Indicate several factors that would cause the natural rate of unemployment to change. Is the actual rate of unemployment currently greater or less than the natural rate of unemployment?

6. Actual and Potential GDP

Actual and Potential GDP Potential output : Maximum sustainable output level consistent with the economy’s resource base, given its institutional arrangements. Actual and potential output will be equal when the economy is at full employment.

Actual and Potential GDP: 1960-1998 1965 1970 1975 1980 1985 1990 1995 2,000 4,000 6,000 2000 Real GDP (Billions of 1987 $) Source: U.S. Department of Commerce, Bureau of Economic Analysis. Actual GDP Potential GDP 1990–1991 Recession 1980 Recession 1982 Recession 1974–1975 Recession 1970 Recession Here we illustrate both actual and potential GDP. Note the gap (shaded area) between actual and potential GDP during periods of recession.

7. Effects of Inflation: -- An Overview

Effects of Inflation: -- An Overview The Rate of Inflation is calculated as: Inflation Rate = This Year’s Price Index Last Year’s Price Index Last Year’s Price Index - * 100 Inflation is a rise in the general level of prices. High rates of inflation are almost always associated with substantial year-to-year swings in the inflation rate.

The Inflation Rate: 1953-1998 Year -5 10 15 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Year Sources: Derived from computerized data supplied by FAME ECONOMICS. Also see Economic Report of the President (annual). 1973–1981 average inflation rate = 9.2% 1983–1998 average inflation rate = 3.3% 1953–1965 average inflation rate = 1.3% Here we present the annual rate of inflation for the last 45 years. Between 1953 and 1965, prices increased at an annual rate of only 1.3%. In contrast, the inflation rate averaged 9.2% during the 1973-1981 era, reaching double-digit rates during several years. Since 1982, the rate of inflation has been lower (the average annual rate was about 3.3% from 1983-1998) and more stable.

Effects of Inflation: -- An Overview Anticipated and Unanticipated Inflation: Unanticipated inflation: An increase in the price level that comes as a surprise, at least to most individuals. Anticipated inflation: A change in the price level that is widely expected.

Effects of Inflation: -- An Overview There are harmful effects of high and variable rates of inflation. Because unanticipated inflation alters the outcomes of long-term projects like the purchase of a machine or operation of a business, it will increase the risks and retard the level of such productive activities. Inflation distorts information delivered by prices. People will respond to high and variable rates of inflation by spending less time producing and more time trying to protect their wealth and income from uncertainty created by the inflation.

What Causes Inflation? Nearly all economists believe that rapid expansion in the supply of money is the cause of inflation.

Questions for Thought: 1. Indicate how an unanticipated 5 percent jump in the inflation rate will influence the wealth of the following: a. A person whose major asset is a house with a 30-year mortgage at a fixed interest rate. b. A family holding most of its wealth in long-term fixed yield bonds. c. A retiree drawing a monthly pension. d. A heavily indebted small-business owner. e. The owner of an apartment complex with substantial outstanding debt at a fixed interest rate. f. A worker whose wages are determined by a three-year union contract ratified three months ago. 2. Suppose that the consumer price index at year-end 1998 was 150 and by year-end 1999 had risen to 155. What was the inflation rate during 1999? 3. What is the difference between anticipated and unanticipated inflation?

End Chapter 8