Chapter 26 Business Cycles, Unemployment, and Inflation Textbook Graphs and Tables Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 1

Business Cycles Business cycle: alternating rises and declines in the level of Real GDP, which may last several years. 2

Two Recent (Real) Business Cycles 3

% Changes in Real GDP (2005 $) For more info: 4

Causes of Business Cycles Shocks: unexpected events that markets can’t adjust to in the short-term. Supply shocks: the supply of goods or resources changes suddenly – Irregular Innovation – Productivity Changes 5

Causes of Business Cycles - Shocks Demand shocks: the demand for goods or resources changes suddenly → total spending changes (GDP = C + Ig + G + Xn) – Monetary factors – Political events – Financial instability Shocks can be positive or negative. 6

Cyclical Impact: Components of Consumption 7

Unemployment Labor force: people who are willing and able to work Unemployed: people who are not currently working, but have actively looked for work in prior four weeks. Unemployment rate = 100*(unemployed/labor force ) 8

GDP % change and Unemployment rate 9

Three Types of Unemployment 1.Frictional: consists of workers who are searching for jobs or waiting to take a job. 2.Structural: when changes in consumer demand or technology over time change the structure of the job market (labor demand). 3.Cyclical: business cycle unemployment caused by a decline in total spending and production. 10

“Full” Employment The economy is “fully employed” when there is only frictional and structural unemployment; i.e. there is no cyclical unemployment. The unemployment rate when the economy is “fully employed” is called the Natural Rate of Unemployment (NRU) – could be between 5- 6% today. 11

Full Employment & Potential GDP When the economy achieves the NRU, then the economy produces its potential GDP. Potential (full employment) GDP: the amount of output that the economy could have produced each year without changing the rate of inflation. → GDP gap = actual GDP – potential GDP 12

13 See also:

Unemployment Rates by Demographic Group 14

Inflation Inflation: the percentage increase in the general price level. CPI (Consumer Price Index): the price of a “market basket” of goods and services that are purchased by the average urban consumer. 15

Calculating Inflation Inflation rate from year 2008 to 2009: = 100*[CPI (2009) – CPI (2008)]/CPI (2008) = 100*(214.5 – 215.3)/215.3 = –0.4% deflation. 16

Types of Inflation Demand-Pull: when increases in the price level are caused by an “over-heated” economy – when total spending exceeds the economy’s capacity of production for several periods. Cost-Push: when increases in the price level are caused by rising production costs, which results in decreases in production and employment. 17

Inflation and Core Inflation 18

Inflation and Real Income Real income = nominal income / price index. → %∆ real income ≈ %∆ nominal income – %∆ price level (inflation) Inflation tends to erode the purchasing power of income. 19

Who is hurt by unanticipated inflation? 1.Fixed-income receivers 2.Savers 3.Creditors 20

Who is unaffected or helped by unanticipated inflation? 1.Flexible-income receivers may get cost of living adjustments. 2.Borrowers (debtors) 21

Real vs. Nominal Interest Rates An interest rate is the rate of return by a borrower to a lender. The real interest rate is the “purchasing power” rate of return. The nominal interest rate is the “dollar value” rate of return. → real interest rate ≈ nominal interest rate - inflation rate 22