AP Macroeconomics Business cycles, Unemployment, inflation, interest rates Use map for business cycle

What are business cycles? Alternating periods of economic growth & contraction. Commonly called “business fluctuations” because they are not easily predicted.

Peak Expansion Recession Trough Point where Real GDP stops going up Expansion Period of recovery from a recession Continues until a new peak is reached Recession Period of decline in Real GDP Slow expansion (Below 3%) results in GROWTH RECESSION Must decline for 2 consecutive quarters   Trough Point where Real GDP stops doing down

A severe recession can result in a DEPRESSION Economic Conditions High unemployment and major shortages

Essential Question: Why are markets unstable? What to do? THEY ARE NOT! Classical View Say’s Law: supply creates its own demand If you build it, they will come… Classical Response Laissez faire LR market self adjust THEY ARE SO!! Keynesian View Markets inherently UNSTABLE Insufficient demand drags economy down Keynesian Response Govt intervenes SR Fiscal/Monetary Policy Keynes—In the long run, we are all dead.

Business Cycles in the U.S. The Great Depression Worst and most prolonged economic downturn Marked by the stock market crash on “BLACK TUESDAY” - October 29, 1929 Between 1929 and 1933, GDP declined nearly 50%. Unemployment peaked at 24.9% (1933). Great Depression Overview Decade long depression ended with ramp up for WWII World War II U.S. economy returned to its growth trend Spending on wartime goods helped stimulate the economy. Since then, the overall trend has been 3% growth. Incomes in manufacturing had dropped by 70 percent, and incomes in construction had dropped by more than 80 percent. Government was the only industry that had grown over the period.

A Model of the Macro Economy Internal market forces External shocks Policy levers DETERMINANTS Output Jobs Prices Growth International balances OUTCOMES MACRO ECONOMY The preceding information can be summarized as follows. LO1

Macroeconomic Performance Macro outcomes include: Output - total value of goods and services produced. Jobs - levels of employment and unemployment. Prices - average price of goods and services. Growth - year-to-year expansion in production capacity. International balances - international value of the dollar; trade and payments balances with other countries. Macroeconomic outcomes include effects on output, growth, international balances, jobs and prices. LO1

Macroeconomic Performance Determinants of macro performance include: Internal market forces - population growth, spending behavior, intervention & innovation. External shocks - wars, natural disasters, trade disruptions, etc. Policy levers - tax policy, government policy, changes in the availability of money, credit regulation, etc. Macroeconomic performance is influenced by a wide range of factors, including but not limited to internal market forces, such as population, external shocks, such as war and policy levers, such as tax policy. LO1

Business Cycle Remix: Which economic school of thought is concerned about the SR or LR business cycle? Keynes and Friends… Say and Friends… In the long run, we’re all dead. Therefore, focus on SR with policy changes In the long run, economy will self adjust… “supply creates is own demand” Therefore, laissez faire

: Causes Irregularity of Investment (expansion/contraction) Changes in productivity and inventories Prices are “sticky” downward Changes in total spending (aggregate demand) Durable goods manufacturing is most susceptible to the effects of the business cycle- their purchase can be postponed.

Unemployment Terms Population – the number of people in a country Civilian Labor Force – People aged 16-65 who are either working or actively seeing work – doesn’t include the armed forces, institutionalized, disabled, those not seeking work Labor Force Participation Rate – percent or working age population in the labor force - US is 66% Employed – 16 or over with a job – can be either part or full time (at least 1 hour every 2 weeks) Unemployed – over 16 who don’t have a job but have actively searched in the last two weeks Unemployment rate – number of unemployed /# of people in the labor force

Figuring Unemployment Under 16 and/or Institutionalized (71.4 million) Unemployment rate = # of unemployed labor force X 100 Not in labor force (81.7 million) Unemployment rate = 14,265,000 154,142,000 Total population (307.3 million) X 100 = 9.3% Employed (139.9 million) Labor force (154.2 million) Unemployed (14.3 million)

Unemployment This is one of the problems associated with a declining economy. The Bureau of Census identified unemployed persons in their monthly sample. They then turn over their information to the Bureau of Labor Statistics. The official unemployment rate is the result.

Limitations of the Unemployment Rate The unemployment rate understates employment conditions for two reasons.  First, the unemployment rate does not count those who have become too frustrated or discouraged to look for work. Second, people are considered employed even when they hold part-time jobs; being employed is not the same as being fully employed. are you unemployed?

Kinds of Unemployment Frictional. Structural Seasonal Cyclical Watch the video and take notes! Types of Unemployment

Full Employment This can only occur when there is not any cyclical unemployment in the economy, but…….full employment does not mean zero unemployment.  Associate this with the NRU (natural rate of unemployment). This is the level of u when the economy is producing at full potential. US NRU is about 4-5%. FE is found on the PPC, LRAS, and LRPC (we will learn about this!)

Economic Cost of Unemployment GDP Gap GDP gap = actual GDP – potential GDP Can be negative or positive LO3

Why Unemployment is BAD Okun’s Law – every 1% increase in the u% creates a 2% decline in real GDP.   Example – 1992 u rate was 7.4% which was 1.4% above the NRU. 1.4% x 2 indicates that in 1992 the GDP gap (actual vs. potential GDP) was 2.8%. The burden of unemployment is not equally shared in society. It causes social unrest and is hard on individuals/families. Unemployment in one sector has a “trickle down” effect in other sectors of our economy.

Chapter 26 – Growth and Instability Some Formulas… Chapter 26 – Growth and Instability Some Formulas….   Growth is a rise in Real GDP or a rise in Real GDP Per Capita   Formula for the Rate of Growth is new GDP – Previous GDP/Previous GDP x 100   Rule of 70 - years for GDP to double – Formula = 70/annual % rate of growth   Unemployment rate = unemployed/labor force x 100

Inflation Types of Inflation Demand Pull Inflation - demand side When resources are fully employed, the business sector cannot respond to excess demand by expanding output. Excess demand bids up the prices of limited real output – too much spending chasing too few goods!

Cost-Push Inflation – supply side A rise in per unit production costs at each level of spending ( per unit cost = total input cost/units of output) The major source of cost push inflation has been supply shocks – abrupt increases in the cost of raw material or energy inputs (rising oil prices) Reduces real output

Hyperinflation Extremely rapid inflation whose impact on real output and employment usually is devastating. This type of inflation can lead to economic collapse.

Redistributive Effects of Inflation Nominal Income – number of dollars received as wages, rent, interest, or profits Real Income – measure of the amounts of goods and services nominal income can buy (income adjusted for inflation) Real Income = Nominal Income / price index (in hundredths) Anticipations Anticipated Inflation – we can reduce effects of inflation on real income Unanticipated Inflation – unexpected

Who is Hurt by Inflation? Fixed-Income Receivers – SS, welfare, landlords, min wage workers Savers – paper assets decline in value Creditors – paid back in inflated dollars Who is Unaffected or Hurt by Inflation? Flexible-Income Receivers – indexed to CPI Cost-of-Living Adjustments (COLAs) – automatic raise in pay when inflation sets in Debtors – borrowers (Fed govt paying back loans by issuing new ones)

Anticipated Inflation – inflation premium - a raise in the interest rate the lender charges anticipating inflation Nominal Interest Rate - % increase in money the borrower pays the lender Real Interest Rate - % increase in purchasing power the borrower pays the lender Inflation Premium – anticipated inflation 6% 11% = + 5% Inflation Premium Nominal Interest Rate Real Interest Rate

Real (r%) and Nominal Interest (i%) Rates The nominal interest (i%) rate is the interest rate usually reported and not corrected for inflation (π%). It is the interest rate that a bank pays. The real interest rate (r%) is the nominal interest rate that is corrected for the effects of inflation (π%).

Dollar Figures from Different Times Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2001:

Real (r%) and Nominal Interest (i%) Rates You borrowed $1,000 for one year. Nominal interest rate was 15%. During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation r% = i% - π% r% = 15% - 10% r% = 5%

Summary The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the CPI measures the inflation rate.

Summary The consumer price index is an imperfect measure of the cost of living for the following three reasons: substitution bias, the introduction of new goods, and unmeasured changes in quality. Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point.

Summary The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

Summary Dollar figures from different points in time do not represent a valid comparison of purchasing power. Various laws and private contracts use price indexes to correct for the effects of inflation. The real interest rate equals the nominal interest rate minus the rate of inflation r% = i% - π%