1. Chapter 13: Business Cycles, Unemployment, and Inflation McGraw-Hill/IrwinCopyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

2. Business Cycles LO: 13-1  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. Recession is a period of declining real GDP, accompanied by lower income and higher unemployment. 13-2

3. The Business Cycle Level of Real Output Time Peak Recession Expansion Trough Growth Trend LO: 13-1 13-3

4. 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. LO: 13-1 Demand shocks are unexpected changes in the demand for goods and services. Supply shocks are unexpected changes in the supply of goods and services. 13-4

5. Unemployment  Unemployment increases during recessions.  To determine the unemployment rate, the U.S. Bureau of Labor Statistics surveys some 60,000 households each month. LO: 13-2 Unemployment Rate Unemployed Labor Force = x 100 Labor force includes all persons 16 years and older who are not in institutions and who are either employed or unemployed and seeking work. 13-5

6. Labor Force, Employment, and Unemployment in 2007 Under 16 And/or Institutionalized (71.8 Million) Total Population (303.6 Million) Not in Labor Force (78.7 Million) Employed (146.0 Million) Labor Force (153.1 Million) Unemployed (7.1 Million) LO: 13-2 Unemployment rate: (7.1 mil./153.1 mil.) x 100% = 4.6% 13-6

7. Three Types of Unemployment LO: 13-3 Frictional Unemployment People searching for jobs or waiting to take jobs in the near future. search unemployment wait unemployment Cyclical Unemployment Unemployment that is associated with the recessionary phase of the business cycle. Structural Unemployment Unemployment that occurs due to mismatch between available jobs and the skills or locations of those unemployed. 13-7

8. Full Employment and Potential Output  Because of frictional and structural unemployment, full employment occurs at less than 100 percent employment of the labor force.  Economy is fully employed when there is only frictional and structural unemployment and no cyclical unemployment.  Today, full employment is believed to occur when the unemployment rate is below 5 percent.  The level of GDP that occurs at full employment is called potential output. LO: 13-3 13-8

9. 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. LO: 13-3 GDP gap = actual GDP – potential GDP 13-9

10. Unemployment and GDP Gap Source: Congressional Budget Office & Bureau of Economic Analysis GDP gap (positive) GDP gap (negative) Potential GDP Actual GDP LO: 13-3 13-10

11. Inflation  Inflation is a rise in the general level of prices in an economy.  When there is inflation, each dollar of income buys fewer goods and services; the purchasing power of money declines.  On average, the prices of goods and services are rising; however, not all prices go up—the prices of some products remain fairly constant or decrease. LO: 13-2 13-11

12. Measuring Inflation  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. LO: 13-2 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. CPI Price of the Most Recent Market Basket in the Particular Year Price of the Same Market Basket in 1982-1984 = x 100 13-12

13. Inflation Rate  The rate of inflation for a certain year is found by comparing, in percentage terms, that year’s index with the index in the previous year.  For example, the CPI rose from 201.6 in 2006 to 207.3 in 2007.  Rate of inflation = (207.3-201.6)/201.6 x 100% = 2.8%  So the rate of inflation for 2007 was 2.8 percent. LO: 13-2 13-13

14. Types of Inflation  Demand-pull inflation occurs due to increases in the price level caused by excessive spending beyond the economy’s capacity to produce.  Excess demand from expanding output bids up the prices of the limited output.  Cost-push inflation occurs due to increases in the price level caused by sharp rises in the cost of key resources.  Supply shocks are the main source of cost-push inflation. LO: 13-3 13-14

15. 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. LO: 13-3 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. 13-15

16. Anticipated Inflation is Reflected in Interest Rates  Nominal Interest Rate  Real Interest Rate  Inflation Premium Nominal Interest Rate Inflation Premium 11% 5% 6% =+ LO: 13-3 Real Interest Rate 13-16

17. 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 can increase real output and lead to economic growth according to others. LO: 13-3 13-17