1. 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.

2. 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
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3. GDP in 1996 dollars, 1958-2002 Shaded areas indicate recessions 10-3
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4. Recessions Since 1945
10-4
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5. Hypothetical Business Cycles
10-5
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6. Business Cycle Theories
Endogenous theories
Innovation theory
Psychological theory
Inventory cycle theory
Monetary theory
Underconsumption theory
Exogenous theories
Sunspot theory
War theory
10-6
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7. 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
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8. 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
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9. 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
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10. 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
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11. 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
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12. 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
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13. Unemployment (Continued)
The conservative criticism
The true unemployment rate is lower than the official rate
10-13
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14. How Is the Unemployment Rate Computed?
Number of Unemployed
UR =
Number employed
+ Number unemployed
= Labor Force
Labor Force
10-14
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15. 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
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16. 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.

17. 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 = = 4.0 %
10-17
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18. 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
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19. 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
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20. Types of Unemployment Frictional unemployment Structural unemployment
Cyclical unemployment
10-20
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21. 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
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22. 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
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23. 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
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24. 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 % (Natural)
Structural % (Natural)
5.0% (Full unemployment)
Cyclical % (Not natural)
Unemployment Rate % + +
10-24
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25. 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
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26. 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
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27. 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
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28. Finding Percentage Change in the Price Level
Year CPI
By what percentage did the cost of living rise?
10-28
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29. Finding Percentage Change in the Price Level
Year CPI
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.

30. Finding Percentage Change in the Price Level
Original Number
Year CPI
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.

31. Finding Percentage Change in the Price Level
Original Number
Year CPI
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.

32. Finding Percentage Change in the Price Level
Original Number
Year CPI
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 = X 100
10-32
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

33. Finding Percentage Change in the Price Level
Original Number
Year CPI
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 = X 100
Percentage change = 130.7
10-33
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34. 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.

35. 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
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36. 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
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37. 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
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38. 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
10-38
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39. 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
Year CPI
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.

40. 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
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
10-40
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41. Disinflation Disinflation occurs when the RATE OF INFLATION declines
Year CPI Inflation Rate % % % % %
the rate of inflation declined but prices continued to increase just at a lower rate!
10-41
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42. 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
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43. 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
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44. 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
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45. 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
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46. 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
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47. 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
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48. 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.

49. 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
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50. Consumer Price Index 1915 – 2002 (1967=100)
10-50
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51. Theories of the Causes of Inflation
Demand-Pull Inflation
Cost-Push inflation
10-51
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52. 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
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53. 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
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54. 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.

55. 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.

56. 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.

57. Cost-Push Inflation Supply-side cost shocks
Finally, we have supply-side shocks, most prominently the oil price shocks of 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.

58. 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
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59. 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
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60. 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,
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.