1. Chapter 10 Business Cycles, Unemployment, and Inflation McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Learning Objectives Compare and contrast potential GDP and real GDP. Define the unemployment rate and distinguish between the different types of unemployment. Explain the tradeoff between unemployment and inflation. Define recessions and discuss the impact of recessions on workers and businesses. List the possible causes of recession. 10-2

3. Potential versus Real GDP Potential GDP is the output of the economy assuming no strains on production or unused resources. –Potential and actual GDP can be different. –The economy normally operates at levels above or below potential. The rate at which potential GDP rises is the potential growth rate. 10-3

4. Potential Growth The potential growth rate in the economy is a combination of the long- term growth rate of the labor force plus the long-term growth rate of productivity. The estimated growth rate in potential GDP for the U.S. is around 3% per year. Projections of potential GDP are made to forecast the sustainable growth path for the economy. 10-4

5. The Path of Potential GDP 10-5

6. The Output Gap As noted previously, the actual level of real GDP may be higher or lower than potential GDP. The output gap is the difference between actual and potential GDP. The output gap is negative when actual GDP is less than potential, and positive when the output is greater than potential. 10-6

7. The Output Gap 10-7

8. Unemployment Unemployment is a key measure of the health of the economy. The unemployment rate is the percentage of the labor force who are unemployed. –The labor force is the sum of the employed workers and the unemployed workers. Unemployment occurs when actual GDP is below potential GDP, and the economy slows. 10-8

9. Unemployment Rate, 1960-2010 10-9

10. Types of Unemployment Unemployment can be classified into 3 categories : –Frictional unemployment arises due to the job search process. –Structural unemployment comes when there is a mismatch between the skills of unemployed workers and the needs of employers with unfilled jobs. –Cyclical unemployment is caused by a lack of demand for the products sold by the employer. 10-10

11. The Unemployment Puzzle Wages are the price of labor. Thus, one would expect wages to fall when unemployment is high. –This does not occur because wages are sticky. Sticky wages mean that is difficult to change wages in the short run. One reason wages are sticky is due to the presence of unions. 10-11

12. Trade-off between Unemployment and Inflation The unemployment rate rises when actual GDP is below potential GDP. In contrast, the unemployment rate falls when actual GDP is above potential GDP. –But then wages and inflation begin to rise. Thus, low unemployment is linked to higher inflation. 10-12

13. Trade-off between Unemployment and Inflation If the economy grows too fast – that is, if actual GDP is too high relative to potential GDP – we get rising inflation. If the economy grows too slowly - if actual GDP is too low relative to potential GDP – we get unemployment. The job for policymakers is to find the right balance between inflation and unemployment. 10-13

14. Inflation and Potential GDP Given the link between GDP, inflation, and unemployment: –We can define potential GDP as the maximum amount of economic output an economy can sustain at any moment without inducing an increase in the inflation rate. Potential GDP is effectively the “speed limit” for the economy. 10-14

15. Natural Rate of Unemployment The natural rate of unemployment is defined as the level of unemployment where inflation is more or less stable. –When the unemployment rate is below the natural rate, the inflation rate increases. –When the unemployment rate is above the natural rate, the inflation rate falls. The natural rate of unemployment is also called the “non-accelerating inflation rate of unemployment,” or NAIRU for short. 10-15

16. Recessions A recession is defined as a significant decline in economic activity spread across the economy, lasting more than a few months. In a recession, GDP is running below its potential and the unemployment rate is high. During a recession: –It’s harder to find a job. –Profits aren’t as high. –Malls are empty. –Tax revenues fall short of predictions. 10-16

17. The Business Cycle The peak is the date the recession starts. The trough is the date the recession ends. The expansion is the period of time from the trough, through recovery, and all the way to the next peak. The pattern of recession, recovery, and expansion is the business cycle. 10-17

18. The Typical Business Cycle 10-18

19. The Impact of Recession on Workers Unemployed workers and their families suffer the most from a recession. During a recession, it is hard to find a job as the economy shrinks and companies stop hiring. The labor market typically doesn’t fully recover until well after the recession has ended. 10-19

20. The Impact of Recession on Businesses Recessions negatively impact businesses, as the demand for their product declines. This results in a downward shift in the demand curve for their product. Demand falls because consumers have less income to spend. Businesses also cut back on expansion plans and investment in new equipment. 10-20

21. The Impact of Recession on Businesses Demand curve for cars during the recession Q P Demand curve for cars pre-recession Price of cars Q1Q1 Quantity of cars demanded/supplied Supply curve for cars P1P1 B A 10-21

22. What Happens in a Recession EmploymentBusinesses lay off workers and cut back on hiring. Retail salesStores see falling sales, and some close. Home constructionFewer homes are built. Household income, adjusted for inflation Many households see their real incomes drop. Business profitsBusinesses make less money. Business investmentBusinesses cut spending. Industrial productionFactories produce less. Tax revenuesGovernments collect less taxes. Aspect of the EconomyWhat Happens 10-22

23. The Great Recession: Real GDP 10-23

24. The Great Recession: Private-Sector Jobs 10-24

25. Why Do Recessions Happen? The cause of recessions is a controversial issue among economists. But there are certain triggers that may set the stage for a recession. One potential trigger is problems in the financial markets. The Great Recession was largely caused by problems in the financial markets. 10-25

26. Problems in Financial Markets Individuals and businesses borrow money from the financial markets to finance various types of expenditures. When financial markets stop working, it becomes harder to borrow and the economy slows. Banks tighten lending standards so consumers have less money available to buy homes and cars. Small businesses also find it difficult to borrow. 10-26

27. Why Do Recession Happen? Another cause is an unexpected negative supply shift. An example would be a sudden rise in the price of oil. The higher price of oil causes the supply schedule in many individual industries to shift left. Another example of a negative supply shift is a terrorist attack that forces the government and businesses to adopt tighter security measures. 10-27

28. Impact of a Negative Supply Shift Demand curve Q P Supply curve with higher oil prices Price of groceries Q1Q1 Quantity of groceries demanded/supplied Original supply curve P1P1 10-28

29. Negative Demand Shifts A final trigger for a recession is a negative demand shift. –Recession is caused by a large drop in demand. –A good example of a demand-driven recession was the recession of 2001, which was primarily caused by a decline in business spending on computers, communications equipment, and other information technology gear. –The decline in demand results in an increase in the unemployment rate. 10-29

30. Inflation Fighting A third trigger for a recession is that the economy gets overheated and inflation rises. –Policymakers must slow it down to curb the inflationary threat. –They may slow growth so much that it results in a recession. –A good example is the recession of 1980 and 1981. 10-30