Chapter 26 Business Cycles, Unemployment & Inflation

Chapter 26

Business Cycles, Unemployment &

Inflation

The United States has experienced remarkable economic growth over time. But this growth has not been smooth, steady, and predictable from year to year. At various times the United States has experienced recessions, high unemployment rates, or high inflation rates.

The goal in this chapter is to examine the concepts, terminology, and facts relating to macroeconomic instability.

The business cycle represents the ups and downs in economic activity as measured by changes in real GDP over several years. Individual cycles vary substantially in duration and intensity. There are 4 phases of the business cycle.

1. Peak- has occurred when real GDP has reached a temporary maximum. Here the economy is at or near full employment and the level of real output is close to the economy’s capacity. The price level is likely to rise during this phase.

2. Recession- is a period of decline in total output, income, and employment. This downturn, which lasts a minimum of 6 months, is marked by the widespread contraction of business activity in many sectors of the economy with increases in the unemployment rate.

U.S. Recessions since 1950Period Duration/months ↓ in real GDP1953-54 10 −2.6%1957-58 8 −3.7%1960-61 10 −1.1%1969-70 11 −0.2%1973-75 16 −3.2%1980 6 −2.2%1981-82 16 −2.9%1990-91 8 −1.4%2001 8 −0.4%2007-2009 18 −3.7%

3. Trough- of the recession or depression marks the low point in real GDP. It may be short-lived or quite long.

4. Recovery- also called expansion, is a period in which real GDP, income, and employment rise. The economy again approaches full employment. If spending expands more rapidly that output, prices will begin to rise and inflation will occur.

The business cycle dating committee of the National Bureau of Economic Research (NBER), a nonprofit research organization, declares the start and end of recessions in the United States. All recessions are post dated because it takes time to collect and analyze the enormous amount of data coming in.

There may be several contributing factors which add to the volatility of the business cycle, but most economists agree that the immediate cause of the large majority of cyclical changes in the levels of real output and employment is unexpected changes in the level of total spending.

Ex. If total spending unexpectedly falls and firms cannot lower prices, firms will sell fewer units of output. They will respond by cutting production levels and laying off workers. The result is a recession. 

Unemployment The U.S. Bureau of Labor Statistics (BLS) conducts a nationwide random survey of some 60,000 households each month to determine who is employed and who is unemployed. The BLS divides the U.S. population into 3 groups.

One group is made up of people under 16 years of age and people who are institutionalized. A second group, labeled “not in the labor force,” is composed of adults who are potential workers but are not employed and are not seeking work. The 3rd group is the labor force, which constituted slightly more than 50% of the total population in 2009.

Civilian labor force- are those 16 and over who are working or looking for a job. Unemployment rate = # unemployed but looking ÷ civilian labor force × 100

2 Criticisms of the unemployment rate 1. Part-time workers- The BLS lists all

part-time workers as fully employed. Some people work part-time by choice, but others want full time work but can’t get it. By counting these workers as fully employed, the official BLS data understates the true unemployment rate

2. Discouraged workers- represent workers, who after unsuccessfully seeking employment for a time, become discouraged and drop out of the labor force. This number was approximately 778,000 people in 2009. By not counting these workers as unemployed, the official BLS data again understates the true rate of unemployment.

Types of unemployment 1. Frictional Unemployment- represents workers who are “between jobs” or “searching and waiting” for work. This could represent people who are voluntarily changing jobs, those who were fired, those who are seasonally unemployed, and even people entering the job market for the first time.

Frictional unemployment is inevitable and, at least in part, desirable.

2. Structural Unemployment- Changes over time in consumer demand and in technology alter the structure of the total demand for labor, both occupationally, and geographically. Workers who find that their skills and experience have become obsolete or unneeded thus find that they have no marketable talents.

They will need to adapt or develop new skills that employers need and want. The distinction between frictional and structural is hazy at best. The key difference is that the frictionally unemployed have marketable skills and either live in areas where jobs exist or are able to move to areas where they do.

The structurally unemployed won’t find new jobs without retraining, more education, and/or relocating.

3. Cyclical Unemployment- Unemployment that is caused by a decline in total spending that occurs during a recession. This type of unemployment results from insufficient demand for goods and services.

Definition of Full Employment Because frictional and structural unemployment is largely unavoidable, full employment is something less than 100% employment. Economists describe the unemployment rate that is consistent with full employment as the full-employment rate of unemployment, or the natural rate of unemployment (NRU).

At the NRU, the economy is said to be producing its potential output. This is the real GDP that occurs when the economy is fully employed. Full employment does not mean zero unemployment.

Remember, frictional and structural unemployment will always be with us to some extent. The first 4-5% represents frictional plus structural and anything above that represents cyclical. Today, the NRU is estimated to be 4 to 5%.

Economic Cost of Unemployment The basic economic cost of unemployment is forgone output, or lost GDP. In terms of chapter 1’s analysis, unemployment above the NRU means society is operating at some point inside its PPF.

Economists call this sacrifice of output a GDP gap- the difference between actual and potential GDP.

GDP gap = actual GDP – potential GDP 

This gap can be either negative (actual GDP < potential GDP) or positive (actual GDP > potential GDP). It also indicates the close correlation between the actual unemployment rate and the GDP gap. The higher the unemployment rate, the larger the GDP gap.

Okun’s Law Okun’s Law indicates that for every 1% which the actual unemployment rate exceeds the natural rate, a negative GDP gap of about 2% occurs. Ex. If the actual unemployment rate is 9.3%, the NRU is 5%, and potential GDP is $14 trillion, then how big is the negative GDP gap?

Inflation is a rise in the general level of prices. When inflation occurs, each dollar of income will buy fewer goods and services than before. Inflation reduces the “purchasing power” of money.

Deflation: a decrease in the general/average price level as measured by an index number. The effects of deflation are the opposite of inflation.

Measurement of Inflation The main measure of inflation in the U.S. is the Consumer Price Index (CPI), compiled by the Bureau of Labor Statistics (BLS). The government uses this index to report inflation rates each month and each year. It is also used to adjust Social Security benefits and income tax brackets for inflation.

The CPI reports the price of a market basket of some 300 consumer goods and services that are purchased by a typical urban consumer. The BLS updates the composition of the market basket every 2 years so that it reflects the most recent patterns of consumer purchases and captures the inflation that consumers are currently experiencing.

The BLS arbitrarily sets the CPI equal to 100 for the 1982-1984 period. CPI = price of mb in given year ∕ price of mb in base year(1982-84) x 100 Rate of inflation = Δ In price index/CPI from 1 year to another ÷ original price index/CPI × 100

Year CPI Rate of inflation or deflation 1 150 2 160 3 163 4 172 5 170 6 169

Types of Inflation Nearly all prices in the economy are set by supply and demand. Consequently, if the economy is experiencing inflation and the overall level of prices is rising, we need to look for an explanation in terms of supply and demand.

1. Demand-pull Inflation- Usually, increases in the price level are caused by an excess of total spending beyond the economy’s capacity to produce. Where inflation is rapid and sustained, the cause invariably is an over issuance of money by the central bank. Demand pull can be described as “too many dollars chasing too few goods.”

2. Cost-push Inflation- Inflation may also arise on the supply, or cost, side of the economy. This view explains rising prices in terms of factors that raise per-unit production costs at each level of spending.

Per-unit production cost = total input cost ÷ units of output

Rising per-unit production costs squeeze profits and reduce the amount of output firms are willing to supply at the existing price level. As a result, the economy’s supply of goods and services declines and the price level rises.

In this scenario, costs are pushing the price level upward. The main source of this kind of inflation is abrupt increases in the cost of raw materials or energy inputs, like oil.

Redistributive Effects of Inflation - Inflation redistributes real income. This redistribution helps some people and hurts others while leaving many unaffected.

Nominal income is the number of dollars received as wages, rent, interest, or profits. It’s the amount of money you have in your pocket. Real income is a measure of the amount of goods and services nominal income can buy; it is the purchasing power of nominal income, or income adjusted for inflation.

Real income = nominal income ÷ price index (in hundredths)

Nominal income Price index Real income $10/hr. 100 $10/hr. 120 $15/hr. 125

When inflation occurs, not everyone’s nominal income rises at the same pace as the price level.

Therein lies the potential for redistribution of real income from some to others.

Ex. Price level rises by 6% and Bob’s nominal income rises by 6%, then his real income rises by? (0) Bob is no better off, but no worse off than before.

Nominal inc. − Inflation = real inc. 6 − 6 = 0

The redistribution effects of inflation depend on whether or not it is expected. We will first discuss situations involving unanticipated inflation. We will then discuss situations involving anticipated inflation. These are situations in which people see inflation coming in advance.

Who is Hurt?/Unanticipated

1. Fixed-income receivers- People whose incomes are fixed see their real incomes fall when inflation occurs.Elderly couple living on a private pension or annuity.

Landlords who receive lease payments of fixed dollar amounts.Public sector workers.Minimum wage workers and families living on fixed welfare incomes.

2. Savers- As prices rise, the real value, or purchasing power, of an accumulation of savings deteriorates.Savings accounts.Insurance policies.Annuities.Certificates of Deposit.Bonds.

3.Creditors- This represents people who loan money to others. As prices go up, the purchasing power of the dollar does down. So the borrower pays back less valuable dollars than those received from the lender. In other words borrowing dear dollars and paying back cheap dollars.

Who is Unaffected or Helped?

1.Flexible-income receivers- People who derive their incomes solely from Social Security are largely unaffected by inflation because their benefits are indexed to the CPI.

Some union workers also get automatic cost-of-living adjustments (COLA) in their pay when the CPI rises, although such increases rarely equal the full percentage rise in inflation.

Also, some business owners may benefit from inflation. If product prices rise faster than resource prices, business revenues will increase more rapidly than costs.

2. Debtors- Borrowers benefit because they borrow dear dollars and pay back cheap dollars.

Anticipated InflationThe redistribution effects of inflation are less severe or are eliminated altogether if people anticipate inflation and can adjust their nominal incomes to reflect the expected price level increases.

The COLA’s required by labor unions are one way workers can protect themselves against anticipated inflation.

Also, lenders can protect themselves by charging an inflation premium. This is when the lender increases the interest rate by the amount of the anticipated inflation.

Ex. A 1 year loan charging 5% interest. If the expected rate of inflation is 6%, then the bank should charge 11%; 6% to cover the expected inflation and 5% as the agreed upon interest rate for borrowing the money.

In our example the real interest rate is 5%. The nominal interest rate is the percentage increase in money that the borrower pays the lender, including that resulting from the built-in expectation, if any. Nominal interest rate = real interest rate + expected rate of inflation (11%) = (5%) + (6%)