Chapter 10 Economic Fluctuations, Unemployment, and Inflation 10-1 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 10

Economic Fluctuations, Unemployment, and Inflation

10-1Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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



GDP in 1996 dollars, 1958-2002

Shaded areas indicate recessions


Recessions Since 1945

Hypothetical Business Cycles


Year

ProsperityPeak

Trough Trough

Peak

Peak

2005 2010 2015

Business Cycle Theories

• Endogenous theories– Innovation theory– Psychological theory– Inventory cycle theory– Monetary theory– Underconsumption theory

• Exogenous theories– Sunspot theory– War theory


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


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


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


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



• 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



• 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



• The conservative criticism– The true unemployment rate is lower than

the official rate


10-14

How Is the Unemployment Rate Computed?

UR = ------------------------------------------Number of Unemployed

Labor Force Number employed

+ Number unemployed

= Labor Force

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

10-15




+ Number unemployed

= Labor Force

2000 Number unemployed = 5,655,000

+ Number employed = 135,208,000

Labor Force = 140,863,000


10-16




+ Number unemployed

= Labor Force




UR = ---------------------------------------5,655,000

140,863,000


10-17




+ Number unemployed

= Labor Force




UR = ---------------------------------------5,655,000

140,863,000

UR = .0401453 = 4.0 %


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



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

Types of Unemployment

• Frictional unemployment

• Structural unemployment

• Cyclical unemployment


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


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


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


Natural Unemployment Rate

10-24

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 2.5% (Natural)

Structural 2.5% (Natural)

5.0% (Full unemployment)

Cyclical 1.7% (Not natural)

Unemployment Rate 6.7%

+

+


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

Natural Unemployment Rate


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


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


Finding Percentage Change in the Price Level

Year CPI

1972 125.3

1982 289.1

By what percentage did the cost of living rise?



Year CPI

1972 125.3

1982 289.1


10-29

Percentage change = ---------------------------- X 100Change

Original Number



Year CPI

1972 125.3

1982 289.1


10-30


Original Number

Change = 163.8

Original Number



Year CPI

1972 125.3

1982 289.1


10-31


Original Number

Change = 163.8

Original Number

Percentage change = ---------------------------- X 100163.8125.3



Year CPI

1972 125.3

1982 289.1By what percentage did the cost of living rise?

10-32


Original Number

Change = 163.8

Original Number

Percentage change = ---------------------------- X 100163.8

125.3

Percentage change = 1.307 X 100



Year CPI

1972 125.3

1982 289.1By what percentage did the cost of living rise?

10-33


Original Number

Change = 163.8

Original Number

Percentage change = ---------------------------- X 100163.8

125.3

Percentage change = 1.307 X 100

Percentage change = 130.7Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

A Magic Number

10-34

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?


A Magic Number

10-35

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%



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

10-37

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”


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 1929 -33


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 1929 -33

10-39

Year CPI

1929 17.1

1930 16.7

1931 15.2

1932 13.7

1933 13.0

1934 13.4

General price levels are declining when the CPI is decreasing

General price levels are rising when the CPI is increasing


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 1929 -33

10-40

Year CPI

1929 17.1

1930 16.7

1931 15.2

1932 13.7

1933 13.0

1934 13.4

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


Disinflation

• Disinflation occurs when the RATE OF INFLATION declines

Year CPI Inflation Rate

1980 82.4 13.5%

1981 90.9 10.3%

1982 96.5 6.2%

1983 99.6 3.2%

1984 103.9 4.3%

1981 -83 the rate of inflation declined . . . but prices continued to increase . . . just at a lower rate!


10-42

Consumer Price Index (CPI)

The most important measure of inflation is the Consumer Price Index (CPI)

CPI = --------------------------------- X 100Cost of livingcy

Cost of livingby


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



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



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


The Real Rate of Interest

10-46

• 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



10-47


Expected Rate of inflation 6%

+ Real Rate of Interest 5%

Nominal Rate of Interest 11%



10-48





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



10-49





But if the rate of inflation keeps growing – even if it is correctly anticipated – our economy will be in big trouble


Consumer Price Index1915 – 2002 (1967=100)

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved. 10-50

Theories of the Causes of Inflation

• Demand-Pull Inflation

• Cost-Push inflation


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


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


Cost-Push Inflation

• There are three variants of cost-push inflation– The wage-price spiral– Profit-push inflation– Supply-side cost shocks


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


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


Cost-Push Inflation

• Supply-side cost shocks– Finally, we have supply-side shocks, most

prominently the oil price shocks of 1973-74 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


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


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


Conclusion• One thing the economy has rarely been able to attain

simultaneously is a low unemployment rate and stable prices


The Misery Index, 1948-2002Economic Report of the President, 2002

Chapter 10 Economic Fluctuations, Unemployment, and Inflation 10-1 Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Documents

mcgrawhill companies

business cycle forecasting

types of unemployment

true unemployment rate

vendors performance

state unemployment insurance

theories of inflation

economic forecasting