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

26Business Cycles, Unemployment, and Inflation

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Prof. Mohammad El-Sakka – Kuwait University

• Introduction: This chapter looks at trends of real GDP growth and the macroeconomic problems of the business cycle, unemployment and inflation.

• Learning objectives – After reading this chapter, students should be able to:

• Describe the business cycle and its primary phases.• Illustrate how unemployment and inflation are measured.• Explain the types of unemployment and inflation and their

various impacts.

The Business Cycle

26-2


• Overview of the Business Cycle• Historical record:• 1. The United States’ impressive long‑run economic growth

has been interrupted by periods of instability.• 2. Uneven growth has been the pattern, with inflation often

accompanying rapid growth, and declines in employment and output during periods of recession and depression (see Figure 26.1 and Table 26.1).

The Business Cycle

24-3

The Business CycleU.S. Recessions since 1950

PeriodDuration,Months

Depth(Decline in Real

Output)1953-54 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

2007-09 18 -3.7Source: National Bureau of Economic Research, http://www.nber.org and Minneapolis Federal Reserve Bank, http://www.minneapolisfed.org Output data are in 2000 dollarsLO1 26-4

http://www.nber.org/

http://www.minneapolisfed.org/

http://www.minneapolisfed.gov/


• Four phases of the business cycle are identified over a several‑year period. (See Figure 26.1)

• 1. A peak is when business activity reaches a temporary maximum with full employment and near-capacity output.

• 2. A recession is a decline in total output, income, employment, and trade lasting six months or more.

• 3. The trough is the bottom of the recession period.• 4. Recovery is when output and employment are expanding

toward full‑employment level.

The Business Cycle

24-5

The Business CycleLe

vel o

f rea

l out

put

Time

Peak

Peak

Peak

Recession

RecessionExpansion Expansion

Trough

Trough

Growth

Trend

LO1 26-6


• There are several theories about causation.• 1. Major innovations may trigger new investment and/or

consumption spending.• 2. Changes in productivity may be a related cause.• 3. Monetary factors• 4. Political events• 5. Financial Stability• 6. Most agree that the level of aggregate spending is

important, especially changes on capital goods and consumer durables.

• Cyclical fluctuations: Durable goods output is more volatile than non-durables and services because spending on latter usually can not be postponed.

Causation: A First Glance

24-7


• Unemployment (One Result of Economic Downturns)• Measuring unemployment (see Figure 26.2 for 2009):• 1. The population is divided into three groups:

• those under age 16 or institutionalized, • those “not in labor force,” • the labor force that includes those age 16 and over who are willing

and able to work, and actively seeking work (demonstrated job search activity within the last four weeks).

• 2. The unemployment rate is defined as the percentage of the labor force that is not employed. (Note: Emphasize not the percentage of the population.)

Unemployment

24-8

Unemployment

Under 16and/or

Institutionalized (71.4 million)

Not inlaborforce

(81.7 million)

Employed(139.9 million)

Unemployed(14.3 million)

Total population (307.3 million)

Labor force (154.2 million)

Unemployment rate =

14,265,000 154,142,000

X 100 = 9.3%

Unemployment rate = # of unemployed labor force

X 100

LO2 26-9


• 3. The unemployment rate is calculated by random survey of 60,000 households nationwide. (Note: Households are in survey for four months, out for eight, back in for four, and then out for good; interviewers use the phone or home visits using laptops.) Two factors cause the official unemployment rate to understate actual unemployment.

• a. Part‑time workers are counted as “employed.”• b. “Discouraged workers” who want a job, but are not

actively seeking one, are not counted as being in the labor force, so they are not part of unemployment statistic.

Unemployment

24-10


• Types of unemployment:• 1. Frictional unemployment: consists of those searching

for jobs or waiting to take jobs soon; it is regarded as somewhat desirable, because it indicates that there is mobility as people change or seek jobs.

• 2. Structural unemployment: due to changes in the structure of demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs changes.

• 3. Cyclical unemployment: is caused by the recession phase of the business cycle.

Types of Unemployment

24-11


• As firms respond to insufficient demand for their goods and services, output and employment are reduced.

• Extreme unemployment during the Great Depression (25 percent in 1933) was cyclical unemployment.

• 4. It is sometimes not clear which type describes a person’s unemployment circumstances.

Types of Unemployment

24-12


• Definition of “Full Employment”• Full employment does not mean zero unemployment.• The full‑employment unemployment rate is equal to the total

frictional and structural unemployment.• The full‑employment rate of unemployment is also referred

to as the natural rate of unemployment.• The natural rate is achieved when labor markets are in

balance; the number of job seekers equals the number of job vacancies.

• The natural rate of unemployment is not fixed but depends on the demographic makeup of the labor force and the laws and customs of the nations.

Definition of Full Employment

24-13


• Recently the natural rate has dropped from 6% to 4 to 5% as demographic factors, job search methods, and public policies change.

• Economic cost of unemployment:• GDP gap and Okun’s Law: GDP gap is the difference

between potential and actual GDP. (See Figure 26.3) Economist Arthur Okun quantified the relationship between unemployment and GDP as follows: For every 1 percent of unemployment above the natural rate, a negative GDP gap of about 2 percent occurs. This is known as “Okun’s law.”

• Unequal burdens of unemployment exist. (See Table 26.2)• Rates are lower for white‑collar workers.• Teenagers have the highest rates.

Economic Cost of Unemployment

24-14


• African-Americans have higher rates than whites.• Rates for males and females are historically comparable, though

during the Great Recession females had a significantly lower rate.• Less educated workers, on average, have higher unemployment

rates than workers with more education.• “Long‑term” (15 weeks or more) unemployment rate is much lower

than the overall rate, although it has nearly tripled from 1.5% in 2007 to 4.7% in 2009 due to the Great Recession.

• Noneconomic costs include loss of self‑respect and social and political unrest.

• International comparisons. (See Global Perspective 26.1)

24-15

Unequal BurdensUnemployment Rates by Demographic Group: Full Employment Year (2007) and Recession Year (2009)*

Demographic GroupUnemployment Rate

2007 2009Overall 4.6% 9.3%

Occupation: Managerial and professional Construction and extraction

2.1 4.6

7.6 19.7

Age: 16-19 African American, 16-19 White, 16-19 Male, 20+ Female, 20+

15.7 24.3

29.4 39.5

13.9 21.8

4.1 9.6

4.0 7.5

Race and ethnicity: African American Hispanic White

8.3 14.8

5.6 12.1

4.1 8.5

Gender: Women Men

4.5 8.1

4.7 10.3

Education:** Less than high school diploma High school diploma only College degree or more

7.1 14.6

4.4 9.7

2.0 4.6

Duration: 15 or more weeks 1.5 4.7

LO3 26-16

Global Perspective

LO3 26-17


LO3


26-18


LO3 26-19


• Inflation: Defined and Measured• Definition: Inflation is a rising general level of prices (not all

prices rise at the same rate, and some may fall).• The main index used to measure inflation is the Consumer

Price Index (CPI). To measure inflation, subtract last year’s price index from this year’s price index and divide by last year’s index; then multiply by 100 to express as a percentage.

• “Rule of 70” permits quick calculation of the time it takes the price level to double: Divide 70 by the percentage rate of inflation and the result is the approximate number of years for the price level to double. If the inflation rate is 7 percent, then it will take about ten years for prices to double. (Note: You can also use this rule to calculate how long it takes savings to double at a given compounded interest rate.)

Inflation

24-20


• Facts of inflation:• In the past, deflation has been as much a problem as

inflation. For example, between 2008 and 2009, the CPI decreased by.4%. The prospect of deflation has been a concern of economic policymakers.

• All industrial nations have experienced the problem (see Global Perspective 26.2).

• Some nations experience astronomical rates of inflation (Zimbabwe’s was 14.9 billion percent in 2008 before doing away with their existing currency).

• The inside covers of the text contain historical rates for the U.S.

Inflation

24-21

Inflation

LO2

Inflation Rates in Five Industrial Nations

26-22

Inflation

LO2 26-23


• Causes and theories of inflation:• Demand‑pull inflation: Spending increases faster than

production. It is often described as “too much spending chasing too few goods.”

• CONSIDER THIS … Clipping Coins• Princes would clip coins, paying peasants with the clipped coins and

using the clippings to mint new coins.• Clipping was essentially a tax on the population as the increased

money supply caused inflation and reduced the purchasing power of each coin.

Inflation

24-24


• Cost‑push or supply‑side inflation: Prices rise because of rise in per-unit production costs (Unit cost = total input cost/units of output).

• Output and employment decline while the price level is rising.

• Supply shocks have been the major source of cost-push inflation. These typically occur with dramatic increases in the price of raw materials or energy.

• Complexities: It is difficult to distinguish between demand‑pull and cost‑push causes of

inflation, although cost‑push will die out in a recession if spending does not also rise.

Inflation

24-25


• Core Inflation• Food and energy prices are very volatile due to changes in

supply and demand which are usually temporary changes.• To prevent a misinterpretation of the changes in the CPI that

might be due to temporary changes in supply and demand, economists use core inflation.

• Core inflation doesn’t include food and energy goods.• If core inflation is low and stable, current policy may not

need to be changed even if the CPI is rising.• Economists will be greatly concerned if core inflation

increases.

Inflation

24-26


• Redistributive effects of inflation:• The price index is used to deflate nominal income into real

income. Inflation may reduce the real income of individuals in the economy, but won’t necessarily reduce real income for the economy as a whole (someone receives the higher prices that people are paying).

• Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects.

• Fixed‑income groups will be hurt because their real income suffers. Their nominal income does not rise with prices.

• Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power.

Inflation

24-27


• Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender.

• If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders.

• “Inflation premium” is amount that interest rate is raised to cover effects of anticipated inflation.

• “Real interest rate” is defined as nominal rate minus inflation premium. (See Figure 26.5)

Inflation

24-28


• Final points• Unexpected deflation, a decline in price level, will have the

opposite effect of unexpected inflation.• Many families are simultaneously helped and hurt by

inflation because they are both borrowers and earners and savers.

• Effects of inflation are arbitrary, regardless of society’s goals.

Inflation

24-29

Anticipated Inflation

NominalInterest

Rate

RealInterest

Rate

InflationPremium

11%

5%

6%= +

LO3 26-30


• Output Effects of Inflation• Cost‑push inflation, where resource prices rise

unexpectedly, could cause both output and employment to decline. Real income falls.

• Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous economy, or it may have an undesirable impact on real income.

• Danger of creeping inflation turning into hyperinflation, which can cause speculation, reckless spending, and more inflation (see examples in text of Japan following World War II, and Germany following World War I).

Inflation

24-31


• LAST WORD: The Stock Market and The Economy: How, if at all, do changes in stock prices relate to macroeconomic stability?

• Do changes in stock prices and stock market wealth cause instability? The answer is yes, but usually the effect is weak.

• There is a wealth effect: Consumer spending rises as asset values rise and vice versa if stock prices decline substantially.

• Also, there is an investment effect: Rising share prices lead to more capital goods investment and the reverse in true for falling share prices.

Last word

24-32


• Stock market “bubbles” can hurt the economy by encouraging reckless speculation with borrowed funds or savings needed for other purposes. A “crash” can cause unwarranted pessimism about the underlying economy.

• A related question concerns forecasting value of stock market averages. Stock price averages are included as one of ten “Leading Indicators” used to forecast the future direction of the economy. (See Last Word, Chapter 30). However, by themselves, stock values are not a reliable predictor of economic conditions.

Last word

24-33

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