CHAPTER 26: BUSINESS CYCLES, UNEMPLOYMENT, AND INFLATION

Introduction While long-run economic growth is sustained, short-run economic perfonnance is much more variable. Business cycles commonly result in changes in output, unemployment, and inflation. Chapter 26 explores macroeconomic instability, explaining the phases and causes of business cycles. Discussion continues with the measurement, types, and causes and effects of unemployment and inflation. An understanding of business cycles and their effects lays the foundation for understanding macroeconomic models, competing theories, and government policies to address macroeconomic instability. Material from Chapter 26 is very likely to appear in several multiple-choice questions on the AP macroeconomics exam and occasionally is part of a free-response question as well.

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The business cycle

Business cycles are increases and decreases in real GDP over time and composed of four phases. The peak is the highest point of real GDP in the cycle, where the economy experiences full employment, output at or near capacity, and generally rising prices. A recession is a period of decrease in real GOP, generally six months or longer, during which employment and prices tend to fall. The trough is the lowest point of real GOP in the cycle, where output and employment reach their lowest levels. An extended, very deep trough is considered a depression. Expansion, or recovery, is the fourth phase of the business cycle. Real GDP again begins to rise, and employment and prices rise along with it. Business cycles vary in depth and duration.

Taking the EEK! Out of Economics It is important to remember how GOP, prices, and employment change in each phase of the business cycle. If you keep in mind that all three factors generally move in the same direction, it will help you to keep the effects straight. Some students expect prices to rise during an economic downturn, thinking finns must raise their prices to make up for lost sales. Remember, if demand and production are dropping, finns must lower prices to attract customers back; consumers respond to higher prices by buying even less.

Causes of Business Cycles Unexpected spending changes in the economy are the primary cause of business cycles. Inventions and innovation lead finns to increase investment spending to adopt new technologies. Changes in labor productivity, the money supply, consumer confidence, and unexpected economic shocks also can affect economic perfonnance.

Chapter 26: Business Cycles, Unemployment, and Inflation 175

An im:rease in investment spending. productivity. consumer confidence. or the money supply results in greater demand. This increased demand raises output. and employment increases as workers are hired to produce that output. The increased demand pushes up the price level, so real GOP. employment. and prices increase together.

If the level of spending in the economy falls due to reduced productivity. consumer confidence, investment spending. money supply or an economic shock, firms reduce output. Fewer workers are needed to produce the reduced output, so employment falls. Prices tend to be sticky downward in the short run but fall if the downturn is sustained. Again, real GOP, employment, and prices move in the same direction.

Business Cycle Impacts on Production While business cycles impact all sectors of the economy, the strength of impact differs among industries. Producers of capital goods (such as construction and equipment) and consumer durable goods (such as cars and appliances) tend to be more deeply affected by changes in the business cycle. When product demand falls, firms expect a lower return on investment in capital, so they instead produce with existing resources. During economic downturns, consumers also reduce purchases of homes, cars, computers, and appliances, making repairs rather than buying new items. When the economy is strong, consumption of such items tends to rise significantly. Thus, producers of these capital and durable goods tend to sustain strong cyclical swings in economic activity.

Producers of services and non-durable consumer goods are less likely to face strong cyclical changes in demand for their products. During recessions, consumers still tend to purchase food, gasoline, medical care, and haircuts, and demand does not significantly increase during expansions. As a result, output and employment in capital goods and durable goods industries tend to be more strongly affected by economic cycles than in service and non-durable goods industries.

Unemployment To calculate the unemployment rate, the Bureau of Labor Statistics calls approximately 60,000 households per month. Respondents are placed in two categories. Those who are under sixteen, institutionalized, or not working by choice (for example, retired. students, or homemakers) are outside the labor force. They are not included in unemployment statistics because they are unavailable or unwilling to join the workforce. The second category is the labor force, consisting of people who are willing and able to work. Within the labor force are two groups: the employed and the unemployed. Those who are unemployed are not working but are actively seeking work.

Unemployed Unemployment Rate x 100

Labor Force

It is important to note that the official unemployment rate underestimates unemployment. Because samples are used, many unemployed people may be missed in the sample, such as people without phones or living with others. Underemployed workers work part-time because they cannot find full-time jobs or work in jobs for which they are overqualified because they cannot find appropriate jobs. They are counted a~ fully employed, though the designation isn't fully accurate. DIscouraged workers are also entIrely left out of the statistics. Discouraged

176 Chapter 26: Business Cycles. Unemployment. and Inflation

workers are those who have been unemployed for so long that they have stopped looking for work. They would accept a job if offered, but under the definition of unemployment, they have left the labor force and are not included. Because of the method of gathering data, underemployment, and discouraged workers, the official unemployment rate underestimates the actual level of unemployment in the economy.

Types of Unemployment People are unemployed for a variety of reasons. One type of unemployment is frictional unemployment, which refers to people temporarily between jobs. People who have been fired, have quit, or are looking for first jobs briefly experience frictional unemployment while they search for new jobs. Frictional unemployment always exists, as there are always people moving between jobs.

A second type of unemployment is seasonal. Lifeguards at outdoor pools in the north, field workers harvesting crops, and commercial fishennen experience unemployment at the same time every year based on seasonal conditions. Workers in these jobs understand the seasonal nature of the work and often seek other jobs during the off-season.

Structural unemployment occurs when a worker's skills do not match the available jobs. Structural unemployment can result from a change in product demand, as when autos replaced horses, reducing demand for blacksmiths to make horseshoes. It also results from industry migration; when steel production grew overseas and mills closed here, U.S. steelworkers lost careers. Automation can also cause structural unemployment when machines replace workers. Structural unemployment is long-tenn, requiring workers to relocate to where jobs still exist or retrain for new careers where demand is higher.

The fourth type of unemployment, cyclical unemployment, results from swings in the business cycle. You can see the word "cycle" right in the word "cyclical." When total spending in the economy falls and finns reduce output during a recession, they lay off workers. During expansion, cyclical unemployment falls. Cyclical unemployment is generally the target of government policy to stabilize the economy.

Full Employment It is impossible for an economy to reach zero percent unemployment, because frictional, seasonal, and structural unemployment always exist in a dynamic economy. Full employment is defined as the absence of cyclical unemployment. Full employment is also known as the natural rate of unemployment. At the natural rate of unemployment, the economy is producing at the full potential output; real GOP is at capacity.

The natural rate of unemployment can change over time as demographics and policies change. The natural rate of unemployment rose as women and teenagers joined the labor force in large numbers and as unemployment benefits allowed people to extend their job searches longer. It fell as birth rates fell and fewer people entered the labor force, as the Internet made job searches easier, and as changes in government policy required work for welfare recipients. An unemployment rate of 4 to 5 percent is now considered full employment.

Effects of Unemployment As we learned in Chapter 1, unemployment is illustrated by a point inside the production possibilities curve. So the cost of unemployment is the forgone output that could have been made by society. The GOP gap is the difference between potential and actual GDP:

Chapter 26: Business Cycles. Unemployment, and Inflation 177

GOP Gap = Actual GOP - Potential GOP

Potential GOP increases each year at the expected rate of long-run growth, around 2 to 3 percent. If unemployment is higher than the natural rate, it reduces actual output, resulting in the GOP gap. The higher the unemployment rate, the higher the GOP gap. If unemployment is less than the natural rate of unemployment, actual GOP can exceed the expected potential GOP, resulting in a negative gap-more output than expected. But because rapid expansion causes inflationary pressure, it cannot be sustained long-term.

Okun's Law defines the relationship between unemployment and the GDP gap. Under Okun's Law, for every percentage point the unemployment rate is above the natural rate of unemployment, the GOP gap increases 2 percentage points. So if the natural rate of unemployment is 5 percent and current unemployment is 7 percent, the GOP gap would be 4 percent.

The effects of unemployment are distributed unequally. Workers with less education and low skills, teens, African-Americans, and Hispanics are more likely to be unemployed and unemployed longer than other workers. Deep and sustained unemployment can also lead to poverty, crime, divorce, and even political unrest, if severe enough.

Inflation Inflation is an increase in the general price level. Ouring a period of inflation, the value or purchasing power of the dollar decreases, and people cannot buy as much as they once could with the same income.

Inflation is primarily measured by the consumer price index (CPI). The Bureau of Labor Statistics creates a "market basket" of hundreds of goods and services that a typical urban consumer would buy in a month. To fmd the consumer price index, use the formula below:

Total Price of the Market Basket This Year CPI x 100

Total Price of the Market Basket in the Base Year

To find the rate of inflation for the year, use this formula:

This Year's CPI - Base Year's CPI Rate of Inflation ------------- x 100

Base Year's CPI

Causes of Inflation Demand-pull inflation, the most common kind of inflation in the United States, is an increase in the price level resulting from demand that is greater than the ability of the economy to produce the output. A significant increase in the money supply can cause such an increase in demand. Because firms are producing at capacity, they cannot increase output, so demand pulls the price up, resulting in inflation.

Cost-push inflation occurs when the cost of production rises, and firms pass the increased cost on to consumers. A supply shock such as a rise in material costs can cause cost-push inflation.

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Increased costs reduce the finn's profit, so the finn reduces output and pushes the price upward. As supply falls, output and employment fall while prices rise.

Nominal and Real Income As w~ saw with GOP, i?flation can distort the value of production. In the same way, inflation can distort the value of mcome. Nominal income is the income earned in the current value of dollars. Re~l income is the measure of what one's income will actually buy or, in other words, the purchasmg power of a dollar.

Nominal Income Real Income =

Price Index (as a Decimal)

If you earned $10,000 this year and the price index is l.05 (an inflation rate of 5 percent), your real wage for this year is $9,523.81. In other words, it will cost your entire $10,000 income in its current value to buy what $9,523.81 would have bought at its value last year.

This is important when we compare the inflation rate to the change in nominal income to see if nominal income kept up with inflation, rose above inflation, or fell behind.

% Change in Real Income = % Change in Nominal Income - % Change in Price Level

If you received a 3 percent raise at work this year and the inflation rate was 3 percent, you would experience no change in real income; although you would be paid more in current dollars, the value of those dol1ars fel1 enough that you could not purchase any more than you did last year. If your nominal income rises more quickly than the price level, your real income increases; if your nominal income rises less quickly than the price level, your real income actual1y declines. In the latter case, even though the amount on your paycheck has increased, it won' t stretch to buy as much as last year's income at its value did.

Unanticipated Inflation When people do not prepare for inflation, some are hurt, some are helped, and others are unaffected by the inflation. People living on a fixed income, such as retirees on a fixed pension or workers earning the minimum wage, are hurt by inflation. They receive the same dol1ar amount of income, but it wil1 not buy as much as it once did. Savers are also hurt by inflation, because the interest rate on the savings account or CD does not increase with the inflation rate, so the interest payment wil1 not stretch as far as it once did.

Lenders are also hurt, but borrowers are helped by unanticipated inflation. Inflation erodes the value of money over time, so the money has a greater value at the time it is loaned than when it is repaid. As a result, the money repaid is not worth as much as the money originally borrowed. The lender receives the ful1 amount of the loan back but that money wil1 not buy as much as it would have when the loan was originated.

People who have flexible incomes are less likely to feel the impact of unanticipated inflation. If firms must raise wages to attract workers to meet the. incre.ased ~emand, wage~ may ke~p pace or even exceed the inflation rate. If firms are able to raise pnces higher than the mcrease m production costs, profits can increase as wel1.

Chapter 26: Business Cycles, Unemployment, and Inflation 179

Anticipated Inflation I f people are able to anticipate inflation, they can mitigate or eliminate the effects on their real incomes. Social Security benefits automatically adjust with inflation, and some workers have cost-of-living adjustments (COLAs) built into their contracts. Lenders also try to recoup the diminishing value of the dollar over time by building the expected inflation rate into the interest rate they charge customers.

Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate

If a bank would charge a 4% interest rate for a one-year loan in the absence of inflation and the bank expects a 3% increase in the price level next year, it would charge 7% interest on the loan, so the repaid dollars (with the 3% inflation premium) hold the overall same value as the dollars originally loaned.

Deflation Deflation is a general decrease in prices, which can occur as the result of a deep, sustained recession. Deflation can help those living on fixed incomes, savers, and lenders, because their fixed incomes now buy more. Borrowers lose from deflation, as the dollars they repay are worth more than the dollars originally borrowed.

Hyperinflation Hyperinflation is an extreme level of inflation. Prices rise so quickly that wages, profits, and costs of resources become unpredictable. As money essentially becomes worthless, consumers funnel their money into precious metals and other investments that will hold value, but do not produce output in the country. Eventually, many countries experiencing hyperinflation collapse, both economically and politically. Governments can undertake policies to help prevent hyperinflation and other effects of economic instability in order to promote economic growth.

Multiple-Choice Questions I. A recession is generally characterized by

I. a decrease in Real GDP. II. a decrease in employment. III. an increase in price level.

(A) I only (B) III only (C) I and II only (D) II and III only (E) I, II, and III

2. Which event could lead to a recessionary phase of the business cycle? (A) an increase in worker productivity (B) firms investing in new technology (C) an increase in consumer confidence (D) a supply shock that reduces the costs of production for firms (E) a reduction in the money supply

3. Which sectors of the economy are most strongly impacted by business cycles? (A) capital goods and consumer durable goods (B) services and consumer non-durable goods (C) public goods and exports

180 Chapter 26: Business Cycles, Unemployment. and Inflation

(D) imports and financial instruments (E) tax revenues and energy

4. Unemployment measures the percentage of people in the labor force who (A) are not working. (8) are not looking for jobs. (C) are actively looking for jobs. (D) have given up looking for jobs. (E) are not working or are only working part-time.

5. The official unemployment rate is not completely accurate because it leaves out I. people who have given up looking for work. II . people who have not filed for unemployment benefits. III. people who are working part-time but want full-time jobs. IV. people who do not have phones.

(A) I only (8) I and IV only (C) II and III only (D) II, III, and IV only (E) I, III, and IV only

6. A college graduate searching for her first job is experiencing (A) frictional unemployment. (8) structural unemployment. (C) seasonal unemployment. (D) cyclical unemployment. (E) underemployment.

7. Full employment is achieved when the economy experiences no (A) frictional unemployment. (8) structural unemployment. (C) seasonal unemployment. (D) cyclical unemployment. (E) underemployment.

8. If the consumer price index for this year is 240 and the CPI for last year was 200, what is the rate of inflation for this year? (A) -40% (8) 1.2% (C) 20% (D) 40% (E) 83%

9. IfDon ' s nominal income increases by 5% and the inflation rate increases by 3%, how did Oon's real income change? (A) It fell by 8%. (8) It fell by 2%. (C) It rose by 2%. (D) It rose by 5%. (E) It rose by 8%.

Chapter 26: Business Cycles, Unemployment, and Inflation 181

10. Which of the lollowing factors would cause demand-pull inflation? (A) an increase in the cost of raw materials for firms (8) an increase in the money supply (C) a significant decrease in the supply of energy products (D) a serious crop failure (E) a reduction in imports allowed into the country

II . Which of the following people is least likely to be hurt by unanticipated inflation? (A) retirees living on a fixed pension (8) people who have borrowed money to buy cars (C) savers earning income from interest on savings accounts (D) workers earning the minimum wage (E) creditors who provide loans to customers

12. If a bank charges customers a nominal interest rate of 12% for car loans and expects a 7% inflation rate over the life of the loan, what is the real interest rate? (A) -5% (8) 5% (C) 5.8% (D) 19% (E) 12%

Free-Response Question In Sereneland, the inflation rate increases by its expected average 2% per year. (a) Explain the effect of this inflation on the real income of a worker whose nominal income

rises 2% per year. (b) Now assume that this year, the inflation rate unexpectedly jumped to 10%. Explain the

effect of this increase in inflation on each of the following. (i) the worker whose nominal income rose 2% this year (ii) a retiree living on a fixed pension (iii) a senior citizen living on Social Security which is indexed with a COLA (iv) a homeowner paying a 30-year home mortgage with a fixed interest rate

Multiple Choice Explanations I. (C) As real GDP falls , fewer workers are needed to make the diminishing number of

products. While prices tend to be sticky downward, at the minimum they would remain the same and would not rise.

2. (E) A reduction in the money supply makes it more difficult and expensive for firms and consumers to obtain credit, so demand would fall.

3. (A) Capital goods are affected because firms can wait to invest until they expect a profitable return on their investment. Consumer durable goods are strongly affected because they tend to consume a large proportion of the consumer's budget, and consumers can make do with existing goods until the economy improves.

4. (C) Unemployment only measures those available for work who want jobs and are actively looking but cannot find one.

5. (E) Whether a person has filed for unemployment benefits is irrelevant to the calculation of the official unemployment rate.

6. (A) Frictional unemployment is the temporary unemployment that comes with entering the labor force or searching for a new job after losing another.

182 Chapter 26: Business Cycles, Unemployment, and Inflation

7.

8.

9.

10.

11.

12.

(D) Full employment . IT k d I

OCcurs where output is maximized so firms are not laymg 0 wor ers ue to ow product dem d ' (C) I fl . . an .

natIOn Rate == (ThIs Year's CPI - Last Year's CPI) I Last Year's CPI = (240-200) I 200 == 40 I 200 == 0.20 x 100 == 20%

~C) Don's paycheck rose by 5% but because prices increased by 3%, Don's real mcome- what he can buy with his paycheck-only rose 2%. (B) If too much money chases too few goods the excess demand pulls prices up. The other four options cause cost-push inflation by reducing supply. (B) Borrowers can actually gain from inflation, because the dollars they use to pay back the loan are not worth as much as the dollars they borrowed. (B) Real Interest Rate == Nominal Interest Rate _ Expected Inflation Rate == 12% -7% == 5%

Free-Response Explanation 10 points (2 + 8) (a) 2 points:

• I point is earned for stating that the worker' s real income would not change. • I point is earned for explaining that the wage increase only equals inflation.

(b) 8 points:

• I point is earned for stating that the worker' s real income would fall 8%. • I point is earned for explaining that the change in real wage equals the change in nominal

wage minus the change in the inflation rate (2% - 10% == -8%). • 1 point is earned for stating that the retiree's real income would fall. • I point is earned for explaining that prices increased but the retiree's income did not. • I point is earned for stating that the senior citizen's real income did not change. • I point is earned for explaining that the COLA is designed to change the nominal income

at the same rate as inflation, to keep real income the same. • I point is earned for stating that the homeowner gains from inflation. • I point is earned for explaining that the money repaid is not worth as much as the money

that was borrowed.

U loyment and Inflation Chapter 26: Business Cycles, nemp , 183