Chapter 3: Business Cycle, Inflation and Unemployment

8/10/2019 Chapter 3: Business Cycle, Inflation and Unemployment

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Chapter 3

Business Cycle, Unemployment,

and Inflation


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The Business Cycle

The business cycle may be defined as the

periodic ups and downs of the economy. It

generally affects national output, income and

employment, and normally lasts between two

to ten years. The depression after the great

stock market crash in the US in October 1929

lasted arguably for seven years (up to 1936)


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The Business Cycle


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The Business Cycle

Peaks and depressions are theturning points od the cycle, whilerecessions and recoveries are themajor phases.

Recessions generally characterized by

a weakness in aggregate demand inrelation to aggregate supply resultingto a general build-up of unwantedinventory that results to widespreadunemployment. The economy is saidto be in recession when the real GNPdeclines for at least two consecutivequarters in a given year.

The peak in the business cycle is themost ideal stage. It is characterizedby full employment of resources, highemployment, high income and highoutput. At this stage, crime rate isbecoming negligible as peoplebecome generally contented withtheir lives as their level of incomegenerally support their needs andwants.

Since the general appreciation andacceptance of the macroeconomicstheory and the widespread utilizationof fiscal and monetary policyworldwide, recessions had beenshallow and no economy in the freeworld had since experienced adepression.


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The Business Cycle

Depression is the lowest point of the business cycle. It ischaracterized by relatively very low level of aggregatedemand that results to very low level of business activity,low income, alarmingly widespread unemployment andrapidly increasing crime rate.

Recovery is the phase in the business cycle characterized bythe increasing level of business activity resulting from thepick-up of aggregate demand, which is further resulting

from increasing national income. At this stage, unwantedinventory is slowly and consistently being wiped out due toa general increase in demand


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The Business Cycle

Business cycle is a description of the fluctuations in the general level of economicactivity in an economy as measured by changes in variables such as real GDP,employment, and unemployment

1. Business Peak. When most businesses in the economy are operating at capacity,real GDP is growing rapidly and unemployment has fallen. It is not sustainable

over along period of time and thus leads to contraction.

2. Contraction. Aggregate business condition slow, real GDP growth falls and mayeven turn negative, and unemployment begins to rise.

3. Recessionary Through. Economic slowdown reaches at its lowest. From thispoint onward, aggregate economic activity tends to rise.

4. Expansion. This is when aggregate activity completely recovers from theprevious slowdown. Real GDP growth rises, firms begin to increase their capacityutilization, and unemployment begins.


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Table 3.1

Relationship of Cycle and Economic

SectorsEconomic

Slowdown

Slowdown

Recovery

Economic

Expansion

Expansion Peak

Economy

Slowing

Slow

Growing

Decelerating

Monetary Policy

Neutral

Easy

Neutral

Tight

Interest Rates

Falling

Falling

Rising

Rising

Profits

Slowing

Falling

Rising

Decelerating

Sector Group

Expected to do Well

Finance

Health care

Consumer

Cyclical

Basic capital goods

Technology and

energy

Utilities

Stock

Characteristics

Non-cyclical

Blue chip

High yield

Economic sensitive

visible earning

growth oriented

Cyclical leverage

high growth

Non-cyclical visible

earning high-yield


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Output and Employment

The use of index leading to economicindicators is a composite index of 11key variables that generally turndown prior to a recession and turn upprior to recovery. The changes in theindex are used to forecast futurechanges in the state of economy, but

there is a significant variability in thelead-time of the index; and hence,the index is not always an accurateindicator of the economys future.

1. Length of average work week inhours

2. First partial weekly claims forunemployment compensation

3. New orders

4. Percentage of companies receiving

slower deliveries from suppliers ofmanufactured goods

5. Arrival of new contracts and orderof new plant and equipment

6. Permits for a new structure chart

7. Change of unfilled orders fordurable goods

8. Change of material prices

9. Changes in S and P index

10. Change in money supply

11. Index of consumer expectations


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Key Labor Market Indicators

1. Civilian Labor Force. Number of persons, 16

years of age or greater, who are either

employed or are actively seeking for work

2. Unemployed. A person who is not currently

employed who is either a) actively looking for

a job or b) waiting to begin or to return to a

job.

3. Labor Force Participation Rate. Number of

persons in the civilian labor force, who are 15

years old or older and are either employed or

actively seeking for work, as a percentage of

total civilian population 15 years of age or

older.

4. Unemployment Rate. Percentage of persons

in the labor force who are currentlyunemployed.

Problems in Measuring Unemployment

a. It doesnt count discouraged workers as

unemployed because they have given up

looking for a job;

b. It doesnt adjust for underemployed workers

those working part-time who would prefer beworking full time; and

c. It doesnt count non-marketemployment such as stay-at-homefathers/mothers as employed, eventhough they would be consideredemployedif working as maids, cooks, ornannies.

5. Full Employment. Level of employmentthat result from the efficient use oflabor force after making allowances forthe normal rate of unemploymentconsistent with information costs,dynamic changes and structuralcharacteristics of the economy

6. Natural Rate of Unemployment.Long-

run average level of unemployment dueto frictional and structural conditions inthe economys labor markets. This levelis not set in stone but rather is affectedby dynamic economic change and publicpolicy over time.


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Key Labor Market Indicators

Inflation. The sustained rise in the generallevel of prices of goods and services in theeconomy. Annual inflation rate is calculatedas the percent change in a chosen price index(PI).

Harmful Consequences of Inflation

a. Anticipated Inflation. An increase in thegeneral level of prices that was expectedby most decision-makers on the economy.

b. Unanticipated Inflation. An increase in thegeneral level of prices that was notexpected by most decision-makers on theeconomy

Unanticipated inflation alters the outcomeof the long-term projects, increases the risksof long-term investment activities, and oreduces the amount of long-term investment

undertaken. Less investment today is likely tlead to lower levels and growth of output inthe future.

Inflation distorts the information containedn prices. This distorts the signals of scarcityor plenty contained in prices, reducing theeffectiveness of markets and harmingeconomic activity.

High and variable rates of inflation leadpeople to try to protect themselves frominflation risk. This is likely to harm currentproduction as resources are devoted toinflation protection.

Inflation Ratet =PIt PIt 1

PIt 1x100


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Fiscal Policy

To explain the process which fiscal policy affects aggregate demand andaggregate supply, it can be simply said that:

Fiscal policy affects Da directly through government spending andindirectly though effects of taxes on consumption and investment. Taxesmay affect Sa by changing incentives for workers and firms. Fiscal policycan be restrictive (lowers Da) or expansionary (raises Da)

It will also explain the importance of the timing of changes in fiscalpolicies and the difficulties in achieving proper timing.

Recognition lags, implementation lags, before policy passes;effectiveness lags before policy works. If timed correctly, it can stabilizeeconomy; if not, policy will bring more instability (usually in oppositedirection).


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Fiscal Policy

Discuss the impact of expansionary and restrictive fiscal policy based onthe basic Keynesian model, the crowding-out model, the new classicalmodel and the supply-side mode;

1. Keynesian Model. Assumes SRAS is upward-sloping when the economyis in recession (below LRAS), expansionary fiscal policy shifts out AD,moves economy back to LRAS

2. Crowding-Out Model. Similar but notes expansionary fiscal policy raisesgovernment deficit, which changes interest rates and exchange rates.These changes lower investment and net exports, partly offsettingexpansionary fiscal policy

3. New Classical Model. Believes fiscal policy has no effect because anychange in deficit (from spending or tax changes) is offset by changes inprivate saving behavior.

4. Supply-Side Model. Believes tax changes affect productivity and so canincrease equilibrium output in the long run.


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Fiscal Policy

National Income Identity:

Y= C + I + G + NX

Rearrange yields

YCG = I + NX or

(YCT) + (TG) = I + NX

Where:

YCT = Private Savings = S

TG = budget balance

Note: if S and I re fixed, then increased in Budget Deficit, {(TG)more negative}, implies that NX s more negative, i.e. larger CurrentAccount Deficit


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Fiscal Policy

Supply-Side Effect of Fiscal Policy

Changes in tax rates, particularly marginal tax

rates, affects aggregate supply thorough their

impact on the relative attractiveness of productiveactivity In comparison to leisure time and tax

avoidance. Supply-side tax cuts are a long-term

growth-oriented strategy that will eventually

increase both SRAS and LRAS.


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Fiscal Policy

Budget Deficits, Inflation, and Real Interest

Rates

In theory, higher government budget deficits

should lead to higher real interest rates b loanablefunds market analysis. In practice, effect is not asstrong as expected.

Higher government budget deficits may lead to

higher inflation rates and higher nominal interestrates, if government finances deficit by printingmoney


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Unemployment

Unemployment may be defined as a condition in theeconomy where a significant number in the laborforce are out-of-work. It is a situation in the economywhereby for one reason or another, available

resources are not fully used for productive purposes.

The rate of unemployment may be measured bythe ratio of the actual number of people who are

out-of-wok by the total who are in the laborforce:

Unemployment Rate=Number without Work

Number in the Labor Force


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Unemployment

However, not everyone who are alive and kicking are members ofthe labor force. There are those who are not. These are:

1. Retirees who are 65 and above.

2. Retardates (physical and mental)

3. Below 15 years old

4. Students who are currently enrolled

Therefore, only those who do not fall in any of the abovecharacteristics who are out of work should be included in counting

the number of people who are unemployed because any personwho belongs to any of the above categories is considered as notbelonging to the labor force.


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Unemployment

Example.

Given an economy with a labor force of5,000,000 out of total population of15,000,000. If 2,000,000 are out-of-work,and the breakdown of those who are not

working are:

500,000 retirees

130,000 retardates

200,000 below 15 years old

300,000 students presently enrolled

And the remaining does not belong toany of the four categories.

Question;

What is the economys unemploymentrate?

Solution:

= 2,000,0001,130,000

= 870,000

These are the actual number ofpeople who are counted as unemployed

Answer:= 870,000 / 5,000,000

= 17% This is the economysunemployment rate


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Types of Unemployment

Frictional Unemployment. Thepeople who fall under thisclassification are those who aretemporarily out-of-work but are sureto have work very shortly. These arethose who have just resigned from aprevious job but who are just

completing the requirements to startin another job; those OFWs who justfinished their contracts but about tosign another contact and will leavefor abroad shortly; those who work incontractual basis in malls, and otherstores. E.g., SM, Jollibee, McDonalds,

who had end-of-contract but willsoon be rehired after a month ortwo.

Structural unemployment. Thepeople who belong to thisclassification are those who becomeunemployed due to changes in theoperating and market environments.These are those who lost their jobsbecause their skills became irrelevant

due to changing technology andconsumer demand. For example, askilled typist who, for one reason oranother, cannot adopt to learn howto use a computer will find himselfirrelevant and unemployed later on.Another example is a worker whose

only skill is to make hula-hoops. Sincenobody buys this thing anymore, hewill become unemployed later on ifhe refuses or fails to learn anotherskill that could make him relevantagain.


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Types of Unemployment

Cyclical Unemployment. Thepeople who fall under thiscategory are those who lost theirjob because of the downturn(recession) in the economy. Forexample, at the lowest point of

the Asian financial crisis, the realestate industry suffered the most,so that those who were workingin this industry got unemployedbecause of the severe lack ofdemand for housing and officespace. They are the victims ofcyclical unemployment. As of thiswriting real, estate industry hasnot yet recovered fully after fiveyears starting 1997.

Seasonal Unemployment. Thosewho experience this kind ofunemployment are the peoplewho are engaged in theproduction of goods and serviceswhose demand are affected by

the changes in the season. Forexample, those who make a livingin producing Christmas tree,Christmas cards, fireworks andothers that are only in demandduring the Christmas and NewYear months (November toDecember); those who makeraincoats and umbrellas whoseproducts are principally indemand only during rainy months(June to October).


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General Theories of Unemployment

1. Classical Theory. States that unemployment is a unction of wage artesuch that a lower wage level, unemployment is reduced and higher wagelevel, unemployment increases.

Since a theory is supposed to be premised on the set of observable factsleading to its formulation, we can say that this theory actually holds at that

time. Remember that the classical thoughts held from the time of Adam Smithin the 18thcentury up to the time of Alfred Marshall at the beginning of the20thcentury, until its final demise in 1936.

During these times, the prevalent economic activities were agriculture andhandicrafts, and industry was just in its infancy stage. At this time, landlordswere also farmers by skills and shop owners are also craftsmen themselves.Hence, when wage increases; these owners can easily turn themselves from

owner-manager to owner-farmer or owner-craftsman. In other words, theycan do away with extra hands if they think that the marginal output of theirextra hands will not justify their marginal costs attached to their employmentin their fields or shops.


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This graph shows the

relationship of wage

and quantity of labor

employed at differentwage levels as viewed

by the classical

economists


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2. Keynesian Theory.

In his General Theory of Employment, Interest and Money, J.M.Keynes argued that in the modern industrial set-up, wage isnot the primary determinant of employment but other factors.

He suggested that for as long as the firm believes thatadditional labor will give it positive marginal income, it willcontinue to hire labor regardless of the age rate is pays.

In a vibrant economy, a high wage rate gives the consumer

high purchasing power which can sustain demands for goodsand services produced by the firm which will motivate the firmto employ more resources and hire more labor to cope withthe high demand. Hence, promoting more employmentdespite high wages instead of instigating unemployment.


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Inflation

Inflation may be defined as a phenomenonwhereby a sustained increase in the generalprice level is happening, lead by the market

increases in the prices of basic commodities.

In the Philippines, inflation rate is indicated

by the upward movement of the price of thebasket of commodities that are included in thecalculation of the national price index.


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Inflation

1. Demand-Pull Inflation. This kind of inflationhappens when the increase in aggregate demandgrows faster than the increase in the aggregatesupply which creates a shortage of supply in theeconomy it happens when the level of moneysupply exceeds the ideal level, so that additionalpurchasing power is put in the hands of theconsumers without the corresponding additionaloutput created in the economy so that there istoo much money chasing too few goofs.

2. Cost-Push Inflation. This type of inflation occurswhen external forces affect the price equilibriumin an economy.

For example, the real cause of the increase in thedomestic price of gasoline comes from outside ofour shore. Wherever OPEC (Organization ofPetroleum Exporting Countries) increases prices the

price of its crude oil, inflation is brought to ourshores. Since OPEC is not part of our country, (theyare mostly composed of middle Eastern countries),our government is not able to do anything about it.

As it name implies, cost-push inflation always

starts from the arbitrary decision of those

resource owners with market power to increase

the price of their products to gain higher

returns.

3. Structural Inflation. This type of inflation

happens when some sectors of the economy

us unable to adjust to changes in the level

and composition of aggregate demand. For

example, when supply is unable to respond to

an abrupt increase in demand, like when an

earthquake hit Baguio in 1990, prices of basic

commodities skyrocketed in that area

because supply cannot pass through thedestroyed roads leading to that place. It can

also happen to a particular industry that

experience acute shortage of skilled labors

that is unable to produce enough supply to

cope with existing demand.


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Measurement of Inflation

Inflation rate can be

calculated by dividing

the change in the price

index by the price indexof the base year:

Where: CPI =

Consumer Price Index

Example:

Given:

CPI1= 120

CPI2= 130

Find:

Inflation Rate =

Inflation Rate=(CPI2-CPI1)

(CPI1)

Inflation Rate=130-120

120=8.33%


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Inflation

Who are Affected?

Inflations affects everyone, both individuals and

firms; households and government; rich and poor

alike; employed and unemployed. Inflation isalways a public issue; hence, governments always

consider the inflationary effect of most of their

spending and tax collection policies.

Documents

Chapter 3: Business Cycle, Inflation and Unemployment