Business Cycles, Unemployment, and Inflation

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

The Business Cycle

• Alternating increases and decreases in economic activity over time

• Phases of the business cycle

• Peak

• Recession

• Trough

• Expansion

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The Business CycleL

evel

of

real

ou

tpu

t

Time

Peak

Peak

Peak

Recession

Recession

Expa

nsio

n Exp

ansi

on

Trough

Trough

Growth

Trend

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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 -3.7

Source: National Bureau of Economic Research, www.nber.org, and Minneapolis Federal Reserve Bank, www.minneapolisfed.gov. Output data are in 2000 dollars

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Causation: A First Glance

• Business cycle fluctuations

• Economic shocks

• Prices are “sticky” downwards

• Economic response entails decreases in output and employment

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Causation: A First Glance

• Causes of shocks

• Irregular innovation

• Productivity changes

• Monetary factors

• Political events

• Financial instability

•Recession of 2007

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Cyclical Impact

• Durable goods affected most

• Capital goods

• Consumer durables

• Nondurable consumer goods affected less

• Services

• Food and clothing

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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

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Unemployment

• Criticisms of unemployment

• Involuntary part-time workers counted as if full-time

• Discouraged workers are not counted as unemployed

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Types of Unemployment

• Frictional unemployment

• Individuals searching for jobs or waiting to take jobs soon

• Structural unemployment

• Occurs due to changes in the structure of the demand for labor

• Cyclical unemployment

• Caused by the recession phase of the business cycle

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Definition of Full Employment

• Natural Rate of Unemployment (NRU)

• Full employment level of unemployment

• Can vary over time•Demographic changes

•Changing job search methods

•Public policy changes

• Actual unemployment can be above or fall below the NRU

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Economic Cost of Unemployment

• GDP Gap

• GDP gap = actual GDP – potential GDP

• Can be negative or positive

• Okun’s Law

• Every 1% of cyclical unemployment creates a 2% GDP gap

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Economic Cost of Unemployment

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Economic Cost of Unemployment

Economic Cost of Unemployment

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Unequal Burdens

• Occupation

• Age

• Race and ethnicity

• Gender

• Education

• Duration

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

Demographic Group

Unemployment Rate

2007 2009

Overall 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

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Noneconomic Costs

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• Loss of skills and loss of self-respect

• Plummeting morale

• Family disintegration

• Poverty and reduced hope

• Heightened racial and ethnic tensions

• Suicide, homicide, fatal heart attacks, mental illness

• Can lead to violent social and political change

Global Perspective

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Inflation

• General rise in the price level

• Inflation reduces the “purchasing power” of money

• Consumer Price Index (CPI)

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CPIPrice of the Most Recent Market

Basket in the Particular Year

Price estimate of the MarketBasket in 1982-1984

= x 100

CPI207.3 - 201.6

201.6= x 100= 2.8%

Inflation

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Inflation Rates in Five Industrial Nations

Inflation

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Types of Inflation

• Demand-Pull inflation

• Excess spending relative to output

• Central bank issues too much money

• Cost-Push inflation

• Due to a rise in per-unit input costs

• Supply shocks

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Inflation

• Difficult to distinguish inflation types

• Types differ in sustainability

• Demand-pull continues as long as the excess spending continues

• Cost-push ends in a recession

• Core inflation

• Without food and energy goods

• Focuses on more stable prices

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Redistribution Effects of Inflation

• Nominal income

• Unadjusted for inflation

• Real income

• Nominal income adjusted for inflation

• Anticipated vs. unanticipated incomePercentagechange in real income =

Percentage change in nominal income

Percentage change inprice level

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Who is Hurt by Inflation?

• Fixed-income receivers

• Real incomes fall

• Savers

• Value of accumulated savings deteriorates

• Creditors

• Lenders get paid back in “cheaper dollars”

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Who is Unaffected by Inflation?

• Flexible-income receivers

• COLAs

• Social Security recipients

• Union members

• Debtors

• Pay back the loan with “cheaper dollars”

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Anticipated Inflation

• Real interest rate

• Rates adjusted for inflation

• Nominal interest rate

• Rates not adjusted for inflation

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Anticipated Inflation

NominalInterest

Rate

RealInterest

Rate

InflationPremium

11%

5%

6%

= +

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Other Redistribution Issues

• Deflation

• Mixed effects

• Incomes may rise

• Fixed assets values may fall

• For fixed-rate mortgages, real debt declines

• Arbitrariness

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Does Inflation Affect Output?

• Cost-Push inflation

• Reduces real output

• Redistributes a decreased level of real income

• Demand-Pull inflation

• One view is that zero inflation is best

• Another view is that mild inflation is best

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Hyperinflation

• Extraordinarily rapid inflation

• Devastates an economy

• Businesses don’t know what to charge

• Consumers don’t know what to pay

• Money becomes worthless

• Zimbabwe’s 14.9 billion percent inflation in 2008

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The Stock Market and the Economy

• Stock prices changing

• Wealth effect

• Investment effect

• Typical changes lead to weak effects

• Stock market bubbles

• Huge unwarranted rises in stock prices

• Excessive optimism and frenzied buying

• Can be detrimental to an economy