27

Business Cycles, Unemployment,

and Inflation

McGraw-Hill/Irwin

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

The Business Cycle

Economic cycle or Boom-Bust cycle

Alternating increases and decreases in
economic activity over time

is measured and tracked in terms of GDP

and unemployment

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27-2

How do business
cycles work?

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27-3

Phases of Business cycle

Expansion
Peak
Contraction
Trough

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27-4

Hypothetical Business cycle

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27-5

The Business Cycle

Peak

Peak

Rec
ess
io

an

si

on

th
w
o
r
G
n

Re
ces
sio
n

Ex
pa
ns
i on

d
Tren

Trough

Ex
p

Level of real output

Peak

Trough

Time

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27-6

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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27-7

Causation: A First Glance

General Sources of Shocks that can

cause business cycle
Irregular innovation
Productivity Changes
Monetary factors
Political events
Financial instability
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27-8

Cyclical Impact

During a recession, industries that

produce capital goods and consumer
durables normally suffer greater
output and employment declines than
do service and nondurable consumer
goods industries

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27-9

Unemployment

Is the state a person is in if he or she

cannot get a job despite being willing
to work and actively seeing work.

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27-10

Measurement of Unemployment

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27-11

The BLS divides the total U.S population into

three groups:

First group- people under 16 years of age

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- People who are institutionalized

Second group- not in labor force
- adults who are potential workers
Third group- labor force
- people who are able and willing to
work
27-12

Unemployment Rate =
Unemployment/Labor Force x
100

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27-13

Types of Unemployment

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26-14

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Frictional unemployment
-workers who are either searching for jobs or
waiting to take jobs in the future
Structural unemployment
-workers who find that their skills and experience
have become obsolete or unneeded thus find
that they have no marketable talents
Cyclical unemployment
- Caused by a decline in total spending
- Results from insufficient demand for goods and
services
27-15

Definition of Full Employment

Economist say that the economy is

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fully employed when it is

experiencing only frictional and
structural unemployment
Fully employed economy does not
mean zero employment

26-16

Economic Cost of Unemployment

GDP Gap
Above the natural rate means that

society is operating at some point

inside its possibility curve
GDP gap = actual GDP potential
GDP
Can be negative or positive

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26-17

Economic Cost of Unemployment

Okuns Law
Indicates that for every 1 percent-

age point by which the actual

employment rate exceeds the
natural rate, a negative GDP gap of
about 2 percent occurs

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26-18

Unequal Burdens

Occupation
Age
Race and ethnicity
Gender
Education
Duration

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26-19

Noneconomic Costs

Widespread joblessness increases

poverty
Heightens racial and ethnic
tensions
Reduces hope for material
advancement

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26-20

Noneconomic Costs

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,

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mental illness
Can lead to violent social and political
change
26-21

Inflation

A sustained increase in the aggregate

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or general price level in an economy.

There is an increase in the cost of living

26-22

Inflation

General rise in the price level

Inflation reduces the purchasing power

of money
Consumer Price Index (CPI)

CPI =
CPI =
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Price of the Most Recent Market

Basket in the Particular Year
Price estimate of the Market
Basket in 1982-1984

207.3

201.6

201.6

x
x

100

100
= 2.8%
26-23

Types of Inflation

Demand-Pull inflation
Excess spending relative to output
Central bank issues too much

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money
Cost-Push inflation
Due to a rise in per-unit input costs
Supply shocks

26-24

Complexities

It is difficult to distinguish between

Demand-pull inflation and Cost-push
inflation

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26-25

Complexities

Another complexity is that cost-push

inflation and demand- pull inflation differ in
sustainability
Demand-pull inflation will continue as
long as there is excess in total spending
Cost-push inflation is automatically self
limiting

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26-26

Core Inflation

The underlying increase in Consumer

Price index after volatile food and energy
prices are removed

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26-27

Redistribution Effects of Inflation

Nominal income
Number of dollars received as

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wages, rent, interest, or profit

Real income
The measure of amount of goods
and services nominal income can
buy

26-28

Redistribution Effects of Inflation

Real income = Nominal income/ Price

index in Hundreds
Real Income will remain the same
when nominal income rises as the
same percentage rate as does the
price index
Percentage change in real income ~=
Percentage change in nominal income
Percentage change in Price level
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26-29

Anticipated vs. Unanticipated

income

Anticipation
The redistribution effects of inflation
depend whether or not it is
expected

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26-30

Who is Hurt by Inflation?

Unanticipated inflation hurt fixed

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income receiver, savers and creditors;

It redistributes real income away from
them and towards the other

26-31

Who is Hurt by Inflation?

Fixed-income receivers

People whose incomes are fixed see their real

income fall when inflation occurs

Savers

As price rise, the real value or purchasing

power of an accumulation of savings
deteriorates

Creditors (Lenders)

As the price rise, the value of money repaid to

the lender has less purchasing power than
when the money is lend

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26-32

Who is Unaffected(Helped) by
Inflation?

Unanticipated
Inflation redistributes real income
towards them and away from the
others

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26-33

Unanticipated inflation

Flexible-income receivers
Social Security recipients
COLAs
Union members
Debtors
Pay back the loan with cheaper
dollars

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26-34

Anticipated inflation

Anticipated inflation
The redistribution effects of inflation
are less severe are eliminated if
people anticipate inflation

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26-35

Anticipated inflation

Labor union will insist Labor contracts

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with the cost of living adjustments

The charged of inflation premium of
lenders
Financial institution developed
variable interest rate mortgages

26-36

 Real interest rate- percentage

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increase in purchasing power that the

borrower pays the lender
Nominal interest rate- percentage
increase in money that the borrower
pays the lender
Nominal Interest Rate = Real Interest
Rate + Inflation premium (expected
rate of inflation)
26-37

Other redistribution issues

Deflation declines in the price level,

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effects are reverse of those of

inflation
Mixed effect- individuals who are
simultaneously hurt and helped by an
anticipated inflation
Arbitraries- The redistribution effects
of inflation occurs regardless of
societys goals and values
26-38

Does Inflation Affect Output?

Cost-push inflation
Reduces real output
Redistributes a decreased level of

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real income
Demand-pull inflation
One view is that zero inflation is
best
Another view is that mild inflation is
best
26-39

Hyperinflation

Extraordinarily rapid inflation

Can have a devastating impact on
real output and employment

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26-40