Business Cycles, Unemployment, and Inflation

Chapter 26

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

26-2

Chapter Objectives

• The business cycle and its phases

• Measuring unemployment and inflation

• The types and impacts of unemployment and inflation

26-3

The Business Cycle

Leve

l of R

eal O

utpu

t

Time

Peak

Peak

Peak

Recession

Recession

Expa

nsio

n Expa

nsio

n

Trough

Trough

GrowthTrend

Durable and nondurable industries affected differently

26-4

Causes of Business Cycles

• Shocks and price stickiness– Change in output instead of price

• Supply and productivity shocks– innovation

• Monetary shocks• Financial bursts and bubbles• Unexpected political events• Common link

– Unexpected changes in spending

26-5

Unemployment

• Twin problems of the business cycle– Unemployment– Inflation

• Measurement of unemployment– Who’s in the labor force

• Problems with the unemployment rate– Part-time employment– Discouraged workers

Unemployment RateUnemployedLabor Force= x 100

26-6

UnemploymentUnder 16And/or

Institutionalized(71.8 Million)

2007 data

TotalPopulation

(303.6 Million)

Not inLabor Force(78.7 Million)

Employed(146.0 Million)

LaborForce(153.1 Million)

Unemployed(7.1 Million) Source: Bureau of Labor Statistics

26-7

Unemployment

• Types of unemployment–Frictional (search and wait)–Structural (occupational and

geographical)–Cyclical

• Full employment redefined–No cyclical unemployment

• Natural rate of unemployment • Full employment rate

26-8

Unemployment

• Natural rate of unemployment–1980’s 6%–Today 4-5%

• Aging labor force• Temp agencies and the internet• New welfare laws and work

requirements• Prison population has doubled

26-9

Cost of Unemployment

• Foregone output• Potential output• GDP gap

–(Actual output – potential output)–Negative or positive

• Okun’s Law–Each 1% above NRU creates negative

2% output gap

26-10

Unemployment

5,000

6,000

7,000

8,000

9,000

10,000

11,000

12,000

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

The GDP Gap12,000

11,000

10,000

9,000

8,000

7,000

6,000

5,000GD

P (b

illio

ns o

f 199

6 do

llars

)

0

2

4

6

8

10

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

The Unemployment Rate10

8

6

4

2

0

Une

mpl

oym

ent

(per

cent

of c

ivili

anLa

bor f

orce

)

Source: Congressional Budget Office & Bureau of Economic Analysis

GDP gap(positive)

GDP gap(negative)

Potential GDP

Actual GDP

26-11

Unemployment

• Unequal burdens–Occupation–Age–Race and ethnicity–Gender–Education–Duration

• Noneconomic costs–Psychological, social, political

26-12

Unemployment

Source: Bureau of Labor Statistics

Unemployment Rates in Five Industrial Nations,1995-2005

26-13

Inflation

• Rise in general level of prices• Consumer price index (CPI)

–Market basket –300 goods and services–Typical urban consumer–2 year updates

CPIPrice of the Most Recent Market

Basket in the Particular Year

Price estimate of the MarketBasket in 1982-1984

= x 100

Rate of Inflation

• Rate of inflation

This year index – last year index

last year index

26-14

26-15

InflationAnnual Inflation Rates in the United States,1960-2007

0

5

10

15

1960 1970 1980 1990 2000

Infla

tion

Rat

e (p

erce

nt)

Source: Bureau of Labor Statistics

26-16

Inflation

Source: Bureau of Labor Statistics

Inflation Rates in Five Industrial Nations,1995-2005

26-17

Inflation

• Types of Inflation– Demand pull: resources fully employed, cant

meet demand, higher prices– Cost-push: rise in ATC, lower output, higher

prices – often due to supply shocks– Complex dynamic, often hard to diagnose

• Redistributive Effects– Nominal (just dollars) and real

(nominal/price index) income– Growth in nominal income vs. inflation rate– Anticipated vs. unanticipated inflation

26-18

Inflation

• Who is hurt by inflation?– Fixed-income receivers– Savers– Creditors

• Who is unaffected or not hurt by inflation?–Flexible-income receivers

• Cost-of-living adjustments (COLAs)• Demand-pull beneficiaries

–Debtors

26-19

Anticipated Inflation

–Nominal Interest Rate –Real Interest Rate–Inflation Premium

NominalInterest

Rate

RealInterest

Rate

InflationPremium

11%

5%

6%= +

26-20

Other Inflation Issues• Deflation• Mixed effects - diversified• Arbitrariness – whammy…• Cost-push inflation and real output

– “Stagflation”• Demand-pull inflation and real output

– Efficiency loss?– A little inflation as a trade-off for more

productivity?• Hyperinflation

– No stability - chaos

26-21

The Stock Market

• Stock prices and macro instability• The market for stocks• Volatile stock prices• Wealth effect• Investment effect• Little impact on macroeconomy• Stock market bubbles do have an

impact• Index of Leading Indicators

26-22

Key Terms• business cycle• peak• recession• trough• expansion• labor force• unemployment rate• discouraged workers• frictional unemployment• structural unemployment• cyclical unemployment• full-employment rate of

unemployment• natural rate of unemployment

(NRU)• potential output• GDP gap

• Okun’s law• inflation• Consumer Price Index (CPI)• demand-pull inflation• cost-push inflation• per-unit production costs• nominal income• real income• anticipated inflation• unanticipated inflation• cost-of-living adjustments

(COLAs) • real interest rate• nominal interest rate• deflation• hyperinflation

26-23

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