Figure Sarver

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1 I. Learning Objectives In this chapter students will learn: A. About the business cycle and its primary phases. B. How unemployment and inflation are measured. C. About the types of unemployment and inflation and their various economic impacts. II. The Business Cycle A. Business cycles alternating rises and declines in the level of economic activity, sometimes over several years. B. Phases of the Business Cycle (Figure 26.1) Figure Peak business activity has reached a temporary maximum with full employment and output at or near capacity. Price levels are generally rising. 2. Recession decline in total output, income, and employment lasting six months or more. Significantly higher unemployment is a hallmark of recessions (Table 26.1). 3. Trough the bottom of the recession period when output and employment reach their lowest levels. 4. Expansion real GDP, output, and employment expand toward full employment level. If spending rises more quickly than production capacity, inflation will occur. C. The National Bureau of Economic Research (NBER) declares the start and end of recessions in the United States. D. Economic fluctuations are generally driven by unexpected economic shocks, and short run price stickiness is a major factor in preventing the economy from rapidly adjusting to such shocks. E. Causation 1. Irregular innovation 2. Productivity changes 3. Monetary factors 4. Political events 5. Financial instability

2 6. Whatever the source of economic shocks, most economists agree that the immediate cause of the large majority of cyclical changes in the levels of real output and employment is unexpected changes in the level of total spending. F. Capital goods and consumer durable goods are affected most by the business cycle, because spending for nondurable goods and services usually cannot be postponed. III. Unemployment A. Measurement of Unemployment 1. The unemployment rate is calculated by a nationwide random survey of 60,000 households. 2. The population is divided into three groups (Figure 26.2): a. Not members of the potential labor force (under age 16 or institutionalized) b. Not in the labor force (age 16 and over who are potential workers, but choose not to work, such as stay at home parents, full time students, and retirees) c. The labor force (age 16 and over who are willing and able to work). This includes those who are employed as well as those who are unemployed and have actively searched for a job within the last four weeks. 3. The unemployment rate is defined as the percentage of the labor force that is not employed (not the percentage of the population).

3 4. Two factors cause the official unemployment rate to understate actual unemployment. a. Underemployed workers part time workers who want full time work but cannot find it are counted as employed. b. Discouraged workers people who have been unemployed for so long that they have given up looking for work are counted as outside the labor force. They want a job, but are not actively seeking one, so they are not part of the unemployment statistic. B. Types of Unemployment 1. Frictional unemployment those searching for jobs or waiting to take jobs soon (voluntarily changing jobs, getting fired, looking for a first job, temporary layoff due to seasonal demand). It is regarded as somewhat desirable, because it indicates that there is mobility as people change or seek jobs. These people usually find jobs within a few months. 2. Structural unemployment changes in consumer demand and technology alter the structure of demand for labor, both occupationally and geographically. The composition of the labor force does not respond immediately or completely to the new structure of job opportunities (certain skills become obsolete due to a lack of product demand or because the worker has been replaced by technology; changes in the geographic distribution of jobs). It is serious and tends to be long term, because workers must retrain for new careers. 3. Cyclical unemployment caused by a decline in total spending, usually during the recession phase of the business cycle. As firms respond to insufficient demand for their goods and services, output and employment are reduced. 4. It is sometimes not clear which type describes a person s unemployment circumstances. C. Definition of Full Employment 1. The full employment unemployment rate (the natural rate of unemployment) equals the total frictional and structural unemployment. This occurs when the economy is producing at its potential output. 2. Full employment does not mean zero unemployment, because the frictionally unemployed need time to find their new jobs, and the structurally unemployed need time to train for their new careers. 3. The natural rate of unemployment is not fixed but depends on the demographic makeup of the labor force and the laws and customs of the nation. The natural rate of unemployment is currently between 4 and 5 percent. 4. The unemployment rate can briefly fall below the natural rate of unemployment when the demand for labor is very strong, and it can rise above the natural rate of unemployment when cyclical unemployment is high.

4 D. Economic Cost of Unemployment 1. GDP Gap and Okun s Law a. The GDP gap is the difference between actual and potential GDP (Figure 26.3). GDP Gap = Actual GDP Potential GDP

5 b. Okun s Law for every 1 percent of unemployment above the natural rate, a negative GDP gap of about 2 percent occurs. c. Actual GDP can exceed potential GDP for short periods of time, but it causes inflationary pressure and cannot be sustained indefinitely. 2. Unequal burdens of unemployment fall on the following groups (Table 26.2): a. Workers in lower skilled occupations b. Teenagers c. African Americans and Hispanics d. Rates for males and females are comparable, though males had a significantly higher unemployment rate during the Great Recession. e. Less educated workers f. The number of persons unemployed for long periods 15 weeks or more is much lower than the overall rate, but it significantly rises during recessions. It rose from 1.5 percent of the labor force in 2007 to 4.7 percent in The average length of unemployment rose to nine months in 2010, as a result of the Great Recession. E. Noneconomic costs include loss of skills, loss of self respect, family disintegration, social and political unrest, and increased poverty. F. Unemployment rates differ greatly among nations, largely because nations have different natural rates of unemployment (Global Perspective 26.1). IV. Inflation A. Inflation a rise in the general level of prices, which reduces the purchasing power of money. Not all prices rise at the same rate; some may remain steady or even fall. B. The main measure of inflation is the Consumer Price Index (CPI). The Bureau of Labor Statistics reports prices of a market basket of 300 goods and services purchased by the typical urban consumer. C. The rate of inflation is the percentage growth of the CPI from one year to the next. D. The rule of 70 permits quick calculation of the time it takes the price level to double. Divide 70 by the percentage rate of inflation to find the approximate number of years for the price level to double. E. In rare cases, as in 2009, the price level actually decreases, known as deflation.

6 F. Facts of Inflation 1. Inflation reached double digit rates in the 1970s and 1980s, but has moderated since then (Figure 26.4). 2. In the past, deflation has been as much a problem as inflation. For example, the 1930s Depression was a period of declining prices and wages. The prospect of deflation was also a concern of economic policymakers in the past decade. 3. All industrial nations have experienced inflation (Global Perspective 26.2). Some nations experience extreme inflation Zimbabwe s 2008 inflation rate was 14.9 billion percent until it eliminated its currency. G. Types of Inflation 1. Demand pull inflation excess demand bids up the price of limited output; too much spending chasing too few goods. a. When demand pull inflation is rapid and sustained, the cause invariably is an over issuance of money by the central bank. b. Consider This Clipping Coins i. Princes would clip coins, paying peasants with the clipped coins and using the clippings to mint new coins. ii. Clipping was essentially a tax on the population, as the increased money supply caused inflation and reduced the purchasing power of each coin. 2. Cost push inflation prices rise because of an increase in per unit production costs. a. The decrease in supply causes output and employment to decline while the price level is rising. b. Supply shocks, due to abrupt increases in the costs of raw materials or energy inputs, have been the major source of cost push inflation. 3. Complexities a. It is difficult to distinguish between demand pull and cost push causes of inflation unless the original source of inflation is known.

7 b. Demand pull inflation will continue as long as there is excess total spending, while cost push inflation is automatically self limiting. 4. Core Inflation a. Some price flexible items in the CPI particularly food and energy experience rapid changes in supply and demand, causing price volatility. Such changes are usually temporary and cancel each other out over time. b. Core inflation measures only the prices of the more stable elements of CPI. Policymakers use the core inflation rate in making economic policy decisions. V. Redistributive Effects of Inflation A. Nominal and Real Income 1. Nominal income the number of dollars received as wages, rent, interest, or profit. 2. Real income a measure of the amount of goods and services nominal income can buy. 3. If nominal incomes rise at the same rate as inflation, real income will not change. But if the price level changes at a different rate than a person s nominal income, real income will be affected. % change in real income = % change in nominal income % change in price level B. Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects. C. Who is Hurt by Inflation? 1. Fixed income receivers their real income suffers because their nominal income does not rise with prices. 2. Savers interest rate returns may not cover the cost of inflation, so their savings will lose purchasing power. 3. Creditors (lenders) borrowers pay back dollars that are less valuable than those received from the lender, so the creditor s real income declines. D. Who is Unaffected or Helped by Inflation? 1. Flexible income receivers incomes can be indexed to inflation (Social Security) or negotiated wages can include automatic cost of living adjustments (COLAs). In such cases, nominal incomes rise with the inflation rate, keeping real income stable. Business owners and landlords may benefit from demand pull inflation, if incomes rise more quickly than production costs. 2. Debtors (borrowers) borrowers receive dear money and are paying back cheap dollars that have less purchasing power, so their real income increases. E. Anticipated Inflation

8 1. If inflation is anticipated, the effects of inflation may be less severe; wage and pension contracts may have built in inflation clauses, and interest rates can be increased to cover the cost of inflation to savers and lenders. 2. An inflation premium (the expected rate of inflation) is amount that lenders raise the interest rate to cover effects of anticipated inflation. 3. Nominal interest rate = Real interest rate + the expected rate of inflation (Figure 26.5). F. Other Redistribution Issues 1. Unexpected deflation, a decline in price level, will have the opposite effects of unexpected inflation. 2. Many families are both helped and hurt by inflation because they are simultaneously borrowers and earners and savers. 3. The redistribution effects of inflation are arbitrary, regardless of society s goals and values. VI. Does Inflation Affect Output? A. Cost push inflation, where resource prices rise unexpectedly, reduces real output and employment, causing real income to fall. B. Mild inflation (less than 3 percent) has uncertain effects. It may be a healthy byproduct of a prosperous economy, or it may have a negative effect, as people undertake activities to avoid inflation. C. Hyperinflation extraordinarily rapid inflation can cause speculation, reckless spending, and more inflation. Because consumers and firms are so heavily focused on avoiding inflation or protecting their incomes, production and output significantly decrease. VII. LAST WORD: The Stock Market and the Economy A. Do changes in stock prices and stock market wealth cause instability? The answer is yes, but usually the effect is weak. 1. The wealth effect consumer spending rises as asset values rise (and vice versa). 2. The investment effect rising share prices lead to more capital goods investment (and vice versa).

9 B. Stock market bubbles can harm the economy by encouraging reckless speculation with borrowed funds or savings needed for other purposes. A stock market crash can cause unwarranted pessimism about the underlying economy. C. Stock price averages are included as one of ten Leading Indicators used to forecast the future direction of the economy. However, by themselves, stock values are not a reliable predictor of economic conditions.