ECON 201. The Business Cycle. Business Cycle 4 phases 10/1/2009. Chapter 6 Business Cycles, Unemployment, & Inflation

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1 ECON 201 Chapter 6 Business Cycles, Unemployment, & Inflation The Business Cycle The U.S. has experienced economic instability associated with business cycles. Business Cycles alternating rises and declines in the level of economic activity, sometime over several years. Business Cycle 4 phases 1. A peak is when business activity reaches a temporary maximum with full employment and near capacity output. 2. A recession is a decline in total output, income, employment, and trade lasting six months or more. 3. The trough is the bottom of the recession period. 4. Recovery is when output and employment are expanding toward full employment level. 1

2 Theories about Causation Major innovations may trigger new investment and/or consumption spending. Changes in productivity may be a related cause. Central banks adjusting the money supply Unexpected political events, wars, things like 9/11 Theories about Causation Most economists agree that the immediate cause of large scale cyclical changes is the expected change in the level of total spending So the level of aggregate spending is important, especially changes on capital goods and consumer durables. 2

3 Durable & Non Durable Goods Consumer Durables are affected most by the business cycle. Examples: Capital Goods (housing, commercial buildings, heavy equipment) Consumer Durables (automobiles, refrigerators, computers) Twin Problems The twin problems that arise from the business cycle are: Unemployment Inflation Unemployment 3 Groups 1. Under age 16 or institutionalized 2. Not in labor force 3. Labor Force includes those age 16 and over who are willing and able to work, and actively seeking work (demonstrated job search activity within the last four weeks). 3

4 Unemployment Rate The percentage of the labor force that is not employed (not the percentage of the population). Measured by the U.S. Bureau of Labor Statistics (BLS). Unemployment Rate Unemployed Labor Force = x 100 Unemployment Rate Calculated by random survey of 60,000 households nationwide. (Households are in survey for four months, out for eight, back in for four, and then out for good; interviewers use the phone or home visits using laptops) Unemployment Rate Underestimated Two Factors: 1. Part time workers are counted as employed. 2. Discouraged workers who want a job, but are not actively seeking one, are not counted as being in the labor force, so they are not part of unemployment statistic. 4

5 Three Types of Unemployment 1. Frictional 2. Structural 3. Cyclical l Types of Unemployment Frictional Unemployment consists of those searching for jobs or waiting to take jobs soon; it is regarded as somewhat desirable, because it indicates that there is mobility as people change or seek jobs. Types of Unemployment Structural Unemployment: due to changes in the structure of demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs changes. Examples : Glass blowers were replaced by bottle making machines. Oil field workers were displaced when oil demand fell in 1980s. Foreign competition has led to downsizing in U.S. industry and loss of jobs. 5

6 Types of Unemployment Cyclical Unemployment caused by the recession phase of the business cycle. As firms respond to insufficient i tdemand dfor their goods and services, output and employment are reduced. Extreme unemployment during the Great Depression (25 percent in 1933) was cyclical unemployment. Full Employment Does not mean zero unemployment something less that 100% employment of the Labor Force. The full employment unemployment rate = total frictional and structural unemployment. The full employment rate of unemployment is also referred to as the Natural Rate of Unemployment (NRU). Economic Cost of Unemployment: GDP gap and: GDP gap is the difference between potential and actual GDP. GDP Gap = Actual GDP - Potential GDP 6

7 Unequal Burdens of Unemployment Exist Rates are lower for white collar workers. Teenagers have the highest rates. Race and Ethnicity. Rates for males and females are comparable, though females had a lower rate in Less educated workers, on average, have higher unemployment rates than workers with more education. Inflation Defined: Inflation is a rising general level of prices (not all prices rise at the same rate, and some may fall). The main index used to measure inflation is the Consumer Price Index (CPI). To measure inflation, subtract last year s price index from this year s price index and divide by last year s index; then multiply by 100 to express as a percentage (also measured by the BLS). Consumer Price Index (also measured by the BLS) CPI = Price of the Most Recent Market Basket in the Particular Year Price of the Same Market Basket in x 100 7

8 Two Types of Inflation 1.Demand Pull 2.Cost Push Causes and Theories of Inflation Cost push or supply side inflation: Prices rise because of rise in per unit production costs (Unit cost = total input cost/units of output). Output and employment decline while the price level is rising. Supply shocks have been the major source of cost push inflation. These typically occur with dramatic increases in the price of raw materials or energy. Causes and Theories of Inflation Demand pull inflation: Spending increases faster than production. It is often described as too much spending chasing too few goods. 8

9 Redistribution Effects of Inflation Inflation redistributes real income from some people to others. Nominal & Real Income Nominal Income # of dollars received as wages, rent, interest, or profits. Real Income measure of the amount of goods and services nominal income can buy (the purchasing power of nominal income, or income adjusted for inflation). Real income = nominal income / price index (in hundredths) Who is Hurt by Inflation? Fixed Income Receivers Savers Creditors Who is Unaffected or Hurt by Inflation? Flexible Income Receivers Cost of Living Adjustments (COLAs) Debtors 9

10 Redistributive Effects of Inflation If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders. Inflation premium is amount that interest rate is raised to cover effects of anticipated inflation. Real interest rate is defined as nominal rate minus inflation premium. Inflation affecting output? As costs rise, demand falls for goods and services, so firms produce less, and unemployment goes up. Deflation the general decline in the level of prices in the economy very, very bad!!! Hyperinflation extraordinarily rapid inflation. Normal economic relationships are messed up consumers don t know what to pay, firms don t know what to charge End Chapter 7 10