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Chapter 26

Business Cycles, Unemployment, and Inflation

Textbook Graphs and Tables Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Business Cycles

• Business cycle: alternating rises and declines in the level of Real GDP, which may last several years.

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Two Recent (Real) Business Cycles

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% Changes in Real GDP (2005 $)

• For more info: http://www.minneapolisfed.org/publications_papers/studies/recession_perspective/index.cfm

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Causes of Business Cycles

• Shocks: unexpected events that markets can’t adjust to in the short-term.

• Supply shocks: the supply of goods or resources changes suddenly– Irregular Innovation– Productivity Changes

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Causes of Business Cycles - Shocks

• Demand shocks: the demand for goods or resources changes suddenly → total spending changes (GDP = C + Ig + G + Xn)– Monetary factors– Political events– Financial instability

• Shocks can be positive or negative.

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Cyclical Impact: Components of Consumption

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Unemployment

• Labor force: people who are willing and able to work

• Unemployed: people who are not currently working, but have actively looked for work in prior four weeks.

• Unemployment rate = 100*(unemployed/labor force )

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GDP % change and Unemployment rate

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Three Types of Unemployment

1. Frictional: consists of workers who are searching for jobs or waiting to take a job.

2. Structural: when changes in consumer demand or technology over time change the structure of the job market (labor demand).

3. Cyclical: business cycle unemployment caused by a decline in total spending and production.

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“Full” Employment

• The economy is “fully employed” when there is only frictional and structural unemployment; i.e. there is no cyclical unemployment.

• The unemployment rate when the economy is “fully employed” is called the Natural Rate of Unemployment (NRU) – could be between 5-6% today.

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Full Employment & Potential GDP

• When the economy achieves the NRU, then the economy produces its potential GDP.

• Potential (full employment) GDP: the amount of output that the economy could have produced each year without changing the rate of inflation.→ GDP gap = actual GDP – potential GDP

13See also: http://www.washingtonpost.com/wp-srv/business/the-output-gap/index.html

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Unemployment Rates by Demographic Group

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Inflation

• Inflation: the percentage increase in the general price level.

• CPI (Consumer Price Index): the price of a “market basket” of 200-300 goods and services that are purchased by the average urban consumer.

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Calculating Inflation

Inflation rate from year 2008 to 2009:

= 100*[CPI (2009) – CPI (2008)]/CPI (2008)

= 100*(214.5 – 215.3)/215.3 = –0.4% deflation.

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Types of Inflation

• Demand-Pull: when increases in the price level are caused by an “over-heated” economy – when total spending exceeds the economy’s capacity of production for several periods.

• Cost-Push: when increases in the price level are caused by rising production costs, which results in decreases in production and employment.

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Inflation and Core Inflation

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Inflation and Real Income

• Real income = nominal income / price index.

→ %∆ real income ≈ %∆ nominal income – %∆ price level (inflation)

• Inflation tends to erode the purchasing power of income.

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Who is hurt by unanticipated inflation?

1. Fixed-income receivers

2. Savers

3. Creditors

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Who is unaffected or helped by unanticipated inflation?

1. Flexible-income receivers may get cost of living adjustments.

2. Borrowers (debtors)

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Real vs. Nominal Interest Rates

• An interest rate is the rate of return by a borrower to a lender.

• The real interest rate is the “purchasing power” rate of return.

• The nominal interest rate is the “dollar value” rate of return.

→ real interest rate ≈ nominal interest rate - inflation rate