economic growth, business cycles, unemployment, and...

Economic Growth, Business Cycles,

Unemployment, and Inflation

CHAPTER 24

Remember that there is nothing

stable in human affairs; therefore

avoid undue elation in prosperity,

or undue depression in adversity.

— Socrates

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Economic Growth, Business Cycles, Unemployment, and Inflation 24

Macroeconomics

• Macroeconomics is the study of the economy as a whole—the “big picture”

• We look at the aggregate, or the whole economy

McGraw-Hill/Irwin Colander, Economics 2


Macroeconomics

• Macro was created to:

1. Measure the health of the whole economy

2. Guide government policies to fix problems



Two Frameworks: The Long Run and the Short Run

• To analyze macro issues, we look at two frameworks: the long run and the short run

• The long-run growth framework focuses on incentives for supply

• Sometimes called supply-side economics

• Issues of growth are considered in a long-run framework

24-4


The Short Run

• The short-run business cycle focuses on demand

• Sometimes called demand-side economics

• Business cycles are generally considered in a short-run framework

• Inflation and unemployment fall within bothframeworks



Economic Growth

• Growth is measured by:

• An increase in real GDP over time

• An increase in real GDP per capita over time (usually used to determine standard of living; more on this in CH 25)



Why Does the Economy Fluctuate?

• Retailer and producers send misleading information about consumer demand

• Advances in technology, productivity, or resources

• Outside influences (wars, supply shocks, panics)



The Business Cycle



The Business Cycle

• These fluctuations (and many more) are what make up the business cycle

• The business cycle is the upward or downward movement of economic activity, or real GDP

24-9


The Business Cycle

• Economists debate the causes of business cycles

• Keynesians: generally favor activist government policy—fluctuations should be controlled

• Classicals: generally favor laissez-faire policies—fluctuations are expected



U.S. Business Cycles

Percentage fluctuations in real GDP around trends

1860 1800 1900 1920 1940 1960 1980 2000

20

10

0

-10

-20

Business cycles have always been a part of the U.S. economic scene

Civil War

Panic of 1863

Panic of 1907

Recovery of 1895

World War IWorld War II

Korean War

Vietnam War

Great Depression

24-11


The Phases of the Business Cycle

• The four phases of the business cycle are:

• Expansion: where real GDP is growing

• Peak: the top of the business cycle (right before the downturn)

24-12



• Contraction: period where real GDP is falling

– A recession is two consecutive quarters where real GDP has fallen

– A depression is a prolonged period of economic decline




• Trough: the bottom of the business cycle where the contraction has ended and is about to make an upward turn



Draw the Business CycleTotal Output

Quarters21 3 4 21 3 4 21 3

Peak

Trough

Recession ExpansionExpansion

24-15


Why do Business Cycles Occur?

Duration (in months)

Business Cycles

Pre-World War II

(1854 – 1945)

Post-World War II

(1945 – 2006)

Number 22 11

Average duration 50 67

Length of longest cycle 99 (1870-79) 128 (1991-2001)

Length of shortest cycle 28 (1919-21) 28 (1980-82)

Ave. length of expansions 29 28

Length of shortest expansion 10 (1919-20) 12 (1980-81)

Length of longest expansion 80 (1938-45) 120 (1991-2001)

Ave. length of recessions 21 10

Length of shortest recession 7 (1918-19) 6 (1980)

Length of longest recession 64 (1873-79) 16+ (2007-)

24-16


Leading Indicators

• Leading indicators are the signs that indicate when a recession is about to occur



Examples of Leading Indicators

• Average work week

• Unemployment claims

• New orders for consumer goods

• Vendor performance

• Index of consumer expectations

• New orders for capital goods

• Building permits

• Stock prices

• Interest rate spread

• Money supply, M2

24-18


Unemployment



Unemployment

• The unemployment rate is the percentage of people who are willing and able to work but who are not working

24-20


Types of Unemployment

• Frictional unemployment: unemployment caused by people entering the job market/people quitting a job just long enough to look for and find another job

• People between jobs that are temporarily unemployed

• Examples: a parent reentering the workforce or a college graduate looking for a job




• Structural unemployment: unemployment caused by changes in the structure of the labor force make some skills obsolete

• Workers do not have transferable skills and these jobs will never come back

• Workers must learn new skills to get a job

• Also includes the outsourcing of jobs to other countries




• Cyclical unemployment: unemployment due to economic downturns/the business cycle




• Seasonal unemployment: unemployment due to seasonal work

• Example: an unemployed construction worker during the winter



Full Employment

• Full employment: an economic climate where nearly everyone who wants a job has one (5% unemployment)



Target Rate/Natural Rate of Unemployment

• The target rate/natural of unemployment is the lowest rate of unemployment that policy makers believe is achievable under existing conditions

• Generally, this is around 5%

• This means full employment is about 95%

24-26


Target Rate/Natural Rate of Unemployment

• The target rate/natural of unemployment changes due to:

• Inflation rates

• Demographics

• Social and institutional structures

• Changing government institutions



Whose Responsibility is Unemployment?

• Classical economists believe that individuals are responsible for their own jobs

• If people really want a job, they will find one

24-28


Whose Responsibility is Unemployment?

• Keynesian economists tend to say that society owes people jobs that fit with their training or past job experience

• Jobs should be close enough to home so that people don’t have to move



Calculating the Unemployment Rate

• The labor force is made up of those at least 16 years of age who are willing and able to work

• The labor force excludes those incapable of working and those not looking for work




• We start with the total civilian population and subtract those unavailable for work (those under age 16, in prison, or otherwise not available to work)

• Then, subtract those not in the labor force (homemakers, disabled, etc.)

• You are left with the potential workforce




Unemployment Rate = Number UnemployedLabor Force

X 100

24-32


Accuracy of the Unemployment Rate

• Does not include discouraged workers, people who do not look for a job because they feel they don’t have a chance of finding one

• Therefore, the unemployment rate is understated

24-33



• Does not take into account the underemployed, which are part-time workers who would prefer full-time work

• Includes people who say they are unemployed, but voluntarily don’t work




• The labor force participation rate is also looked at: this measures the labor force as a percentage of the total population at least 16 years of age

• The employment-population ratio is the number of people who are working as a percentage of people available to work




• Potential output is output that would be achieved at the target rates of unemployment and capacity utilization

• Okun’s rule of thumb states that a 1% change in the unemployment rate will be associated with a 2% change in output in the opposite direction

+ 1% Δ unemployment – 2% Δ in output

24-36


Inflation/Deflation



Inflation/Deflation

• Inflation a rise in the price level that reduces the purchasing power of money

• Deflation is a continual fall in the price level

• Hyperinflation: when inflation hits triple digits

24-38


Who Is Helped/Hurt by Unanticipated Inflation

Hurt by Inflation

• People who borrow money

• A business where the price of the product increases faster than the price of resources

Helped by Inflation

• Lenders: People who lend money (at fixed interest rates)

• People with fixed incomes

• Savers



Measuring Inflation

• A price index: a number that summarizes what happens to a weighted composite of prices of a selection of goods over time

• The most commonly used measurement inflation for consumers is the Consumer Price Index (CPI)



Price Indexes

• The CPI measures prices of only the goods and services bought by consumers

• Looks at a market basket of about 400 goods and services

24-41

CPI= Year 1 - Year 2Price of same market basket in the base year

X 100


Price Indexes

• Example: the market basket in 2009 was $540 and in 2010 it was $675. Calculate the price index.

• 675/540 x 100=125



Price Indexes

• Now, calculate inflation between those two years.

125-100

100


X 100 = 25%


Real vs. Nominal Interest Rates

• Nominal interest rate: the rate you pay or receive

• Real interest rate: the nominal interest rate adjusted for inflation

• Real interest rate=Nominal interest rate –inflation



Chapter Summary • Economists use two frameworks to analyze

macroeconomic problems:

• The long-run growth framework focuses on supply

• The short-run business cycle framework focuses on demand

• Growth is measured by the change in:

• Real gross domestic product (GDP)

• Per capita real GDP

24-45


Chapter Summary

• Business cycles are fluctuations of real output around the secular growth trend

• Phases of the business cycle are peak, downturn, trough, upturn

• Unemployment is calculated as the number of unemployed people divided by the labor force

• Unemployment rises during a recession and falls during an expansion

24-46


Chapter Summary • The target rate of unemployment is the lowest

sustainable rate of unemployment possible under existing institutions

• The lower the target rate of unemployment, the higher an economy’s potential output

• A real concept is a nominal concept adjusted for inflation

• Real output equals nominal output divided by the price index

• Inflation is the continual rise in the price level24-47


Chapter Summary

• The CPI, the PPI, and the GDP deflator are all price indexes used to measure inflation

• Expectations of inflation can provide pressure for inflation to continue even when other causes don’t exist

• Inflation redistributes income from people who do not raise their prices to people who do raise their prices

• Inflation reduces the information that prices convey

24-48

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