ECON 102 – Introduction to Economics II
Spring 2006
Dr. Ebru Güven Solakoğlu
Fatih University
Week 3
Business Fluctuations, Unemployment and Economic Growth
Business Cycle: ........................................................................................................... 1
Unemployment:........................................................................................................... 2
Economic Interpretation of Unemployment: .............................................................. 3
The Natural Rate of Unemployment (NRU) ............................................................... 4
Basic Facts about Potential Real GDP: ....................................................................... 4
The short-term variations in economic activity are known as business cycles, or business
fluctuations.
Why is it important to understand the business fluctuations?
 Because, increases in real GDP imply that the economy’s aggregate production has
increased. More production means,
1. more goods and services are available for consumption,
2. more resource are being used; therefore more people are employed, which is
good for employment opportunities and income.
 Because, decreases in real GDP imply decreases in income, employment
opportunities and the standard of living.
The theory of aggregate demand is the best way to understand business fluctuations.
Business Cycle:
Business cycle describes the fluctuations in real GDP. The fluctuations are neither
regular nor predictable. But over the long run what we observe is the trend is upward.
Business cycle is characterized by peaks and troughs of real GDP fluctuating about an
upward trend line.
Real
GDP
peak
expansion
contraction
trough
recession
recovery
time
Peak: the highest level of real GDP in the cycle.
An economy at its peak is operating at close to full capacity.
Contraction: A downturn from peak economic activity during which real GDP declines
from its previous value.
Recession: A (severe) contraction that occurs for 2 consecutive three-month periods.
Trough: the lowest level of real GDP in the cycle.
Expansion: an upturn of economic activity following a trough. (real GDP increases)
Recovery: an expansion in economic activity after a trough if the expansion follows a
recession.
Unemployment:
Statistics on unemployment and the labor force are among the most carefully designed
and comprehensive economic data the nation collects. The data are gathered monthly in
a procedure known as “random sampling “ of the population.
Survey divides the population of those 16 years and older into four groups:
1. Employed: people who perform any paid work, as well as those who have jobs
but are absent from work because of illness, strikes, or vacations.
2. Unemployed: people who are available for work and have actively sought
employment during the previous four weeks.
3. Labor Force: the number of people over the age of 16 who are either employed
or actively seeking work (unemployed).
4. Not in the labor force: people who are retired, too ill to work, or simply not
looking for work.
Unemployment Rate: the ratio of the number of people classified as unemployed to the
labor force.
Example:
+16 employed
+16 seeking work
1,000
100
+16 has been seeking work
for more than 4 weeks
150
Unemployment
Labor force
Unemployment rate = 150/1250 = 12%
Problems in calculating the unemployment rate:
1. reductions in paid work hours – underestimates unemployment
2. survey problems – Wrong answers such as “not seeking for a job” as he looks for
higher wages, or “actively seeking” but unrealistic about skills.
Economic Interpretation of Unemployment:
What is the relationship between different kinds of unemployment and the business
cycle?
Frictional Unemployment: the usual amount of unemployment resulting from
- people who have left jobs that did not work out
- people who are entering or reentering the labor force
Structural Unemployment: results from permanent shifts in the pattern of demand for
goods and services or from changes in technology. Therefore workers need to learn new
skills or move to other locations.
Cyclical Unemployment: occurs during periods of contraction or recession, or in any
period when the economy fails to operate at its potential.
Total amount of unemployment in any month
= frictional + structural + cyclical unemployment
where frictional and structural unemployment result from natural and unavoidable
occurrence in a dynamic economy, and the cyclical unemployment is the result of
imbalances between aggregate purchases and the aggregate production corresponding
to full employment ( this is controllable).
The Natural Rate of Unemployment (NRU)
The percentage of the labor force that can normally be expected to be unemployed for
reasons other than cyclical fluctuations in real GDP.
NRU = (frictional + structural unemployment) / labor force
When the actual rate of unemployment is no more than NRU, the economy operates at
full employment. Since NRU is not equal to zero, then full employment cannot be zero
unemployment.
Potential Real GDP: The level of real GDP that would prevail if the economy were fully
employed (if actual unemployment rate is equal to NRU) over a period of one year.
When,
- the actual unemployment rate
-
=
>
<
NRU
NRU
NRU
 GDP is at its potential GDP.
 GDP is below its potential GDP.
 GDP is above its potential GDP.
We call the last case “overheated economy .“ Typically, working overtime
- increase unit costs of production,
- increases wages (which means increases labor costs),
When actual GDP > potential GDP , then prices increase,
higher prices decrease the aggregate quantity of goods and services demanded
and cause (actual) real GDP to decline.
Basic Facts about Potential Real GDP:
1. Potential real GDP is not the economy’s “capacity” output even though actual
GDP can exceed potential GDP, this situation cannot persist for long periods.
2. It is not easy to measure potential real GDP
a. NRU can vary from year to year
b. Therefore, it is difficult to determine the output level associated with NRU.
3. potential real GDP grows over time.
In some years economy may grow more slowly than the growth in
potential real GDP, and in some years it may grow faster.
Potential real GDP growth depends on growth in labor force and other
resources, improvements in technology, etc.
Ideally, we would like to see the economy operate most of the time at
potential real GDP.