Chapter 8
Business Cycles;
Unemployment; and Inflation
Chapter 8 Vocabulary
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Economic growth
Rule of 70
Productivity
Business cycle
Discouraged workers
Frictional unemployment
Structural unemployment
Cyclical unemployment
Labor force
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Natural rate of
unemployment
Potential output
GDP gap
Okun’s Law
Inflation
Per-unit production costs
Nominal income
Real income
Deflation
Stagflation
Hyperinflation
2
The Business Cycle
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The United States’ GDP is not
constant from year to year.
Instead, the GDP grows most years
and then shrinks in some years (like
in 2009)
The ups and downs in GDP over time
is referred to as the business cycle.
3
4
The Business Cycle Illustrated:

Peak
• temporary maximum in Real GDP. At this point the
unemployment rate is probably at or below the natural rate of
unemployment, and the inflation rate is probably increasing.
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Recession
• The contractionary phase of the business cycle. A period of
decline in Real GDP accompanied by an increase in
unemployment.
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Trough
• The bottom of the business cycle. Unemployment is probably
high and inflation is probably low.
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Recovery (or Expansion)
• The phase of the business cycle where the economy is returning
to full employment.
5
The Business Cycle Illustrated:
indicating the most recent recession dates
Dec. 2007
March 2001
June 2009
March 1991
Nov. 2001
6
Macroeconomics

Macroeconomics focuses on two basic issues:
1. The secular trend is a long term trend (years) of
economic growth with intermittent periods of
upturns and downturns in the economy. Growth
occurs as each peak of the business cycle is at a
higher point than the previous peak.
2. Fluctuations in economic performance:
 An economy is considered to be in a recession
(textbook definition) when it fails to grow for at
least six consecutive months (2 quarters – GDP
is a quarterly measure)
 Real world recession is defined by the NBER
(National Bureau of Economic Research) which
determines significant declines in economic
activity.
7
Who/When:
Determining a Recession
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National Bureau of Economic
Research
8
Fluctuations in Investment and Consumer
Spending in Recent Recessions
Annual
percent
change
Consumer
spending
5%
Investment
spending
2.9%
2.4%
0
–5
-0.6%
-1.2%
-1.1%
–10
-10.1%
–15
-10.6%
-15.9%
–20
–25
-22.5%
-28.8%
–30
1973–1975
1980
1981–1982
1990–1991
2001
Why we have business cycles
 Possible causes of business cycles
1. slowing of “aggregate” demand (total spending)
2. technology/innovations (these occur at irregular intervals)
3. changes in money supply
4. inventory adjustments (inventories build up and
production is reduced until inventories are reduced)
 **Investment is the most volatile component of Aggregate
Demand (see previous slide)
 What sectors are most affected during a recession?
Industries most affected by recessions are
durable goods and capital goods producers.
They have pricing power and can reduce
production until the slowdown has ended.
10
Examining some of the Causes and
the 2001 Recession
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1. technology and innovations boomed
during the 90s and Y2K
2. changes in the money supply. The Fed
thought the economy was growing too fast
(4.5% GDP) and shrunk the money supply
and an monthly unemployment rate was
below the NRU%.
3. Inventory adjustments. Business were
left with large inventories after the 90s
boom and Y2K so production declined.
11
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Inventories and the End of a
Recession
Recession Began in March 2001 and ended November 2001
Why Investment is Volatile
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Durability
• Capital goods have a long life-span, therefore once it is
built there is no immediate need for further investment
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Irregularity of Innovation
• Innovation does not proceed in a smooth linear fashion,
instead there are bursts of innovation followed by
periods of relative stability
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Variability of Profits
• Profitability is subject to the forces of competition,
cyclical changes in the economy, and human
management decisions
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Variability of Expectations
• Political, social and natural phenomenon shape our
positive and negative expectations of the future
13
The U.S. Unemployment Rate, 1948-2008
Rate
12%
10
8.1%
8
6
4
2
1948
1960
1970
1980
1990
2000
2008 2012
Year
What is our Current
Unemployment Rate
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BLS Unemployment Data
15
Monthly Unemployment Data 1999 - 2013
The last recession ended in June 2009
16
Examining Unemployment
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During periods of poor economic
performance, such as economic recessions
when real GDP declines, unemployment
rises sharply and becomes a cause of
concern.
During times of good economic performance
and rapid economic growth, unemployment
is reduced and inflation may become a
problem. Approximately 70% of the cost of
production is wages. Lower unemployment
= higher wages = higher production costs.
Unemployment data is compiled by the
Bureau of Labor Statistics. Unemployment
data is collected through a national
household survey.
17
Examining Unemployment
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The unemployed are those individuals
who do not currently have a job but who
are actively looking for work. People NOT
looking for work are NOT part of the
unemployment statistics.
The employed are individuals who
currently have jobs.
The employed plus the unemployed
comprise the labor force.
18
Examining Unemployment

The unemployment rate (U%)
is the percentage of labor force
unemployed (jobless and looking
for work.)
X 100
19
Breakdown of the U.S. Population
and the Labor Force
20
Problems in the Unemployment Measure

The official statistics for unemployment do not include the
full range of individuals who would like to participate fully in
the labor market.
• Individuals who want to work, have searched for work in
the prior year, but are not currently looking for work
because they believe they won’t be able to find a job are
called discouraged workers. These individuals are
not included in unemployment data.
• Workers who would like to be employed full-time but
hold part-time jobs are known as individuals working
part time for economic reasons. These individuals
ARE included as employed workers in unemployment
data.
• Some individuals are “underemployed”. During a
downturn in the economy, people accept jobs for which
they are overqualified but are included as employed.
21
Who Are the Unemployed?
Selected U.S. Unemployment Statistics:
Unemployment Rates for February 2004
30.0
25.1
25.0
20.0
16.6
15.2
15.0
10.0
5.0
9.8
5.6 5.1 4.9
4.9
9.1
3.4 3.6
0.0
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The Four Types of Unemployment:
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Cyclical unemployment is the unemployment that
accompanies fluctuations in real GDP. Occurs during
recessions.
Frictional unemployment is the unemployment that
occurs naturally during the normal workings of an
economy. It occurs because it simply takes time for people
to find the right jobs. People are searching for jobs/better
jobs.
Structural unemployment occurs when the economy
evolves. It occurs when different sectors give way to other
sectors or certain jobs are eliminated while new types of
jobs are created. Skills become obsolete.
Seasonal unemployment occurs due to weather
variations
23
The Natural Rate of
Unemployment (NRU)
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The level of unemployment at which there is no cyclical
unemployment is called the natural rate of
unemployment (or the Full Employment
Unemployment Rate). Sometimes this natural rate is
also referred to a the ”NAIRU” or the non-accelerating
inflation rate of unemployment.
The natural rate of unemployment is the economist’s
notion of what the rate of unemployment should be
when there is full employment. In the U.S. the
natural rate of unemployment is around 4.5-5%.
Economists predict that when the current economic
slowdown ends, the natural rate will be about 5-6%.
Frictional + Structural unemployment = Natural rate of
unemployment.
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Economic costs of unemployment
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GDP Gap is when the actual GDP falls below the
potential GDP. The GDP in the U.S. has the potential
of 3.5% growth each year.
Okun’s Law states that for every 1% of cyclical
unemployment (or employment above the natural rate
of unemployment) an economy will lose 2% of GDP
GDP Gap produces lower government revenues and
increased government spending
A look back at unemployment rates (adjust start year
to 1980 – 2011)
http://data.bls.gov/timeseries/LNS14000000
25
Employment Trends
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Careers and Projections
26
Measuring Price Levels for
Inflation
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Price Level: A weighted average of
the prices of all goods and services.
Price Index: A measure of the price
level using the specific market basket
of goods (remember the GDP Price
Index in the previous chapter).
Consumer Price Index (CPI): the
weighted average of prices of a
market basket of goods and services
purchased by a typical urban
household, about 13,000 items.
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What is Inflation
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What is Inflation? Essentially it
means that if inflation is 5% in
a year, you have 5% less
purchasing power. Your $1 in
January will purchase you $.95
worth of goods at the end of
the year.
If inflation is 5% annually and
you receive a 3% pay raise,
you have lost 2% or your
purchasing power.
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Inflation and Does it Matter
Hourly earnings
Roast coffee
431%
220%
Eggs
508%
595%
White bread
Gasoline
1,052%
200
400
1,200%
600
800
1,000
Percent increase
Data represents changes from 1970 through 2008
The Consumer Price Index
and the Cost of Living
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Economists have developed a number
of different measures to track the cost
of living over time. Each of the
measures uses a different market
basket of goods.
The best known of these measures is
the Consumer Price Index (CPI).
The CPI measures changes in prices
facing consumers.
Other measures of inflation
• Producer Price Index – measures inflation
at the production level.
• GDP Deflator/GDP Price Index
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McFlation
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Some economists suggest that there
may be a better way to measure
inflation: The Cost of Big Macs
McFlation Index
31
The Consumer Price Index
and the Cost of Living
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Example:
Cost of a market basket in 1992 (the
base year) = $200
Cost of the same market basket in
2004 = $250
CPI92= (200/200) x 100 = 100 (The
base year index is always 100)
CPI04= (250/200) x 100 = 125
32
Inflation (a general increase in
overall price level)
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The percentage rate of change of a price
index is the inflation rate.
Inflation Rate = percentage rate of
change of a price index
Suppose that a price index in a country
was 200 in 1998 and 210 in 1999, the
inflation rate between 1998 and 1999
was:
Inflation rate = (210 – 200)/200 = .05 = 5%
In other words, the country experienced a 5%
inflation rate during that year.
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Types of Inflation

Demand Pull Inflation (caused by an
increase in aggregate demand or total
spending)
• Consumers have too money; spending
exceeds supply

Cost Push Inflation (caused by a
decrease in aggregate supply)
• Per unit production costs increase

Per unit production cost = total input cost divided
by units of output
• Supply shocks (like a rapid increase in oil
prices)
• Wage push
34
Problems in Measuring
Changes in Prices
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Cost-of-living adjustments (COLA) are
automatic increases in wages or other
payments that are tied to a price index.
If the CPI overstates increases in the cost
of living, the government and employers
might be overpaying Social Security
recipients and workers for changes in the
cost of living. Or if inflation is undermeasured, then social security is not
keeping up with inflation.
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Are You Beating (CPI) Inflation or
is Inflation Beating You?
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Nominal Income: the currentdollar amount of a person’s
income.
Real Income: nominal income
adjusted for price changes.
Real Income (in base year
prices) = [(Nominal
Income)/CPI]x100
Or a 5% pay raise with 3%
inflation = real income gain of 2%
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Real Interest Rates

Lenders adjust interest rates on
loans based upon anticipated rate
of inflation. For example
• Nominal interest rate is 9%
• Anticipated rate of inflation is 3%
• Real interest rate is 6%
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The Costs of Inflation
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The cost of unexpected or
unanticipated inflation is arbitrary
redistributions of income. Inflation
creates winners and losers.
Winners
• Borrowers (debtors)
• Government (the biggest debtor)

Losers
• Lenders (creditors)
• People on fixed incomes
• Savers
38
Problems with Inflation

Rule of 70
• Divide 70 by inflation rate to determine
how long it will take prices to double.
• If inflation is 5%, then 70/5 = 14
 Prices will double in 14 years
• Rule of 70 can also be applied to
measure how much savings or
investments will increase at a given
return rate.
• If $2000 is invested at a 10% rate of
return, the $2000 will be $4000 in 7
years
39
Why inflation is hard to control

Inflation may cause a “Wage-Price
Spiral”
• Workers demand higher wages
• Higher wages increases the cost of
production (cost push inflation)
• This leads to higher prices so workers
demand higher wages to offset the
higher prices; etc.
• The seriousness of inflation is why
controlling inflation is the #1 goal of
the Federal Reserve.
40
The Perils of Deflation

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Deflation refers to a sustained
decrease in the average level of
prices and wages in the economy.
Deflation is the most serious
problem facing an economy. The
biggest problem caused by a
decreasing prices and wages is that
people cannot repay their debts,
which do not fall with deflation.
Also as prices fall, quantity
supplied decreases and as a result
unemployment increases.
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42
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http://inflationdata.com/inflation/Infl
ation_Rate/HistoricalInflation.aspx?d
sInflation_currentPage=0