Economic Fluctuations, Unemployment, and

Inflation

Chapter 10

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objectives

After reading this chapter you should be able to:1. Analyze the business cycle.

2. List and discuss various business cycle theories.

3. Understand how economic forecasting is done.

4. Calculate the unemployment rate.

5. List and identify the types of unemployment.

6. Construct a consumer price index.

7. Name and explain the theories of inflation.

8. Compute the misery index.

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Business Cycle

Business cycles: alternating increases and decreases in the level of business activity of varying amplitude and length

How do we measure “increases and decreases in business activity?”

• Percent change in real GDP.

Why do we say “varying amplitude and length?”• Some downturns are mild and some are severe• Some are short (a few months) and some are long (over a year)

Do not confuse with seasonal fluctuations!

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Real GDP 1958-2009, in 2000 dollars

Note: “Years” is on horizontal axis and “real GDP” is on vertical axis.

General trend of economic growth Recession years are shaded.

• Note downward slope on graph indicating that real GDP is decreasing during recession years.

Source: U.S. Dept. of Commerce, Business Cycle Indicators, March 2010.

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Three-Phase Business Cycle

1. Recession: economic downturn from peak to trough

2. Recovery: expansion from trough to previous peak, marked by rising real GDP

3. Prosperity: expansion beyond previous peak.

Note: Measure a full business cycle from peak to peak or from trough to trough.

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Fluctuations in Real GDP: 1860 – 2009

Source: Historical Statistics of the United States and U.S. Department of Commerce www.doc.gov.

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Recession

What is a recession? • Generally, 2 or more quarters of declining real GDP • Implication: it’s not officially a called a recession until the economy

has already been declining for 6 months!

Who decides when we’re in a recession?• National Bureau of Economic Research

NBER is a private research organization, not a federal agency. • NBER’s Business Cycle Dating Committee used 4 barometers:

1. Employment

2. Industrial production

3. Personal income minus government transfer payments

4. Manufacturing and trade revenue

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Post-World War II Recessions*

*June 2009 is the author’s guess as to when the recession ended.

Note: These recessions were of varying duration and severity.

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Another Look at Expansions and Recessions

Can you find a pattern? Neither can economists! That’s why recessions are hard to predict.

*June 2009 is the author’s guess as to when the recession ended.

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Business Cycle Theories Endogenous theories:

1. Innovation theory: innovation leads to saturation. 2. Psychological theory: alternating optimism and pessimism3. Inventory cycle theory: inventory and demand not in sync4. Monetary theory: changes in money supply by Federal Reserve5. Underconsumption theory: or overproduction

Exogenous theories:1. The external demand shock theory: effect of foreign economies2. War theory: war stimulates economy; peace leads to recession3. The price shock theory: fluctuations in oil prices

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Business Cycle Forecasting The Ten Leading Economic Indicators

1. Average workweek of production workers in manufacturing

2. Average initial weekly claims for state unemployment insurance

3. New orders for consumer goods and materials

4. Vendors performance (companies receiving slower deliveries from suppliers)

5. New orders for capital goods

6. New building permits issued

7. Index of stock prices

8. Money supply

9. Spread between rates on 10-year Treasury bonds and Federal funds

10. Index of consumer expectations

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Unemployment Unemployment: when people in the labor force are

willing and able to work, but are not working.• Measured separately from unemployment benefits.

Statistics compiled monthly by Bureau of Labor Statistics (BLS)

• A person who worked one day last month is counted as employed.

• Someone who works part-time but who wants to work full-time is counted as employed.

• Retirees and others not looking for work are “not in the labor force.”

Unemployment rate: the percent of the labor force that is unemployed

• Number of unemployed/Labor Force

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Categorizing the U.S. Population (Dec. 2007 data)

Formula for Unemployment Rate (UR):

UR = Number of Unemployed

Labor Force

Try calculating the 2007 unemployment rate.

Civilian Non-institutionalPopulation233 million

Civilian Labor Force

154 million

Not in the Labor Force79 million

Employed146.2 million

Unemployed7.7 million

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The Unemployment Rate, 1948-2009

• Unemployment trended upward between 1969 and 1982, and trended downward after that.

• After going above 10 percent in late 2009, it is very unlikely that our unemployment will get down again to 5 percent before mid-decade.

Source: Economic Report of the President 2010.

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How Accurate is the Unemployment Rate?

Liberals think unemployment is underestimated.• BLS does not count discouraged workers as part of the

labor force. Discouraged workers: those who have given up

looking for work and dropped out of the labor force. To be unemployed, must be actively seeking work.

• BLS counts as people as employed if they are involuntarily part-time, that is, they want full-time jobs but cannot find them.

Conservatives think unemployment is overestimated.

• Some people who respond that they are actively seeking work may be going through the motions while collecting unemployment compensation, TANF, etc.

• The BLS misses people who work in the underground economy, including illegal immigrants.

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Unemployment Rate for Selected Groups of American Workers, October 2009

Teenagers, African Americans, and Latinos have much higher unemployment rates than the average for all workers.

What is the impact of a college degree on the likelihood you will be unemployed?

Source: Bureau of Labor Statistics: http://www.bls.gov/ces/.

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Unemployment Rates for Workers Under 25 in 2009

Sources: OECD; The New York Times, April 17, 2010 p. B3.

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Unemployment as a Lagging Indicator

Why does the unemployment rate usually peak well after a recession ends?

1. It takes many employers months to become convinced that the economy is actually in recovery.

2. Many employers reduce hours for their current employees. Before they add more workers, they may want to

increase the hours of their current workers.

Examples:• The 1990-91 recession ended in March 1991, but the

unemployment rate did not peak until June.• The 2001 recession ended in November 2001, but the

unemployment rate peaked in June 2003.

The Great Recession may be over, but the unemployment rate remains high.

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Questions for Thought and Discussion Why might the official unemployment rate be

understating the unemployment problem?• Which groups do liberals think are missed by our current

approach to collecting the data?

Why might the official unemployment rate be overstating the unemployment problem?

• Which groups do conservatives think are counted as unemployed, even though they shouldn’t be?

Who do you agree with?

Which business cycle theory best explains the origins of the Great Recession?

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Types of Unemployment

1. Frictional Unemployment (not problematic)• People who are between jobs or just entering or reentering

the labor market.

2. Structural Unemployment• People who are out of work for a relatively long period of time

(due to technological or economic displacement or lack of skills).

3. Cyclical Unemployment• People who are out of work due to downturn in business

cycle.

4. Seasonal Unemployment (not problematic) Unemployment rate never reaches zero, due to

frictional and structural unemployment.

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Natural Unemployment Rate

Natural unemployment rate is lowest non-inflationary rate. It serves as a “floor” for policy makers.

• If unemployment is pushed lower than the “natural rate,” employers will bid up wages competing for workers.

• Upward pressure on prices (inflation) results. • When unemployment is high, workers do not have the

bargaining power to ask for high wages.• It has fallen since the 1980s due to the aging of the population,

the rise of the prison population, the expanding temporary-help industry, and the increase in worker insecurity due to downsizing and offshoring.

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Is the Natural Unemployment Rate Falling?

The “natural” unemployment rate changes in response to economic and social trends.

The natural rate has fallen since the 1980s. Why?1. There are fewer youths in labor force.

2. There are more males in prison.

3. The fear of corporate downsizing and off-shoring.

4. The expansion of temporary work force.

5. It is easier for disabled to qualify for Social Security, so they are not in the labor force.

6. The labor force (denominator) is bigger, due to influx of workers (immigrants, women leaving welfare).

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Inflation Inflation: a sustained rise in the average price level

over a period of years.• U.S. inflation has been persistent since World War II.

When the overall price level is rising, the prices of some goods and services are going down. Examples?

• LCD TVs• DVD players• Laser printers• Digital cameras• Contact lenses

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Consumer Price Index (CPI) and Inflation Rate

The most common indicator used to measure inflation is the Consumer Price Index (CPI).

• CPI measures changes in our cost of living.

CPI is also based on data collected by the Bureau of Labor Statistics (BLS).

The CPI is based on what it costs an average family to live.• BLS employees check prices of 80,000 items every month.• Compare prices with prices in base year. • Use this information to calculate percent increase or decrease in

overall prices.

Inflation rate is percent change in the CPI.

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Consumer Price Index, 1915–2009 (1967=100)

Note: Each year is compared with 1967, the base year.

Source: U.S. Bureau of Labor Statistics, stats.bls.gov.

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Annual Percentage Change in CPI, 1946-2009

Since World War II, we have had two periods of price stability—from 1952 through 1965, and from 1991 to the present.

Source: Economic Report of the President, 2010.

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A Magic Number

The CPI is set at 100 for a base year.

The number 100 is magic! It lends itself to calculating percentage changes.

Suppose we want to find out by what percentage prices have risen since the base year?

If the CPI today is 136.4, by what percentage did prices rise since the base year?

136.4 – 100 = 36.4%

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Finding Percentage Change in the Price Level

Year CPI

1972 125.3

1982 289.1By what percentage did the cost of living rise?

Percentage change = ---------------------------- X 100

Change

Original Number

Change = 163.8

Original Number

Percentage change = ---------------------------- X 100

163.8

125.3Percentage change = 1.307 X 100

Percentage change = 130.7

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Deflation

Deflation is a decline in the general level of prices for a period of years.

• This is the OPPOSITE of inflation.• This last occurred between 1929–1933 during the Great

Depression.

In recent months, some economists and policy makers, including members of the Federal Reserve, have expressed concerns that deflation could return to the U.S. if there is a second recession.

Why is deflation bad for the economy?• Businesses have inventories that decline in value.• Wages fall, leading to a deflationary spiral.

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Disinflation Disinflation occurs when the RATE OF INFLATION

declines.

Year CPI Inflation Rate

1980 82.4 13.5%

1981 90.9 10.3%

1982 96.5 6.2%

1983 99.6 3.2%

1984 103.9 4.3%

From 1981–1983 the rate of inflation declined, but prices continued to increase . . . just at a lower rate!

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Hypothetical Illustration

Note that deflation occurs only when the rate falls below zero (negative).

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Why has inflation remained low since 1992?

Imported goods are competing with American-made goods and driving down prices.

Rise of huge discount stores. E-commerce has increased competition. Wave of technical innovations has lowered prices of

electronics and other goods and increased worker productivity.

Firms have become “lean and mean” by downsizing and holding down wage increases.

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Questions for Thought and Discussion Explain the difference between inflation, deflation,

and disinflation.• Which one is usually good news for the economy?

Inflation devalues money. The same amount of money will buy less in the future. Who is hurt by inflation? Who is helped?

• What about debtors (people who owe money to be paid back in the future)?

• What about creditors (lenders)? • What happens to retirees on fixed incomes?

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Theories of the Causes of Inflation

Demand-Pull Inflation• Caused by excessive demand for goods and services.• The economy is already operating at full capacity. • Demand-pull inflation is often summed up as “too many dollars

chasing too few goods.”

Cost-Push inflation• Wage-price spiral• Profit-push inflation• Supply-side cost shocks (oil prices increasing)

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Inflation vs. Price Stability

Inflation is relative concept. When are regular price increases a policy problem?

• Creeping inflation: small, predictable increases• Hyperinflation: sudden, large price increases

Inflation as a Psychological Process:• If people believe prices will rise, they will act in a way that

keeps them rising.• This can trigger hyperinflation spiral.

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Stagflation

Stagflation is the contraction of the words stagnation and inflation.

• This word got a lot of use in the recessions of 1973–1975 and 1980 and 1981–1982 when we experienced the worst of both worlds, declining output and inflation.

Stagflation is measured by the Misery Index. • The misery index is calculated by adding the unemployment

rate and the inflation rate. • The Misery Index was unusually low in the 1990s until the

Great Recession.

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The Misery Index, 1948 - 2009

Source: Economic Report of the President, 2010.

You’ll note that this combined rate of unemployment and inflation rose to a peak in 1979 and has declined substantially since then.

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Three Goals, Three Problems, Three Indicators

Goal = Economic Growth• Problem = Recession• Indicator = real GDP

Goal = Full Employment• Problem = Unemployment• Indicator = Unemployment Rate

Goal = Price Stability• Problem = Inflation (or Deflation)• Indicator = Consumer Price Index

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Questions for Thought and Discussion

Where are all the jobs? • To keep up with growth in labor force, there is a need of 150,000

new jobs per month.• During the administration of Bill Clinton, we added an average of

230,000 jobs per month.• During George W. Bush’s administration, we averaged a gain of

less than 70,000 jobs per month.• What are some of the reasons for slower job growth even before

the Great Recession?