Business Cycles, Unemployment, and Inflation

BUSINESS CYCLES, UNEMPLOYMENT, AND INFLATION

business cycle peak recession

trough expansion unemployment rate

labor force discouraged workers frictional unemployment

structural unemployment cyclical unemployment

full-employment rate of unemployment natural rate of unemployment (NRU)

potential output GDP gap Okun’s law inflation

Consumer Price Index (CPI) deflation demand-pull inflation

cost-push inflation per-unit production costs core inflation

real income nominal income unanticipated inflation

cost-of-living adjustments (COLAs) anticipated inflation nominal interest rate

real interest rate hyperinflation

CHAPTER OUTLINE

Although the long-term trend for the U.S. economy is one of economic growth and expansion, the growth pattern has been interrupted by periods of economic instability, or business cycles.

The business cycle means alternating periods of prosperity and recession even if the long-term trends show economic growth.

The typical cyclical pattern, however, is peak, recession, trough, and expansion to another peak. Peak is the maximum level of real output at the start of the cycle. It is followed by a recession, which is a period of decline in real output that lasts six months or longer. When real output is no longer declining, it has hit its trough. This low point is followed by expansion or recovery in which the economy experiences an increase in real output.
These recurrent periods of ups and downs in real output (and associated income and employment) are irregular in their duration and intensity.

Economists think that changes in the levels of output and employment are largely the result of economic shocks. They require difficult adjustments to be made by households and businesses in the economy and such adjustments are not easily or quickly made because prices tend to be sticky. For example, if total spending unexpectedly falls and prices are relatively fixed, business firms will not be able to sell all their output and have to cut back on production. As a consequence, GDP falls, income falls, unemployment rises, and the economy moves into recession. The possible economic shocks to the economy that cause unexpected changes include irregular periods of innovation; changes in productivity; monetary factors; political events or shifts; and financial instability. Although economic shocks come from different sources, the immediate cause of most cyclical changes in output and employment is unexpected changes in the level of total spending in the economy.
The business cycle affects almost the entire economy, but it does not affect all parts in the same way and to the same degree: The production of capital and consumer durable goods fluctuates more than the production of consumer nondurable goods and services during the cycle, because the purchase of capital and consumer durable goods can be postponed.

One of the twin problems arising from the economic instability of the business cycle is unemployment.

The unemployment rate is calculated by dividing the number of persons in the labor force who are unemployed by the total number of persons in the labor force. Unemployment data have been criticized for at least two reasons:

Part-time workers are considered fully employed.
Discouraged workers who have left the labor force are not counted as unemployed.

Full employment does not mean that all workers in the labor force are employed and there is no unemployment; some unemployment is normal. There are at least three types of unemployment.

Frictional unemployment is due to workers with marketable skills searching for new jobs or waiting to take new jobs. This type of unemployment is short term, inevitable, and also generally desirable because it allows people to find more optimal employment.
Structural unemployment is due to the changes in technology and in the types of goods and services consumers wish to buy. These changes affect the total demand for labor in particular industries or regions. Such unemployed workers have few desired marketable skills so they often need retraining, more education, or have to move if they are to be employed.
Cyclical unemployment arises from a decline in total spending in the economy that pushes an economy into an economic downturn or recession. With the onset of recession, businesses cut production, real GDP falls, and unemployment eventually rises.

“Full employment” is less than 100 percent because some frictional and structural unemployment is unavoidable. The full-employment unemployment rate or the natural rate of unemployment (NRU) is the sum of frictional and structural unemployment and is achieved when cyclical unemployment is zero (the real output of the economy is equal to its potential output ). NRU is the unemployment rate that is consistent with full employment. It is not, however, automatically achieved and changes over time. Currently it is about 4 to 5 percent of the labor force.
Unemployment has an economic cost.

The GDP gap is a measure of that cost. It is the difference between actual and potential GDP. When the difference is negative, it means that the economy is underperforming relative to its potential.
Okun’s law predicts that for every 1 percent the actual unemployment rate exceeds the natural rate of unemployment, there is a negative GDP gap of about 2 percent.
This cost of unemployment is unequally distributed among different groups of workers in the labor force. Workers in lower-skilled occupations have higher unemployment than workers in higher-skilled occupations. Teenagers have higher unemployment rates than do adults. The unemployment rate for African Americans and Hispanics is higher than it is for whites. Less educated workers have higher unemployment rates than more educated workers.

Unemployment also has noneconomic costs in the form of social, psychological, and health problems forindividuals and families. High unemployment rates in nations also can contribute to political unrest and violence.
Unemployment rates differ across nations because of differences in phases of the business cycle and natural rates of unemployment.

3Over its history, the U.S. economy has experienced not only periods of unemployment but periods of inflation.

Inflation is an increase in the general level of prices in the economy. During any period, the prices of products can rise, fall, or stay the same. Inflation occurs when there is an overall rise in the prices of products.
The primary measure of inflation in the United States is the Consumer Price Index (CPI).

The index is calculated by comparing the prices of a “market basket” of consumer goods in a particular year to the prices for that same market basket in a base period, and then multiplying it by 100 to get a percentage change.
The rate of inflation from one year to the next is equal to the percentage change in the CPI between the current year and the preceding year. The CPI was 207.3 in 2007 and 201.6 in 2006. The rate of inflation was 2.8 percent. The calculation is [(207.3 - 201.6)\201.6] *100 = 2.8%. The CPI was 215.3 in 2008 and 214.5 in 2009. The rate of inflation from 2008 to 2009 was 0.4 percent. This decline in the price level means that economy experienced deflation over that year period.
The rule of 70 can be used to calculate the number of years it will take for the price level to double at any given rate of inflation. For example, if the rate of inflation is 3 percent a year, it will take about 23 years for the price level to double [70/3 = 23].

The United States has experienced both inflation and deflation, but the past half-century has been a period of inflation. Other industrial nations have also experienced inflation.
There are at least two types of inflation. They may operate separately or simultaneously to raise the price level.

Demand-pull inflation is the result of excess total spending in the economy, or “too much spending chasing too few goods.” With this inflation, increasing demand is pulling up the price level.
Cost-push inflation is the result of factors that raise per-unit production costs. This average cost is found by dividing the total cost of the resource inputs by the amount of output produced. As these costs rise, profits get squeezed and firms cut back on production. The rising costs push the price level higher, and output also declines. The major source of this inflation has been supply shocks from an increase in the prices of resource inputs.

It is difficult to distinguish between demand-pull and cost-push inflation in the real world. Demand-pull inflation can continue as long as there is excess spending. Cost-push inflation is self-limiting because as the price level rises, it reduces output and employment, and these recession effects constrain additional price increases.
Measures of inflation can vary considerably from month to month because of volatility in the prices of certain items in the CPI such as the cost of food or energy. Economists and policy-makers often use a measure of core inflation that removes from the inflation rate calculation the often temporary and volatility swings in food and energy prices.

Inflation arbitrarily redistributes real income and wealth. It benefits some groups and hurts other groups in the economy.

Whether someone benefits or is hurt by inflation is measured by what happens to real income. Inflation injures those whose real income falls and benefits those whose real income rises.

Real income is determined by dividing nominal income by the price level expressed in hundredths.
The percentage change in real income can be approximated by subtracting the percentage change in the price level from the percentage change in nominal income.
The redistribution effects of inflation depend on whether it is anticipated or unanticipated.

Unanticipated inflation hurts fixed-income receivers, savers, and creditors because it lowers the real value of their assets.
Unanticipated inflation may not affect or may help flexible-income receivers. For example, some union workers get automatic cost-of-living adjustments (COLAs) in their pay when the CPI rises. It helps debtors because it lowers the real value of debts to be repaid.
When there is anticipated inflation people can adjust their nominal incomes to reflect the expected rise in the price level, and the redistribution of income and wealth is lessened. To reduce the effects of inflation on a nominal interest rate, an inflation premium (the expected rate of inflation) is added to the real interest rate.
There are three other redistribution issues associated with inflation. There can be a decline in the price level, or deflation, and if unanticipated, it has the reverse effects that inflation has on various groups. Inflation can have mixed effects (positive or negative), depending on the composition of a household’s assets. The effects of inflation are arbitrary and not directed at any one group or type.

Inflation also has an effect on real output that varies by the type of inflation and its severity.

Cost-push inflation reduces real output, employment, and income.
Views of mild demand-pull inflation vary. It may reduce real output, or it may be a necessary by-product of economic growth.
Hyperinflation —extremely high rates of inflation—can lead to a breakdown of the economy by redistributing income and reducing real output and employment.