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Chapter 10
Economic Fluctuations, Unemployment, and Inflation
10-1Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Objectives
• Examine the business cycle• Consider various business cycle theories• Show how economic forecasting is done• Measure the GDP gap• Learn how the unemployment rate is computed• Look at the types of unemployment• Construct a consumer price index• Consider the theories of inflation
10-2Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-3Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
GDP in 1996 dollars, 1958-2002
Shaded areas indicate recessions
10-4Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Recessions Since 1945
Hypothetical Business Cycles
10-5Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Year
ProsperityPeak
Trough Trough
Peak
Peak
2005 2010 2015
Business Cycle Theories
• Endogenous theories– Innovation theory– Psychological theory– Inventory cycle theory– Monetary theory– Underconsumption theory
• Exogenous theories– Sunspot theory– War theory
10-6Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
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
10-7Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Business Cycle Forecasting(Continued)
• The Ten Leading Economic Indicators– 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
10-8Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Unemployment• The problem
– One of the most devastating experiences a person can have is to be out of work for a prolonged period
– Discouraged workers are those who have given up looking for work and have simply dropped out of the labor force
• The Bureau of Labor Statistics does not count discouraged workers as part of the labor force
• There were over 5 million Americans classified as discouraged in 2002 and 2002
• Had they been counted the unemployment would have been almost double
10-9Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Unemployment(Continued)
• The liberal criticism– 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
– The true unemployment rate is higher than the official rate
10-10Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Unemployment(Continued)
• The conservative criticism– Some just go through the motions of looking
for work to remain eligible for benefits and are not really looking for work
– Huge numbers of Americans – as well as illegal immigrants are working in the underground economy
• These people are employed off the books, do not report their income, and are not counted as employed by the bureau of labor statistics
10-11Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Unemployment(Continued)
• The conservative criticism– The percentage of married women in the labor force
has risen from 25 percent in the late 1940s to about 65 percent today (this raises the unemployment rate in three ways)
• Married women who are reentering the labor force will have to find jobs
• Because their husbands are employed they can shop around for a while
• Their husbands, if unemployed, can also shop around for a while if their wives are working
10-12Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Unemployment(Continued)
• The conservative criticism– The true unemployment rate is lower than
the official rate
10-13Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-14
How Is the Unemployment Rate Computed?
UR = ------------------------------------------Number of Unemployed
Labor Force Number employed
+ Number unemployed
= Labor Force
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-15
How Is the Unemployment Rate Computed?
UR = ------------------------------------------Number of Unemployed
Labor Force Number employed
+ Number unemployed
= Labor Force
2000 Number unemployed = 5,655,000
+ Number employed = 135,208,000
Labor Force = 140,863,000
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-16
How Is the Unemployment Rate Computed?
UR = ------------------------------------------Number of Unemployed
Labor Force Number employed
+ Number unemployed
= Labor Force
2000 Number unemployed = 5,655,000
+ Number employed = 135,208,000
Labor Force = 140,863,000
UR = ---------------------------------------5,655,000
140,863,000
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-17
How Is the Unemployment Rate Computed?
UR = ------------------------------------------Number of Unemployed
Labor Force Number employed
+ Number unemployed
= Labor Force
2000 Number unemployed = 5,655,000
+ Number employed = 135,208,000
Labor Force = 140,863,000
UR = ---------------------------------------5,655,000
140,863,000
UR = .0401453 = 4.0 %
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Unemployment Rates for Blacks
• Historically, the unemployment rate for blacks has been double that of whites– During recessions the black unemployment
rate is rarely below 10 percent
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10-19Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Unemployment Rate, 1948-2000
Economic Report of the President, 2001; Economic Indicators, May 2003
Unemployment went up between 1969 and 1982 and went down after that
Types of Unemployment
• Frictional unemployment
• Structural unemployment
• Cyclical unemployment
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Frictional Unemployment
• The frictionally unemployed are people who are between jobs or just entering or reentering the labor market– Usually weeks or months pass before
positions are filled– At any given time, about 2 or 3 percent of
the labor force is frictionally unemployed
10-21Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Structural Unemployment• A person who is out of work for a relatively
long period of time, say, a couple of years, is structurally unemployed. Some examples are– Steelworkers and coal miners who are out of work
because the local steel plant and coal mine have closed
– Clerical workers, typists, and inventory control clerks who have been made obsolete by a computer system
– People who are functionally illiterate are virtually shut out of the labor force
• One in five adult Americans is functionally illiterate• Our educational system turns out 1 million more functional
illiterates every year– About 2 to 3 percent of our labor force is always
structurally unemployed
10-22Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Cyclical Unemployment
• Cyclical unemployment is anything above the sum of frictional and structural unemployment– Caused by the ups and downs in our
economy known as the business cycle
• Fluctuations in our unemployment rate are due to cyclical unemployment
10-23Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Natural Unemployment Rate
10-24
Most economists estimate the natural unemployment rate to be 5 or 6 percent. If we take a 5 percent unemployment rate as our working definition of full employment, anything above 5 percent would be cyclical unemployment
Frictional 2.5% (Natural)
Structural 2.5% (Natural)
5.0% (Full unemployment)
Cyclical 1.7% (Not natural)
Unemployment Rate 6.7%
+
+
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
As the unemployment rate falls, and it becomes increasingly difficult to find employees, employers will bid up wage rates, pushing up the rate of inflation
Once the unemployment rate falls below its natural rate, then inflationary wage pressure emerges
Natural Unemployment Rate
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Inflation
• Defining inflation– Generally, we consider inflation a sustained rise in
the average price level over a period of years• When the overall price level is rising, the prices of some
goods and services are going down, i.e., TV prices in the 1970s and the 1980s, the price of VCRs, and more recently the price of cellular phones
– U.S. inflation has been persistent since World War II
10-26Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Consumer Price Index (CPI)
• The CPI, which measures changes in our cost of living, is reported near the middle of every month by the Bureau of Labor Statistics– The CPI is based on what it cost an average
family to live
10-27Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Finding Percentage Change in the Price Level
Year CPI
1972 125.3
1982 289.1
By what percentage did the cost of living rise?
10-28Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Finding Percentage Change in the Price Level
Year CPI
1972 125.3
1982 289.1
By what percentage did the cost of living rise?
10-29
Percentage change = ---------------------------- X 100Change
Original Number
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Finding Percentage Change in the Price Level
Year CPI
1972 125.3
1982 289.1
By what percentage did the cost of living rise?
10-30
Percentage change = ---------------------------- X 100Change
Original Number
Change = 163.8
Original Number
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Finding Percentage Change in the Price Level
Year CPI
1972 125.3
1982 289.1
By what percentage did the cost of living rise?
10-31
Percentage change = ---------------------------- X 100Change
Original Number
Change = 163.8
Original Number
Percentage change = ---------------------------- X 100163.8125.3
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Finding Percentage Change in the Price Level
Year CPI
1972 125.3
1982 289.1By what percentage did the cost of living rise?
10-32
Percentage change = ---------------------------- X 100Change
Original Number
Change = 163.8
Original Number
Percentage change = ---------------------------- X 100163.8
125.3
Percentage change = 1.307 X 100
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Finding Percentage Change in the Price Level
Year CPI
1972 125.3
1982 289.1By what percentage did the cost of living rise?
10-33
Percentage change = ---------------------------- X 100Change
Original Number
Change = 163.8
Original Number
Percentage change = ---------------------------- X 100163.8
125.3
Percentage change = 1.307 X 100
Percentage change = 130.7Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
A Magic Number
10-34
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?
The base year is set at 100.
If the CPI today is 136.4, by what percentage did prices rise since the base year?
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
A Magic Number
10-35
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?
The base year is set at 100.
If the CPI today is 136.4, by what percentage did prices rise since the base year?
136.4 – 100 = 36.4%
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-36Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Annual Percentage Change in the Consumer Price Index, 1946-2002
Economic Report of the President, 2002
Since World War II we have had two periods of price stability-from 1952 through 1965 and from 1991 to the present
10-37
Inflation Seems Inevitable
• It appears that it takes a recession to deflate “inflation”
• Sir Frederick Keith-Ross (1957)– “Inflation is like sin; every
government denounces it and every government practices it”
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
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 -33
10-38Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
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 -33
10-39
Year CPI
1929 17.1
1930 16.7
1931 15.2
1932 13.7
1933 13.0
1934 13.4
General price levels are declining when the CPI is decreasing
General price levels are rising when the CPI is increasing
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
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 -33
10-40
Year CPI
1929 17.1
1930 16.7
1931 15.2
1932 13.7
1933 13.0
1934 13.4
General price levels are declining when the CPI is decreasing
General price levels are rising when the CPI is increasing
Business owners dislike inflation but they hate deflation a lot more
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
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%
1981 -83 the rate of inflation declined . . . but prices continued to increase . . . just at a lower rate!
10-41Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
10-42
Consumer Price Index (CPI)
The most important measure of inflation is the Consumer Price Index (CPI)
CPI = --------------------------------- X 100Cost of livingcy
Cost of livingby
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Anticipated and Unanticipated Inflation: Who Is Hurt by
Inflation and Who Is Helped?• Debtors benefit from unanticipated
inflation– They get to repay their loan in dollars that
are worth less than the dollars they borrowed
– The biggest debtor and gainer from unanticipated inflation has been the U.S. government
10-43Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Anticipated and Unanticipated Inflation: Who Is Hurt by
Inflation and Who Is Helped?• Creditors, the people who lend out money, are
hurt by unanticipated inflation– The ultimate creditors, or lenders, are the people
who put their money in banks, life insurance, or any other financial instrument paying a fixed rate of interest
• People who live on fixed incomes, particular retired people who depend on pensions (except Social Security) and those who hold long-term bonds, are hurt by unanticipated inflation
10-44Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Anticipated and Unanticipated Inflation: Who Is Hurt by
Inflation and Who Is Helped?• When inflation is fully anticipated,
theoretically, there are no winners and losers– Creditors have learned to charge enough
interest to take into account, or anticipate, the rate of inflation over the course of the loan
• This is tacked onto the regular interest rate that the lender would charge had no inflation been expected
10-45Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Real Rate of Interest
10-46
• The real rate of interest is the rate that would be charged without inflation
Expected Rate of inflation
+ Real Rate of Interest
Nominal Rate of Interest <-------what we pay
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Real Rate of Interest
10-47
• The real rate of interest is the rate that would be charged without inflation
Expected Rate of inflation 6%
+ Real Rate of Interest 5%
Nominal Rate of Interest 11%
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Real Rate of Interest
10-48
• The real rate of interest is the rate that would be charged without inflation
Expected Rate of inflation 6%
+ Real Rate of Interest 5%
Nominal Rate of Interest 11%
If the nominal interest rate accurately reflects the inflation, then the inflation has been fully anticipated and no one wins or loses, except the people who borrow money at the higher nominal rate of interest
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Real Rate of Interest
10-49
• The real rate of interest is the rate that would be charged without inflation
Expected Rate of inflation 6%
+ Real Rate of Interest 5%
Nominal Rate of Interest 11%
But if the rate of inflation keeps growing – even if it is correctly anticipated – our economy will be in big trouble
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Consumer Price Index1915 – 2002 (1967=100)
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Theories of the Causes of Inflation
• Demand-Pull Inflation
• Cost-Push inflation
10-51Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Demand-Pull Inflation
• When there is excessive demand for goods and services, we have demand-pull inflation– This occurs when people are willing and able
to buy more output than our economy can produce because our economy is already operating at full capacity
10-52Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Demand-Pull Inflation
• Demand-pull inflation is often summed up as “too many dollars chasing too few goods”– Just where did all of this money come
from”? Milton Friedman, a Nobel laureate in economics, suspects the seven governors of the Federal Reserve System, which controls the rate of growth of the money supply
10-53Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Cost-Push Inflation
• There are three variants of cost-push inflation– The wage-price spiral– Profit-push inflation– Supply-side cost shocks
10-54Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Cost-Push Inflation
• The wage-price spiral– Wages constitute nearly two-thirds of the
cost of doing business– Whenever workers receive a significant wage
increase, this increase is passed along to consumers in the form of higher prices
– Higher prices raise everyone’s cost of living, engendering further wage increases
10-55Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Cost-Push Inflation
• Profit-push inflation– Because just a handful of firms dominate
many industries, they have the power to administer prices rather than accept the dictates of the market forces of supply and demand
– To the degree that they are able, these firms will respond to any rise in cost by passing them on to their customers
10-56Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Cost-Push Inflation
• Supply-side cost shocks– Finally, we have supply-side shocks, most
prominently the oil price shocks of 1973-74 and 1979
• OPEC nations raised the price of oil• When the price of oil rises, the cost of making
many other things rise as well
– Cost increases are quickly translated into price increases
10-57Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Inflation as a Psychological Process
• If people believe prices will rise, they will act in a way that keeps them rising
• To break the back of inflationary psychology is to bring down the rate of inflation for a sufficiently long period of time for people to actually expect price stability to continue
• This has happened in the recent past only after successive recessions have wrung inflation out of the economy
10-58Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Creeping Inflation and Hyperinflation
• Inflation is a relative term– Creeping inflation in one country would be
hyperinflation in another
• But once we cross the line between creeping inflation and hyperinflation – which keeps shifting- we run into trouble– It becomes increasingly difficult to conduct normal
economic affairs– Prices are raised constantly– It becomes impossible to enter into long-term
contracts– No one is sure what the government might do
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Conclusion• One thing the economy has rarely been able to attain
simultaneously is a low unemployment rate and stable prices
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The Misery Index, 1948-2002Economic Report of the President, 2002
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