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Economic Growth, Business Cycles,
Unemployment, and Inflation
CHAPTER 24
Remember that there is nothing
stable in human affairs; therefore
avoid undue elation in prosperity,
or undue depression in adversity.
— Socrates
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Macroeconomics
• Macroeconomics is the study of the economy as a whole—the “big picture”
• We look at the aggregate, or the whole economy
McGraw-Hill/Irwin Colander, Economics 2
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Macroeconomics
• Macro was created to:
1. Measure the health of the whole economy
2. Guide government policies to fix problems
McGraw-Hill/Irwin Colander, Economics 3
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Two Frameworks: The Long Run and the Short Run
• To analyze macro issues, we look at two frameworks: the long run and the short run
• The long-run growth framework focuses on incentives for supply
• Sometimes called supply-side economics
• Issues of growth are considered in a long-run framework
24-4
Economic Growth, Business Cycles, Unemployment, and Inflation 24
The Short Run
• The short-run business cycle focuses on demand
• Sometimes called demand-side economics
• Business cycles are generally considered in a short-run framework
• Inflation and unemployment fall within bothframeworks
McGraw-Hill/Irwin Colander, Economics 5
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Economic Growth
• Growth is measured by:
• An increase in real GDP over time
• An increase in real GDP per capita over time (usually used to determine standard of living; more on this in CH 25)
McGraw-Hill/Irwin Colander, Economics 6
Economic Growth, Business Cycles, Unemployment, and Inflation 24
The Business Cycle
McGraw-Hill/Irwin Colander, Economics 7
Economic Growth, Business Cycles, Unemployment, and Inflation 24
The Business Cycle
• These fluctuations (and many more) are what make up the business cycle
• The business cycle is the upward or downward movement of economic activity, or real GDP
24-8
Economic Growth, Business Cycles, Unemployment, and Inflation 24
The Business Cycle
• Economists debate the causes of business cycles
• Keynesians: generally favor activist government policy—fluctuations should be controlled
• Classicals: generally favor laissez-faire policies—fluctuations are expected
McGraw-Hill/Irwin Colander, Economics 9
Economic Growth, Business Cycles, Unemployment, and Inflation 24
U.S. Business Cycles
Percentage fluctuations in real GDP around trends
1860 1800 1900 1920 1940 1960 1980 2000
20
10
0
-10
-20
Business cycles have always been a part of the U.S. economic scene
Civil War
Panic of 1863
Panic of 1907
Recovery of 1895
World War IWorld War II
Korean War
Vietnam War
Great Depression
24-10
Economic Growth, Business Cycles, Unemployment, and Inflation 24
The Phases of the Business Cycle
• The four phases of the business cycle are:
• Expansion: where real GDP is growing
• Peak: the top of the business cycle (right before the downturn)
24-11
Economic Growth, Business Cycles, Unemployment, and Inflation 24
The Phases of the Business Cycle
• Contraction: period where real GDP is falling
– A recession is two consecutive quarters where real GDP has fallen
– A depression is a prolonged period of economic decline
McGraw-Hill/Irwin Colander, Economics 12
Economic Growth, Business Cycles, Unemployment, and Inflation 24
The Phases of the Business Cycle
• Trough: the bottom of the business cycle where the contraction has ended and is about to make an upward turn
McGraw-Hill/Irwin Colander, Economics 13
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Draw the Business CycleTotal Output
Quarters21 3 4 21 3 4 21 3
Peak
Trough
Recession ExpansionExpansion
24-14
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Why do Business Cycles Occur?
Duration (in months)
Business Cycles
Pre-World War II
(1854 – 1945)
Post-World War II
(1945 – 2006)
Number 22 11
Average duration 50 67
Length of longest cycle 99 (1870-79) 128 (1991-2001)
Length of shortest cycle 28 (1919-21) 28 (1980-82)
Ave. length of expansions 29 28
Length of shortest expansion 10 (1919-20) 12 (1980-81)
Length of longest expansion 80 (1938-45) 120 (1991-2001)
Ave. length of recessions 21 10
Length of shortest recession 7 (1918-19) 6 (1980)
Length of longest recession 64 (1873-79) 16+ (2007-)
24-15
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Leading Indicators
• Leading indicators are the signs that indicate when a recession is about to occur
McGraw-Hill/Irwin Colander, Economics 16
• Average work week
• Unemployment claims
• New orders for consumer goods
• Vendor performance
• Index of consumer expectations
• New orders for capital goods
• Building permits
• Stock prices
• Interest rate spread
• Money supply, M2
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Unemployment
McGraw-Hill/Irwin Colander, Economics 17
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Unemployment
• The unemployment rate is the percentage of people who are willing and able to work but who are not working
24-18
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Types of Unemployment
• Frictional unemployment: unemployment caused by people entering the job market/people quitting a job just long enough to look for and find another job
• People between jobs that are temporarily unemployed
• Examples: a parent reentering the workforce or a college graduate looking for a job
McGraw-Hill/Irwin Colander, Economics 19
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Types of Unemployment
• Structural unemployment: unemployment caused by changes in the structure of the labor force make some skills obsolete
• Workers do not have transferable skills and these jobs will never come back
• Workers must learn new skills to get a job
• Also includes the outsourcing of jobs to other countries
McGraw-Hill/Irwin Colander, Economics 20
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Types of Unemployment
• Cyclical unemployment: unemployment due to economic downturns/the business cycle
McGraw-Hill/Irwin Colander, Economics 21
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Types of Unemployment
• Seasonal unemployment: unemployment due to seasonal work
• Example: an unemployed construction worker during the winter
McGraw-Hill/Irwin Colander, Economics 22
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Full Employment
• Full employment: an economic climate where nearly everyone who wants a job has one (about 5% unemployment)
McGraw-Hill/Irwin Colander, Economics 23
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Target Rate/Natural Rate of Unemployment
• The target rate/natural of unemployment is the lowest rate of unemployment that policy makers believe is achievable under existing conditions
• Generally, this is around 5%
• This means full employment is about 95%
24-24
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Whose Responsibility is Unemployment?
• Classical economists believe that individuals are responsible for their own jobs
• If people really want a job, they will find one
24-25
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Whose Responsibility is Unemployment?
• Keynesian economists tend to say that society owes people jobs that fit with their training or past job experience
• Jobs should be close enough to home so that people don’t have to move
McGraw-Hill/Irwin Colander, Economics 26
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Calculating the Unemployment Rate
• The labor force is made up of those at least 16 years of age who are willing and able to work
• The labor force excludes those incapable of working and those not looking for work
McGraw-Hill/Irwin Colander, Economics 27
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Calculating the Unemployment Rate
• We start with the total civilian population and subtract those unavailable for work (those under age 16, in prison, or otherwise not available to work)
• Then, subtract those not in the labor force (homemakers, disabled, etc.)
• You are left with the potential workforce
McGraw-Hill/Irwin Colander, Economics 28
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Calculating the Unemployment Rate
Unemployment Rate = Number UnemployedLabor Force
X 100
24-29
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Accuracy of the Unemployment Rate
• Does not include discouraged workers, people who do not look for a job because they feel they don’t have a chance of finding one
• Therefore, the unemployment rate is understated
24-30
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Accuracy of the Unemployment Rate
• Does not take into account the underemployed, which are part-time workers who would prefer full-time work
• Includes people who say they are unemployed, but voluntarily don’t work
McGraw-Hill/Irwin Colander, Economics 31
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Accuracy of the Unemployment Rate
• The labor force participation rate is also looked at: this measures the labor force as a percentage of the total population at least 16 years of age
• The employment-population ratio is the number of people who are working as a percentage of people available to work
McGraw-Hill/Irwin Colander, Economics 32
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Accuracy of the Unemployment Rate
• Potential output is output that would be achieved at the target rates of unemployment and capacity utilization
• Okun’s rule of thumb states that a 1% change in the unemployment rate will be associated with a 2% change in output in the opposite direction
+ 1% Δ unemployment – 2% Δ in output
24-33
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Inflation/Deflation
McGraw-Hill/Irwin Colander, Economics 34
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Inflation/Deflation
• Inflation a rise in the price level that reduces the purchasing power of money
• Deflation is a continual fall in the price level
• Hyperinflation: when inflation hits triple digits
24-35
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Who Is Helped/Hurt by Unanticipated Inflation
Hurt by Inflation
• People who borrow money
• A business where the price of the product increases faster than the price of resources
Helped by Inflation
• Lenders: People who lend money (at fixed interest rates)
• People with fixed incomes
• Savers
McGraw-Hill/Irwin Colander, Economics 36
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Measuring Inflation
• A price index: a number that summarizes what happens to a weighted composite of prices of a selection of goods over time
• The most commonly used measurement inflation for consumers is the Consumer Price Index (CPI)
McGraw-Hill/Irwin Colander, Economics 37
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Price Indexes
• The CPI measures prices of only the goods and services bought by consumers
• Looks at a market basket of about 400 goods and services
24-38
CPI= Year 1 - Year 2Price of same market basket in the base year
X 100
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Price Indexes
• Example: the market basket in 2014 was $540 and in 2015 it was $675. Calculate the price index.
• 675/540 x 100=125
McGraw-Hill/Irwin Colander, Economics 39
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Price Indexes
• Now, calculate inflation between those two years.
125-100
100
McGraw-Hill/Irwin Colander, Economics 40
X 100 = 25%
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Real vs. Nominal Interest Rates
• Nominal interest rate: the rate you pay or receive
• Real interest rate: the nominal interest rate adjusted for inflation
• Real interest rate=Nominal interest rate –inflation
McGraw-Hill/Irwin Colander, Economics 41
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Chapter Summary • Economists use two frameworks to analyze
macroeconomic problems:
• The long-run growth framework focuses on supply
• The short-run business cycle framework focuses on demand
• Growth is measured by the change in:
• Real gross domestic product (GDP)
• Per capita real GDP
24-42
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Chapter Summary
• Business cycles are fluctuations of real output around the secular growth trend
• Phases of the business cycle are peak, downturn, trough, upturn
• Unemployment is calculated as the number of unemployed people divided by the labor force
• Unemployment rises during a recession and falls during an expansion
24-43
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Chapter Summary • The target rate of unemployment is the lowest
sustainable rate of unemployment possible under existing institutions
• The lower the target rate of unemployment, the higher an economy’s potential output
• A real concept is a nominal concept adjusted for inflation
• Real output equals nominal output divided by the price index
• Inflation is the continual rise in the price level24-44
Economic Growth, Business Cycles, Unemployment, and Inflation 24
Chapter Summary
• The CPI, the PPI, and the GDP deflator are all price indexes used to measure inflation
• Expectations of inflation can provide pressure for inflation to continue even when other causes don’t exist
• Inflation redistributes income from people who do not raise their prices to people who do raise their prices
• Inflation reduces the information that prices convey
24-45