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Chapter 09 – Business Cycles, Unemployment, and Inflation

CHAPTER NINE

BUSINESS CYCLES, UNEMPLOYMENT, AND INFLATION

CHAPTER OVERVIEW

This chapter discusses the business cycle, unemployment, and inflation. It sets the stage for the

analytical presentation in later chapters.

The business cycle is introduced in historical perspective and is presented in stylized form (Figure 9.1).

While hinting at various business cycle theories, the authors stress the general belief that changes in

aggregate spending, especially durable goods and investment spending, are the immediate cause of

economic instability. Non-cyclical fluctuations are also treated briefly before the analysis of

unemployment and inflation.

In the section on unemployment, the various types of unemployment—frictional, structural, and cyclical—

are described. Then the problems involved in measuring unemployment and in defining the

full-employment unemployment rate are considered. The economic and non-economic costs of

unemployment are presented, and finally, Global Perspective 9.1 gives an international comparison of

unemployment rates.

Inflation is accorded a rather detailed treatment from both a cause and an effect perspective.

International comparisons of inflation rates in the post-1992 period are given in Global Perspective 9.2.

Demand-pull and cost-push inflation are described. Considerable emphasis is placed on the fact that the

redistributive effects of inflation will differ, depending on whether inflation is anticipated or

unanticipated. The chapter ends with historical cases of hyperinflation to remind students that

inflationary fears have some basis in fact.

WHAT’S NEW

There is a new “Last Word” discussing the slow recovery in employment after the Great Recession.

There are two new “Consider This” pieces: The first new CT discusses how downwardly sticky wages

cause unemployment to spike. The second new CT discusses how moderate inflation might help to reduce

unemployment by allowing firms to make real wage cuts without cutting nominal wages.

There is almost an entirely new set of learning objectives for this chapter.

There is a new Quick Review (QR 9.5) at the end of the chapter.

Tables and graphs have been updated.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. Explain what is meant by a business cycle.

2. Describe the four phases of an idealized business cycle.

3. Identify two types of non-cyclical fluctuations in business activity.

4. Describe how innovation and/or random events might cause business cycles.

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5. Explain why business cycles affect capital and consumer durable goods industries more than non-

durable goods and service industries.

6. Describe how the Bureau of Labor Statistics (BLS) measures unemployment.

7. Evaluate strengths and limitations of BLS unemployment statistics.

8. State causes of frictional, cyclical, and structural unemployment.

9. Identify the full employment or natural rate of unemployment.

10. Identify the economic costs of unemployment and the groups that bear unusually heavy

unemployment burdens.

11. Define inflation and list two types of inflation.

12. List three groups who are hurt and two groups who may benefit from unanticipated inflation.

13. Present three possible effects of inflation on output and employment.

14. Compare U.S. inflation and unemployment rates to one or more industrialized nations.

15. Define and identify terms and concepts at the end of the chapter.

COMMENTS AND TEACHING SUGGESTIONS

1. Many students will benefit from the use of numeric examples (real or hypothetical). A good

springboard into the discussion of unemployment is to provide students with a set of profiles of

individuals, where information is given as to employment status and reasons for unemployment of

lack of participation in the labor force.

2. Most students have a vague idea of what is meant by unemployment or inflation. Few have

considered how these problems impact the economy or themselves. Having students collect prices

(at the beginning and end of term) not only provides the opportunity to construct a price index and

calculate inflation, it also puts them more in tune with market conditions.

3. It makes this chapter more relevant to have students find the latest data on these measures. See

web-based questions at the end of the chapter or an Internet source such as www.econdata.net.

4. To help students better understand the types of unemployment, you may want to use the following

“Concept Illustration” (that appeared in the previous edition’s “Analogies, Anecdotes, and

Insights.”)

Concept Illustration … Types of Unemployment

Imagine a fictitious country named Miniature that has a stable population of 120 people, of which

100 are in the labor force. Of these 100 people, 95 are employed and 5 are unemployed. That

means Miniature’s unemployment rate is 5 percent (= 5/100).

Suppose we could take a group photo of the unemployed workers each month so as to obtain a

continuing record of their monthly numbers and reveal whom they are. By comparing the monthly

photos over long periods, we could sort out the types of unemployment occurring in Miniature.

Suppose that in a typical month there are 5 people in the photo. Also, suppose that 4 of these

people are never the same individuals who were in the photo the previous month and the other

person never shows up in the photo for more than two or three consecutive months.

We can reasonably conclude that Miniature is experiencing frictional unemployment and structural

unemployment. The frictionally unemployed workers are quickly finding jobs, and after retraining or

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relocation, the structurally unemployed workers are obtaining new jobs within a few months. Taking the

places of these formerly unemployed persons are newly unemployed people who are looking for new

jobs, waiting for future jobs, retraining, or relocating. Five percent of the labor force is unemployed each

month, but nobody is unemployed for any substantial length of time. Miniature is not suffering an

“unemployment problem.”

In contrast, suppose that over a six-month period we observe that the number of people in the

unemployment photo increases from 5 to 10, with no change in the size of the labor force.

Thereafter, the 10 percent unemployment rate continues for a full year. A comparison of the

monthly photos reveals that it is mainly the same people who are employed month after month.

We can reasonably conclude that Miniature is now experiencing cyclical unemployment. Total

spending must have declined, reducing production and employment. The increase in the

unemployment rate from 5 percent to 10 percent has accompanied this recession. Miniature now

has a serious “unemployment problem.” Cyclical unemployment is involuntary, relatively long

lasting, and creates serious financial hardship for those people unemployed. It also results in an

irretrievable loss of output to society. (Note that there could also be a more serious form of

structural unemployment contributing to the increased rate and duration).

5. Table 9.2 can be used to discuss the definition of unemployment and its limitations. Current data to

update the table can be found in the Monthly Labor Review, Employment and Earnings, Economic

Indicators, or see web-based question 1. Make it clear that a portion of each unemployment

statistic is due to frictional and structural unemployment, which are found even in a “full

employment” economy. Frictional unemployment indicates a healthy economy with labor

mobility. Structural unemployment is viewed as serious, but not responsive to economic policies

alone.

6. Have students consider the losses from unemployment. Perhaps they could write a feature article

on losses due to GDP gap, higher inflation, or the social and personal losses incurred by those

unemployed.

7. For a deeper understanding of the costs of inflation, you may wish to share the following “Concept

Illustration” with your students:

Concept Illustration … Costs of Inflation

The following metaphors highlight some of the more subtle, but very present, costs imposed by

rising prices.

Menu costs: Inflation requires firms to change the prices they charge from one period to another.

This new pricing of products and the communication of the new prices to customers requires time

and effort that could otherwise be used for more productive purposes. These inflation costs are

sometimes called menu costs, because they are similar to the costs incurred by restaurants that need

to print new menus when prices rise. Menu costs include all costs associated with the inflation-

caused need to change prices.

Yardstick costs Inflation interferes with money functioning as a measure of value and thus

requires more time and effort to determine what something is worth (in real terms). Dollar price

tags lose some of their meaning when inflation occurs, because the dollar’s value has declined

relative to before. It is as if a yardstick that formerly measured 36 inches now measures 34, 33, or

even fewer inches. All inflation-caused costs associated with determining real versus nominal

values can be thought of as yardstick costs.

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Shoe-leather costs We have noted that people try to protect their financial assets against erosion

from inflation by limiting the amounts of money they hold in their billfolds and in their non-

interest-bearing checking accounts, putting those funds instead into interest-bearing saving

accounts or stock and bond funds. But people actually need more money to buy the higher priced

goods and services. So, they figuratively walk to and from financial institutions much more often

in order to move money from these latter accounts to checking accounts or to get cash when it is

needed. In the process they wear out their shoes—they incur so-called shoe-leather costs. These

costs include all time and resource costs associated with the inflation-induced need to make more

financial transactions.

8. The Wall Street Journal is a good source of information on the most current economic situation.

They have a “Newspaper-in-Education” program that provides various teaching aids, in addition to

favorable subscription rates for students. Call 1-800-JOURNAL contact their website for more

information. Among their aids is a stylized Wall Street Journal Education edition, which gives

information on dates on which important economic statistics are announced each month or each

quarter. Your local newspaper and periodicals may have similar education programs. The

Economist includes up-to-date macroeconomic information and presents stories of U.S.

macroeconomic policies and conditions that are detailed but accessible.

9. Unemployment and inflation have a human face. A dramatic reading of quotes from a book such as

Studs Terkel’s Hard Times can be used to bring statistics to life. You or your students may be

acquainted with individuals who lived through the depression years or who have suffered from

periods of unemployment. Inviting them to discuss the impact of these experiences also helps to

make this material more interesting for students.

STUDENT STUMBLING BLOCKS

1. This chapter includes lots of descriptive detail. Help your students sort out the forest from the trees

—be clear about what you expect them to know from this chapter.

2. Struggling students often have difficulty because they lack very basic math skills. Sometimes, they

simply have not used fractions, percentages or decimals lately. Do not take it for granted that

college students will be prepared for the simple calculations in this chapter. One skill that is

frequently missing is the ability to make reasonable estimates of a correct answer (a ball park

guess) without actually crunching the numbers. Give students practice with simple questions first –

for example, GDP loss when the unemployment rate is 1% above the natural rate (applying Okun’s

Law). Then demonstrate the gap for every 1% beyond that.

3. Students often confuse being “unemployed” v. being “not in the labor force.” You may need to

stress to some that just because one of their parents is “not employed” (e.g. a homemaker) doesn’t

mean they don’t work hard – simply that they don’t work in the paid labor force. Some students

will be bothered that those in the underground economy are counted as “not in the labor force” or,

in some cases, “unemployed.” Emphasize that the classification is based on the BLS survey and

may not accurately represent their true status (such as we do in the discussion of discouraged

workers). Help students avoid reaching the conclusion that the underground economy is excluded

because it produces economic “bads.” It also produces “goods,” just as the measured economy

produces “bads.”

4. In anticipation of future chapters, the sections on demand-pull and cost-push inflation will be

helpful. Emphasize the analysis of Figure 9.5. It also helps to reinforce Chapter 7’s distinction

between nominal and real GDP.

5. Students are often confused between terms like “deflation” (falling prices) and “disinflation” (a

falling rate of inflation). There may be similar confusion between “rising prices” and a “rising

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inflation.” As you look ahead to the policy chapters, you need to decide whether it is better now or

later to define disinflation and distinguish between it and deflation, especially given that one is

feared and the other is often considered desirable.

LECTURE NOTES

I. Introduction: This chapter looks at trends of real GDP growth and the macroeconomic

problems of the business cycle, unemployment and inflation.

Learning objectives – After reading this chapter, students should be able to:

A. Describe the business cycle and its primary phases.

B. Illustrate how unemployment is measured and explain the different types of unemployment.

C. Explain how inflation is measured and distinguish between cost-push inflation and demand-

pull inflation.

D. Relate how unanticipated inflation can redistribute real income.

E. Discuss how inflation may affect the economy’s level of real output.

II. Overview of the Business Cycle

A. Historical record:

1. The United States’ impressive long-run economic growth has been interrupted by periods

of instability.

2. Uneven growth has been the pattern, with inflation often accompanying rapid growth,

and declines in employment and output during periods of recession and depression (see

Figure 9.1 and Table 9.1).

B. Four phases of the business cycle are identified over a several-year period. (See Figure 9.1)

1. A peak is when business activity reaches a temporary maximum with full employment

and near-capacity output.

2. A recession is a decline in total output, income, employment, and trade lasting six months

or more.

3. The trough is the bottom of the recession period.

4. Recovery is when output and employment are expanding toward full-employment level.

C. There are several theories about causation.

1. Major innovations may trigger new investment and/or consumption spending.

2. Changes in productivity may be a related cause.

3. Monetary factors

4. Political events

5. Financial Stability

6. Most agree that the level of aggregate spending is important, especially changes on

capital goods and consumer durables.

D. Cyclical fluctuations: Durable goods output is more volatile than non-durables and services

because spending on latter usually can not be postponed.

III. Unemployment (One Result of Economic Downturns)

A. Measuring unemployment (see Figure 9.2 for 2012):

1. The population is divided into three groups: those under age 16 or institutionalized, those

“not in labor force,” and the labor force that includes those age 16 and over who are

willing and able to work, and actively seeking work (demonstrated job search activity

within the last four weeks).

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2. The unemployment rate is defined as the percentage of the labor force that is not

employed. (Note: Emphasize not the percentage of the population.)

3. The unemployment rate is calculated by random survey of 60,000 households

nationwide. (Note: Households are in survey for four months, out for eight, back in for

four, and then out for good; interviewers use the phone or home visits using laptops.)

Two factors cause the official unemployment rate to understate actual unemployment.

a. Part-time workers are counted as “employed.”

b. “Discouraged workers” who want a job, but are not actively seeking one, are not

counted as being in the labor force, so they are not part of unemployment statistic.

B. Types of unemployment:

1. Frictional unemployment consists of those searching for jobs or waiting to take jobs

soon; it is regarded as somewhat desirable, because it indicates that there is mobility as

people change or seek jobs.

2. Structural unemployment: due to changes in the structure of demand for labor; e.g.,

when certain skills become obsolete or geographic distribution of jobs changes.

3. Cyclical unemployment is caused by the recession phase of the business cycle.

a. As firms respond to insufficient demand for their goods and services, output and

employment are reduced.

b. Extreme unemployment during the Great Depression (25 percent in 1933) was

cyclical unemployment.

4. It is sometimes not clear which type describes a person’s unemployment circumstances.

C. Definition of “Full Employment”

1. Full employment does not mean zero unemployment.

2. The full-employment unemployment rate is equal to the total frictional and structural

unemployment.

3. The full-employment rate of unemployment is also referred to as the natural rate of

unemployment.

4. The natural rate is achieved when labor markets are in balance; the number of job seekers

equals the number of job vacancies.

5. The natural rate of unemployment is not fixed but depends on the demographic makeup

of the labor force and the laws and customs of the nations.

6. Recently the natural rate has dropped from 6% to 5 to 6% as demographic factors, job

search methods, and public policies change.

D. Economic cost of unemployment:

1. GDP gap and Okun’s Law: GDP gap is the difference between potential and actual GDP.

(See Figure 9.3) Economist Arthur Okun quantified the relationship between

unemployment and GDP as follows: For every 1 percent of unemployment above the

natural rate, a negative GDP gap of about 2 percent occurs. This is known as “Okun’s

law.”

2. Unequal burdens of unemployment exist. (See Table 9.2)

a. Rates are lower for white-collar workers.

b. Teenagers have the highest rates.

c. African-Americans have higher rates than whites.

d. Rates for males and females are historically comparable, though during the Great

Recession females had a significantly lower rate.

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e. Less educated workers, on average, have higher unemployment rates than workers

with more education.

f. “Long-term” (15 weeks or more) unemployment rate is much lower than the overall

rate, although it has nearly tripled from 1.5% in 2007 to 4.7% in 2009 due to the

Great Recession.

E. Noneconomic costs include loss of self-respect and social and political unrest.

F. International comparisons. (See Global Perspective 9.1)

G. Consider This … Downwardly Sticky Wages and Unemployment

1. Labor markets have an important quirk that helps explain why unemployment goes up so

much during a recession.

2. Wages are flexible upward but sticky downward. Individuals are willing to accept

nominal wage increases but do not accept nominal pay cuts.

3. Managers usually opt for layoffs instead of nominal pay cuts. This results in

unemployment.

IV. Inflation: Defined and Measured

A. Definition: Inflation is a rising general level of prices (not all prices rise at the same rate, and

some may fall).

B. The main index used to measure inflation is the Consumer Price Index (CPI). To measure

inflation, subtract last year’s price index from this year’s price index and divide by last year’s

index; then multiply by 100 to express as a percentage.

C. “Rule of 70” permits quick calculation of the time it takes the price level to double: Divide

70 by the percentage rate of inflation and the result is the approximate number of years for

the price level to double. If the inflation rate is 7 percent, then it will take about ten years for

prices to double. (Note: You can also use this rule to calculate how long it takes savings to

double at a given compounded interest rate.)

D. Facts of inflation:

1. In the past, deflation has been as much a problem as inflation. For example, between

2008 and 2009, the CPI decreased by.4%. The prospect of deflation has been a concern

of economic policymakers.

2. All industrial nations have experienced the problem (see Global Perspective 9.2).

3. Some nations experience astronomical rates of inflation (Zimbabwe’s was 14.9 billion

percent in 2008 before doing away with their existing currency).

4. The inside covers of the text contain historical rates for the U.S.

E. Causes and theories of inflation:

1. Demand-pull inflation: Spending increases faster than production. It is often described

as “too much spending chasing too few goods.”

2. Consider This … Clipping Coins

a. Princes would clip coins, paying peasants with the clipped coins and using the

clippings to mint new coins.

b. Clipping was essentially a tax on the population as the increased money supply

caused inflation and reduced the purchasing power of each coin.

3. Cost-push or supply-side inflation: Prices rise because of rise in per-unit production

costs (Unit cost = total input cost/units of output).

a. Output and employment decline while the price level is rising.

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b. Supply shocks have been the major source of cost-push inflation. These typically

occur with dramatic increases in the price of raw materials or energy.

4. Complexities: It is difficult to distinguish between demand-pull and

cost-push causes of inflation, although cost-push will die out in a recession if spending

does not also rise.

F. Core Inflation

1. Food and energy prices are very volatile due to changes in supply and

demand which are usually temporary changes.

2. To prevent a misinterpretation of the changes in the CPI that might be

due to temporary changes in supply and demand, economists use core inflation.

a. Core inflation doesn’t include food and energy goods.

b. If core inflation is low and stable, current policy may not need to be

changed even if the CPI is rising.

c. Economists will be greatly concerned if core inflation increases.

V. Redistributive effects of inflation:

A. The price index is used to deflate nominal income into real income. Inflation may reduce the

real income of individuals in the economy, but won’t necessarily reduce real income for the

economy as a whole (someone receives the higher prices that people are paying).

B. Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust

their work or spending activities to avoid or lessen the effects.

C. Fixed-income groups will be hurt because their real income suffers. Their nominal income

does not rise with prices.

D. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the

cost of inflation. Their savings will lose purchasing power.

E. Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest

payments may be less than the inflation rate, so borrowers receive “dear” money and are

paying back “cheap” dollars that have less purchasing power for the lender.

F. If inflation is anticipated, the effects of inflation may be less severe, since wage and pension

contracts may have inflation clauses built in, and interest rates will be high enough to cover

the cost of inflation to savers and lenders.

1. “Inflation premium” is amount that interest rate is raised to cover effects of anticipated

inflation.

2. “Real interest rate” is defined as nominal rate minus inflation premium. (See Figure 9.5)

G. Consider This … Could a Little Inflation Help Reduce Unemployment?

1. Proponents of a little inflation argue that this might boost firms’ profits and their demand

for labor by increasing the price they can sell their goods and services.

2. Opponents argue that it is implausible to assume that wages and other costs would

remain fixed.

H. Final points

1. Unexpected deflation, a decline in price level, will have the opposite effect of unexpected

inflation.

2. Many families are simultaneously helped and hurt by inflation because they are both

borrowers and earners and savers.

3. Effects of inflation are arbitrary, regardless of society’s goals.

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VI. Output Effects of Inflation

A. Cost-push inflation, where resource prices rise unexpectedly, could cause both output and

employment to decline. Real income falls.

B. Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous

economy, or it may have an undesirable impact on real income.

C. Danger of creeping inflation turning into hyperinflation, which can cause speculation,

reckless spending, and more inflation (see examples in text of Japan following World War II,

and Germany following World War I).

VII. LAST WORD: Unemployment After the Great Recession

A. The Great Recession began in December of 2007 and ended in June 2009. During this

period there was a rapid decline in employment which was followed by a very slow

recovery.

B. There are number of potential reasons for this slow recovery.

1. Higher Federal Minimum Wage

2. Longer Unemployment Benefits

3. Structural Adjustments

4. Higher Labor Costs

QUIZ

1. A nation has a population of 300 million people. Of these, 80 million are retired, in the military,

in institutions, or under 16 years old. There are 210 million who are employed and 10 million

who are unemployed. What is the unemployment rate?

A. 3.3 percent

B. 3.6 percent

C. 4.5 percent

D. 5.2 percent

2. The rate of unemployment when the economy is at its potential output is called the:

A. Full-employment rate of unemployment

B. Natural rate of unemployment

C. Structural rate of unemployment

D. Frictional rate of unemployment

3. Kevin has lost his job in an automobile plant because of the use of robots for welding on the

assembly line. Kevin plans to go to technical school to learn how to repair microcomputers. The

type of unemployment Kevin is faced with is:

A. Cyclical

B. Frictional

C. Structural

D. Natural

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4. If the annual inflation rate is 5 percent a year, about how many years will it take for the price

level to double?

A. 10 years

B. 12 years

C. 14 years

D. 16 years

5. The industries or sectors of the economy in which business cycle fluctuations tend to affect

output the most are:

A. military goods and capital goods.

B. services and nondurable consumer goods.

C. clothing and education.

D. capital goods and durable consumer goods.

6. In which phase of the business cycle will the economy most likely experience rising real output

and falling unemployment rates?

A. Expansion

B. Recession

C. Peak

D. Trough

7. During periods of full employment the:

A. burden of unemployment is quite evenly distributed among males and females, African-

Americans and whites, and young and old workers.

B. unemployment rate for teenagers is below the rate for the labor force as a whole.

C. unemployment rate for women is considerably lower than that for men.

D. unemployment rate for African-Americans is about twice the rate for whites.

8. A college graduate using the summer following graduation to search for a job would best be

classified as:

A. not officially a member of the labor force.

B. a part of structural unemployment.

C. a part of cyclical unemployment.

D. a part of frictional unemployment.

9. If actual GDP is $340 billion and there is a positive GDP gap of $20 billion, potential GDP is:

A. $360 billion.

B. $660 billion.

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C. $320 billion.

D. $20 billion.

10. In which of the following cases would real income rise?

A. Nominal income rises by 8 percent, and the price level rises by 10 percent.

B. Nominal income rises by 2 percent, and the price level remains unchanged.

C. Nominal income falls by 4 percent, and the price level fall by 4 percent.

D. Real income will rise in all of the above cases.

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