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Chapter 09 - Business Cycles, Unemployment, and Inflation
Chapter 09 - Business Cycles, Unemployment, and Inflation
McConnell, Brue, and Flynn 20e
DISCUSSION QUESTIONS
1. What are the four phases of the business cycle? How long do business cycles last? Why does
the business cycle affect output and employment in capital goods industries and consumer
durable goods industries more severely than in industries producing consumer nondurables? LO1
Answer: The four phases of a typical business cycle, starting at the bottom, are
trough, recovery, peak, and recession. As seen in Table 9.1, the length of a
complete cycle varies from about 2 to 3 years to as long as 15 years.
2. How, in general, can a financial crisis lead to a recession? How, in general, can a major new
invention lead to an expansion? LO1
Answer: Unexpected financial bubbles (rapid asset price increases) followed by bursts
For example, the severe recession of 2007-2009 was precipitated by a combination of
excessive money and a financial frenzy that led to overvalued real estate and
Significant new products or production methods such as those associated with the
9-1
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consent of McGraw-Hill Education.
Chapter 09 - Business Cycles, Unemployment, and Inflation
No, an increase in the unemployment rate does not necessarily mean a decline in the size
of the labor force. For example, individuals who were not in the labor force before
4. How, in general, do unemployment rates vary by race and ethnicity, gender, occupation, and
education? Why does the average length of time people are unemployed rise during a recession?
LO2
Answer: Race and ethnicity: The unemployment rate for African Americans and
Gender: The unemployment rates for men and women are very similar.
Education: Less-educated workers, on average, have higher unemployment rates than
Duration: The number of persons unemployed for long periods— 15 weeks or more—as
5. Why is it difficult to distinguish between frictional, structural, and cyclical unemployment?
Why is unemployment an economic problem? What are the consequences of a negative GDP
gap? What are the noneconomic effects of unemployment? LO2
Answer: It is not easy to distinguish between these three types of unemployment
because the sum of frictional and structural unemployment is itself changing, thus
it is difficult to determine the full-employment unemployment rate. For example,
9-2
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consent of McGraw-Hill Education.
Chapter 09 - Business Cycles, Unemployment, and Inflation
Unemployment is an economic problem because of the concept of opportunity
The “GDP gap” is the difference between what the economy could produce at its
The noneconomic effects of unemployment include the sense of failure created in
6. Since the United States has an unemployment compensation program that provides income for
those out of work, why should we worry about unemployment? LO2
Answer: The unemployment compensation program merely gives the
unemployed enough funds for basic needs. Furthermore, many of the
7. What is the Consumer Price Index (CPI) and how is it determined each month? How does the
Bureau of Labor Statistics calculate the rate of inflation from one year to the next? What effect
does inflation have on the purchasing power of a dollar? How does it explain differences between
nominal and real interest rates? How does deflation differ from inflation? LO3
Answer: The CPI is constructed from a “market basket” sampling of goods that
consumers typically purchase. Prices for goods in the market basket are collected
To calculate the rate of inflation, the BLS subtracts the CPI for the previous year
9-3
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consent of McGraw-Hill Education.
Chapter 09 - Business Cycles, Unemployment, and Inflation
Inflation reduces the purchasing power of the dollar. Facing higher prices with a
given number of dollars means that each dollar buys less than it did before.
Deflation means that the price level is falling, whereas with inflation overall
8. Distinguish between demand-pull inflation and cost-push inflation. Which of the two types is
most likely to be associated with a negative GDP gap? Which with a positive GDP gap, in which
actual GDP exceeds potential GDP? What is core inflation? Why it is calculated? LO3
Answer: Demand-pull inflation occurs when prices rise because of an increase in
Cost-push inflation is most likely to be associated with a negative GDP gap, as the
Demand-pull inflation is more likely to occur with a positive GDP gap, because
9. Explain how an increase in your nominal income and a decrease in your real income might
occur simultaneously. Who loses from inflation? Who gains? LO4
Answer: If a person’s nominal income increases by 10 percent while the cost of
living increases by 15 percent, then her real income has decreased from 100 to
The losers from inflation are those on incomes fixed in nominal terms or, at least,
10. Explain how hyperinflation might lead to a severe decline in total output. LO5
Answer: With inflation running into the double, triple, quadruple, or even greater
number of digits per year, it makes little sense to save. The only sensible thing to
9-4
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consent of McGraw-Hill Education.
Chapter 09 - Business Cycles, Unemployment, and Inflation
Eventually, money may become worthless. No one will work for money. Barter
11. LAST WORD Why was the 2009 hike in the minimum wage probably not responsible for
much of the slow growth in employment after the Great Recession? What is inefficiently long
search and how is it affected by the duration of unemployment benefits? How might Obamacare
have discouraged hiring?
Answer: At any given time, fewer than 3 percent of workers are employed at
“Inefficiently long search” means that many unemployed workers used the
extended period during which they could survive on unemployment benefits to
Obamacare might discourage companies from hiring because it increases labor
REVIEW QUESTIONS
1. Place the phases of the business cycle in order. LO1
Recession
Trough
Peak
Expansion
Answer: Peak, Recession, Trough, Expansion.
2. Most economists agree that the immediate cause of the large majority of cyclical changes in the
levels of real output and employment is unexpected changes in ___________________. LO1
a. The level of total spending.
b. The level of the stock market.
9-5
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consent of McGraw-Hill Education.
Chapter 09 - Business Cycles, Unemployment, and Inflation
c. The level of the trade deficit.
d. The level of unemployment.
Answer: a. The level of total spending.
Most economists agree that the immediate cause of the large majority of cyclical changes
Total spending may change for a number of reasons including political events, financial
3. Suppose that an economy has 9 million people working full time. It also has 1 million people
who are actively seeking work but currently unemployed as well as 2 million discouraged
workers who have given up looking for work and are currently unemployed. What is this
economy’s unemployment rate? LO2
a. 10 percent.
b. 15 percent.
c. 20 percent.
d. 25 percent.
Answer: a. 10 percent.
This economy’s unemployment rate is 10 percent because the number of unemployed is 1
To apply the formula, we need numbers for “unemployed” and “labor force.” Let’s start
We next need to figure out how many “unemployed” workers there are. Remember that
as far as the unemployment statistic is concerned, we are looking for people who want
By plugging in our values for the labor force (10 million) and the number of
4. Label each of the following scenarios as either frictional unemployment, structural
unemployment, or cyclical unemployment. LO2
a. Tim just graduated and is looking for a job.
b. A recession causes a local factory to lay off 30 workers.
c. Thousands of bus and truck drivers permanently lose their jobs when driverless, computer-
driven vehicles make human drivers redundant.
d. Hundreds of New York legal jobs permanently disappear when a lot of legal work gets
outsourced to lawyers in India.
9-6
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consent of McGraw-Hill Education.
Chapter 09 - Business Cycles, Unemployment, and Inflation
Answers:
a. frictional unemployment
Let’s go through each scenario in order.
Tim just graduated and is looking for a job is an example of frictional unemployment
A recession causes a local factory to lay off 30 workers is an example of cyclical
Thousands of bus and truck drivers permanently lose their jobs when driverless,
Hundreds of New York legal jobs permanently disappear when a lot of legal work
5. The unemployment rate that is consistent with full employment is known as
_________________________. LO2
a. The natural rate of unemployment.
b. The unnatural rate of unemployment.
c. The status quo rate of unemployment.
d. Cyclical unemployment.
e. Okun’s rate of unemployment.
Answer: a. The natural rate of unemployment.
The natural rate of unemployment is in fact defined as the unemployment rate that is
Keep in mind that when we say full employment, we mean that the economy is only
6. A country’s current unemployment rate is 11 percent. Economists estimate that its natural rate
of unemployment is 6 percent. About how large is this economy’s negative GDP gap? LO2
a. 1 percent.
b. 3 percent.
c. 6 percent.
d. 10 percent.
This economy’s negative GDP gap should be about 10 percent.
9-7
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consent of McGraw-Hill Education.
Chapter 09 - Business Cycles, Unemployment, and Inflation
This estimate is based upon Okun’s law, which indicates that for every 1 percentage point
To apply Okun’s law to the current situation, we first note that actual unemployment
7. Cost-push inflation occurs when there is __________________________. LO3
a. Excess inventory.
b. A trade deficit.
c. Rising per-unit production costs.
d. Excess demand for goods and services.
Answer: c. Rising per-unit production costs.
Cost-push inflation occurs when rising per-unit production costs squeeze company
profits, thereby causing firms to reduce the amount of output that they are willing to
supply at the current price level. This leads to higher unemployment because fewer
workers are needed to produce less output.
8. Jimmer’s nominal income will go up by 10 percent next year. Inflation is expected to be -2
percent next year. By approximately how much will Jimmer’s real income change next year?
LO3
a. -2 percent.
b. 8 percent.
c. 10 percent.
d. 12 percent.
Jimmer’s real income will rise by 12 percent next year. You can see this by rearranging
Using that formula, we see that the percentage change in Jimmer’s real income will be
approximately equal to the 10 percent increase in his nominal income minus the
9. Kaitlin has $10,000 of savings that she may deposit with her local bank. Kaitlin wants to earn a
real rate of return of at least 4 percent and she is expecting inflation to be exactly 3 percent. What
is the lowest nominal interest rate that Kaitlin would be willing to accept from her local bank?
LO4
a. 4 percent.
9-8
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consent of McGraw-Hill Education.
Percentage
change in
nominal income
Percentage
change in price
level
Percentage
change in real
income
-=
Chapter 09 - Business Cycles, Unemployment, and Inflation
b. 5 percent.
c. 6 percent.
d. 7 percent.
Answer: d. 7 percent.
The lowest nominal interest rate that Kaitlin would be willing to accept is 7 percent.
She would of course be happier to get more than 7 percent. But the lowest nominal rate
Given that the real interest rate that Kaitlin desires is 4 percent and given that she is
expecting inflation to be 3 percent, the right-hand side of the formula tells us to add the
By contrast, if she were to accept a nominal interest rate of 5 percent, then she would
Using this version of the formula, we can see that the real interest rate in this situation
10. True or False: Lenders are helped by unanticipated inflation. LO4
Answer: false.
This statement is false because lenders are actually hurt (rather than helped) by
Unanticipated inflation hurts lenders by reducing real returns. As an example, suppose
Thus, you will suffer substantial financial harm because the unexpectedly high inflation
11. Economists agree that inflation reduces real output. LO5
a. Cost-push.
b. Demand-pull.
9-9
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consent of McGraw-Hill Education.
Chapter 09 - Business Cycles, Unemployment, and Inflation
Answer: a. cost-push.
The correct answer is that economists agree that cost-push inflation reduces real output.
Cost-push inflation reduces real output because the unexpected increases in resource
PROBLEMS
1. Suppose that a country’s annual growth rates were 5, 3, 4, -1, -2, 2, 3, 4, 6, and 3 in yearly
sequence over a 10-year period. What was the country’s trend rate of growth over this period?
Which set of years most clearly demonstrates an expansionary phase of the business cycle?
Which set of years best illustrates a recessionary phase of the business cycle? LO1
Feedback: The trend rate of growth equals the average for the 10-year period, which is
2.7 percent. (= (5 + 3 + 4 – 1 – 2 + 2 + 3 + 4 + 6 + 3) / 10).
2. Assume the following data for a country: total population, 500; population under 16 years of
age or institutionalized, 120; not in labor force, 150; unemployed, 23; part-time workers looking
for full-time jobs, 10. What is the size of the labor force? What is the official unemployment rate?
LO2
Feedback: To find the size of the labor force subtract population under 16 years of age or
institutionalized (120) and those not in the labor force (150) from the population (500).
3. Suppose that the natural rate of unemployment in a particular year is 5 percent and the actual
rate of unemployment is 9 percent. Use Okun’s law to determine the size of the GDP gap in
percentage-point terms. If the potential GDP is $500 billion in that year, how much output is
being forgone because of cyclical unemployment? LO2
9-10
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Chapter 09 - Business Cycles, Unemployment, and Inflation
Feedback: On the basis of recent estimates, Okun’s law indicates that for every 1
The actual rate of unemployment exceeds the natural rate of unemployment by 4% (= 9%
4. If the CPI was 110 last year and is 121 this year, what is this year’s rate of inflation? In
contrast, suppose that the CPI was 110 last year and is 108 this year. What is this year’s rate of
inflation? What term do economists use to describe this second outcome? LO3
Feedback: The inflation rate is the percentage change in the CPI over a period of time.
For the values above we have:
5. How long would it take for the price level to double if inflation persisted at (a) 2, (b) 5, and (c)
10 percent per year? LO3
Feedback: The “Rule of 70,” which is to divide 70 by the inflation rate, gives us the time
it takes for the price level to double.
Years to double = (70 / Inflation Rate)
Using this formula we have:
(a) The price level will double in 35 years if the inflation rate is 2% (= 70/2).
6. If your nominal income rose by 5.3 percent and the price level rose by 3.8 percent in some
year, by what percentage would your real income (approximately) increase? If your nominal
income rose by 2.8 percent and your real income rose by 1.1 percent in some year, what must
have been the (approximate) rate of inflation? LO4
Feedback: To find the approximate percentage change in the real value of your income,
9-11
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Chapter 09 - Business Cycles, Unemployment, and Inflation
We can also rearrange the equation above as follows:
7. Suppose that the nominal rate of inflation is 4 percent and the inflation premium is 2 percent.
What is the real interest rate? Alternatively, assume that the real interest rate is 1 percent and the
nominal interest rate is 6 percent. What is the inflation premium? LO4
Feedback:
To find the approximate real interest rate subtract the inflation premium from the nominal
interest rate.
Real interest rate = nominal interest rate - inflation premium
We can also rearrange the equation above as follows:
Inflation premium = nominal interest rate - real interest rate
9-12
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