978-0077660772 Chapter 9 Solution Manual

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

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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,

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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

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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

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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.

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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.

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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.

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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.

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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.

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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

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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,

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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

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