978-1259723223 Chapter 29

Chapter 29 – Business Cycles, Unemployment, and Inflation

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Chapter 29 – Business Cycles, Unemployment, and Inflation

McConnell, Brue, and Flynn 21e

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

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

3. How is the labor force defined and who measures it? How is the unemployment rate

calculated? Does an increase in the unemployment rate necessarily mean a decline in the size of

the labor force? Why is a positive unemployment rate—one more than zero percent—fully

compatible with full employment? LO2

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Answer: The U.S. Bureau of Labor Statistics (BLS) measures the labor force.

The BLS defines the labor force by dividing the total U.S. population into three groups.

One group is made up of people under 16 years of age and people who are

institutionalized, for example, in mental hospitals or correctional institutions. Such

people are not considered potential members of the labor force. A second group, labeled

“Not in labor force,” is composed of adults who are potential workers but are not

employed and are not seeking work. For example, they are homemakers, full-time

students, or retirees. The third group is the labor force, which constituted slightly more

than 50 percent of the total population in 2009. The labor force consists of people who

are able and willing to work. Both those who are employed and those who are

unemployed but actively seeking work are counted as being in the labor force.

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

(students just graduating college) may start looking for a job. In this case, the number of

unemployed increases, the labor force increases, and the unemployment rate increases.

The natural rate of unemployment is the sum of frictional and structural unemployment.

This value is always positive because people are transitioning to new jobs by choice or

because the industry they were in is no longer globally competitive. This is why a

positive rate of unemployment is fully compatible with full employment.

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

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

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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

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

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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

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

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10. Explain how hyperinflation might lead to a severe decline in total output. LO5

11. LAST WORD Did the eventual recovery of the unemployment rate after the Great Recession

indicate recovery in all aspects of employment? Explain and give examples.

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REVIEW QUESTIONS

1. Place the phases of the business cycle in order. LO1

a. Recession

b. Trough

c. Peak

d. 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.

c. The level of the trade deficit.

d. The level of unemployment.

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.

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Answer: a. 10 percent.

This economy’s unemployment rate is 10 percent because the number of unemployed is 1

million and the size of the labor force is 10 million.

To see why 10 percent is the correct answer, recall that the formula for calculating the

unemployment rate is

To apply the formula, we need numbers for “unemployed” and “labor force.” Let’s start

with the size of the labor force, which by definition is the sum of the number of people

who are employed plus the number of people who are not currently working but who are

actively seeking work. For this economy, the labor force would consequently be 10

million (= 9 million employed + 1 million unemployed but actively seeking work).

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

jobs, are actively seeking jobs, but don’t currently have jobs. That is, we totally exclude

the discouraged workers. They are excluded because, by ceasing to look for work, they

are no longer in the labor force, which by definition consists of everybody willing and

able to work right now. By focusing only on the workers without jobs who are still

actively seeking work, we see that there are 1 million “unemployed” workers in the labor

force.

By plugging in our values for the labor force (10 million) and the number of

“unemployed” (1 million) we see that this economy’s unemployment rate is 10 percent [=

(1 million/10 million) times 100].

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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Answers:

a. frictional unemployment

b. cyclical unemployment

c. structural unemployment

d. structural unemployment

Let’s go through each scenario in order.

Tim just graduated and is looking for a job is an example of frictional unemployment

because Tim is merely transitioning from school to work. He is not unemployed because

of a recession (cyclical unemployment) or because he lacks skills desired by employers

(structural unemployment).

A recession causes a local factory to lay off 30 workers is an example of cyclical

unemployment because the downturn in the business cycle has led to these 30 workers

losing their jobs.

Thousands of bus and truck drivers permanently lose their jobs when driverless,

computer-driven vehicles make human drivers redundant is an example of structural

unemployment because the drivers are losing their jobs as the result of a technological

innovation which has destroyed the demand for human driving skills.

Hundreds of New York legal jobs permanently disappear when a lot of legal work

gets outsourced to lawyers in India is an example of structural unemployment because

the demand for legal skills has permanently dropped in New York due to competition

from India.

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.

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.

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Answer: d. 10 percent.

This economy’s negative GDP gap should be about 10 percent.

This estimate is based upon Okun’s law, which indicates that for every 1 percentage point

by which the actual unemployment rate exceeds the natural rate, a negative GDP gap of

about 2 percentage points occurs.

To apply Okun’s law to the current situation, we first note that actual unemployment

exceeds the natural rate by 5 percentage points (= 11 percent actual rate of unemployment

minus 5 percent natural rate of unemployment). It then follows that the negative GDP gap

must be 10 percent (= 5 percentage points times 2).

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.

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.

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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.

b. 5 percent.

c. 6 percent.

d. 7 percent.

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10. True or False: Lenders are helped by unanticipated inflation. LO4

11. Economists agree that inflation reduces real output. LO5

a. Cost-push.

b. Demand-pull.

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

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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).

The set of years that clearly demonstrate an expansionary phase is years 6 through 9. The

rate of growth is positive and increasing over this period.

The set of years that best illustrate a recessionary phase is years 4 and 5. Growth is

negative (declining GDP) for these years.

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

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

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

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Feedback: The inflation rate is the percentage change in the CPI over a period of time.

For the values above we have:

If the CPI was 110 last year and is 121 this year, the inflation rate was 10%

(= ((121-110)/110) x 100).

If the CPI was 110 last year and is 108 this year, the inflation rate was approximately –

1.8%

(= ((108-110)/110) x 100). This outcome is referred to as deflation by economists.

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

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

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

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Feedback:

8. If the inflation premium is 2 percent and the nominal interest rate is 1 percent, what is the real

interest rate? What if the inflation premium is 3 percent while the nominal interest rate is 0.5

percent? LO4

Feedback:

The nominal interest rate equals the real interest rate plus the inflation premium (the

expected rate of inflation). Nominal interest rate = real interest rate + inflation premium.

So given the inflation premium and the nominal interest rate, we can rearrange this

equation to determine the real interest rate. Real interest rate = nominal interest rate −

inflation premium.