Chapter 09 – Business Cycles, Unemployment, and Inflation
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Chapter 09 Business Cycles, Unemployment, and Inflation
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 26.1, 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
(abrupt asset price decreases) can spill over to the general economy by contracting
lending and eroding the confidence of consumers and businesses.
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
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
Hispanics is higher than that for whites. In general, the unemployment rate for African
Americans is twice that of whites.
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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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, a person who quits a
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 unemployed do not qualify for
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 each
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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? LO3
Answer: Demand-pull inflation occurs when prices rise because of an increase in
aggregate spending not fully matched by an increase in aggregate output. It is sometimes
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? LO3
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 95.65 (=
10. Explain how hyperinflation might lead to a severe decline in total output. LO3
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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 do with
money is to spend it before its value is cut in half within a month, a week, or a day. This
11. LAST WORD Suppose that stock prices were to fall by 10 percent in the stock market. All
else equal, would the lower stock prices be likely to cause a recession? How might lower stock
prices help predict a recession?
Answer: GDP could be reduced if stock owners feel significantly poorer and reduce their
spending on goods and services, including investment in real capital goods. However,
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: Consider the following example. 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?
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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: Consider the following example. 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?
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
Feedback: Consider the following example. 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?
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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
Feedback: Consider the following example. 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?
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: Consider the following example values. 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?
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? LO3
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Feedback: Consider the following example. 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?
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? LO3
Feedback: Consider the following example. 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?