Nominal GDP Growth= Real GDP growth + Inflation

Nominal GDP Growth= Real GDP growth + Inflation

Lecture 3

Chapter 9

Business Cycles, Unemployment and Inflation

The Business Cycle

Alternating increases and decreases in economic activity over time

Phases of the business cycle

Peak

Recession

Trough

Expansion

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Business cycles are alternating increases and decreases in economic activity over time. Each business cycle consists of four phases. A peak is when business activity reaches a temporary maximum with full employment and near-capacity output. A recession is a decline in total output, income, employment, and trade lasting six months or more; this is sometimes referred to as an economic contraction. The trough is the bottom of the recession period and the expansion is when output and employment are recovering and expanding toward the full employment level.

Level of real output

Time

Peak

Peak

Peak

Recession

Recession

Expansion

Expansion

Trough

Trough

Growth

Trend

The Business Cycle Continued

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This figure shows the business cycle. Economists distinguish four phases of the business cycle; the duration and strength of each phase may vary. Additionally, individual cycles vary in duration and intensity. You can see that the long run trend is economic growth.

U.S. Recessions since 1950
Period Duration, Months Depth (Decline in Real Output)
1953-54 10 -2.6%
1957-58 8 -3.7
1960-61 10 -1.1
1969-70 11 -0.2
1973-75 16 -3.2
1980 6 -2.2
1981-82 16 -2.9
1990-91 8 -1.4
2001 8 -0.4
2007-09 18 -4.3

Source: National Bureau of Economic Research, www.nber.org, and Minneapolis Federal Reserve Bank, www.minneapolisfed.gov. Output data are in 2000 dollars

The Business Cycle: Recessions

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The NBER is a nonprofit economic research organization. Within the NBER is the Business Cycle Dating Committee whose job it is to declare the start and the end of recessions in the U.S. They declared that the 2007 recession began in December 2007 and ended in June 2009.

The Business Cycle Concluded

Business cycle fluctuations

Economic shocks

Prices are “sticky” downwards

Economic response entails decreases in output and employment

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The United States’ long run economic growth has been interrupted by periods of instability. Uneven growth has been the pattern, with inflation often accompanying rapid growth, and declines in employment and output during periods of recession and depression. Economic shocks are unexpected events that individuals and firms may have trouble adjusting to. Prices can be inflexible downwards which means that if total spending unexpectedly decreases and firms cannot lower prices, the firms will end up selling fewer units of output. The “sticky” prices result in slower sales which will cause firms to cut back on production; this causes GDP to fall. Then employment will fall because of the reduced demand for output and an economic contraction will occur. Inflexible prices are thought to be a major factor in preventing the economy from quickly adjusting to economic shocks. These shocks are outlined on the next slide.

Causation: A First Glance

Causes of shocks

Irregular innovation

Productivity changes

Monetary factors

Political events

Financial instability

Recession of 2007

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The following are economic shocks that can cause business cycles. Major innovations may trigger new investment and/or consumption spending. But these occur irregularly and unexpectedly and may contribute to the variability of economic activity. Examples include the computer and the internet. Changes in productivity may be a related cause. Unexpected changes in resource availability or unexpected changes in the rate of technological advances can affect productivity.

As the monetary authorities print more money, an inflationary boom can occur. Printing less money than what people were expecting can trigger an output decline.

As the economy adjusts to political events like peace treaties or war, economic strains can occur. Rapid asset price increases or decreases can spill over to the general economy and cause booms and busts. The recession of 2007 was led by excessive money, overvalued real estate, and unsustainable mortgage debt.

Cyclical Impact

Durable goods affected most

Capital goods

Consumer durables

Nondurable consumer goods affected less

Services

Food and clothing

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Most agree that the level of aggregate spending is important, especially the changes in spending on capital goods and consumer durables. Recall that the definition of durable goods is a good with an expected life of 3 or more years. Spending on durable goods output is more volatile than nondurables and services because spending on nondurables or services often cannot be postponed. Also, durable goods items such as a new automobile or a new washer and dryer are generally more expensive for households to purchase, making durable goods more vulnerable in times of declining income and uncertainty for households.

Unemployment

Under 16

and/or Institutionalized (69.5 million)

Not in

labor

force

(94.1 million)

Employed

(149.9 million)

Unemployed

(7.9 million)

Total population (321.4 million)

Labor force (157.8 million)

Unemployment rate =

7,900,000

157,800,000

× 100 = 5.0%

Unemployment rate =

# of unemployed

labor force

× 100

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The BLS is the Bureau of Labor Statistics, an agency within the Department of Labor. The unemployment rate is calculated by taking a random survey of 60,000 households nationwide. (Note: Households are in the 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.)

The population is divided into three groups:

Group 1 consists of those under age 16 or institutionalized. In this country, if you are under 16 you are expected to be in school. If you are in an institution such as a nursing home or prison you obviously cannot present yourself to the labor market.

Group 2 consists of those “not in labor force”. Examples of individuals who are not in the labor force are full-time college students who are not working, stay at home parents, and retirees.

Group 3 consists of those age 16 and over who are willing and able to work, and actively seeking work (individuals who have demonstrated job search activity within the last four weeks).

So, Group 3 is the labor force. The labor force is simply described as those who are either employed or unemployed. To be counted as unemployed you must be a part of the labor force.

Figure 29.2 shows the labor force, employment, and unemployment in 2015. The labor force consists of persons 16 years of age or older who are not in institutions and who are employed, or unemployed but seeking employment. The unemployment rate is defined as the percentage of the labor force that is not employed and is found by taking the number of those unemployed and dividing that number by the labor force. Remember to multiply the result by 100 so you can express this as a percentage. The BLS rounds the number to one decimal point.

Unemployment

Unemployment Concluded

Frictional unemployment

Individuals searching for jobs or waiting to take jobs soon

Structural unemployment

Occurs due to changes in the structure of the demand for labor

Cyclical unemployment

Caused by the recession phase of the business cycle

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Frictional unemployment is regarded as somewhat desirable, because it indicates that there is mobility as people change or seek jobs. Frictional unemployment is usually a short term type of unemployment. Structural unemployment occurs when certain skills become obsolete or geographic distribution of jobs changes. This can be a long-term type of unemployment. Cyclical unemployment is caused by the recession phase of the business cycle. As firms respond to insufficient demand for their goods and services, output and employment are reduced.

Extreme unemployment during the Great Depression (25 percent in 1933) is an example of cyclical unemployment.

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

Unemployment Continued

Criticisms of unemployment

Involuntary part-time workers counted as full-time

Discouraged workers are not counted as unemployed

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Two factors cause the official unemployment rate to understate actual unemployment. Part-time workers are counted as “employed” even if they really want full-time work. “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 the unemployment statistic. If they are not seeking work, they are officially in group 2 as described on the preceding slide. In 2015, 664,000 people fell into this category, compared to 396,000 in 2007.

Definition of Full Employment

Natural Rate of Unemployment (NRU)

Full employment level of unemployment

Can vary over time

Demographic changes

Changing job search methods

Public policy changes

Actual unemployment can be above or fall below the NRU

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Full employment does not mean zero unemployment, but it does mean that cyclical unemployment is zero. The full employment-unemployment rate is equal to the total frictional and structural unemployment because these types of unemployment are always occurring and are a natural part of our economy. The full employment rate of unemployment is also referred to as the natural rate of unemployment.

The natural rate is achieved when labor markets are in-balance; the number of job seekers equals the number of job vacancies. 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 nation.

Economic Cost of Unemployment

GDP Gap

GDP gap = actual GDP – potential GDP

Can be negative or positive

Okun’s Law

Every 1% of cyclical unemployment creates a 2% GDP gap

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The GDP gap is the difference between potential and actual GDP where potential GDP reflects the level of GDP associated with the natural rate of unemployment. 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.” This means that the country is producing below what could potentially be produced, given our resources and level of technology. You might liken this to operating inside of the PPC if you covered the Production Possibilities Model.

Question

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?

Unemployment rate=(No. of unemployed/Labor Force)*100%=(1/(9+1))*100%=10%

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Question

Label each of the following scenarios as either frictional unemployment, structural unemployment, or cyclical unemployment.

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.

Frictional

Cyclical

Structural

Structural

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Actual and Potential Real GDP & the Unemployment Rate

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This figure shows the actual and potential real GDP and the unemployment rate from 1995-2015. (a) The difference between actual and potential GDP is the GDP gap. A negative GDP gap measures the output the economy sacrifices when actual GDP falls short of potential GDP. A positive GDP gap indicates that actual GDP is above potential GDP. (b) A high unemployment rate means a large GDP gap (negative), and a low unemployment rate means a small or even positive GDP gap.

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Unemployment Rate

A high unemployment rate means a large GDP gap, and a low unemployment rate means a small or even positive GDP gap.

Unequal Burdens

Occupation

Age

Race and ethnicity

Gender

Education

Duration

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Unequal burdens of unemployment exist, see the next slide for the table of data. Rates are lower for white collar workers. Teenagers have the highest unemployment rates. African-Americans have higher unemployment rates than whites. Rates for males and females are comparable, though females currently have a lower unemployment rate. Less educated workers, on average, have higher unemployment rates than workers with more education. The “long term” (15 weeks or more) unemployment rate is much lower than the overall rate, although it increased from 1.5% in 2007 to 4.7% in 2009.

Unequal Burdens Continued

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Unemployment Rates by Demographic Group: Full Employment Year (2007) and Recession Year (2009)*
Demographic Group Unemployment Rate
2007 2009
Overall 4.6% 9.3%
Occupation: Managerial and professional Construction and extraction
2.1 4.6
7.6 19.7
Age: 16-19 African American, 16-19 White, 16-19 Male, 20+ Female, 20+
15.7 24.3
29.4 39.5
13.9 21.8
4.1 9.6
4.0 7.5
Race and ethnicity: African American Hispanic White
8.3 14.8
5.6 12.1
4.1 8.5
Gender: Women Men
4.5 8.1
4.7 10.3
Education:** Less than high school diploma High school diploma only College degree or more
7.1 14.6
4.4 9.7
2.0 4.6
Duration: 15 or more weeks 1.5 4.7

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This table illustrates civilian labor force data for people age 25 or over. As you can see, the overall unemployment rate was 4.6 percent in 2007, and 9.3 percent in 2009.

Global Perspective

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This Global Perspective shows the unemployment rates in five industrialized nations, 2004-2014. Compared with Italy, France, and Germany, the United States has had a relatively low unemployment rate in recent years.

Inflation

General rise in the price level

Inflation reduces the “purchasing power” of money

Consumer Price Index (CPI)

CPI

Price of the Most Recent Market

Basket in the Particular Year

Price estimate of the Market

Basket in the base year

=

×

100

Inflation

CPI2 – CPI1

CPI1

=

×

100 = 1.6%

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Not all prices rise at the same rate, and some prices may stay constant while other prices fall. Reduced purchasing power means that each dollar of income will buy fewer items than before. The CPI-U is the most commonly reported measure of inflation. The main index used to measure inflation is the Consumer Price Index (CPI). The CPI-U is the measure the media reports. This is the CPI for all urban consumers and thought to cover 87% of our population’s purchasing experiences. There are other price indexes reported by the BLS and each is important to different groups. For example, there is the CPI-W, the CPI-C, the PPI etc. To measure inflation, subtract last year’s price index from this year’s price index and divide by last year’s index. Finally, multiply by 100 to express as a percentage.

In this numerical example, using CPI data for 2014, there is a price index of 236.7 and 2013 has a price index of 233.0. You can calculate the inflation rate and find it is 1.6%. The BLS rounds to the tenths decimal place. “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. Here the inflation rate is 1.6% so divide 70 by 1.6 and you get the number 43.75. Therefore, it would take about 44 years for prices to double at that rate of inflation. If the inflation rate is 7 percent, then it will take about ten years for prices to double.

Inflation Continued

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This global perspective shows the inflation rates of five different countries. You can see that for the United States the inflation rate has been generally slightly higher than the other countries.

Inflation Concluded

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This figure shows the inflation rate in the U.S. from 1960 to 2015.

Types of Inflation

Demand-Pull inflation

Excess spending relative to output

Central bank issues too much money

Cost-Push inflation

Due to a rise in per-unit input costs

Supply shocks

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Demand-pull inflation is a result of spending increasing faster than production. It is often described as “too much spending chasing too few goods.”

Cost-push inflation occurs as prices rise because of a rise in per-unit production costs (Unit cost = total input cost/units of output).

In cost-push inflation, prices rise but output falls. Rising costs reduce profits and reduce the amount of output producers are willing to supply at the existing price level. As a result, the economy’s supply of goods and services declines and the price level rises. 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.

Types of Inflation Continued

Difficult to distinguish inflation types

Types differ in sustainability

Demand-pull continues as long as the excess spending continues

Cost-push ends in a recession

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It is difficult to distinguish between the causes of inflation, although cost-push will die out in a recession if spending does not also rise. Because food (like oranges) and energy products (like gasoline) prices are subject to wide swings that can be temporary in nature, the BLS also reports the core CPI which is the CPI less food and energy. The policy makers are mainly interested in whether the underlying core CPI is rising and how quickly. Based on that analysis, they may take measures to try to stop it.

Redistribution Effects of Inflation

Nominal income

Unadjusted for inflation

Real income

Nominal income adjusted for inflation

Anticipated vs. unanticipated income

Percentage

change in real income

=

Percentage change in nominal income

Percentage change in

price level

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Nominal income is the number of dollars received as wages, rent, interest, or profit. Real income refers to the purchasing power of your income (how much can actually be purchased with your income). Anticipated inflation is much less harmful than unanticipated inflation. Real income can decrease even with an increase in nominal income if the inflation rate is higher than the increase in nominal income.

Question

Your brother graduated from college in December 2006 and started to work at a salary of $36,000. You expect to graduate this December and start work for a salary of $54,000. The Consumer Price Index (CPI) was 80 in December 2006, and it is expected to be 120 in December 2018. Who will have had the higher real salary, you or your brother? Show your work.

Real salary of your brother= (36000/0.8)=45,000

Your real salary=(54000/1.2)=45,000

Both have the same real salary

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Who is Hurt by Inflation?

Fixed-income receivers

Real incomes fall

Savers

Value of accumulated savings deteriorates

Creditors

Lenders get paid back in “cheaper dollars”

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Harm from unanticipated inflation causes real incomes and wealth to be redistributed. Were the inflation to be expected, people could plan ahead for it. Those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects. Unanticipated inflation has stronger impacts. Fixed income groups will be hurt because their real income suffers. Their nominal income does not rise with prices. Savers will be hurt by unanticipated inflation because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power. Creditors (or lenders) can be harmed by unanticipated inflation. Interest on payments received may be less than the inflation rate and loan payments will have less purchasing power for the lender when the lender did not correctly anticipate and account for inflation.

Who is Unaffected by Inflation?

Flexible-income receivers

COLAs

Social Security recipients

Union members

Debtors

Pay back the loan with “cheaper dollars”

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If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses (Cost-of-living adjustments) built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders. Debtors (borrowers) can be helped because interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars.

Anticipated Inflation

Real interest rate

Rates adjusted for inflation

Nominal interest rate

Rates not adjusted for inflation

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If inflation is anticipated, individuals can plan ahead mitigating the effects of inflation.

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

“Real interest rate” is defined as the nominal rate minus the inflation premium.

Anticipated Inflation Continued

Nominal

Interest

Rate

Real

Interest

Rate

Inflation

Premium

11%

5%

6%

=

+

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This figure shows the inflation premium and nominal and real interest rates. The inflation premium — the expected rate of inflation — gets built into the nominal interest rate. Here, the nominal interest rate of 11 percent comprises the real interest rate of 5 percent plus the inflation premium of 6 percent.

Question

Assume you borrow money from the bank and they charge you 8.5% interest. It is expected that inflation rate will be 3%. The bank, therefore, expects to earn a real rate of return, or a real interest rate, of 11.5%. Indicate whether this statement is TRUE or FALSE; and then provide support for your answer.

False, real interest rate=8.5%-3%=5.5%

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Other Redistribution Issues

Deflation

Mixed effects

Incomes may rise

Fixed assets values may fall

For fixed-rate mortgages, real debt declines

Arbitrariness

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In the past, deflation has been as much a problem as inflation. For example, the 1930s depression was a period of declining prices and wages. The effects of deflation are the reverse of those of inflation.

Many families are simultaneously helped and hurt by inflation because they are borrowers and earners and savers.

Effects of inflation are arbitrary in terms of individuals who will benefit and individuals who are harmed, regardless of society’s goals.

Hyperinflation

Extraordinarily rapid inflation

Devastates an economy

Businesses don’t know what to charge

Consumers don’t know what to pay

Money becomes worthless

Zimbabwe’s 14.9 billion percent inflation in 2008

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There is a danger of creeping inflation turning into hyperinflation, which can cause speculation, reckless spending, and more inflation.

The Zimbabwe experience is interesting. The government of Zimbabwe faces a wide variety of difficult economic problems as it struggles with an unsustainable fiscal deficit, an overvalued official exchange rate, hyperinflation, and bare store shelves. Its 1998-2002 involvement in the war in the Democratic Republic of the Congo drained hundreds of millions of dollars from the economy. The government’s land reform program, characterized by chaos and violence, has badly damaged the commercial farming sector, the traditional source of exports and foreign exchange and the provider of 400,000 jobs, turning Zimbabwe into a net importer of food products. The EU and the US provide food aid on humanitarian grounds. Badly needed support from the IMF has been suspended because of the government’s arrears on past loans and the government’s unwillingness to enact reforms that would stabilize the economy. The Reserve Bank of Zimbabwe routinely prints money to fund the budget deficit, causing the official annual inflation rate to rise from 32% in 1998, to 133% in 2004, 585% in 2005, past 1,000% in 2006, and 26,000% in November 2007, and to 11.2 million percent in 2008. Meanwhile, the official exchange rate fell from approximately 1 (revalued) Zimbabwean dollar per US dollar in 2003 to 30,000 per US dollar in September 2007.

Question

Consider the production of fries and burger in an economy:

Where Q represents quantity and P represents prices; 2013 is the base year.

Compute the value of price index using 2013 as the base year. What is the rate of inflation in 2014?

Price Index in 2013=100 (Since 2013 is the base year)

Price index in 2014= [(200×9)+(500×1.6)]/[(200×8.5)+(500×1.5) x 100= 106.1

Rate of inflation= (106.1-100)/100 x100%= 6.1 %

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