26

Business Cycles, Unemployment, and

Inflation

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Objectives

• Describes the business cycle and its phases

• Different types of unemployment

• How inflation is measured and distinguish

between cost push and demand pull inflation

LO1 26-2
 The Business Cycle

• Alternating increases and decreases in economic

activity over time
• Phases of the business cycle
– Peak
– Recession
– Trough
– Expansion
• Indicators of economics performance
• Real GDP, Unemployment & Inflation

LO1 26-3
 The Business Cycle

• Peak
• business activity max; full employment; real output close to
economy’s capacity; price rise
• Recession
• contraction of business activity; decline in output, income
and employment
• Trough
• output and employment lowest level
• Expansion
• real GDP, income and employment rise, price rise

LO1 26-4
 The Business Cycle

Peak

Peak
Level of real output

d
Peak
Tren

i on
ns
r ow th Re
ces

pa
G sio

Ex
n

on
si
Trough
an
Rec
ess p
io
Ex
n
Trough

Time

LO1 26-5
 Unemployment rate

According to ILO, “Unemployment

refers to the share of the labor force
that is without work but available for
and seeking employment.”
 Unemployment

Under 16 Unemployment rate =

and/or
Institutionalized X 100
(71.4 million) # of unemployed
Not in labor force
labor
Total Force (not Unemployment rate =
population seeking work)
(307.3 (81.7 million)
million) X 100 = 9.3%
14,265,000
Employed 154,142,000
Labor
(139.9 million) force
(154.2
million)

Unemployed
(14.3 million)
LO2 26-7
Labor Force Composition
 Unemployment

• Criticisms of unemployment
• Involuntary part-time workers
counted as if full-time
• Discouraged workers are not
counted as unemployed

LO2 26-9
 Types of Unemployment
• Frictional unemployment (wait or search
unemployment)
– Individuals searching for jobs or waiting to take jobs
soon (moving from low to high paying jobs)
• Structural unemployment (e.g. technological
unemployment)
– Occurs due to changes in the structure of the
demand for labor
• Cyclical unemployment
– Caused by the recession phase of the business cycle

LO3 26-10
 Definition of Full Employment
• Full employment less than 100 percent
employment of the labor force
– When experiencing only frictional and structural
unemployment

• Natural Rate of Unemployment (NRU)

– Full employment level of unemployment
– Economy is producing its potential output
– Actual unemployment can be above or fall below the
NRU

LO3 26-11
 Economic Cost of Unemployment

• GDP Gap (forgone output)

– GDP gap = actual GDP – potential GDP
– Can be negative (actual < potential) or positive (actual
> positive)

• Okun’s Law
– Relationship between unemployment and GDP
– Every 1% of unemployment above the natural rate
creates a 2% GDP gap
– Actual unemp= 9.3, NRU=5, -> Actual unemp>NRU by
4% -> GDP gap= 8.6%

LO3 26-12
 Economic Cost of Unemployment
Economic Cost of Unemployment

LO3 26-13
 Noneconomic Costs

• Noneconomic costs in terms of:

• Loss of skills and loss of self-respect
• Family disintegration
• Poverty and reduced hope
• Heightened racial and ethnic tensions
• Suicide, homicide, fatal heart attacks, mental illness
• Can lead to violent social and political change

LO3 26-14
 Inflation
• General rise in the price level
• Inflation reduces the “purchasing
power” of money
• Consumer Price Index (CPI)
Price of the Most Recent Market
Basket in the 2011
CPI2011 =
Price estimate of the Market
x 100
Basket in Base year

CPI 2011 - CPI2010

Inflation = x 100
=%
in 2011 CPI 2010
LO3 26-15
INFLATION RATE
 Types of Inflation

• Demand-Pull inflation
– “Too much spending chasing too few goods”
– Central bank issues too much money
– Excess spending relative to output
– At full capacity, business cannot respond to
excess demand by expanding output

LO3 26-17
 Types of Inflation

• Cost-Push inflation
– Supply shocks
– Due to a rise in per-unit input costs
– Squeeze profits
– Reduce the amount of output firms are willing
to supply
– Price increases

LO3 26-18
 Redistribution Effects of Inflation
• Nominal income
– the number of dollars received as wages, rent, interest
or profits.
– Unadjusted for inflation
• Real income
– Measure of the amount of goods and services nominal
income can buy
• Nominal income adjusted for inflation
Percentage Percentage Percentage
change in 
= change in change in
real income nominal income price level

LO3 26-19
 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”

LO3 26-20
 Who is Unaffected by Inflation?

• Flexible-income receivers
• COLAs
• Debtors
• Pay back the loan with “cheaper
dollars”

LO3 26-21
 Does Inflation Affect Output?
• Cost-push inflation
• Reduces real output
• Redistributes a decreased level of
real income
• Demand-pull inflation
• One view is that zero inflation is best
• Another view is that mild inflation is
best

LO3 26-22