Chapter 10: Economic Fluctuations, Unemployment, and Inflation

Chapter Objectives Examine the business cycle Consider various business cycle theories Show how economic forecasting is done Measure the GDP gap Learn how the unemployment rate is computed Look at the types of unemployment Construct a consumer price index Consider the theories of inflation

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Chapter 10Economic Fluctuations, Unemployment, and Inflation10-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesExamine the business cycleConsider various business cycle theoriesShow how economic forecasting is doneMeasure the GDP gapLearn how the unemployment rate is computedLook at the types of unemploymentConstruct a consumer price indexConsider the theories of inflation10-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.GDP in 1992 dollars, 1964-2000The Conventional Three-Phase Business Cycle10-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Business Cycle TheoriesEndogenous theoriesInnovation theoryPsychological theoryInventory cycle theoryMonetary theoryUnder-consumption theoryExogenous theoriesSunspot theoryWar theory 10-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Business Cycle ForecastingThe Ten Leading Economic Indicators1. Average workweek of production workers in manufacturing2. Average initial weekly claims for state unemployment insurance3. New orders for consumer goods and materials4. Vendors performance (companies receiving slower deliveries from suppliers)5. New orders for capital goods10-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Business Cycle Forecasting (Continued)The Ten Leading Economic Indicators6. New building permits issued7. Index of stock prices8. Money supply9. Spread between rates on 10-year Treasury bonds and Federal funds10. Index of consumer expectations10-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Index of Leading Indicators, 1958-2001Note that the index has turned down well before recessions begin and turned upward before recovery set inThe GDP Gap, 1945-2000The GDP gap is the amount of production by which potential GDP exceeds actual GDP10-9Since potential GDP has exceeded actual GDP for most years since World War II, we have had a GDP gap. However in some periods, most recently from 1996 through 2000, actual GDP has been greater than potential GDP UnemploymentThe problemOne of the most devastating experiences a person can have is to be out of work for a prolonged periodDiscouraged workers are those who have given up looking for work and have simply dropped out of the labor forceThe Bureau of Labor Statistics does not count discouraged workers as part of the labor force and thus as unemployed10-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Unemployment The liberal criticismA person who worked one day last month is counted as employedSomeone who works part-time but who wants to work full-time is counted as employedThe true unemployment rate is higher than the official rate10-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Unemployment The conservative criticismSome just go through the motions of looking for work to remain eligible for benefits and are not really looking for workHuge numbers of Americans – as well as illegal immigrants are working in the underground economyThese people are employed off the books, do not report their income, and are not counted as employed by the bureau of labor statistics10-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Unemployment The conservative criticism (continued)The percentage of married women in the labor force has risen from 25 percent in the late 1940s to about 65 percent today (this raises the unemployment rate in three ways)Married women who are reentering the labor force will have to find jobs; because their husbands are employed they can shop around for a whileTheir husbands, if unemployed, can also shop around for a while if their wives are workingThe percentage of married women in the labor forceThe true unemployment rate is lower than the official rate10-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-15How Is the Unemployment Rate Computed? UR = Number of Unemployed Labor Force Number employed+ Number unemployed Labor ForceCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-16How Is the Unemployment Rate Computed? UR = Number of Unemployed Labor Force Number employed+ Number unemployed Labor ForceJuly 2000 Number unemployed = 5,650,000 + Number employed = 134,749,000 Labor Force = 140,399,000 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-17How Is the Unemployment Rate Computed?UR = ------------------------------------------Number of Unemployed Labor Force Number employed + Number unemployed Labor ForceJuly 2000 Number unemployed = 5,650,000 + Number employed = 134,749,000 Labor Force = 140,399,000 UR = ---------------------------------------5,650,000140,399,000Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-18How Is the Unemployment Rate Computed?UR = ------------------------------------------Number of Unemployed Labor Force Number employed + Number unemployed Labor ForceJuly 2000 Number unemployed = 5,650,000 + Number employed = 134,749,000 Labor Force = 140,399,000 UR = ---------------------------------------5,650,000140,399,000UR = .0424245 = 4.2 %Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.When It’s a Recession for Whites, It’s a Depression for Blacks Historically, the unemployment rate for blacks has been double that of whitesDuring the 1981-82 recession the unemployment rate for black teenagers topped 50 percent10-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.When It’s a Recession for Whites, It’s a Depression for Blacks There have been major strides toward equality of economic opportunity since the mid-1960s, but these strides have left in their wake a huge Black (and Hispanic) underclassIf you are Black or Hispanic, your chances of being poor are three times as greatIf your are Black or Hispanic, your chances of being unemployed are twice as great 10-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.When It’s a Recession for Whites, It’s a Depression for Blacks It appears that two things can be done to ease the economic burden of minority groupsMake greater efforts to end employment discriminationAvoid recessions and keep the unemployment rate as low as possible10-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Unemployment Rate, 1948-2000Unemployment went up between 1969 and 1982 and went down after thatTypes of UnemploymentFrictional unemploymentStructural unemploymentCyclical unemployment10-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Frictional UnemploymentThe frictionally unemployed are people who are between jobs or just entering or reentering the labor marketUsually weeks or months pass before positions are filledAt any given time, about 2 or 3 percent of the labor force is frictionally unemployed10-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Structural UnemploymentA person who is out of work for a relatively long period of time, say, a couple of years, is structurally unemployed. Some examples areSteelworkers and coal miners who are out of work because local steel plants and coal mines have closedClerical workers, typists, inventory control clerks who have been made obsolete by a computer systemPeople who are functionally illiterate and who are virtually shut out of the labor forceOne in five adult Americans is functionally illiterateOur educational system turns out 1 million more functional illiterates every yearAbout 2 to 3 percent of our labor force is always structurally unemployed10-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Cyclical UnemploymentCyclical unemployment is anything above the sum of frictional and structural unemploymentCaused by the ups and downs in our economy known as the business cycleFluctuations in our unemployment rate are due to cyclical unemployment10-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Natural Unemployment Rate10-27Most economists estimate the natural unemployment rate to be 5 or 6 percent. If we take a 5 percent unemployment rate as our working definition of full employment, anything above 5 percent would be cyclical unemploymentFrictional 2.5% (Natural)Structural 2.5% (Natural) 5.0% (Full unemployment) Cyclical 1.7% (Not natural) Unemployment Rate 6.7%++Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. • If it is increasingly difficult to find employees, employers will bid up wage rates, pushing up the rate of inflation • Once the unemployment rate falls below its natural rate, then inflationary wage pressure emergesNatural Unemployment Rate 10-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.InflationDefining inflationGenerally, we consider inflation to be a sustained rise in the average price level over a period of yearsWhen the overall price level is rising, the prices of some goods and services are going down [e.g., TV prices in the 1970s and the 1980s, the price of VCRs, and more recently the price of cellular phones]U.S. inflation has been persistent since World War II10-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Consumer Price Index (CPI)The CPI, which measures changes in our cost of living, is reported near the middle of every month by the Bureau of Labor StatisticsThe CPI is based on what it cost an average family to live10-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Finding Percentage Change in the Price LevelYear CPI1972 125.31982 289.1By what percentage did the cost of living rise?10-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Finding Percentage Change in the Price LevelYear CPI1972 125.31982 289.1By what percentage did the cost of living rise?10-32Percentage change = ---------------------------- X 100ChangeOriginal NumberCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Finding Percentage Change in the Price LevelYear CPI1972 125.31982 289.1By what percentage did the cost of living rise?10-33Percentage change = ---------------------------- X 100ChangeOriginal NumberChange = 163.8Original NumberCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Finding Percentage Change in the Price LevelYear CPI1972 125.31982 289.1By what percentage did the cost of living rise?10-34Percentage change = ---------------------------- X 100ChangeOriginal NumberChange = 163.8Original NumberPercentage change = ---------------------------- X 100163.8125.3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Finding Percentage Change in the Price LevelYear CPI1972 125.31982 289.1By what percentage did the cost of living rise?10-35Percentage change = ---------------------------- X 100ChangeOriginal NumberChange = 163.8Original NumberPercentage change = ---------------------------- X 100163.8125.3Percentage change = 1.307 X 100 = 130.7%Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.A Magic Number10-37The number 100 is magic! It lends itself to calculating percentage changes. Suppose we want to find out by what percentage prices have risen since the base year?The base year is set at 100.If the CPI today is 136.4, by what percentage did prices rise since the base year?Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.A Magic Number10-38The number 100 is magic! It lends itself to calculating percentage changes.Suppose we want to find out by what percentage prices have risen since the base year?The base year is set at 100.If the CPI today is 136.4, by what percentage did prices rise since the base year?136.4 – 100 = 36.4%Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Annual Percentage Change in the Consumer Price Index, 1946-2000Since World War II we have had two periods of price stability-from 1952 through 1965 and from 1991 to the present10-40Inflation Seems InevitableIt appears that it takes a recession to deflate “inflation”Sir Frederick Keith-Ross (1957)“Inflation is like sin; every government denounces it and every government practices it”Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.DeflationDeflation is a decline in the general level of prices for a period of yearsThis is the OPPOSITE of inflationThis last occurred between 1929 -3310-41Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.DeflationDeflation is a decline in the general level of prices for a period of yearsThis is the opposite of inflationThis last occurred between 1929 -3310-42Year CPI1929 17.11930 16.71931 15.21932 13.71933 13.01934 13.4 General price levels are declining when the CPI is decreasing.General price levels are rising when the CPI is increasingCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.DisinflationDisinflation occurs when the RATE of inflation declinesYear CPI Inflation Rate1980 82.4 13.5%1981 90.9 10.3%1982 96.5 6.2%1983 99.6 3.2%1984 103.9 4.3%1981 -83 the rate of inflation declined . . . but prices continued to increase . . . just at a lower rate!10-43Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-44Consumer Price Index (CPI)The most important measure of inflation is the Consumer Price Index (CPI)CPI = --------------------------------- X 100Cost of livingcyCost of livingbyCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Anticipated and Unanticipated Inflation: Who Is Hurt by Inflation and Who Is Helped?Debtors benefit from unanticipated inflationThey get to repay their loan in dollars that are worth less than the dollars they borrowedThe biggest debtor and gainer from unanticipated inflation has been the U.S. government10-46Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Anticipated and Unanticipated Inflation: Who Is Hurt by Inflation and Who Is Helped?Creditors, the people who lend out money, are hurt by unanticipated inflationThe ultimate creditors, or lenders, are the people who put their money in banks, life insurance, or any other financial instrument paying a fixed rate of interestPeople who live on fixed incomes, particular retired people who depend on pensions (except Social Security) and those who hold long-term bonds, are hurt by unanticipated inflation10-46Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Anticipated and Unanticipated Inflation: Who Is Hurt by Inflation and Who Is Helped?When inflation is fully anticipated there are no winners and losersCreditors have learned to charge enough interest to take into account, or anticipate, the rate of inflation over the course of the loanThis is tacked onto the regular interest rate that the lender would charge had no inflation been expected10-47Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Real Rate of Interest10-48The real rate of interest is the rate that would be charged without inflation Expected Rate of inflation + Real Rate of Interest Nominal Rate of Interest <-------what we payCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Real Rate of Interest10-49The real rate of interest is the rate that would be charged without inflation Expected Rate of inflation 6% + Real Rate of Interest 5% Nominal Rate of Interest 11%Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Real Rate of Interest10-50The real rate of interest is the rate that would be charged without inflation Expected Rate of inflation 6% + Real Rate of Interest 5% Nominal Rate of Interest 11%If the nominal interest rate accurately reflects the inflation, then the inflation has been fully anticipated and no one wins or loses, except the people who borrow money at the higher nominal rate of interest Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Real Rate of Interest10-51The real rate of interest is the rate that would be charged without inflation Expected Rate of inflation 6% + Real Rate of Interest 5% Nominal Rate of Interest 11%But if the rate of inflation keeps growing – even if it is correctly anticipated – our economy will be in big troubleCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Theories of the Causes of InflationDemand-Pull InflationCost-Push inflation10-52Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Demand-Pull InflationWhen there is excessive demand for goods and services, we have demand-pull inflationThis occurs when people are willing and able to buy more output than our economy can produce because our economy is already operating at full capacity 10-53Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Demand-Pull Inflation Demand-pull inflation is often summed up as “too many dollars chasing too few goods”Just where did all of this money come from”? Milton Friedman, a Nobel laureate in economics, suspects the seven governors of the Federal Reserve System, which controls the rate of growth of the money supply10-54Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Cost-Push InflationThere are three variants of cost-push inflationThe wage-price spiralProfit-push inflationSupply-side cost shocks10-55Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Cost-Push Inflation: The Wage-Price Spiral Wages constitute nearly two-thirds of the cost of doing businessWhenever workers receive a significant wage increase, this increase is passed along to consumers in the form of higher pricesHigher prices raise everyone’s cost of living, engendering further wage increases10-56Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Cost-Push Inflation: Profit Push Because just a handful of firms dominate many industries, they have the power to administer prices rather than accept the dictates of the market forces of supply and demandTo the degree that they are able, these firms will respond to any rise in cost by passing them on to their customers10-57Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Cost-Push Inflation: Supply- Side Cost ShocksFinally, we have supply-side shocks, most prominently the oil price shocks of 1973-74 and 1979OPEC nations raised the price of oilWhen the price of oil rises, the cost of making many other things rise as wellCost increases are quickly translated into price increases10-58Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Inflation as a Psychological ProcessIf people believe prices will rise, they will act in a way that keeps prices risingTo break the back of inflationary psychology, policymakers need to bring down the rate of inflation for a sufficiently long period of time for people to actually expect price stability This has happened in the recent past only after successive recessions have “wrung” inflation out of the economy10-59Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Creeping Inflation and Hyperinflation Inflation is a relative termCreeping inflation in one country would be hyperinflation in anotherOnce we cross the line between creeping inflation and hyperinflation—which keeps shifting—we run into troubleIt becomes increasingly difficult to conduct normal economic affairsPrices are raised constantlyIt becomes impossible to enter into long-term contractsNo one is sure what the government might do10-60Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.ConclusionOne thing the economy has rarely been able to attain simultaneously is a