CHAPTER OVERVIEW - Seneca Valley School District



chapter Twenty-Six

Business Cycles, Unemployment, and Inflation

CHAPTER OVERVIEW

This chapter discusses the business cycle, unemployment, and inflation. It sets the stage for the analytical presentation in later chapters.

The business cycle is introduced in historical perspective and is presented in stylized form (Figure 26.1). While hinting at various business cycle theories, the authors stress the general belief that changes in aggregate spending, especially durable goods and investment spending, are the immediate cause of economic instability. Non-cyclical fluctuations are also treated briefly before the analysis of unemployment and inflation.

In the section on unemployment, the various types of unemployment—frictional, structural, and cyclical—are described. Then the problems involved in measuring unemployment and in defining the full-employment unemployment rate are considered. The economic and non-economic costs of unemployment are presented, and finally, Global Perspective 7.2 gives an international comparison of unemployment rates.

Inflation is accorded a rather detailed treatment from both a cause and an effect perspective. International comparisons of inflation rates in the post-1992 period are given in Global Perspective 7.2. Demand-pull and cost-push inflation are described. Considerable emphasis is placed on the fact that the redistributive effects of inflation will differ, depending on whether inflation is anticipated or unanticipated. The chapter ends with historical cases of hyperinflation to remind students that inflationary fears have some basis in fact.

Concept Illustration … Types of Unemployment

Imagine a fictitious country named Miniature that has a stable population of 120 people, of which 100 are in the labor force. Of these 100 people, 95 are employed and 5 are unemployed. That means Miniature’s unemployment rate is 5 percent (= 5/100).

Suppose we could take a group photo of the unemployed workers each month so as to obtain a continuing record of their monthly numbers and reveal whom they are. By comparing the monthly photos over long periods, we could sort out the types of unemployment occurring in Miniature.

Suppose that in a typical month there are 5 people in the photo. Also, suppose that 4 of these people are never the same individuals who were in the photo the previous month and the other person never shows up in the photo for more than two or three consecutive months.

We can reasonably conclude that Miniature is experiencing frictional unemployment and structural unemployment. The frictionally unemployed workers are quickly finding jobs, and after retraining or relocation, the structurally unemployed workers are obtaining new jobs within a few months. Taking the places of these formerly unemployed persons are newly unemployed people who are looking for new jobs, waiting for future jobs, retraining, or relocating. Five percent of the labor force is unemployed each month, but nobody is unemployed for any substantial length of time. Miniature is not suffering an “unemployment problem.”

In contrast, suppose that over a six-month period we observe that the number of people in the unemployment photo increases from 5 to 10, with no change in the size of the labor force. Thereafter, the 10 percent unemployment rate continues for a full year. A comparison of the monthly photos reveals that it is mainly the same people who are employed month after month.

We can reasonably conclude that Miniature is now experiencing cyclical unemployment. Total spending must have declined, reducing production and employment. The increase in the unemployment rate from 5 percent to 10 percent has accompanied this recession. Miniature now has a serious “unemployment problem.” Cyclical unemployment is involuntary, relatively long lasting, and creates serious financial hardship for those people unemployed. It also results in an irretrievable loss of output to society. (Note that there could also be a more serious form of structural unemployment contributing to the increased rate and duration).

1. Table 26.2 can be used to discuss the definition of unemployment and its limitations. Current data to update the table can be found in the Monthly Labor Review, Employment and Earnings, Economic Indicators, or see web-based question 1. Make it clear that a portion of each unemployment statistic is due to frictional and structural unemployment, which are found even in a “full employment” economy. Frictional unemployment indicates a healthy economy with labor mobility. Structural unemployment is viewed as serious, but not responsive to economic policies alone.

2. Have students consider the losses from unemployment. Perhaps they could write a feature article on losses due to GDP gap, higher inflation, or the social and personal losses incurred by those unemployed.

3. Try web-based question 2 for current inflation data. While we have been concerned with inflation since World War II, it is interesting to note that past (and now current) economists have been as concerned about deflation. A good topic is to ask students how deflation can be a problem, as it has been in Japan and has threatened to be in the U.S. within the past decade.

4. For a deeper understanding of the costs of inflation, you may wish to share the following “Concept Illustration” with your students:

Concept Illustration … Costs of Inflation

On pages 138-139 costs of inflation are explained. The following metaphors highlight some of the more subtle, but very present, costs imposed by rising prices.

Menu costs Inflation requires firms to change the prices they charge from one period to another. This new pricing of products and the communication of the new prices to customers requires time and effort that could otherwise be used for more productive purposes. These inflation costs are sometimes called menu costs, because they are similar to the costs incurred by restaurants that need to print new menus when prices rise. Menu costs include all costs associated with the inflation-caused need to change prices.

Yardstick costs Inflation interferes with money functioning as a measure of value and thus requires more time and effort to determine what something is worth (in real terms). Dollar price tags lose some of their meaning when inflation occurs, because the dollar’s value has declined relative to before. It is as if a yardstick that formerly measured 36 inches now measures 34, 33, or even fewer inches. All inflation-caused costs associated with determining real versus nominal values can be thought of as yardstick costs.

Shoe-leather costs We have noted that people try to protect their financial assets against erosion from inflation by limiting the amounts of money they hold in their billfolds and in their non-interest-bearing checking accounts, putting those funds instead into interest-bearing saving accounts or stock and bond funds. But people actually need more money to buy the higher priced goods and services. So, they figuratively walk to and from financial institutions much more often in order to move money from these latter accounts to checking accounts or to get cash when it is needed. In the process they wear out their shoes—they incur so-called shoe-leather costs. These costs include all time and resource costs associated with the inflation-induced need to make more financial transactions.

5. The Wall Street Journal is a good source of information on the most current economic situation. They have a “Newspaper-in-Education” program that provides various teaching aids, in addition to favorable subscription rates for students. Call 1-800-JOURNAL contact their website for more information. Among their aids is a stylized Wall Street Journal Education edition, which gives information on dates on which important economic statistics are announced each month or each quarter. Your local newspaper and periodicals may have similar education programs. The Economist includes up-to-date macroeconomic information and presents stories of U.S. macroeconomic policies and conditions that are detailed but accessible.

6. Unemployment and inflation have a human face. A dramatic reading of quotes from a book such as Studs Terkel’s Hard Times can be used to bring statistics to life. You or your students may be acquainted with individuals who lived through the depression years or who have suffered from periods of unemployment. Inviting them to discuss the impact of these experiences also helps to make this material more interesting for students.

NOTES

I. Unemployment (One Result of Economic Downturns)

A. Measuring unemployment (see Figure 26.2 for 2007):

1. The population is divided into three groups: those under age 16 or institutionalized, those “not in labor force,” and the labor force that includes those age 16 and over who are willing and able to work, and actively seeking work (demonstrated job search activity within the last four weeks).

2. The unemployment rate is defined as the percentage of the labor force that is not employed. (Note: Emphasize not the percentage of the population.)

3. The unemployment rate is calculated by random survey of 60,000 households nationwide. (Note: Households are in 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.) Two factors cause the official unemployment rate to understate actual unemployment.

a. Part-time workers are counted as “employed.”

b. “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 unemployment statistic.

B. Types of unemployment:

1. Frictional unemployment consists of those searching for jobs or waiting to take jobs soon; it is regarded as somewhat desirable, because it indicates that there is mobility as people change or seek jobs.

2. Structural unemployment: due to changes in the structure of demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs changes.

a. Glass blowers were replaced by bottle-making machines.

b. Oil-field workers were displaced when oil demand fell in 1980s.

c. Airline mergers displaced many airline workers in 1980s.

d. Foreign competition has led to downsizing in U.S. industry and loss of jobs.

e. Military cutbacks have led to displacement of workers in military-related industries.

3. Cyclical unemployment is caused by the recession phase of the business cycle.

a. As firms respond to insufficient demand for their goods and services, output and employment are reduced.

b. Extreme unemployment during the Great Depression (25 percent in 1933) was cyclical unemployment.

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

C. Definition of “Full Employment”

1. Full employment does not mean zero unemployment.

2. The full-employment unemployment rate is equal to the total frictional and structural unemployment.

3. The full-employment rate of unemployment is also referred to as the natural rate of unemployment.

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

5. 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 nations.

6. Recently the natural rate has dropped from 6% to 4 to 5%. This is attributed to:

a. The aging of the work force as the baby boomers approach retirement.

b. Improved job information through the internet and temporary-help agencies.

c. New work requirements passed with the most recent welfare reform.

d. The doubling of the U.S. prison population since 1985.

D. Economic cost of unemployment:

1. GDP gap and Okun’s Law: GDP gap is the difference between potential and actual GDP. (See Figure 26.3) 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.”

2. Unequal burdens of unemployment exist. (See Table 26.2)

a. Rates are lower for white-collar workers.

b. Teenagers have the highest rates.

c. African-Americans have higher rates than whites.

d. Rates for males and females are comparable, though females had a lower rate in 2002.

e. Less educated workers, on average, have higher unemployment rates than workers with more education.

f. “Long-term” (15 weeks or more) unemployment rate is much lower than the overall rate, although it has nearly doubled from 1.1% in 1999 to 2% in 2002.

E. Noneconomic costs include loss of self-respect and social and political unrest.

F. International comparisons. (See Global Perspective 26.1)

II. Inflation: Defined and Measured

A. Definition: Inflation is a rising general level of prices (not all prices rise at the same rate, and some may fall).

B. The main index used to measure inflation is the Consumer Price Index (CPI). To measure inflation, subtract last year’s price index from this year’s price index and divide by last year’s index; then multiply by 100 to express as a percentage.

C. “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. If the inflation rate is 7 percent, then it will take about ten years for prices to double. (Note: You can also use this rule to calculate how long it takes savings to double at a given compounded interest rate.)

D. Facts of inflation:

1. 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 prospect of deflation was a concern of economic policymakers earlier this decade.

2. All industrial nations have experienced the problem (see Global Perspective 26.2).

3. Some nations experience astronomical rates of inflation (Zimbabwe’s was 585 percent in 2005).

4. The inside covers of the text contain historical rates for the U.S.

E. Causes and theories of inflation:

1. Demand-pull inflation: Spending increases faster than production. It is often described as “too much spending chasing too few goods.”

2. CONSIDER THIS … Clipping Coins

a. Princes would clip coins, paying peasants with the clipped coins and using the clippings to mint new coins.

b. Clipping was essentially a tax on the population as the increased money supply caused inflation and reduced the purchasing power of each coin.

3. Cost-push or supply-side inflation: Prices rise because of rise in per-unit production costs (Unit cost = total input cost/units of output).

a. Output and employment decline while the price level is rising.

b. 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.

4. Complexities: It is difficult to distinguish between demand-pull and cost-push causes of inflation, although cost-push will die out in a recession if spending does not also rise.

III. Redistributive effects of inflation:

A. The price index is used to deflate nominal income into real income. Inflation may reduce the real income of individuals in the economy, but won’t necessarily reduce real income for the economy as a whole (someone receives the higher prices that people are paying).

B. Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects.

C. Fixed-income groups will be hurt because their real income suffers. Their nominal income does not rise with prices.

D. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power.

E. Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender.

F. If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders.

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

2. “Real interest rate” is defined as nominal rate minus inflation premium. (See Figure 26.5)

G. Final points

1. Unexpected deflation, a decline in price level, will have the opposite effect of unexpected inflation.

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

3. Effects of inflation are arbitrary, regardless of society’s goals.

III. Output Effects of Inflation

A. Cost-push inflation, where resource prices rise unexpectedly, could cause both output and employment to decline. Real income falls.

B. Mild inflation ( ................
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