Chapter 10

Economic Fluctuations,
Unemployment, and Inflation

McGraw-Hill/Irwin
2009 The McGraw-Hill Companies, All Rights Reserved

Learning Objectives
In this chapter we will:
1.
2.
3.
4.
5.
6.
7.
8.

Examine the business cycle.

Consider various business cycle theories.
Show how economic forecasting is done.
Learn how the unemployment rate is computed.
Look at the types of unemployment.
Construct a consumer price index.
Consider the theories of inflation.
Learn about the misery index.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

10-2

Business Cycle
Definition: alternating increases and decreases in the
level of business activity of varying amplitude and
length
How do we measure increases and decreases in
business activity?
Percent change in real GDP!

Why do we say varying amplitude and length?

Some downturns are mild and some are severe
Some are short (a few months) and some are long (over a
year)

Do not confuse with seasonal fluctuations!

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Real GDP 1958-2007, in 2000 dollars

Note: Years is on horizontal axis and real GDP is on
vertical axis.
General trend of economic growth
Recession years are shaded blue: note downward
slope on graph indicating that GDP is decreasing.

Note: Shaded areas indicate recessions.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Three-Phase Business Cycle

1. Recession: economic downturn

2. Trough: end of recession
3. Recovery: expansion; rising real GDP
Note: Measure from peak to peak or from trough to trough.
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Recession
What is a recession?
Generally, 2 or more quarters of declining real GDP
Implication: its not officially a called a recession until the
economy has already been declining for 6 months!

Who decides when were in a recession?

National Bureau of Economic Research traditionally declares
recessions
Private research organization, not a federal agency

Recession dates from peak of business activity to

trough

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Post-World War II Recessions*

*The February 1945October 1945 recession began before the war ended in August 1945.

Note: These recessions were of varying duration and severity.

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Another Look at Expansions and Recessions

Can you find a pattern? Neither can economists! Thats why

recessions are hard to predict.

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Business Cycle Theories

Endogenous theories:

Innovation theory: innovation leads to saturation.

Psychological theory: alternating optimism and pessimism
Inventory cycle theory: inventory and demand not in sync
Monetary theory: changes in money supply by Federal Reserve
Underconsumption theory: or overproduction

Exogenous theories:
The external demand shock theory: effect of foreign economies
War theory: war stimulates economy; peace leads to recession
The price shock theory: fluctuations in oil prices

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Business Cycle Forecasting

The Ten Leading Economic Indicators
1.
2.
3.
4.

Average workweek of production workers in manufacturing

Average initial weekly claims for state unemployment insurance
New orders for consumer goods and materials
Vendors performance (companies receiving slower deliveries from
suppliers)
5. New orders for capital goods
6. New building permits issued
7. Index of stock prices
8. Money supply
9. Spread between rates on 10-year Treasury bonds and Federal funds
10. Index of consumer expectations

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

10-10

Unemployment
Definition: people in the labor force are willing and able
to work, but are not working.
Measured separately from unemployment benefits.

Statistics compiled monthly by Bureau of Labor

Statistics (BLS)
A person who worked one day last month is counted as
employed.
Someone who works part-time but who wants to work full-time
is counted as employed.
Retirees and others not looking for work are not in the labor
force.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Categorizing the U.S. Population (Dec. 2007

data)
Civilian
Noninstitutional
Population
233 million

Civilian Labor
Force
154 million

Employed
146.2 million

Not in the
Labor Force
79 million

Unemployed
7.7 million

Formula for Unemployment Rate (UR):

UR =

Number of Unemployed
Labor Force

Try calculating the 2007 unemployment rate.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Discouraged Workers
Definition: those who have given up looking for
work and dropped out of the labor force.
BLS does not count discouraged workers as part
of the labor force.
To be unemployed, must be actively seeking
work.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

10-13

Unemployment Rate for Selected Groups of

American Workers, January 2008

Teenagers and African Americans have much higher unemployment

than the average for all workers.
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The Unemployment Rate, 1948-2007

Unemployment trended upward between 1969 and
1982, and trended downward after that.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Questions for Thought and Discussion

Why might the official unemployment rate be
understating the unemployment problem?
Which groups do liberals think are missed by our current
approach to collecting the data?

Why might the official unemployment rate be

overstating the unemployment problem?
Which groups do conservatives think are counted as
unemployed, even though they shouldnt be?

Who do you agree with?

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Types of Unemployment
Frictional Unemployment:
People who are between jobs or just entering or reentering the
labor market.

Structural Unemployment:
People who are out of work for a relatively long period of time
(due to technological or economic displacement or lack of
skills).

Cyclical Unemployment:
People who are out of work due to downturn in business cycle.

Seasonal Unemployment (not problematic)

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10-17

Natural Unemployment Rate

Unemployment rate never reaches zero, due to
frictional and structural unemployment.
Natural unemployment rate is lowest non-inflationary
rate.
If unemployment is really low, employers will bid up wages
competing for workers.
Upward pressure on prices (inflation) results.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

10-18

Is the Natural Unemployment Rate Falling?

Economists placed natural rate at 5 or 6%, but UR
has been less than 5%. Why?
1.
2.
3.
4.
5.

There are fewer youths in labor force.

There are more males in prison.
The fear of corporate downsizing.
The expansion of temporary work force.
It is easier for disabled to qualify for Social Security, so they
are not in the labor force.
6. The labor force (denominator) is bigger, due to influx of
workers (immigrants, women leaving welfare).

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How does the U.S. compare?

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10-20

Inflation
Definition: a sustained rise in the average price level
over a period of years.
U.S. inflation has been persistent since World War II.
When the overall price level is rising, the prices of
some goods and services are going down. Examples?

LCD TVs
DVD players
Laser printers
Digital cameras
Contact lenses

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10-21

The Consumer Price Index (CPI)

CPI measures changes in our cost of living.
Also based on data collected by the Bureau of Labor
Statistics (BLS).
The CPI is based on what it costs an average family to
live.
BLS employees check prices of 80,000 items every month.
Compare prices with prices in base year.
Use this information to calculate percent increase or decrease
in overall prices.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Annual Percentage Change in CPI, 1946-2007

Since World War II, we have had two periods of price stabilityfrom
1952 through 1965, and from 1991 to the present.

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10-23

A Magic Number
The CPI is set at 100 for a base year.
The 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?
If the CPI today is 136.4, by what percentage did
prices rise since the base year?
136.4 100 =
36.4%

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Consumer Price Index, 19152007 (1967=100)

Note: Each year is compared with 1967, the base year.

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10-25

Finding Percentage Change in the Price Level

Original Number
Year

CPI

1972

125.3

By what
percentage did
1982
289.1
the cost of
Change = 163.8
living rise?
Change
Percentage change =
Original
---------------------------X 100
Number
163.
Percentage change =
8
125.
---------------------------X 100
3
Percentage change = 1.307
X 100
Percentage change =
2009 by 130.7
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10-26

Deflation
Deflation is a decline in the general level of prices for a
period of years.
This is the OPPOSITE of inflation.
This last occurred between 19291933.

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10-27

Disinflation
Disinflation occurs when the RATE OF INFLATION
declines.
Year
CPI
Inflation Rate
1980
82.4
13.5%
1981
90.9
10.3%
1982
1983

96.5
6.2%

99.6
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3.2%

From 19811983 the

rate of inflation
declined, but prices
continued to
increase . . . just
at a lower rate!

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Questions for Thought and Discussion

Inflation devalues money. The same amount of
money will buy less in the future
Who is hurt by inflation? Who is helped?
What about debtors (people who owe money to be paid back
in the future)?
What about creditors (lenders)?

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10-29

Theories of the Causes of Inflation

Demand-Pull Inflation
Caused by excessive demand for goods and services.
The economy is already operating at full capacity.
Demand-pull inflation is often summed up as too many dollars
chasing too few goods.

Cost-Push inflation
Wage-price spiral
Profit-push inflation
Supply-side cost shocks (oil prices increasing)

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10-30

Inflation vs. Price Stability

Inflation is relative concept. When are regular price
increases a policy problem?
Creeping inflation: small, predictable increases
Hyperinflation: sudden, large price increases

Inflation as a Psychological Process:

If people believe prices will rise, they will act in a way that
keeps them rising.
This can trigger hyperinflation spiral.

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10-31

Stagflation
Stagflation is the contraction of the words stagnation
and inflation.
This word got a lot of use in the recessions of 19731975 and
1980 and 19811982 when we experienced the worst of both
worlds, declining output and inflation.
Question for discussion: Is stagflation returning?

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10-32

The Misery Index is the combined rate of

unemployment and inflation

The Misery Index, 19482007

Economic Report of the President, 2008

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10-33

Three Goals, Three Problems, Three Indicators

Goal = Economic Growth
Problem = Recession
Indicator = real GDP

Goal = Full Employment

Problem = Unemployment
Indicator = Unemployment Rate

Goal = Price Stability

Problem = Inflation (or Deflation)
Indicator = Consumer Price Index

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10-34

Questions for Thought and Discussion

Where are all the jobs?
To keep up with growth in labor force, there is a need of
150,000 new jobs per month.
During George W. Bushs administration, we averaged a gain
of less than 70,000 jobs per month.

What are some of the reasons for slower job growth?

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10-35