Business Cycles,

Unemployment, and Inflation

Chapter 26
• Fluctuations in output and employment are caused by economic
shocks combining with sticky prices.
• Sources of shocks include unexpected innovations, unexpected
changes in productivity, unexpected changes in the money supply,
unexpected changes in the level of total spending in the economy,
and financial crises.
• During a recession, industries that produce capital goods and
consumer durables normally suffer greater output and employment
declines than do service and nondurable consumer goods industries.
Economic Cost of Unemployment
• GDP Gap and Okun’s Law
Okun’s Law
• Okun's law pertains to the relationship between the U.S. economy's
unemployment rate and its gross national product (GNP). It states
that when unemployment falls by 1%, GNP rises by 3%. However, the
law only holds true for the U.S. economy and only applies when the
unemployment rate is between 3% and 7.5%.
Inflation
• Inflation is a rise in the general level of prices. When inflation occurs,
each dollar of income will buy fewer goods and services than before.
Measurement of Inflation
Types of Inflation
• Demand-Pull Inflation: Demand-pull inflation occurs when total
spending exceeds the economy’s ability to provide goods and services
at the existing price level; total spending pulls the price level upward.
• Cost-Push Inflation: The theory of cost-push inflation explains rising
prices in terms of factors that raise per-unit production costs at each
level of spending.
• The major source of cost-push inflation has been so-called supply
shocks.
Redistribution Effects of Inflation
• Inflation redistributes real income. This redistribution helps some
people and hurts some others while leaving many people largely
unaffected.
Nominal and Real Income
• Nominal income is the number of dollars received as wages, rent,
interest, or profits.
• Real income is a measure of the amount of goods and services
nominal income can buy; it is the purchasing power of nominal
income, or income adjusted for inflation.
Anticipations
• Inflation harms those who receive relatively fixed nominal incomes
and either leaves unaffected or helps those who receive flexible
nominal incomes.
• Unanticipated inflation hurts savers and creditors while benefiting
debtors.
Real and Nominal Interest Rates
• The real interest rate is the percentage increase in purchasing power
that the borrower pays the lender.
• The nominal interest rate is the percentage increase in money that
the borrower pays the lender, including that resulting from the built-
in expectation of inflation, if any.
Other redistribution issues
• Deflation
• Mixed effects
• Arbitrariness
Does Inflation Affect Output?
• Cost-push inflation reduces real output and employment.
• Proponents of zero inflation argue that even mild demand pull
inflation (1 to 3 percent) reduces the economy’s real output. Other
economists say that mild inflation may be a necessary by-product of
the high and growing spending that produces high levels of output,
full employment, and economic growth.
Hyperinflation
• Hyperinflation, caused by highly imprudent expansions of the money
supply, may undermine the monetary system and cause severe
declines in real output.
GDP deflator
• The GDP price deflator measures the changes in prices for all goods
and services produced in an economy.
• Using the GDP deflator helps economists compare the levels of real
economic activity from one year to another.
• Without the GDP deflator, comparing GDP from two different years
would yield a deceptive result if prices changed during the two years.

• GDP Deflator=(Nominal GDP/Real GDP)*100

GDP deflator vs CPI
• The first difference is that the GDP deflator measures the prices of all
goods and services produced, whereas the CPI measures the prices of
only the goods and services bought by consumers.
• The second difference is that the GDP deflator includes only those
goods produced domestically. Imported goods are not part of GDP
and do not show up in the GDP deflator.