Chapter 26 - Business Cycles, Unemployment, and Inflation

Chapter 26 Business Cycles, Unemployment, and Inflation

QUESTIONS
1. What are the four phases of the business cycle? How long do business cycles last? Why does
the business cycle affect output and employment in capital goods industries and consumer
durable goods industries more severely than in industries producing consumer nondurables? LO1
Answer: The four phases of a typical business cycle, starting at the bottom, are trough,
recovery, peak, and recession. As seen in Table 26.1, the length of a complete cycle
varies from about 2 to 3 years to as long as 15 years.
Because capital goods and durable goods last, purchases can be postponed. This may
happen when a recession is forecast. Capital and durable goods industries therefore
suffer large output declines during recessions. In contrast, consumers cannot long
postpone the buying of nondurables such as food; therefore recessions only slightly
reduce non-durable output. Also, capital and durable goods expenditures tend to be
lumpy. Usually, a large expenditure is needed to purchase them, and this shrinks to
zero after purchase is made.
2. How, in general, can a financial crisis lead to a recession? How, in general, can a major new
invention lead to an expansion? LO1

Answer: Unexpected financial bubbles (rapid asset price increases) followed by bursts
(abrupt asset price decreases) can spill over to the general economy by contracting
lending and eroding the confidence of consumers and businesses.
For example, the severe recession of 2007-2009 was precipitated by a combination of
excessive money and a financial frenzy that led to overvalued real estate and
unsustainable mortgage debt. Institutions bundled this debt into new securities
(derivatives), which were sold to financial investors. Some of the investors in turn
bought insurance against losses that might arise from the securities. As real estate prices
plummeted and mortgage defaults unexpectedly rocketed, the securitization and
insurance structure buckled and nearly collapsed. Credit markets froze, pessimism
prevailed, and spending by businesses and households tanked.
Significant new products or production methods such as those associated with the
railroad, automobile, computer, and the Internet can rapidly spread through the economy,
sparking sizeable increases in investment, consumption, output, and employment.
3. How is the labor force defined and who measures it? How is the unemployment rate
calculated? Does an increase in the unemployment rate necessarily mean a decline in the size of
the labor force? Why is a positive unemployment rateone more than zero percentfully
compatible with full employment? LO2

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Answer: The U.S. Bureau of Labor Statistics (BLS) measures the labor force.
The BLS defines the labor force by dividing the total U.S. population into three groups.
One group is made up of people under 16 years of age and people who are
institutionalized, for example, in mental hospitals or correctional institutions. Such
people are not considered potential members of the labor force. A second group, labeled
Not in labor force, is composed of adults who are potential workers but are not
employed and are not seeking work. For example, they are homemakers, full-time
students, or retirees. The third group is the labor force, which constituted slightly more
than 50 percent of the total population in 2009. The labor force consists of people who
are able and willing to work. Both those who are employed and those who are
unemployed but actively seeking work are counted as being in the labor force.
No, an increase in the unemployment rate does not necessarily mean a decline in the size
of the labor force. For example, individuals may start looking for a job who were not in
the labor force before (students just graduating college). In this case, the number of
unemployed increases, the labor force increases, and the unemployment rate increases.
The natural rate of unemployment is the sum of frictional and structural unemployment.
This value is always positive because people are transitioning to new jobs by choice or
because the industry they were in is no longer globally competitive. This is why a
positive rate of unemployment is fully compatible with full employment.
4. How, in general, do unemployment rates vary by race and ethnicity, gender, occupation, and
education? Why does the average length of time people are unemployed rise during a recession?
LO2

Answer: Race and ethnicity: The unemployment rate for African Americans and
Hispanics is higher than that for whites. In general, the unemployment rate for African
Americans is twice that of whites.
Gender: The unemployment rates for men and women are very similar.
Occupation: Workers in lower-skilled occupations (for example, laborers) have higher
unemployment rates than workers in higher-skilled occupations (for example,
professionals).
Education: Less-educated workers, on average, have higher unemployment rates than
workers with more education. Less education is usually associated with lower-skilled,
less-permanent jobs; more time between jobs; and jobs that are more vulnerable to
cyclical layoff.
Duration: The number of persons unemployed for long periods 15 weeks or moreas
a percentage of the labor force is much lower than the overall unemployment rate. But
that percentage rises significantly during recessions because businesses lay-off workers
as a result of the decrease in demand or increase in other production costs.
5. Why is it difficult to distinguish between frictional, structural, and cyclical unemployment?
Why is unemployment an economic problem? What are the consequences of a negative GDP
gap? What are the noneconomic effects of unemployment? LO2

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Answer: It is not easy to distinguish between these three types of unemployment because
the sum of frictional and structural unemployment is itself changing, thus it is difficult to
determine the full-employment unemployment rate. For example, a person who quits a
job in search of a better one would normally be considered frictionally unemployed. But
suppose the former job then disappears completely because the firm is in a declining
industry and can no longer make money. Our still jobless worker could now be
considered structurally unemployed. And then suppose the economy slips into a severe
recession so that our worker cannot find any job and has become cyclically unemployed.
The sum of frictional and structural unemployment fluctuates as the labor force structure
changes. In other words, there is no automatic label on the type of unemployment when
someone is counted as unemployed.
Unemployment is an economic problem because of the concept of opportunity cost.
Quite apart from any idea of consideration for others, unemployment is economic waste:
A unit of labor resource that could be engaged in production is sitting idle.
The GDP gap is the difference between what the economy could produce at its
potential GDP and what it is producing, its actual GDP. The consequence of a negative
GDP gap is that what is not produced the amount represented by the gapis lost
forever. Moreover, to the extent that this lost production represents capital goods, the
potential production for the future is impaired. Future economic growth will be less.
The noneconomic effects of unemployment include the sense of failure created in parents
and in their children, the feeling of being useless to society, of no longer belonging.
6. Since the United States has an unemployment compensation program that provides income for
those out of work, why should we worry about unemployment? LO2
Answer: The unemployment compensation program merely gives the unemployed
enough funds for basic needs. Furthermore, many of the unemployed do not qualify for
unemployment benefits. The programs apply only to those workers who were covered by
the insurance, and this may be as few as one-third of those without jobs. Most of the
unemployed get no sense of self-worth or accomplishment out of drawing this
compensation. Moreover, from the economic point of view, unemployment is a waste of
resources; when the unemployed go back to work, nothing is forgone except undesired
leisure. The unemployed are producing nothingtheir supply is zero but the
compensation helps keep demand in the economy high.
7. What is the Consumer Price Index (CPI) and how is it determined each month? How does the
Bureau of Labor Statistics calculate the rate of inflation from one year to the next? What effect
does inflation have on the purchasing power of a dollar? How does it explain differences between
nominal and real interest rates? How does deflation differ from inflation? LO3
Answer: The CPI is constructed from a market basket sampling of goods that
consumers typically purchase. Prices for goods in the market basket are collected each
month, weighted by the importance of the good in the basket (cars are more expensive
than bread, but we buy a lot more bread), and averaged to form the price level.

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To calculate the rate of inflation, the BLS subtracts the CPI for the previous year from the
CPI for the current year, and then divides this difference by the CPI for the previous year.
Multiplying this value by 100 gives us the percentage change in the price level.
Inflation reduces the purchasing power of the dollar. Facing higher prices with a given
number of dollars means that each dollar buys less than it did before.
The rate of inflation in the CPI approximates the difference between the nominal and real
interest rates. A nominal interest rate of 10% with a 6% inflation rate will mean that real
interest rates are approximately 4%.
Deflation means that the price level is falling, whereas with inflation overall prices are
rising. Deflation is undesirable because the falling prices mean that incomes are also
falling, which reduces spending, output, employment, and, in turn, the price level (a
downward spiral). Inflation in modest amounts (<3%) is tolerable, although there is not
universal agreement on this point.
8. Distinguish between demand-pull inflation and cost-push inflation. Which of the two types is
most likely to be associated with a negative GDP gap? Which with a positive GDP gap, in which
actual GDP exceeds potential GDP? LO3
Answer: Demand-pull inflation occurs when prices rise because of an increase in
aggregate spending not fully matched by an increase in aggregate output. It is sometimes
expressed as too much spending (or money) chasing too few goods. Cost-push
inflation describes prices rising because of increases in per unit costs of production.
Cost-push inflation is most likely to be associated with a negative GDP gap, as the rising
production costs reduce spending and output.
Demand-pull inflation is more likely to occur with a positive GDP gap, because actual
GDP will exceed its potential only when aggregate spending is strong and rising. As the
economy produces above its potential, bottlenecks and more severe resource scarcity
occur, driving up prices.
9. Explain how an increase in your nominal income and a decrease in your real income might
occur simultaneously. Who loses from inflation? Who gains? LO3
Answer: If a persons nominal income increases by 10 percent while the cost of living
increases by 15 percent, then her real income has decreased from 100 to 95.65 (=
110/1.15). Alternatively expressed, her real income has decreased by 4.35 percent (= 100
- 95.65). Generally, whenever the cost of living increases faster than my nominal
income, real income decreases.
The losers from inflation are those on incomes fixed in nominal terms or, at least, those
with incomes that do not increase as fast as the rate of inflation. Creditors and savers also
lose. Typically those holding debt gain.
10. Explain how hyperinflation might lead to a severe decline in total output. LO3

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Answer: With inflation running into the double, triple, quadruple, or even greater
number of digits per year, it makes little sense to save. The only sensible thing to do with
money is to spend it before its value is cut in half within a month, a week, or a day. This
very fact of everyone trying to spend as fast as possible will speed the inflationary spiral
and cause people to spend more and more time trying to figure out what goods are most
likely to go up fastest in price. More and more people will turn away from productive
activity, because wages and salaries are not keeping up with inflation. Instead, they will
spend their time speculating, transferring goods already in existence and producing
nothing.
Eventually, money may become worthless. No one will work for money. Barter and
living by ones wits become the only means of survival. Production falls for this reason
and also because investment in productive capital practically ceases. Unemployment
soars. A massive depression is at hand.
11. LAST WORD Suppose that stock prices were to fall by 10 percent in the stock market. All
else equal, would the lower stock prices be likely to cause a recession? How might lower stock
prices help predict a recession?
Answer: GDP could be reduced if stock owners feel significantly poorer and reduce their
spending on goods and services, including investment in real capital goods. However,
research indicates that downturns in the stock market have not had major impacts on
GDP.
A fall in stock prices might signal a change in expectations. Evidence does suggest that
there is a link between falling stock prices and future recessions. However, this is only
one factor related to predicting recessions and, by itself, a fall in stock prices is not a
reliable predictor of recession.

PROBLEMS
1. Suppose that a countrys annual growth rates were 5, 3, 4, -1, -2, 2, 3, 4, 6, and 3 in yearly
sequence over a 10-year period. What was the countrys trend rate of growth over this period?
Which set of years most clearly demonstrates an expansionary phase of the business cycle?
Which set of years best illustrates a recessionary phase of the business cycle? LO1
Answers: 2.7 percent (rounded to the nearest decimal); years 6-9; years 4 and 5.
Feedback: Consider the following example. Suppose that a countrys annual growth
rates were 5, 3, 4, -1, -2, 2, 3, 4, 6, and 3 in yearly sequence over a 10-year period. What
was the countrys trend rate of growth over this period? Which set of years most clearly
demonstrates an expansionary phase of the business cycle? Which set of years best
illustrates a recessionary phase of the business cycle?
The trend rate of growth equals the average for the 10-year period, which is 2.7 percent.
(= (5 + 3 + 4 1 2 + 2 + 3 + 4 + 6 + 3) / 10).
The set of years that clearly demonstrate an expansionary phase is years 6 through 9. The
rate of growth is positive and increasing over this period.

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The set of years that best illustrate a recessionary phase is years 4 and 5. Growth is
negative (declining GDP) for these years.
2. Assume the following data for a country: total population, 500; population under 16 years of
age or institutionalized, 120; not in labor force, 150; unemployed, 23; part-time workers looking
for full-time jobs, 10. What is the size of the labor force? What is the official unemployment rate?
LO2
Answer: 230; 10%.
Feedback: Consider the following example. Assume the following data for a country:
total population, 500; population under 16 years of age or institutionalized, 120; not in
labor force, 150; unemployed, 23; part-time workers looking for full-time jobs, 10. What
is the size of the labor force? What is the official unemployment rate?
To find the size of the labor force subtract population under 16 years of age or
institutionalized (120) and those not in the labor force (150) from the population (500).
The size of the labor force is 230 (= 500 - 120 -150).
The official unemployment rate is the number of individuals unemployed divided by the
labor force converted into percentage form.
The unemployment rate for the values above is 10% (= (23/230) x 100).
3. Suppose that the natural rate of unemployment in a particular year is 5 percent and the actual
rate of unemployment is 9 percent. Use Okuns law to determine the size of the GDP gap in
percentage-point terms. If the potential GDP is $500 billion in that year, how much output is
being forgone because of cyclical unemployment? LO2
Answer: GDP gap = 8%; $40 billion.
Feedback: Consider the following example. Suppose that the natural rate of
unemployment in a particular year is 5 percent and the actual rate of unemployment is 9
percent. Use Okuns law to determine the size of the GDP gap in percentage-point terms.
If the potential GDP is $500 billion in that year, how much output is being forgone
because of cyclical unemployment?
On the basis of recent estimates, Okuns law indicates that for every 1 percentage point
by which the actual unemployment rate exceeds the natural rate, a negative GDP gap of
about 2 percent occurs.
The actual rate of unemployment exceeds the natural rate of unemployment by 4% (= 9%
- 5%), which is cyclical unemployment.
Using Okuns law, this translates into an 8% GDP gap in percentage-point terms (= 2 x
4%).

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Chapter 26 - Business Cycles, Unemployment, and Inflation

Since potential GDP is $500 billion and we are 8% below this amount, the output forgone
is $40 billion (= 0.08 x $500 billion).
4. If the CPI was 110 last year and is 121 this year, what is this years rate of inflation? In
contrast, suppose that the CPI was 110 last year and is 108 this year. What is this years rate of
inflation? What term do economists use to describe this second outcome? LO3
Answers: 10 percent; -1.8 percent; deflation.
Feedback: Consider the following example. If the CPI was 110 last year and is 121 this
year, what is this years rate of inflation? In contrast, suppose that the CPI was 110 last
year and is 108 this year. What is this years rate of inflation? What term do economists
use to describe this second outcome?
The inflation rate is the percentage change in the CPI over a period of time. For the
values above we have:
If the CPI was 110 last year and is 121 this year, the inflation rate was 10%
(= ((121-110)/110) x 100).
If the CPI was 110 last year and is 108 this year, the inflation rate was approximately 1.8%
(= ((108-110)/110) x 100). This outcome is referred to as deflation by economists.

5. How long would it take for the price level to double if inflation persisted at (a) 2, (b) 5, and (c)
10 percent per year? LO3
Answer: (a) 35 years; (b) 14 years; (c) 7 years.
Feedback: Consider the following example values. How long would it take for the price
level to double if inflation persisted at (a) 2, (b) 5, and (c) 10 percent per year?
The Rule of 70, which is to divide 70 by the inflation rate, gives us the time it takes for
the price level to double.
Years to double = (70 / Inflation Rate)
Using this formula we have:
(a) The price level will double in 35 years if the inflation rate is 2% (= 70/2).
(b) The price level will double in 14 years if the inflation rate is 5% (= 70/14).
(c) The price level will double in 7 years if the inflation rate is 10% (= 70/10).
6. If your nominal income rose by 5.3 percent and the price level rose by 3.8 percent in some
year, by what percentage would your real income (approximately) increase? If your nominal
income rose by 2.8 percent and your real income rose by 1.1 percent in some year, what must
have been the (approximate) rate of inflation? LO3

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Answer: 1.5 percent; 1.7 percent.

Feedback: Consider the following example. If your nominal income rose by 5.3 percent
and the price level rose by 3.8 percent in some year, by what percentage would your real
income (approximately) increase? If your nominal income rose by 2.8 percent and your
real income rose by 1.1 percent in some year, what must have been the (approximate) rate
of inflation?
To find the approximate percentage change in the real value of your income, subtract the
rate of inflation from the nominal percentage change in your income.
Percentage change in real income = Percentage change in nominal income - Inflation rate
This implies the percentage change in real income is approximately 1.5% (= 5.3% 3.8%).
We can also rearrange the equation above as follows:
Inflation rate = Percentage change in nominal income - Percentage change in real income
This implies the inflation rate is approximately 1.7% (= 2.8% - 1.1%) for the second set
of values.
7. Suppose that the nominal rate of inflation is 4 percent and the inflation premium is 2 percent.
What is the real interest rate? Alternatively, assume that the real interest rate is 1 percent and the
nominal interest rate is 6 percent. What is the inflation premium? LO3
Answers: 2 percent; 5 percent.
Feedback: Consider the following example. Suppose that the nominal rate of inflation is
4 percent and the inflation premium is 2 percent. What is the real interest rate?
Alternatively, assume that the real interest rate is 1 percent and the nominal interest rate
is 6 percent. What is the inflation premium?
To find the approximate real interest rate subtract the inflation premium from the nominal
interest rate.
Real interest rate = nominal interest rate - inflation premium
This implies the real interest rate is 2% (= 4% - 2%).
We can also rearrange the equation above as follows:
Inflation premium = nominal interest rate - real interest rate
This implies the inflation premium is 5% (= 6% - 1%).

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