Chapter 10

1. Chapter 10 Business Cycles, Unemployment, and Inflation

2. Chapter Objectives Potential versus actual GDP Potential growth Output gap Types of unemployment Unemployment and inflation Recessions The business cycle

3. Potential versus Actual GDP Potential GDP is the output of the economy assuming no strains on production or unused resources. Potential and actual GDP can be different. The economy normally operates at levels above or below potential. The rate at which potential GDP rises is the potential growth rate.

4. Potential Growth The potential growth rate in the economy is a combination of the long-term growth rate of the labor force plus the long-term growth rate of productivity. The estimated growth rate in potential GDP for the US is around 3% per year. Projections of potential GDP are made to forecast the sustainable growth path for the economy.

5. The Path of Potential GDP

6. The Output Gap As noted previously, the actual level of real GDP may be higher or lower than potential GDP. The output gap is the difference between actual and potential GDP. The output gap is negative when actual GDP is less than potential, and positive when the output is greater than potential.

7. The Output Gap

8. Unemployment Unemployment is a key measure of the health of the economy. The unemployment rate is the percentage of the labor force who are unemployed. The labor force is the sum of the employed workers, plus the unemployed workers. Unemployment occurs when actual GDP is below potential GDP, and the economy slows.

9. Unemployment Rate, Historical

10. Types of Unemployment Unemployment can be classified into 3 categories: Frictional unemployment arises due to the job search process. Structural unemployment comes when there is a mismatch between the skills of unemployed workers and the needs of employers with unfilled jobs. Cyclical unemployment is caused by a lack of demand for the products sold by the employer.

11. The Unemployment Puzzle Wages are the price of labor. Thus, one would expect wages to fall when unemployment is high. This does not occur because wages are sticky. Sticky wages means that is difficult to change wages in the short run. One reason wages are sticky is due to the presence of unions.

12. Trade-off Between Unemployment and Inflation The unemployment rate rises when actual GDP is below potential GDP. In contrast, the unemployment rate falls when actual GDP is above potential GDP. But then wages and inflation begin to rise. Thus, low unemployment is linked to higher inflation.

13. Trade-off Between Unemployment and Inflation If the economy grows too fast – that is, if actual GDP is too high, relative to potential GDP – we get rising inflation. If the economy grows too slowly -if actual GDP is too low, relative to potential GDP – we get unemployment. The job for policymakers is to find the right balance between inflation and unemployment.

14. Inflation and Potential GDP Given the link between GDP, inflation, and unemployment: We can define potential GDP as the maximum amount of economic output an economy can sustain at any moment without inducing an increase in the inflation rate. Potential GDP is effectively the “speed limit” for the economy.

15. Natural Rate of Unemployment The natural rate of unemployment is defined as the level of unemployment where inflation is more or less stable. When the unemployment rate is below the natural rate, the inflation rate increases. When the unemployment rate is above the natural rate, the inflation rate falls. The natural rate of unemployment is also called the “non-accelerating inflation rate of unemployment,” or NAIRU, for short.

16. The Unemployment Rate versus the NAIRU

17. Recessions A recession is defined as a significant decline in economic activity spread across the economy, lasting more than a few months. In a recession, GDP is running below its potential and the unemployment rate is high. During a recession: It’s harder to find a job. Profits aren’t as high. Malls are empty. Tax revenues fall short of predictions.

18. The Last Five Recessions

19. The Business Cycle The peak is the date the recession starts. The trough is the date the recession ends. The expansion is the period of time from the trough, through recovery, and all the way to the next peak. The pattern of recession, recovery, and expansion is the business cycle.

20. The Typical Business Cycle

21. The Impact of a Recession on Workers Unemployed workers and their families suffer the most from a recession. During a recession, it is hard to find a job as the economy shrinks and companies stop hiring. The labor market typically doesn’t fully recover until well after the recession has ended.

22. What Happens in a Recession

23. Impact of a Recession on Businesses Recessions negatively impact businesses, as the demand for their product declines. This results in a downward shift in the demand curve for their product. Demand falls because consumers have less income to spend. Businesses also cut back on expansion plans and investment in new equipment.

24. Impact of a Recession on Businesses Price of cars Supply curve for cars A P B P1 Demand curve for cars pre-recession Demand curve for cars during the recession Q1 Q Quantity of cars demanded/supplied

25. Why Do Recessions Happen? What causes recessions is a controversial issue among economists. But there are certain triggers that may set the stage for a recession. One potential trigger is negative supply shifts. An important cause of recession is an unexpected negative supply shift, such as a big spike in oil prices.

26. Impact of a Negative Supply Shift Supply curve with higher oil prices Price of groceries Original supply curve P1 P Demand curve Q1 Q Quantity of groceries demanded/supplied

27. Negative Demand Shifts A second trigger for a recession is a negative demand shift. Recession is caused by a large drop in demand. A good example of a demand-driven recession was the recession of 2001, which was primarily caused by a decline in business spending on computers, communications equipment, and other information technology gear. The decline in demand results in an increase in the unemployment rate.

28. Technology Bust and Recession of 2001

29. Inflation Fighting A third trigger for a recession is that the economy gets overheated and inflation rises. Policymakers must slow it down to curb the inflationary threat. They may slow growth so much that it results in a recession. A good example is the recession of 1980 and 1981.

30. Problems in Financial Markets A final potential cause of a recession are problems in the financial markets. Individuals and businesses borrow money from the financial markets to finance various types of expenditures. When financial markets stop working, it becomes harder to borrow, and the economy slows. The current problems in the economy are financial market related.