Chapter 9 - Business Cycles, Unemployment, InflationThis chapter provides an introductory look at the macroeconomic problems of unemployment and inflation. We will study economic growth in greater detail in two weeks when we study chapters 8 and 22 Web. Show ReviewReview: The three macroeconomic issues are:
Review: The Business Cycle Unemployment, inflation and economic growth tend to change cyclically over time. The four phases of the business cycle: 1. A peak is when business activity reaches a temporary maximum, unemployment is low, inflation high. Unemployment increases during business cycle recessions and decreases during business cycle expansions (recoveries). Inflation decreases during recessions and increases during expansions (recoveries). Review: Maximizing Satisfaction The primary reason to study unemployment is that it contributes to scarcity. Scarcity always exists since resources are limited and human wants are unlimited. There are five ways to reduce scarcity - the five Es of economics (see diagram below). Full employment is one of the five Es. We defined full employment as "using all available resources". If a society uses ALL AVAILABLE RESOURCES then more goods and services will be produced and scarcity will be reduced Another way to illustrate the effects of unemployed resources is with the production possibilities curve (see graph below). Point "D" illustrates the effect of unemployment. Points "A", "B", and "C" represent the maximum possible levels of production WITH FULL EMPLOYMENT. With unemployment, less will be produced (point "D"). Finally, we have illustrated unemployment before using the AS-AD model. If the equilibrium level of output is less than the full employment level as illustrated on the graph above, this indicates that some available resources are unemployed and less is being produced. What is unemployment?The unemployment rate in the United States was 4.5% in February, 2007 and 9.8% in September, 2009. Whenever we see a "%" we have to ask "percent of what?" In February of 2007 4.5% of what was unemployed?
The authors of our textbook divide the population into three groups:
SUMMARY:
Employed persons consist of:
Unemployed persons are:
Two factors cause the official unemployment rate to understate actual unemployment.
Calculating the Unemployment Rate The unemployment rate is defined as the percentage of the labor force that is not employed. Note that it is NOT the percentage of the POPULATION. To calculate the unemployment rate: UE rate = (# unemployed / labor force) x 100 So using the data for 2007 above:
So the unemployment rate was: (7.1 / 153.1) x 100 = 4.6 % of the labor force. What Is "Full Employment"?Full employment equals between 4 and 5 % unemployment !!! As we discussed above, full employment results in reducing scarcity by producing the economy's potential level of output. The unemployment rate in 2007 was 4.5%, that amounts to about 71 million people unemployed. Remember that unemployed means not working but looking. So with 7.1 million people unemployed we still have FULL EMPLOYMENT!! How can 4% to 5% unemployment be considered full employment? How can 7.1 million people looking for work be called "full employment? It depends on how we define full employment. We have defined full employment as using all available resources so as to achieve the potential level of output for an economy. Full employment is achieving the potential level of output. So, with some types of unemployment an economy can still produce its potential level of output. Full employment means achieving the potential output As we learned in our AS-AD lesson "potential output" is NOT the absolute maximum, but it is the potential level of output under normal circumstances Economists estimate that about 4 %to 5% unemployment is Full Employment. This is called the "full employment rate of unemployment", or the "natural rate of unemployment" and it includes structural and frictional unemployment What? To understand how and economy with 4-5% unemployment can be achieving the potential level of output and therefore have "full" employment" , we must understand the three different types, or causes, of unemployment. Types of Unemployment To understand how we can achieve the potential level of output and still have 4.5 % unemployment we must understand the three types, or causes, of unemployment. The key to understanding what full employment means, is to consider what happens to output with each type of unemployment. 1. Frictional UnemploymentWHAT IS FRICTIONAL UNEMPLOYMENT?Frictional unemployment is the type of unemployment caused by workers looking for their first job, voluntarily changing jobs, and by temporary layoffs. It is unemployed workers between jobs. Frictional unemployment is "good" unemployment because without it the economy could not be producing as much as possible (i.e. achieving the potential level of output). It is sometimes not clear which type of unemployment describes a person's unemployment circumstances. So to repeat: economists estimate that about 4 %to 5% is Full Employment. This is called the "full employment rate of unemployment", or the "natural rate of unemployment" and it includes:
If there is some frictional and structural unemployment in the economy can the potential level of output still be achieved? YES, and economists estimate that there is between 4% and 5% frictional and structural unemployment in the US economy. that is why we are currently at, or below, full employment. The "full employment rate of unemployment" is the unemployment rate occurring when there is no cyclical unemployment and the economy is achieving its potential output Changes in the Full Employment (Natural) Rate of Unemployment 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. in the United States in the 1060s the full employment rate of unemployment was around 4%. this was the target of President Kennedy's tax cut program In the 1970s the full employment rate of unemployment was around 5%. and it was about 6% in the 1980s. Why did the full employment rate of unemployment increase? Or, another way of saying this is "why did the amount of frictional and structural unemployment increase?" There were several cultural and demographic changes during these decades that resulted in more frictional and structural unemployment. After World War II ended in the 1940s the baby boom began. By the 1960s this large increase in population was beginning to enter the labor force. As they begin looking for their first jobs they were frictionally unemployed. Also during these decades the roles of women were changing and more women entered the labor force for the first time (frictional unemployment) and many did not have the necessary skills (structural unemployment). Recently the natural rate has dropped from 6% to 4 to 5%. This is attributed to (1) the aging of the work force with fewer new entrants reducing frictional unemployment, (2) improved job information through the internet and temporary-help agencies which also reduces frictional unemployment, (3) new work requirements passed by congress with the most recent welfare reform which encourage those who are frictionally unemployed to try to get a job quicker, and finally, (4) the doubling of the US prison population since 1985 has removed from the labor force a group of people who have a high rate of unemployment.
Costs of Unemployment GDP gap As we have discussed many times, the problem with unemployed resources is that they could have been used to produce more boats - - or cars or whatever it is that society wants. With unemployment there is more SCARCITY. This loss of goods that could have been produced if we had used all of our resources is called the GDP gap and it is a measure of the cost of unemployment. The GDP gap = actual GDP - potential GDPGDP gap: The amount by which actual gross domestic product falls below potential gross domestic product. GDP stand for Gross Domestic Product. We will study how to measure GDP in chapter 6 next week. For now, GDP is a measure of how much is produced in an economy in a year. If the GDP gap is negative then the potential GDP > the actual GDP and economy is not producing as much as possible. This is how much more output could have been produced if there was full employment. The GDP gap then is the lost output caused by not having full employment. If the GDP gap is positive then the actual GDP is > the potential GDP. It is possible to have a positive GDP gap if AD is very high and it crosses the AS curve in the classical range BEYOND the full employment level of real domestic output. The result is high inflation. One way to measure this cost is with Okun's Law. 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." What this means is for every one percentage point decrease in the unemployment rate output increases about 2%. The larger increase in output is due to more people (discouraged workers) reentering the labor force. So a 1% decrease in unemployment really means that there are more than 1% more people working. Non Economic Costs There are also many non-economic costs associated with inflation. These costs include: Unequal burdens of unemployment exist.
What is Inflation?Measuring Inflation http://www.bls.gov/ Inflation is the annual rate of increase in the price level. US inflation rates: In January of 2007 the inflation rate was 2.1 %. But what does this mean? 2.1% of what? An inflation rate of 2.1% in January of 2007 means that the price level was 2.1% higher than it was in January of 2006. In the chapter on aggregate supply and aggregate demand we learned that the price level is "the average level of prices in the economy". We find the price level on the vertical axis of the AS-AD graph. But how is the price level measured? What numbers would one put along the vertical axis? How can we measure the average level of prices in an economy? To do this economists use a "price index". In order to calculate inflation we need to know how the price level is measured, therefore we need to learn about a price index. Measuring Inflation: Price index Our textbook defines a price index in an index number which shows how the weighted average price of a “market basket” of goods changes over time. What does that mean? There are two price indices that we will use this semester. We will study the GDP Price Index in the chapter on measuring GDP (or real domestic output - RDO). To learn how to measure inflation we will use the CPI, the consumer price index. Calculating Inflation - - - - KNOW THIS !!!!!! Since a price index measures the price level as a percent of a base year and inflation measures the change in the price index from the previous year, to calculate the inflation rate we use the following formula:
x 100 price index for previous yearSo to calculate the inflation rate for 1999 using the CPI data above:
x 100 price index for 1998
x 100 = 2.2 % 163.0For fun try these online inflation calculators:
USING A PRICE INDEX THE PRICE OF GASOLINE:
The Rule of 70 - - - - KNOW THIS !!!!!! The rule of 70 is a quick way to estimate how long it will take for something (like prices) to double if you know the annual percentage increase (like inflation). To determine the number of years it will take for the price level to double; divide 70 by the annual rate of inflation.
For example, if the inflation rate is 3%, it will take 23 1/3 years for prices to double.
This handy little rule can be used for many things. If the population of a country is growing at a rate of 1% a year (which is about the population growth rate of the United States), how many years until the population doubles?
What if the population growth rate is 4 % a year?
= 17.5 years 4Types / Causes / Theories of Inflation Demand-Pull inflation Demand-pull inflation is inflation caused by too much spending (and increase in AD). Cost-push (or supply-side) inflation Cost-push or supply-side inflation caused by reductions in aggregate supply. The main causes of cost-push inflation are (1) "wage-push" as result of union strength and (2) supply shocks that may occur with unexpected increases in the price of raw materials. Effects of Inflation There are two major effects of inflation. "Redistributive effects" means that inflation affects different groups differently. Some people are hurt by inflation and some people are helped by inflation. The "output effects" of inflation include its impact on how much is produced in an economy. Redistributive effects of inflation:
Output Effects of Inflation Demand-pull inflation has a stimulus effect on the economy resulting in greater output. See graph below. |