The Business Cycle

Macroeconomics

The Great Depression was the springboard for modern macroeconomics.

Macroeconomics is the study of aggregate economic behavior, of the economy as a whole.

The basic purpose of macro-economic theory is to explain the business cycle.

Business Cycles

The business cycle is the alternating periods of economic growth and contraction experienced by the economy.

The modern business cycle resembles a roller coaster.

The Business Cycle

Real GDP

Business cycles are measured by changes in real GDP.

Real GDP is the inflation-adjusted value of GDP—the value of output measured in constant prices.

Nominal GDP is measured in current prices

Erratic Growth

Real GDP doesn’t increase in consistent, smooth increments.

It has been a series of steps, stumbles and setbacks.

The Business Cycle in U.S. History

The Great Depression

The most prolonged departure from our long-term growth path.

Real GDP fell 30% 1929-1933.

Real GDP in 1939 was virtually the same as in 1929.

World War II

Greatly increased demand for goods and services.

Marks the end of the Great Depression.

Output grew 19% in 1942 and reached full employment.

Recent Recessions

A recession is a decline in total output (real GDP) for two or more consecutive quarters.

Post-War Recession

Lasted 8 months.Unemployment rate 4.3%.

1981-1982 Recession

Lasted 16 months.

Unemployment rate 10.8%.

Highest unemployment rate since 1930's.

1990-1991 Recession

Very brief – 8 months.

Expansion continued through 1998

Business Slumps, 1929-58

Business Slumps, 1960-92

Unemployment

Unemployment is the inability of labor-force participants to find jobs.

When output declines, jobs are eliminated.

The Labor Force

All persons over age sixteen who are either working for pay or actively seeking paid employment.

The U.S. Labor Force

The Unemployment Rate

The proportion of the labor force that is unemployed

The Unemployment Record

The Full Employment Goal

There are good reasons for pursuing low but not zero unemployment.

Seasonal Unemployment

Caused by seasonal changes.

An example is school is out in summer so teens are looking for summer jobs.

Frictional Unemployment

Brief period of unemployment associated with job search.

Examples include students with marketable skills entering work force after graduation, and workers in between jobs.

Structural Unemployment

Results from mismatch between skills of labor force participants and skills needed by employers.

For example, defense cutbacks made it hard for displaced workers to find jobs in non-defense industry.

Cyclical Unemployment

Not enough jobs to go around due to downturns in the business cycle.

The Great Depression is an example.

The Policy Goal

Avoid as much cyclical and structural unemployment as possible.

Try to achieve full employment.

Full employment is the lowest rate of unemployment comparable with price stability.

Inflation

The biggest fear as an economy reaches full employment is inflation.

The fear of inflation is based on the price pressures that accompany capacity production.

Relative vs. Average Prices

Inflation is an increase in the average level of prices and services, not a change in any specific price.

Deflation is a decrease in the average level of prices of goods and services.

The relative price of a good is its price in comparison with the price of other goods.

It is possible for individual prices to rise or fall without changing the average price level.

Changes in relative prices are market signals which help reallocate resources in the economy.

Redistributions

Although inflation makes some people worse off, it makes other people better off.

Inflation acts just like a tax, taking income or wealth from some people and giving it to others.

Price Effects

Nominal income is the amount of money income received in a given time period, measured in current dollars.

Real income is income in constant dollars — nominal income adjusted for inflation.

Not all prices rise at same rate during inflation.

Student’s Annual Budget

Income Effects

What looks like a price to buyer is income to the seller.

If prices rise, so do incomes.

Nominal Wages and Prices

Wealth Effects

Inflation alters the real value of savings.

Inflation’s Impact, 2001-2011

The Real Story of Wealth

Robin Hood?

Inflation redistributes income through these effects:

Price effects – people who prefer goods and services that increase in price least quickly end up with larger share of real income.

Inflation redistributes income through these effects:

Income effects – people whose nominal incomes rise faster than inflation end up with larger share of total income.

Inflation redistributes income through these effects:

Wealth effects – people who own assets that increase in real value end up better off.

Inflation acts just like a tax taking income or wealth from one group and giving it to another.

Uncertainty

The uncertainties of inflation may cause people to change their consumption, saving, or investment decisions.

Fear of rapidly increasing prices may deter consumers from making long-term purchasing decisions.

Changing price levels can induce people to buy more goods and services before price increases occur.

Measuring Inflation

Consumer Price Index (CPI) — a measure (index) of changes in the average price of consumer goods and services.

Inflation rate — the annual rate of increase in the average price level.

The Bureau of Labor Statistics tells us what is happening to consumer prices by updating the CPI monthly.

The Price Stability Goal

Price stability is the absence of significant changes in the average price level.

The Policy Goal

The Full Employment and Balanced Growth Act of 1978 holds the rate of inflation to less than 3%.

Why 3 Percent?

Congress weighs the tradeoff between inflation and full employment.

Zero percent inflation might harm the goal of full employment.

The CPI is not a perfect measure of inflation.

Because of quality improvements and new products, the CPI is not a perfect measure of inflation.

Quality Improvements

Old products become better as a result of quality improvements.

A 1955 television does not compare in quality to a 2000 television.

New Products

The market basket used to measure the CPI changes.

Products like computers did not exist in the 1972-73 market basket.

DVD players did not exist in the 1987 CPI market basket.