Chapter 10: The Business Cycle

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Chapter 10 The Business Cycle
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• 1. Macroeconomics

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Macroeconomics

• The Great Depression was the springboard for
  modern macroeconomics.

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

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

The business cycle is the alternating periods of
economic growth and contraction experienced by
the economy. Macro policy tries to control the
business cycle.
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Business Cycle

• The model business cycle resembles a roller
  coaster.

Peak
RealGDP

• Output first climbs to a peak.

• Next, the economy begins to decreases,
  eventually reaching a trough.

• After reaching the trough the economy
  recovers, with real GDP again increasing.
  This business cycle repeats in often
  seemingly unpredictable regularity and
  severity.

• A central concern of macroeconomic theory is
  determining whether a recurring business
  cycle exists, and if so, what forces cause it.

Trough
Time
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• 2. Historical Cycles

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Real GDP

• Actual 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. Growth of the U.S. economy has not been a
smooth trend It has been a series of steps,
stumbles and setbacks.
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The Business Cycle in U.S. History
GrowthRate
0.25
0.2
0.15
0.1
0.05
0
-0.05
-0.1
-0.15
1930
1934
1938
1942
1946
1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998

• Above is a graphic representation of the growth
  rate of the U.S. economy over the last 70
  years. Note the historical events that are
  attributable to the business cycles.

• If the long-run average growth rate is 3, note
  that (besides the 90-91 recession) growth
  rates have not been above the long-run average in
  the last decade.

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Booms and Busts

• Economic booms

Growth of 5 of greater. Economic busts Growth
rate falls below zero.
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Great Depression

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

Real GDP fell 30 1929-1933. Economy started to
grow again in 1934. Total output declined again
1936-1937. Real GDP in 1939 was virtually the
same as in 1929, but per capita GDP was lower.
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Recent Recessions

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

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Recent Recessions
9/29-3/33
43
24.9
53.4
13
5/37-6/38
20.0
32.4
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2/45-10/45
4.3
38.3
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11/48-10/49
7.9
9.9
10
7/53-5/54
6.1
10.0
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8/57-4/58
14.3
7.5
10
4/60-2/61
7.2
7.1
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12/69-11/70
6.1
8.1
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11/73-3/75
9.0
14.7
6
1/80-7/80
7.6
8.7
1/81-11/82
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10.8
12.3
8
7/90-2/91
2.2
6.5
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• 3. Unemployment

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Unemployment

• When output declines, jobs are eliminated.

Unemployment is the inability of labor-force
participants to find jobs. The Labor Force All
persons over age sixteen who are either working
for pay or actively seeking paid employment.
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Unemployment
Total Population (U.S. 1998) 270,000,000
In theLabor Force137,700,000
Not in theLabor Force 132,300,000
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Unemployment Rate

• Unemployment Rate

Proportion of the labor force that is
unemployed.

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The Unemployment Rate in U.S. History
Rate ofUnemployment
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20
15
10
5
0
1935
1939
1943
1947
1951
1955
1959
1963
1967
1971
1975
1979
1983
1987
1991
1995

• Above is a graphic representation of the rate of
  unemployment for the U.S. economy over the
  last 65 years.

• Unemployment rates reached record heights during
  the Great Depression. The post-war levels of
  unemployment never reach such extreme levels of
  hardship.

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Types of Unemployment

• Seasonal unemployment

Caused by seasonal changes. An example is school
is out in summer so teens are looking for summer
jobs.
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Types of Unemployment

• Frictional Unemployment

Brief period of unemployment associated with job
search. Students entering work force after
graduation with marketable skills, and workers in
between jobs are examples.
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Types of Unemployment

• 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.
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Types of Unemployment

• Cyclical Unemployment

Not enough jobs to go around due to downturns in
the business cycle. The Great Depression is an
example.
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The Full Employment Goal

• The policy goal avoid as much cyclical and
  structural unemployment as possible.

Unemployment has many negative effects. Full
employment is the lowest rate of unemployment
comparable with price stability. It is estimated
to be between 4 and 6 percent unemployment.
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• 4. Inflation

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Average Prices

• The economy is not necessarily experiencing
  inflation every time the price of a cup of coffee
  rises.

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.
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Relative Prices

• 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. Relative changes can occur in period of
stable average prices.
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Relative Prices
31.0
4.6
18.4
5.1
5.1
16.9
- 7.2
4.0
- 12.1
11.4
- 4.9
- 1.0
1997 Average Inflation Rate
2.7
- 6.1
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Relative Prices

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

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Redistribution

• 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.
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Redistribution Effects
Price Effects

• Nominal income is the amount of money income
  received in a given time period, in current
  dollars.
• Real income is income in constant dollars.
• Not all prices rise at same rate during
  inflation.
• Not everyone suffers equally from inflation.

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Redistribution Effects

• Income effects

What looks like a price to buyer is income to the
seller. If prices rise, so do incomes. Wealth
Effects Inflation alters the real value of
savings.
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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. Income
effects People whose nominal incomes rise
faster than inflation end up with larger share of
total income.
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Robin Hood?

• Wealth effects People who own assets that
  increase in real value end up better off.

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Uncertainty

• Economic decisions increasingly difficult when
  inflation is present.

Changing price levels affect production
decisions Postponing construction. Not
finishing new construction. Changing price levels
can induce people to buy more goods and services
before the price rises.
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Measuring Inflation

• Inflation rate

The annual rate of increase in the average price
level. Consumer Price Index (CPI) A measure
(index) of changes in the average price of
consumer goods and services. It likely overstates
the inflation rate.
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Price Stability Goal

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

It is a major goal of economic policy. It is
officially defined as a rate of inflation of less
than 3. Full Employment and Balanced Growth Act
(1978) set this goal.
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Price Stability Goal

• Why 3?

Zero percent inflation might harm the goal of
full employment. Need to allow price changes to
reflect quality improvements.
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End of Chapter 10 Lecture