Transcript Chapter Objectives - McGraw Hill Higher Education

Chapter 10
Business Cycles,
Unemployment, and
Inflation
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
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Potential versus actual GDP
Potential growth
Output gap
Types of unemployment
Unemployment and inflation
Recessions
The business cycle
10-2
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.
10-3
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.
10-4
The Path of Potential GDP
10-5
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.
10-6
The Output Gap
10-7
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.
10-8
Unemployment Rate, Historical
10-9
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.
10-10
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.
10-11
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.
10-12
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.
10-13
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.
10-14
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.
10-15
The Unemployment Rate versus the
NAIRU
10-16
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:
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It’s harder to find a job.
Profits aren’t as high.
Malls are empty.
Tax revenues fall short of predictions.
10-17
The Last Five Recessions
10-18
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.
10-19
The Typical Business Cycle
10-20
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.
10-21
What Happens in a Recession
Employment
Retail sales
Businesses lay off workers
and cut hiring
Stores see falling sales
Home construction
Fewer homes get built
Household income
Households see their real
income fall
Businesses make less
money
Business profits
Business investment
Businesses cut spending
Industrial production
Factories produce less
Tax revenues
Tax revenues decline
10-22
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.
10-23
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
10-24
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.
10-25
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
10-26
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.
10-27
Technology Bust and Recession of 2001
10-28
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.
10-29
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.
10-30