FOE: Session 8

Business Cycles Inflation Unemployment

Business Cycle: Business Cycle is the recurring and fluctuating levels of economic activity that an economy experiences over a long period of time. The five stages of the business cycle are growth (expansion), peak, recession (contraction), trough and recovery. At one time, business cycles were thought to be extremely regular, with predictable durations, but today they are widely believed to be irregular, varying in frequency, magnitude and duration. Business Cycle (or Trade Cycle) is divided into the following four phases:1. Prosperity Phase: Expansion or Boom or Upswing of economy. 2. Recession Phase: from prosperity to recession (upper turning point). 3. Depression Phase: Contraction or Downswing of economy. 4. Recovery Phase: from depression to prosperity (lower turning Point). The four phases of business cycles are shown in the following diagram:-

The business cycle starts from a trough (lower point) and passes through a recovery phase followed by a period of expansion (upper turning point) and prosperity. After the peak point is reached there is a declining phase of recession followed by a depression. Again the business cycle continues similarly with ups and downs. 1. Prosperity Phase When there is an expansion of output, income, employment, prices and profits, there is also a rise in the standard of living. This period is termed as Prosperity phase.

The features of prosperity are:1. High level of output and trade. 2. High level of effective demand. 3. High level of income and employment. 4. Rising interest rates. 5. Inflation. 6. Large expansion of bank credit. 7. Overall business optimism. 8. A high level of MEC (Marginal efficiency of capital) and investment. Due to full employment of resources, the level of production is Maximum and there is a rise in GNP (Gross National Product). Due to a high level of economic activity, it causes a rise in prices and profits. There is an upswing in the economic activity and economy reaches its Peak. This is also called as a Boom Period. 2. Recession Phase The turning point from prosperity to depression is termed as Recession Phase. During a recession period, the economic activities slow down. When demand starts falling, the overproduction and future investment plans are also given up. There is a steady decline in the output, income, employment, prices and profits. The businessmen lose confidence and become pessimistic (Negative). It reduces investment. The banks and the people try to get greater liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are cancelled and people start losing their jobs. The increase in unemployment causes a sharp decline in income and aggregate demand. Generally, recession lasts for a short period. 3. Depression Phase When there is a continuous decrease of output, income, employment, prices and profits, there is a fall in the standard of living and depression sets in. The features of depression are:1. Fall in volume of output and trade. 2. Fall in income and rise in unemployment. 3. Decline in consumption and demand. 4. Fall in interest rate. 5. Deflation. 6. Contraction of bank credit. 7. Overall business pessimism. 8. Fall in MEC (Marginal efficiency of capital) and investment.

In depression, there is under-utilization of resources and fall in GNP (Gross National Product). The aggregate economic activity is at the lowest, causing a decline in prices and profits until the economy reaches its Trough (low point). 4. Recovery Phase The turning point from depression to expansion is termed as Recovery or Revival Phase. During the period of revival or recovery, there are expansions and rise in economic activities. When demand starts rising, production increases and this causes an increase in investment. There is a steady rise in output, income, employment, prices and profits. The businessmen gain confidence and become optimistic (Positive). This increases investments. The stimulation of investment brings about the revival or recovery of the economy. The banks expand credit, business expansion takes place and stock markets are activated. There is an increase in employment, production, income and aggregate demand, prices and profits start rising, and business expands. Revival slowly emerges into prosperity, and the business cycle is repeated. Thus we see that, during the expansionary or prosperity phase, there is inflation and during the contraction or depression phase, there is a deflation. Inflation: Inflation refers to a continuous rise in general price level which reduces the value of money or purchasing power over a period of time. Statistically speaking, inflation is measured in terms of a percentage rise in the price index (i.e. percentage rate per unit time) usually for an annum (a year) or for 30-31 days (a month). Features of Inflation The characteristics or features of inflation are as follows:1. Inflation involves a process of the persistent rise in prices. It involves rising trend in price level. 2. Inflation is a state of disequilibrium. 3. Inflation is scarcity oriented. 4. Inflation is dynamic in nature. 5. Inflationary price rise is persistent and irreversible. 6. Inflation is caused by excess demand in relation to supply of all types of goods and services. 7. Inflation is a purely monetary phenomenon. 8. Inflation is a post full employment phenomenon. 9. Inflation is a long-term process.

Measuring Inflation An inflation rate gives us a consensus or aggregate measure of the price changes occurring for a number of different goods and services. When we look at individual goods, price changes often vary greatly. During the past decades the prices of goods such as automobiles, gasoline, movies, health care, and housing have increased significantly. In contrast, the price of calculators and computing power has decreased substantially. There are many different measures of inflation; we will focus on the most common index known as the consumer price index (CPI). There are several steps taken in calculating the current CPI:
1. Measuring the price changes of all goods is complex if not impossible. Instead a market

basket of goods is used which represents many of the goods and services that we consume frequently. Items such as housing, food, transportation, communication, etc. are represented by specific goods whose price changes can be accurately recorded over time. 2. The individual items in the market basket are weighted as to their relative importance. The price of gasoline will receive a more significant weighting than that of tomatoes since we spend a greater percentage of our budget on fuel. 3. The prices of individual items and their respective weights are used in calculating the CPI.

Inflation Rate = CPI present year CPI previous year CPI previous year
Although the consumer price index receives the lion's share of publicity and is the most closely followed price index, astute inflation watchers expand their horizons to include other price indexes. The two most important are the producer price index (PPI) and the wholesale price index. The PPI measures the average price level of goods sold by producers to wholesalers. This is a leading indicator, as higher producer prices are often translated into higher consumer prices. The wholesale price index measures the average price level of goods sold by wholesalers to retailers. Types of Inflation There are three main types of inflation: 1. Demand-pull inflation 2. Cost-push inflation 3. Hyperinflation

Demand-Pull Inflation

Figure above illustrates the concept of demand-pull inflation. Consider the demand for automobiles. If economic growth is strong, consumer income rises and the demand for cars such as the Chrysler, BMW convertible and other popular models increases, as shown graphically. The rightward shift in the demand curve for automobiles drives up auto prices from Po to P1. This is known as demand-pull inflation: inflation resulting from the increased demand for goods and services throughout the economy. As this example shows, demandpull inflation is generally driven by purchases of final goods and services. You may have noticed in the above graph that an increase in the demand for automobiles drove up auto prices and increased the quantity supplied by auto manufacturers. An important component used in the production of any automobile is steel. As auto producers increase their output of autos, they will demand more steel used in producing those cars. The price of steel and other inputs used in the production of autos will also rise.

Cost-Push Inflation

Figure above shows the idea behind cost-push inflation: higher production costs shift the supply curve to the left, causing prices to rise. Following our previous example, as Chrysler and other automobile producers increase their output to meet a surge in demand, they must pay higher prices for inputs such as steel. In addition, they will add extra production shifts, incurring increased overtime expenses for labor. As a result, the cost of producing an auto increases. Higher production costs cause the supply curve to shift inward resulting in higher prices for automobiles. The main cause of cost-push inflation is increasing prices of inputs used in production. Commodities can yield an important leading indicator of future inflation, when their prices rise due to greater demand. Since the effects of short-lived supply problems (which are more easily compensated for) are hard to separate, commodities have failed to become a consistent and reliable leading indicator of future inflation. Hyperinflation As unappealing as demand-pull and cost-push inflation sound, they are a drop in the bucket compared to the grandest of all inflations, hyperinflation. The best definition of hyperinflation is price increases that are so out of control as to make the concept of inflation meaningless. For example, in Germany between January 1922 and November 1923 (less than two years!) the average price level increased by a factor of about 20 billion. The German hyperinflation had its roots in the Treaty of Versailles, where the victorious allied nations imposed impossible war "reparation" payments on Germany. Faced with financial debts beyond its economic capacity to generate the required amount of payment, the German government started printing money to meet its obligations. As you see in this course, a major cause of inflation is printing money in large quantities, which can lead to an inflationary spiral.

During the hyperinflation, German workers would be paid in three shifts during the day. For example, after working the morning shift, workers would race to spend their fresh salary, which would be worthless within another few hours. There are pictures of children building play forts with bricks of worthless currency. Observers told stories of how Germans would order two beers at once, fearing that beer prices would rise before they finished their first one. Another story does have a silver lining. If a person purchased a bottle of wine, they could sell the empty bottle the next day for more than the purchase price - wine included. As you might imagine, the value of domestically held savings was wiped out, and the German middle class eroded substantially. The economic chaos opened up an opportunity for Hitler and his brown shirts to take over, leading Germany and the world into World War II. Fortunately, the victorious allies learned their lesson and helped rebuild the devastated Axis governments through the Marshall Plan. Consumer Price Index: Consumer Price Index is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living. Unemployment: While many of us surely dont appreciate it from a personal perspective, unemployment is unavoidable in any economy. However, it is not necessarily harmful. In a healthy economy, a certain degree of unemployment indicated as a percentage reflects the fact that they constantly are job seekers and employers voluntarily running after better opportunities for their own good. For example, a senior software engineer thinks that he deserves more with his advanced knowledge and productive skills, therefore decides to take on a transitional period of a month as unemployed so as to look for a better job. Here you will familiarize yourself with: 1. The concept of unemployment. 2. The types of unemployment. 3. The measurement of unemployment. 4. The costs of unemployment. In economics, unemployment refers to the condition of unwanted job losses, or willing workers without jobs. Its as simple as that, only one thing you should pay attention that the willingness of the unemployed worker to be employed is the key to the idea. Therefore, not everyone whos out of work is seen as unemployed. A person with a large fortune not looking a job is not

counted in the unemployed population in that he is not willing to work in the first place, though hes officially out of work. Some key concepts to understand unemployment:

Adult population Part of the civilian population of individuals 16 years age and older, constituting the base for labor force participation rate calculation. Labor force Individuals aged 16 years and older who is either working or actively looking for work. Its part of the adult population in the economy, constituting base for unemployment rate calculation. Adults who are not actively looking for a job fall out of the group, such as discouraged workers, the retired and so forth. In other words, they are not labor force. Labor force participation rate The ratio of labor force over adult population. Unemployment rate The number of unemployed workers expressed as a percentage of the labor force. It could be anywhere between 1% ~ 30%, though 3% ~ 10% is the most common interval. Discouraged worker People who have given up looking for jobs because of frustration, therefore not calculated in labor force.

Types of Unemployment: There are essentially 4 types of unemployment, namely frictional unemployment, structural unemployment, seasonal unemployment and cyclical unemployment, which respectively states the reason behind each type of unemployment and the paradox that job vacancies and unemployment always coexist.

Frictional unemployment Just as friction always takes place before the slider comes to its final position on the surface, people need time to find the best job, thus voluntarily rubbing back and forth between choices and staying unemployed. Its the same with employers who rarely hire the first applicant that enters the door. Both of them, the job applicants and employers need time to explore the labor force market. Therefore, frictional unemployment is a type of voluntary unemployment that arises because of the time needed to match job seekers with job openings. A good example is that when you make up your mind and set off looking for a better job and abandoning the current one, you are in the frictional unemployment labor force. Frictional unemployment is also sometimes referred to as search unemployment. It refers to the unemployed period when people are between jobs or looking for their first job. This is the one type of unemployment that is probably impossible to eradicate completely. It is far less serious than the chronic lack of work that some people are faced with. In a lot of instances frictional unemployment will be voluntary because people are trying to find the work that offers them the best pay and conditions. The Benefits of Frictional Unemployment

It is normal for us to consider any period without work to be a bad thing, but frictional unemployment can actually be a good thing. It encourages the individual to find work that is going to be best suited to their needs and skills. This not only benefits them but also benefits society as a whole as it is a mechanism that encourages the best people to end up in the most suitable jobs. It is also good for the employers as it means there is a constant flow of people who are looking for new opportunities. So far from it being a bad thing these periods where people are without work might be crucial for a successful economy. What Influences Frictional Unemployment? This type of unemployment is influenced by a number of different factors. The time of year can have a huge impact on the number of people seeking work for the first time. After graduation there will be a whole new cohort of young adults looking for their first opportunities in the business world. The rate of this type of unemployment can also go up depending on location. For example, in rural areas there can be a surge in the number of people looking for work during the winter; this is when there is less to do on the land. Frictional unemployment is also influenced by structural unemployment. There can often be a difference in the number of people who want to work in a certain industry and the number of job opportunities available. A good example of this is the construction industry where a slowdown can leave a lot of people desperate to find any type of work. Structural unemployment can be particularly hard to deal with and it may force people to retrain so as to get work in a completely different industry.

Structural unemployment This happens when a large amount of unemployed workers (labor force supply) dont qualify for a large amount of labor force demand. Its either because that the workers dont have the skills demanded by the employers or they live too far from the demanding area. Thus, unemployment caused by massive mismatch of skills or geographic location is noted as structural unemployment. Major shifts of consumption taste, technological change, tax and a variety of other factors can reduce the demand for certain skills and increase that of others, thus making structural unemployment occur.

Note: While frictional unemployment is short-term and mostly voluntary, structural unemployment poses more of a problem because workers must seek jobs elsewhere or must develop the skills demanded. The process is full of pain and frustration, and may lead to negative impacts on society.

Seasonal unemployment In some markets, the demand for goods and services may expectedly fluctuate fiercely with seasons in a year, incurring waves of demand for related labor force. As the season of Christmas comes, demand for postal services rise sharply so is postal workers because the workload is much bigger than that of any seasons else in the year. After that, demand for postal service drops to normal and so does demand for postal workers, bringing about unemployment. So, unemployment caused by

seasonal changes in labor supply and demand during the year is called seasonal unemployment.

Cyclical unemployment Because of business cycles, many firms reduce the demand for inputs, including labor in recessional periods when production declines. Cyclical unemployment is used to refer to the fluctuation in unemployment that is incurred by business cycles, more specifically, the unemployment caused by economic recessions. Cyclical unemployment can be zero in full expansions during a business cycle. For example, between 1942 and 1945, when the entire America is much too busy producing weaponry for WWII, business cycle arrived at an inflated expansion; thereby cyclical unemployment actually drops to zero, resulting in an average 1.6% unemployment rate during those good years. Cyclical unemployment is closely related to Keynesian economics theory. It refers to a situation where there are more people looking for work than there are jobs available. This type of unemployment is caused by the business cycle. It can occur for a number of reasons but is related to the performance of the economy. A good example is when cyclical unemployment occurs due to a fall in consumer demand. This leads to manufacturers reducing production and thus not needing as many employees. This situation causes increased unemployment. A Closer Look at Cyclical Unemployment and the Business Cycle The reason why we refer to this as cyclical unemployment is that it is directly linked to the business cycle. When business is good there is less unemployment but when things get tough for businesses then unemployment goes on the rise. The term, business cycle can be a bit misleading because it suggests that it is predictable. In fact this cycle can be very unpredictable and this is why sudden mass unemployment can come as a shock. For instance the downturn after the economic crash a few years ago caught most people by surprise. Although the business cycle is not exactly predictable it is said to have four stages. At the beginning of the business cycle there is a slowdown in the economy and this leads to a situation referred to as contraction. Eventually the slowdown causes the economy to reach its lowest point and this is the second stage of the business cycle. At this second stage unemployment will be at its lowest. Next the economy will begin to expand again and employment opportunities will increase. The fourth stage is the peak and here unemployment is at its lowest. When this peak is reached it can occur that there are more jobs available then there are people to fill them. Unfortunately the only place to go after a peak is down. Another way to look at cyclical unemployment is to view it as a negative correlation between the employment rate and GDP. As consumer demand falls it leads to a situation where unemployment increases. The fall in employment levels will lead to even less consumer demand. This can lead to a downward spiral that causes a lot of problems within the economy.

Cyclical Unemployment and Depressions The business cycle is said to usually revolve quite quickly. This should mean then that periods of a lot of unemployment shouldnt last very long. Unfortunately this isnt always the case and sometimes we hit a long period of mass unemployment referred to as a depression. This type of situation is caused by a number of different factors and it can keep the economy in trouble for many years. During this time unemployment becomes a huge problem and it is often necessary for governments to step in. The usual way to do this is by investing in big projects or other Keynesian type solutions. The government might also use incentives such as lower taxes to stimulate the economy.

How shall we measure unemployment? Macroeconomic unemployment is typically measured and comes to be known repeatedly as unemployment rate. But what exactly is unemployment rate? How is it measure? The unemployment rate (UR) expresses the number of people unemployed as a percentage of the labor force (LF). With labor force (LF) comprising of all unemployed (U) and employed (E) people, that is, LF = U + E We have unemployment rate or UR, expressed as UR = U / LF * 100% In a case of 100,000 people in the labor force and 10,000 of whom are unemployed (lost jobs and actively seeking one); the unemployment rate would be calculated as UR = U / LF * 100% = 10,000 / 100,000 * 100% = 10% In addition to labor, land and capital can also be unemployed. With a little common sense, we would expect that a high unemployment rate of labor would result in a low level of utilization of capital, land and other forms of production factors, simply because men are the operators that make these things work for the economy and produce economic value. If more men are laid off their work, more resources are left to rot rather than utilized in production. In case you are confused with concepts like labor force, not in labor force, employed or unemployed used in this section, please refer back to the beginning section what is unemployment anyway? For clarification. And if theres no problem we will have a look at the

compositions of both the adult population and the labor force of United States in 2006 below to have a better grip of where unemployment stands in the economy. How unemployment harms our daily lives and the economy? Lost of income for individuals and outputs for economy would come up first as the costs of unemployment. For individuals and households, unemployment forces them to curtail their consumption drastically and perhaps liquidate some of the assets often at a loss to meet financial obligations. All these have negative impact on the whole economy. For economy as a whole, unemployment reduces the output of goods and services that could otherwise have been produced by unemployed labor force. An economy is producing substantially below its potential if unemployment rate is extremely high, thus everybody in the society loses by consuming and enjoying less because less is produced for distribution. The economic loss caused by unemployment can be measured as a loss in aggregate supply (total output) or aggregate demand (total income), more specifically, the difference of potential GDP minus actual GDP. In non-economic aspects, unemployed individuals might be very much discouraged for their inability to secure jobs, and the feelings of frustration and dismay usually lead to anti-social activities: indulgence, theft, violence, sabotage and other forms of crime, which would pose serious problems especially if the unemployment rate is unbearable. Unemployment ruins family happiness. The misery and suffering cannot be measured by economic statistics, but they significant and as real as it gets.