Chapter 11

THE BUSINESS CYCLE, UNEMPLOYMENT, AND INFLATION

Chapter in a Nutshell

1. The business cycle refers to recurrent ups and downs in the level of economic activity
extending over several years. Although business cycles vary in intensity and duration, we
divide each into four phases: peak, recession, trough, and recovery.
2. When real GDP decreases for at least two consecutive quarters, we say that the economy is in
a recession. A depression is a very deep and prolonged recession. Since no subsequent
recession has approached the severity of the Great Depression, the term depression is often
used as a reference to the slump of the 1930s.
3. Many economists believe that a change in total spending is the immediate determinant of
domestic output and employment. However, other economists maintain that changes in the
supply side of the market, such as the development of better technologies or decreases in
natural resources cause business cycles.
4. The unemployment rate is the number of people unemployed divided by the number of
persons in the labor force. Although economists take great care in calculating the
unemployment rate, it suffers from problems involving part-time employment and discouraged
workers.
5. Not everyone who is unemployed is unemployed for the same reason. In describing labor
markets, economists refer to frictional unemployment, cyclical unemployment, and structural
unemployment. To mitigate the costs of unemployment, government has many programs such
as education and training programs and also unemployment insurance.
6. Economists call the level of unemployment at which there is no cyclical unemployment the
“natural rate of unemployment.” The natural rate of unemployment is the sum of frictional
and structural unemployment and is the economists’ notion of “full employment.” Most
economists estimate the natural rate of unemployment to be between 4 and 6 percent of the
labor force.
7. Inflation is a sustained or continuous rise in the general price level while deflation is a
continuing fall in the average price level. The most frequently cited indicator of inflation is
the consumer price index.
8. Inflation results in a decrease in the purchasing power of a fixed amount of income, a
redistribution of wealth from creditors to debtors, declining real interest rates on savings, and
higher tax revenues for the government.
9. Inflation may be caused by forces taking place on the buyers’ side of the market or the sellers’
side of the market. Inflation originating from upward pressure on the buyers’ side of the
market is called demand-pull inflation. Cost-push inflation is caused by upward pressure on
the sellers’ side of the market.

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 Chapter 11: The Business Cycle, Unemployment, and Inflation 109

Chapter Objectives
After reading this chapter, you should be able to:
1. Discuss the four phases of the business cycle.
2. Assess the effects of the business cycle on different sectors of the economy.
3. Explain what the unemployment rate means and how it is calculated.
4. Identify the various types of unemployment and their costs on the economy.
5. Discuss the importance of the consumer price index as a measure of inflation.
6. Identify who benefits and who is hurt from inflation.

Knowledge Check

Key Concept Quiz

1. business cycle
2. recession
3. trough
4. depression
5. leading economic
indicators
6. unemployment rate
7. discouraged worker
8. frictional unemployment
9. structural unemployment
_____ a. occurs when real GDP decreases for at least six
months
_____ b. a deep and prolonged recession
_____ c. number of people unemployed divided by the labor
force
_____ d. unemployment that arises from normal labor
turnover
_____ e. fluctuating unemployment that coincides with the
business cycle
_____ f. unemployment caused by skills that do not meet
employers needs

10. cyclical unemployment _____ g. unemployment rate at which no cyclical

unemployment exists
11. natural rate of
unemployment _____ h. the low point of real GDP just before it begins to
turn up
12. full employment
_____ i. the recurrent ups and downs in the level of
13. inflation economic activity
14. real income _____ j. used to forecast economic fluctuations
15. capital gain _____ k. an individual who has stopped looking for work
16. demand-pull inflation _____ l. is less than 100% employment of the labor force
______m. measures real purchasing power
______n. inflation originating from upward pressure on the
buyers’ side of the market
______o. the profit you earn when you sell an asset
______p. a sustained rise in the general price level
110 Chapter 11: The Business Cycle, Unemployment, and Inflation

Multiple Choice Questions

1. The four phases of the business cycle are
a. peak, recession, trough, and recovery
b. peak, recession, trough, and boom
c. peak, depression, trough, and boom
d. peak, depression, bust, and boom
2. Business cycles are measured from
a. peak to peak
b. recession to recession
c. depression to depression
d. boom to bust
3. Usually business cycles
a. have averaged four to five years
b. have generated expansions that have lasted four and one-half years on the average
c. have generated recessions that have lasted seven months on average
d. create depressions every two years
4. Business cycles share all of these characteristics except
a. consumer expenditures decline abruptly
b. business inventories of steel, automobiles and other durable goods rise unexpectedly
c. the interest rates rise
d. wage growth slows down
5. During the Great Depression
a. unemployment rates reached 25 percent
b. industrial output fell by 40 percent
c. the United States experienced a long and deep recession
d. all of the above
6. Stagnation in the Japanese economy
a. is good for the United States because U.S. producers no longer need to compete with
the Japanese
b. is bad for the United States because U.S. exports decline
c. is good for the United States because U.S. consumers buy fewer Japanese products
d. is of no concern to the United States
7. All of the following are indicators of a recession except
a. average work week for production workers
b. stock prices
c. interest rates
d. tax cuts
 Chapter 11: The Business Cycle, Unemployment, and Inflation 111

8. Most economists believe that the immediate determinant of output and employment is
a. a change in total spending
b. the development of new technology
c. an increase in the costs of production
d. a decline in the Dow Jones Industrial Average
9. Which of the following is most sensitive to the business cycle
a. durable goods
b. non-durable consumer goods
c. services
d. exports
10. The official unemployment rate tends to underestimate unemployment because
a. it does not count workers under the age of 14
b. it fails to count the employment of all homemakers
c. it counts all those who are employed part-time as fully employed
d. it ignores all full-time students who are not actively seeking employment
11. The degree of unemployment in the U.S. economy is underestimated because
a. the discouraged worker is not considered as being part of the labor force
b. those who are out of work and have stopped looking are not counted in the labor force
c. the underemployed workers are counted as fully employed
d. all of the above
12. When an economy enjoys full employment
a. the unemployment rate equals zero
b. frictional and structural unemployment may be positive
c. cyclical unemployment is positive
d. the economy has a rate of employment equal to the natural rate of employment
13. In an overheated economy
a. actual unemployment rate is less than the natural rate
b. actual unemployment rate is less than full employment
c. cyclical unemployment equals zero
d. frictional unemployment rate plus structural unemployment rate is less than zero
14. When deflation occurs
a. prices rise
b. the average price level declines
c. the purchasing power of money declines
d. interest rates increase
15. If the real interest rate increases, we may conclude that
a. the nominal interest rate increased and the inflation rate remained constant
b. the nominal interest rate decreased and the inflation rate remained constant
c. the nominal interest rate and the inflation rate remained constant
d. the inflation rate has increased
112 Chapter 11: The Business Cycle, Unemployment, and Inflation

16. To the extent that inflation is unanticipated, it creates winners and losers. Unanticipated
inflation helps
a. borrowers at the expense of lenders
b. taxpayers at the expense of government
c. savers at the expense of investors
d. workers at the expense of employers
17. Because of tax indexing, a household is pushed into a higher tax bracket only if its
a. nominal income rises faster than the rate of inflation
b. nominal income rises slower than the rate of inflation
c. nominal income rises equal to the rate of inflation
d. nominal income falls faster than the rate of inflation
18. When buyers’ spending to purchase goods and services outruns sellers’ capacities to supply
them, thus forcing up prices on what is available, _____occurs
a. supply-side inflation
b. monetary inflation
c. demand-pull inflation
d. cost-pull inflation
19. Inflation imposes the greatest burdens on
a. lenders, when it is anticipated
b. lenders, when it is unanticipated
c. borrowers, when it is anticipated
d. borrowers, when it is unanticipated
20. Under which of the following conditions would Tim Nelson desire to be a lender
a. the nominal rate of interest is 15 percent and the inflation rate is 25 percent
b. the nominal rate of interest is 12 percent and the inflation rate is 12 percent
c. the nominal rate of interest is 8 percent and the inflation rate is 9 percent
d. the nominal rate of interest is 6 percent and the inflation rate is 2 percent
21. Suppose that the Wall Street Journal reads: “U.S. Economy Remains in Recession.” The type
of unemployment that would likely occur in this circumstance is
a. structural unemployment
b. frictional unemployment
c. cyclical unemployment
d. sustained unemployment
22. Recurrent expansions and contractions of economic activity that take place over several years
refers to
a. stagflation
b. disinflation
c. depression
d. the business cycle
 Chapter 11: The Business Cycle, Unemployment, and Inflation 113

23. During a recession, the unemployment rate tends to

a. understate the actual amount of unemployment
b. overstate the actual amount of unemployment
c. properly estimate the actual amount of unemployment
d. any of the above
24. If the unemployment rate is 5 percent and 9 million workers are unemployed, then the
civilian labor force equals
a. 140 million people
b. 160 million
c. 180 million
d. 200 million people
25. If Mary Miller’s nominal income increases by 4 percent while the consumer price index
increases by 6 percent, her real income
a. increases by 10 percent
b. increases by 2 percent
c. decreases by 10 percent
d. decreases by 2 percent
26. Suppose that the consumer price index equaled 177.1 in 2001 and 179.9 in 2002. The rate of
inflation between these two years thus equaled
a. 1.6 percent
b. 2.8 percent
c. 3.3 percent
d. 4.1 percent
True-False Questions
1. T F When the economy is fully employed, frictional unemployment equals
zero.
2. T F The natural rate of unemployment results when cyclical unemployment
is equal to zero.
3. T F Demand-pull inflation may be caused by too much money chasing too
few goods.
4. T F Higher resource prices may lead to cost-push inflation.
5. T F An overheated economy tends to realize low rates of unemployment.
6. T F The business cycle is a pattern that has distinct phases.
7. T F When demand decreases, it tends to have a limited effect on
employment.
8. T F An improvement in technology has a more immediate effect on domestic
output and employment than total spending.
9. T F When the economy declines for one quarter, we say that the economy is
in a recession.
114 Chapter 11: The Business Cycle, Unemployment, and Inflation

10. T F The U.S. economy has had several recessions since the Great
Depression.
11. T F When the economy reaches the bottom of the business cycle, it begins to
suffer a recession.
12. T F Cyclical unemployment may be zero, but frictional unemployment is
generally positive.
13. T F Leading economic indicators are used as predictors of an economic
downturn.
14. T F The most frequently cited indicator of inflation is the producer price
index.
15. T F Unanticipated inflation always helps borrowers at the expense of lenders.
16. T F When the nominal rate of interest increases by less than the inflation rate,
the real interest rate declines.
17. T F When the U.S. economy encounters a recession, service industries are
the first to suffer its effects.
18. T F Discouraged workers are not part of the labor force.
19. T F Unemployed workers are part of the labor force.
20. T F The Bureau of Labor Statistics’ method of measuring part-time
employment leads to inaccuracies in the measure of unemployment rate.
21. T F If the nominal interest rate on your savings account equals 2 percent and
the rate of inflation is 3 percent, then the real interest rate on the account
equals 5 percent.
22. T F Suppose that you had $100 to purchase some goods in 2005. Also
suppose that the CPI is 24.1 for 1960 and 179.9 for 2005. You would
have needed $13.40 in 1960 to buy the same amount of goods in 2005.
23. T F Economists maintain that the economy is at “full employment” when 100
percent of its workers are employed.
24. T F An autoworker would be shielded from inflation if the worker has a cost-
of-living provision in an employment contract.
25. T F For the consumer price index to register inflation, the prices of all
consumer goods must increase.
26. T F During a recession, market rigidities may prevent wages from
decreasing, the result being involuntary unemployment for labor.
27. T F Labor economists generally maintain that frictional unemployment is a
much more serious problem for the United States than structural
unemployment.
28. T F The U.S. system of unemployment insurance helps support household
spending during periods of job loss and provides economic security to
workers through income maintenance.
 Chapter 11: The Business Cycle, Unemployment, and Inflation 115

Application Questions
1. The table below shows the price-consumption behavior in the college town of Hallelujah.
Purchased Items Quantity Price (1999) Price (2000)
Mocha Frappucinos 400 $0.25 $0.50
Books 40 $5.00 $2.50
Lunches 100 $1.00 $2.00

In calculating the CPI, use 1999 as the base year. For any year, multiply the price and
quantities of each product, and then sum these costs for all products to find the cost of the
market basket in Hallelujah.
a. What is the CPI for Hallelujah in 1999?

b. What is the CPI for Hallelujah in 2000?

c. What is the rate of inflation between 1999 and 2000?

2. The following table represents some labor force statistics for the island of Rolling Rock

Employed Unemployed Labor

Workers Workers Force Unemployment
Year (Millions) (Millions) (Millions) Rate

1998 200 10.0%

1999 240 5.0 %
2000 276 24
2001 266 14

a. Please complete the table.

b. If the natural rate of unemployment in Rolling Rock is 5%, what is the level of cyclical
unemployment in 1999?
116 Chapter 11: The Business Cycle, Unemployment, and Inflation

c. Is the economy of Rolling Rock experiencing an economic downturn in 2000?

d. Is structural unemployment zero in 2001?

2. Suppose that the nominal income for Germany in 1999 is $3.6 trillion.
a. If the real income is $2.57 trillion (1990 base year), find the CPI for 1999.

b. If nominal income in 1990 is $2.00 trillion, what is the rate of growth in real income
between 1990 and 1999?

Answers to Knowledge Check Questions

Key Concept Answers

1. i 5. j 9. f 13. p
2. a 6. c 10. e 14. m
3. h 7. k 11. g 15. o
4. b 8. d 12. l 16. n

Multiple Choice Answers

1. a 6. b 11. d 16. a 21. c 26. a
2. a 7. d 12. b 17. a 22. d
3. a 8. a 13. a 18. c 23. a
4. c 9. a 14. b 19. b 24. c
5. d 10. c 15. a 20. d 25. d
 Chapter 11: The Business Cycle, Unemployment, and Inflation 117

True-False Answers
1. F 6. F 11. F 16. T 21. F 26. T
2. T 7. F 12. T 17. F 22. T 27. F
3. T 8. F 13. T 18. T 23. F 28. T
4. T 9. F 14. F 19. T 24. T
5. T 10. T 15. T 20. T 25. F

Application Question Answers

1. a. The CPI in 1999 is 100.
b. The CPI for 2000 is 150.
c. The inflation rate is 50%.

2. a. Below is the completed table showing labor statistics for the island of Rolling Rock.

Employed Unemployed Labor

Workers Workers Force Unemployment
Year (Millions) (Millions) (Millions) Rate

1998 180 20 200 10.0%

1999 228 12 240 5.0%
2000 276 24 300 8.0%
2001 266 14 280 5.0%

b. In 1999, cyclical unemployment on Rolling Rock Island equals zero.

c. Yes. Since the unemployment rate exceeds the natural rate of unemployment, positive
cyclical unemployment exists.
d. The structural unemployment is not necessarily zero. Structural unemployment on
Rolling Rock Island may still exist even when the island enjoys full employment in 2001.

3. a. The CPI equals 140.

b. The rate of growth in real income

2.57  2.00
  100  28.5%
2.00