Objectives for Chapter 9

At the end of the Chapter, you will be able to answer the

following:
1. What is a business cycle? What are the various
theories concerning the business cycle?
2. Show how economic forecasting is done.
3. How to compute for the inflation rate and the
unemployment rate?
4. Identify and discuss
unemployment.

the

various

types

of

5. Construct your own price index.

6. Identify what are the various causes of inflation.

Chapter 9
Business Cycle, Inflation and Unemployment

An economist is an expert who will know tomorrow why the

things he predicted yesterday didnt happen today.
- Laurence J. Peter

Economics is not called the dismal science for nothing.

Right now, well be examining some of the problems that
have contributed to this reputation- recessions, inflation,
and unemployment. It would be wonderful if our economy
could grow steadily at say 3 percent a year, with no
recessions, no inflation, and no unemployment. But as you
know, the real world ia a lot more dismal.
Still, for every problem, there may be a solution. For so

much of the following chapter, well consider how to

ameliorate, if not solve, the problems of recession,
inflation, and unemployment.
Is There a Business Cycle?
Economist and non-economist have long debated whether
there is a business cycle. It all depends on what is meant
by the term. If business cycle is defined as increases and
decreases in business activity of fixed amplitude that
occurs regularly at fixed intervals, then there is no
business cycle. In other words, business activity does have
its ups and downs, but some ups are higher than other ups
and some downs are lower than others. Furthermore there
is no fixed length to the cycle.
If we define
Figure 1. Hypothetical Business Cycle
the
business
cycle
as
alternating
increases
and
decreases
in the level
of business
activity
of
varying
amplitude
and length,
then there The three-phase business cycle runs from
is definitely peak to peak, beginning with a recession
a business which ends in a through, followed by a
cycle. What recovery. When the level of the previous
goes up will prosperity is attained, prosperity sets in,
eventually
continuing until a new peak is reached.
come down, and what goes down will rise again.
The Conventional Three-Phase Business Cycle
Well begin our analysis with the first peak in Figure 1. The
decline that sets in after the peak is called a recession,
which ends with a trough. Occasionally there is a false
recovery when business activity turns upward for a few

months but then turns down again. If the next low point is
the lowest since the previous peak, then that is the trough.
Recovery begins with the trough, but the expansion must
eventually reach the level of the previous peak.
Occasionally business activity rises without reaching the
previous peak; unless it does, it does not qualify as a
recovery.
Once a recovery definitely has set in, real GDP moves
upward until it passes the level of the previous peak, when
it enters the third phase of the business cycle: prosperity:
This phase does not necessarily mean there is full
employment, or even that we are approaching full
employment. As long as production (real GDP) is higher
than it was during the previous peak, we are in a prosperity
phase.
Prosperity is the second part of economic expansion and is
accompanied by rising production, falling unemployment,
and often accelerating inflation. Sooner or later we reach
the peak and the process starts over again recession,
recovery, and prosperity.
This is the conventional three-phase cycle. Some people
talk of a fourth phase: depression. Although depressions
are relatively rare we have not have one since the 1930s
there is always talk that possibility that a recession can
turn into a depression.
What is dividing the line between a recession and a
depression? There is no agreed on or official definition.
Obviously, an unemployment rate of 20 percent would be a
depression. But would 10 percent qualify?
Perhaps the best definition was proposed by, among
others, the late long time president of AFL-CIO. He said that
if his neighbor were unemployed, it would be a recession. If
he were unemployed, it would be a depression!

The Problem: Inflation

What exactly is inflation? It is broadly defined as rise in
price level. Generally, we consider inflation as a regular

economic phenomenon where there is a sustained increase

in the general price level of goods and services. It is an
ongoing process. It is usually measured annually, quarterly,
or monthly. The National Statistics Coordination Board uses
various price indices to measure the inflation rate in the
Philippines. In our own lifetimes, we have known little but
inflation.
If the rate of inflation had been 4 percent, would that mean
the price of every good and service went up by 4 percent?
Of course not! The price of some things may not have
changed. And when the overall price level is rising, the
price of other goods are actually going down. Can you think
of examples? In the 1970s and 1980s color TV prices
came going down. Average price of LCD TVs tumbled from
200,000 in 2000 to under 25,000 today. The prices of
cellphones, fax machines, laser printer, iPhones, contact
lenses, microwave ovens, digital cameras, and graphing
calculators have also fallen substantially.

Theories of the Causes of Inflation

Demand-Pull Inflation
When there is excessive demand for goods and services,
we have demand-pull inflation. What is excessive? When
people are willing and able to buy more output than our
economy can produce. Somethings gotta give. And what
gives are prices.
Demand-pull inflation is often summed up as too much
money chasing too few goods. The problem is that we
cant produce any more goods because our economy is
already operating at full capacity,
What happens next if demand keeps rising/ What if people
have money in their pockets and desire to spend it? Again,
somethings gotta give. Output cant rise anymore. Theres
only one thing that can go up: price.
Cost-Push Inflation
There are three variants of cost-push inflation. Most
prominent is the wage-price spiral. Because wages
constitute nearly two-thirds of the cost of doing business,

whenever workers receive a significant wage increase, this

increase is passed along to the consumers in the form of
higher prices. Higher prices raise everyones cost of living,
engendering further wage increase.
The second variant of cost-push inflation is the profitpush inflation. Because just a handful of huge firms
dominate many industries (for example, computer
software, publishing, cigarettes, cars, and oil), these firms
have the power to administer prices in those industries
rather than accept the dictates of the market forces of
supply and demand. To the degree that they are able to
protect their profit margins by raising prices, these firms
will respond to any rise in costs by passing them on to their
customers.
Finally
we
Figure 2. Graphing the Demand-Pull
have
the
and
supply-side
the Cost-Push Inflation
cost shocks,
most
prominently
the oil price
shocks
of
2002, when
the
United
States
declared war
against
Al
Qaeda
in
Iraq.
OPEC Demand-pull inflation is set off by an
increase in demand for goods and services
nations
without increase in supply. The left graph
quadrupled
shows how price increase.
the prices of
oil. When the Cost-push inflation happens when production
price of oil costs rise. Sellers can no longer supply the
rises, the cost of making many other things rises as well,
for example, electricity, fertilizer, gasoline, heating oil, and
long-distance freight carriage. And as we have seen again
and again, cost increases are quickly translated into price
increases. Cost-push inflation is shown graphically in Figure
2.
Price Index

The Consumer Price Index (CPI), which measures

changes in the cost of living, is one of the price indices
that are used to measure inflation. Consumer Price
Index: the weighted average (quantities are based on
the relative importance to HH) of the prices of a fixed
bundle of G&S.
Bundle is called a market basket and is meant to represent
the consumption of a typical urban family.
CPI

= cost of basket in current year

x 100

cost of same basket in base year

= 100 in base year
Used for Cost of Living Adjustments (COLA) in union
contracts and G programs. Accurate reflection of your cost
of living only if you consume that bundle. E.g. if elderly and
consume a lot of health care the CPI understates your rate
of inflation because health care has relatively high inflation
rate. Thus, even though social security has COLA, elderly
still suffer decrease in standard of living as purchasing
power decreases.
To
1)
2)
3)

create an index like CPI:

select a demographic group
determine market basket (items and amounts)
select base year (arbitrary; does not matter since
relative)
4) collect price data
Once get index calculate inflation as follows:
Inflation % =
next
=
Index

t-1

Index

t-1

% change in index from 1 year to

Index t

Figure 3. The GDP Deflator in the Philippines from

1988-2005.

GDP Deflator: a different type of price index from the CPI.

Includes much wider group of G&S (basically whatever

is in GDP not just consumer goods consumed by
typical urban family)
Figure 3. Inflation Rate in the Philippines 19882005

Source: National Statistics Office

CPI includes imports (part of HH basket) but deflator

does not since imports are subtracted from GDP.
CPI has fixed bundle which means it does not account
for substitutions as prices increase COL overstated.
Deflator reflects changes in the GDP composition

brought about by market responses to price changes.

I.e. deflator looks at current basket of G&S not some
fixed basket.
Costs of Inflation:
Inflation does not automatically imply that standard of
living is decreasing but it is problematic:
1) Redistributes income among people in economy
2) Decreases investment both in physical and human
capital
3) Inefficiencies: costs of keeping up with inflation.

Unemployment
Unemployment is the condition of not being able to
find work. Technically in economics it only covers those
who are willing but are not able to find work.
Therefore in measuring the unemployment rate, we only
consider the labor force and not the entire labor supply of
the nation. We would define unemployment rate then
as the percentage of the population who are 16-60
years old, who are willing but are not able to work
in the formal economy.
Usually, unemployment is counter-cyclical and inflation is
pro-cyclical. Thus, usually, high unemployment and high
inflation do not occur at the same time. However, in the
case of stagflation it is possible to get both stagnation
(high unemployment) and high inflation; this occurred in
the 70s.
Those not in the labor supply are not looking for work
because either they, (1) do not want a job, either they are
retired, homemaker, or student, or, (2) are discouraged.
Unemployed individuals are those who are available for
work and have made an effort to find a job in the past 6
months. Employed individuals are everyone else
including those who worked 1 hour/week or more for pay
and those who worked 15 hours/week in a family
business without pay.

The following are the means for computing

unemployment rate and the labor participation rate:

the

Limitations of Unemployment Rate:

1) Does not capture demographic, regional or industry
patterns.
2) Does not capture discouraged worker effect: decline in
Unemployment rate due to people who want to work
but grow discouraged and drop out of the labor force.
3) Does
not
capture
the
extent
of
underemployment, quality of job, employment
in underground or the level of job security.
4) Does not capture the length of time individual is out of
work.
Thus the unemployment rate is only a general guide to the
state of the labor market.

Types of Unemployment
There are generally two types of unemployment and these
are the avoidable and unavoidable unemployment.
Avoidable unemployment - This is unemployment that
usually associated with insufficient demand for workers
caused by many factors such as poor performance of the
economy or of the firm. A good example of an avoidable
unemployment is one that is caused by a firm shutting
down due to mismanagement or bankruptcy.
Unavoidable unemployment This is unemployment

that is inevitable. There are three subtypes of unavoidable

unemployment.
1) Frictional
This occurs because of people quitting jobs to find a
better fit, ex-students looking for first jobs and seasonal
workers. Not necessarily a bad thing. Never equals zero. It
is unemployment associated with the changes in the
various aspects of the economy and the society. Another
example of frictional unemployment is when a new B.S.
Economics graduate joins the labor force.
2) Structural
Happens when new technologies and new goods need new
skills and workers with old skills cannot find jobs. It occurs
when the location and qualifications of the labor force do
not match the available jobs. For example, when a factory
in Bulacan moved their production to Clark, Pampanga,
thousands of workers were displaced because some were
unwilling to be relocated to its new location.
The skills may also be lacking in the labor force. In the
Philippines, there are many jobs that are available in the
agricultural sector, so the country needs more
agriculturists and other skills related to this sector.
However, most colleges and universities produce more
business and HRM graduates, nurses, and the like that are
not in line with agriculture. This leads to structural
unemployment.
3) Cyclical
Unemployment associated with general downturns in
economy. In a recession, output decreases and firms
employ less capital and labor. It can also be
unemployment brought about a decrease in production of
output by firms when they are not within their peak
season.
How much is Full Employment
Full employment does not mean that unemployment is at
zero. Full employment is unavoidable unemployment

or if cyclical unemployment is zero. The full

employment is referred to as the natural rate of
unemployment. It is expressed in the formula below.
Natural Rate of Unemployment = Frictional + Structural
Prevails even in normal times when real GDP = potential
GDP. The economy has been considered to be at full
employment at 5-6%.
Okuns Law
This was developed by Arthur Okun who is a
macroeconomist and served the economic council of the
U.S. president Lyndon Johnson. He developed the
relationship between GDP and unemployment. As a result
of his finding, he concluded that for every 2-3% movement
in the GDP, unemployment changes by 1% in the opposite
directions.
Costs of Unemployment:
1) Social costs: depression, suicide, poor health
2) Decrease in current output: since not achieving
potential GDP by efficiently employing all K and L we
lose G&S which could have been produced if we were
on the frontier of the PPF.
3) Decrease in future output: since level of investment
during a recession declines this means decreased
economic growth.
Underemployment
Another big social and economic issue in the Philippines is
underemployment. People are underemployed if either
they are working on a part-time basis, or they are
paid full time but are not busy because of the
demand for the product is low. Underemployment also
takes place when a person is employed in a job that is
not in line with his/her skills and education.
For the past decade, there are thousands of graduates in
some particular courses, such as B.S. Nursing and B.S.

Hotel and Restaurant Management. However, some of

them are working along BPO companies such as call
centers; others are working along banks, department
stores. They are technically underemployed, however, this
is not to discredit this people, because their job have value
in the Philippine economy and they pay proper taxes, but
then again, in a strict sense, it is still unemployment
because there is wastage of resources, in a way that they
are not able to fully utilize their education that they earned
for 4-5 years in the universities.

Inequality and Poverty

The Distribution of Income
At the beginning of this course, we named three questions
that every society must answer. One of these questions
was for whom is production taking place? Who gets the
goods and services that are produced is determined by
peoples incomes. In earlier chapters, we examined the
factors that determine peoples incomes in a market
economy --- both wages and profits. Now, let us see how
these incomes are actually distributed in the Philippines.
The most common portrayal of the distribution of income is
to imagine that we could line up every household in the
country according to income. At one end of the line is the
household with the lowest income. At the other end of the
line is the household with the highest income. Households
stand in the line in order of their income. Then, assume
that we divide the line into five equal parts (called
quintiles). The question that is asked is: what percent of
all of the income was earned by the households in that
quintile?
For 2002, the answer is that the lowest quintile (those 20%
of people with the lowest incomes) earned only 3.5% of all
of the income earned. The second quintile earned 8.8% of
all of the income earned. The third quintile earned 14.8%
of all of the income earned. The fourth quintile earned
23.3% of all of the income earned while the top quintile
earned 49.7%. Therefore, the top 20% of income earners
earned almost as much income in 2002 than the other

80%.
A Dutch economist once tried to put this into human
perspective. He imagined that the person with the median
income (the income so that half of households earn more
and half of households earn less) could be stretched or
shrunk to be the average size (about 5 6).
Then
everyone else would be stretched or shrunk so that their
size related to the average size as their income relates to
the median income. How tall would each person be? A
widow collecting full social security benefits would be
about 1 10. A woman with two children collecting full
welfare benefits in DSWD would be about 11. The person
on General Relief would be much less than this. So, if you
can imagine someone 5 6 looking down on these people,
you get a sense of the disparity.
On the other hand, the person with the median income
would have to look up to the person with the highest
income. This person would be nearly 25,000 feet tall --- 25
times the height of the Empire State Building in New York.
Let us put some perspective on these numbers. What do
we mean by rich? If I tell you I earned 1,000,000 this
year, would you call me rich? The answer is probably
yes. What about 500,000? 250,000? 150,000?
100,000? 75,000? 50,000? If you are like most
people, you start to
waver
at
around
150,000. Most people
say that people earning
less than 100,000 to
150,000 annually are
not rich.
In fact,
these people tend to
call
themselves
middle
class.
At
150,000 of income,
people tend to differ
with some saying they
are rich while others
say they are not. At
250,000 of income,
most people say they
are indeed rich. If we

define rich as having an income over 150,000, then only

about 5% of Filipinos are rich. The point of this is that the
number of rich people is very small in the Philippines;
however, those that are rich are much richer than the rest
of the society.
As with most statistics, there is controversy concerning
these statistics. For example, what exactly is income?
These statistics include all earnings in the labor market
plus cash transfers, such as social security or welfare
benefits. They do not consider the taxes people paid on
their incomes. Nor do they consider in-kind transfers, such
as relief goods or medical aid. Also, how should we
consider households of different sizes? A household of two
adults with an income of 130,000 per year is in a very
different situation from another with the same income but
with eight children.
The Census Bureau has tried to
calculate the income distribution in many different ways.
What they find is the following. First, if one examine only
earnings in the labor market, the distribution of income is
more unequal than the distribution described above. This
means that cash transfers tend to make the distribution
more equal than it otherwise would be. Second, if all of the
taxes paid are taken into consideration, the distribution is
affected very little. Third, if in-kind transfers, such as relief
goods and medical aid, are taken into consideration, the
distribution becomes more equal. But if other government
programs, such as spending for education, are considered
the reverse is true. However, the conclusions discussed
below do not seem to depend on the particular measure of
income used.
Another conclusion involves a
comparison
of
the
income
distribution of the Philippines with
that of other countries. Are we
more equal or unequal than other
countries? The Philippines has a
more unequal distribution than do
the other countries with whom
the
Philippines
normally
compares itself.
Thailand and
Malaysia are similar to the
Philippines. Countries such as
Canada,
Britain,
Belgium,

Top 5 Riches Men in

the Philippines
1.
2.
3.
4.

Henry Sy
Lucio Tan
John Gokongwei
Jaime Zobel
Ayala
5. Enrique Razon
6. George Ty
7. Andrew Tan
8. Betty Go
9. Henry Tan Cak
Tiong
10.Danding
Cojuanco
As of june 2012
Sources:
www.forbesmag.com

Australia, and the Netherlands are more equal.

The
Scandinavian countries (Denmark, Norway, and Sweden)
are even more equal. The most equal distributions are
found in East Asian countries, especially Japan and Taiwan.
On the other hand, the Philippines have a more equal
distribution than Bangladesh or Laos and Pakistan. The
fact that there is greater income inequality in other
countries that are basically capitalist and market-oriented
tells us that some aspects of income inequality are unique
to the Philippines.
Our data on income inequality take a snapshot every
year. While the bottom 20% of households earn a lower
percent than they did previously, we need to note that the
people who comprise the bottom 20% (or any other
percentile) are not the same from year to year. Some
people in the bottom 20% will move to higher levels in the
future. And some people in the bottom 20% had been in
higher percentiles in previous years. There have been
studies that compare household incomes over varying
periods of time. These studies find considerable mobility.
For example, one study found that about 30% of
households move between quintiles from one year to the
next. Almost half will change quintiles over five years and
almost two-thirds will change quintiles over a ten-year
period. There is about equal probability that a household
will move down to a lower quintile (usually due to loss of
employment) as will move up to a higher quintile (usually
due to new employment, marriage, or a spouse becoming
employed for the first time). Many in the lowest quintile
are young people who will move up as they gain more work
experience. On the other hand, recent studies have found
evidence of lower rates of intergenerational mobility. Even
though people do tend to find themselves in a higher or
lower quintile than their parents were, there is a high
correlation between ones income and that of ones
parents. As just one example, a study from 1992 found
that, if your father was in the bottom 20% of the income
distribution, there was a 42% chance that you also would
be in the bottom 20% of the income distribution. These
data contradict one of the most deeply held values in the
Philippines which is equality of opportunities.

Summary

Business cycle is the alternating increases and

decreases in the level of business activity of varying
amplitude and length

The decline that sets in after the peak is called a

recession, which ends with a trough. Recovery
begins with the trough, but the expansion must
eventually reach the level of the previous peak.
Once a recovery definitely has set in, real GDP
moves upward until it passes the level of the
previous peak. When it enters the third phase of the
business cycle: prosperity. Prosperity is the second
part of economic expansion. Sooner or later we

Generally, we consider inflation as a regular

economic phenomenon where there is a sustained
increase in the general price level of goods and
services. It is an ongoing process.

There are two generally accepted causes of

inflation. These are demand-pull inflation and cost
push inflation.

Demand-pull inflation is often summed up as too

much money chasing too few goods. Cost-Push
Inflation

There are three variants of cost-push inflation. Most

prominent is the wage-price spiral. The second
variant of cost-push inflation is the profit-push
inflation. Finally we have the supply-side cost
shocks inflation.

Unemployment is the condition of not being able to

find work. There are generally two types of

Questions for Review and Application

1. Why is high inflation rate bad for the economy?
2. Right now, our economy is going through what phase
in the business cycle? How do you know this?
3. Being unemployed means different things to different
people. Illustrate this by making up examples of
three different unemployed people.
4. Mang Pandoy is laid off from work. How does he
make ends meet until he finds another job?

Quiz for Chapter 9. Business Cycle,

Inflation, and Unemployment
Name:
___________________________________
_________________
Section:
______________
Date:
____________
________________

Score:
Professor:

Direction: Multiple Choice: Choose the best answer.

______1. Which of the following is true about the
distribution of income of the Philippines?
A.
B.
C.
D.

It has been getting more unequal over time

It is more unequal than most other countries
It is more equal than the distribution of wealth
All of the above

______2. In the three-phase business cycle, the prosperity

phase is always followed immediately by:
A. recovery
B. trough

C. depression
D. recession

______3. Which of the following could explain why income

has become more unequally distributed over the past 20
years?
A. the demand for higher skilled workers has risen
faster than the demand for lower skilled workers
B. the expansion of immigration
C. the decline of labor unions
D. all of the above
______4. We have business cycle of ___________.
A.
B.
C.
D.

The same length and amplitude

The same length but different amplitudes
The same amplitude but different lengths
Different lengths and amplitudes

______5. It is the condition of an individual who is willing

but are not able to find work:
A. Unemployment
B. Underemployment

C. Displacement
D. All of the Above

Answer questions 6-9 using one of these three choices.

A. Frictionally unemployed
B. Structurally unemployed
C. Cyclically unemployed
______6. Mang Pandoy, a factory worker who is laid off
until business
picks up, is _____________.
______7. Kanor Katigbak, a man in his mid-50s whose
skills have
become obsolete, would be ______________.
______8. Ella Carlos, an autoworker who is still out of work
two years
ago after her plant closed due to mismanagement,
is
____________.
______9. Sophia, who is a new graduate from a month ago,
is currently
looking for work, is _____________.
______10. The inflation rate is computed by the
____________.
A.
B.
C.
D.

Department of Trade and Industry

Department of Finance
National Economic and Development Authority
National Statistics Office