ATW 108 Macroeconomics

Chapter 4:
Business Cycles, Unemployment &
Inflation
DR. TANG CHOR FOON
Centre for Policy Research & International Studies
Universiti Sains Malaysia,
Room: 116, Tel: 04 653 2044
E-mail: tcfoon@usm.my / tcfoon@gmail.com
LEARNING OUTLINES
Business cycle and its primary phase

Unemployment and types of unemployment

Inflation, difference between inflation and

demand-pull inflation

How unanticipated inflation can re-distribute real

income

How inflation may affect the real output in an

economy?
BUSINESS CYCLE
Business Cycle refers to the alternating period of
economic expansion and economic recession over
a period of time.

Business Cycle upward or downward movement

of economic activity that occur around the growth
trend.

Classical economists argue that the government should

just accept that business cycles occur and take a laissez-
faire stance
Keynesian economists argue that government can temper
these fluctuations with policy actions.
 BUSINESS CYCLE

Percentage fluctuations in Business cycles have always been a

real GDP around trends part of the U.S. economic scene
20 World War II
Recovery of World War I
1895 Korean
10 Civil War War Vietnam
War Financial Crisis of
2007
0

-10 Panic of
Panic of 1907
1893
Great
-20 Depression
1860 1880 1900 1920 1940 1960 1980 2000 2020
Malaysia Per Capita Real GDP & Growth Rate (1970-
2013)
35000 10
Per capita real GDP (Constant MYR, 2010)

Per capita real GDP Growth Rate (%)

30000
5
25000

0
20000

Oil Price 911

15000
Crisis, 73 Global -5
Tragedy
Financial
10000
World Crisis, 07
-10
5000 Economic Asian Financial
Crisis, 85/86 Crisis, 97/98
0 -15
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
Year

Growth GDP

Source: International Financial Statistics (IFS), International Monetary Fund

The Phases of the Business Cycle
The 4 phases of the business cycles are:
Peak
Recession (downturn)
Trough
Expansion (upturn)

A recession is a decline in real output that persists

for more than two consecutive quarters of a year

An expansion is an upturn that lasts at least two

consecutive quarters of a year
 Business Cycles Phases
Total
Output
Boom

Peak
Secular
Growth
Trend

Trough

Expansion Recession Expansion

Quarters
1 2 3 4 1 2 3 4 1 2 3
 Duration & Timing of Business Cycles since
1854, The United States
Duration (in months)
Pre-World War II Post-World War II
Business Cycles (1854 1945) (1945 2012)
Number 22 11
Average duration 50 66
Length of longest cycle 99 (1870-79) 128 (1991-2001)
Length of shortest cycle 28 (1919-21) 28 (1980-82)
Ave. length of expansions 29 59
Length of shortest expansion 10 (1919-20) 12 (1980-81)
Length of longest expansion 80 (1938-45) 120 (1991-2001)
Ave. length of recessions 21 11
Length of shortest recession 7 (1918-19) 6 (1980)
Length of longest recession 65 (1873-79) 18 (2007-2009)
Why Do Business Cycle Happen?
Here we are going to discuss about: Why does
output move up and down rather than just staying
stable on the smooth growth trend line?

SHOCK is the Key

Economic Shocks
Prices are sticky downwards
Economic response due to decreases in output
and employment
Why Do Business Cycle Happen?
What cause the Shock?
1) Irregular Innovation New product or production methods

2) Productivity Changes unexpected change in productivity

due to change in resources availability and technology.

3) Monetary Factors central bank shock economy by printing

money more than people expect or the other way around.

4) Political Events war, terrorism, election

5) Financial Instability Unexpected change in assets price

Business Cycle:
Durable vs Non-durable Goods
Durable goods affected most
Capital goods
Consumer durables

Nondurable consumer goods affected less

Services
Food and clothing
UNEMPLOYMENT
Under 16 Unemployment rate =
and/or
Institutionalized # of unemployed
X 100
Total population (314.9 million)

(71.6 million) labor force

Not in
labor Unemployment rate =
force
(88.3 million) 12,500,000
X 100 = 8.0%
155,000,000
Employed Labor
(142.5 million) force (155
million)

Unemployed
(12.5 million)
Type of Unemployment
Frictional unemployment
Individuals searching for jobs or waiting to take
jobs soon
Structural unemployment
Occurs due to changes in the structure of the
demand for labour which mean that a worker
loses his/her job because that job is no longer a
part of the structure of the economy. Therefore,
no demand.
Cyclical unemployment
Caused by the recession phase of the business
cycle
Additional Type of Unemployment
Seasonal unemployment
Arises due to seasonal variation in the
activities of particular industries. Usually refer
to the agricultural industry.
Technological unemployment
This is a special type of structural
unemployment
Occurs because of changes in the
techniques of production
Definition of Full Employment
Natural Rate of Unemployment (NRU)
Unemployment at Full employment level, so full
employment doesnt mean zero unemployment
but it does mean that cyclical unemployment is
zero.
NRU = Frictional + Structural unemployment
Can vary over time
Demographic changes
Changing job search methods
Public policy changes
Actual unemployment can be above or fall
below the NRU
Cost of Unemployment Okuns Law
GDP Gap
GDP gap = actual GDP potential GDP
Can be negative or positive

Okuns Law
Every 1% of cyclical unemployment creates a 2%
GDP gap
GDP GDP P
P
U NRU
GDP

2
 Unequal Burden
Unemployment Rate
Demographic Group 2007 2009
Overall 4.6% 9.3% (4.7%)

Occupation Occupation:
Managerial and professional 2.1 4.6 (2.5%)
Construction and extraction
Age 7.6 19.7 (12.1%)

Race and ethnicity

Age:
15.7 24.3 (8.6%)
16-19
African American, 16-19 29.4 39.5 (10.1%)
Gender White, 16-19 13.9 21.8 (7.9%)
Male, 20+
Education Female, 20+
4.1
4.0
9.6 (5.5%)
7.5 (3.5%)
Duration Race and ethnicity:
African American 8.3 14.8 (6.5%)
Hispanic 5.6 12.1 (6.5%)
White
4.1 8.5 (4.4%)
Gender:
Women 4.5 8.1 (3.6%)
Men 4.7 10.3 (5.6%)

Education:**
Less than high school diploma 7.1 14.6 (7.5%)
High school diploma only 4.4 9.7 (5.3%)
College degree or more
2.0 4.6 (2.6%)
Duration:
1.5 4.7 (3.2%)
15 or more weeks
 Non-Economic Cost of Unemployment
1. Loss of skills and loss of self-respect
2. Plummeting morale
3. Family dis-integration
4. Poverty and reduced hope
5. Heightened racial and ethnic tensions
6. Suicide, homicide, fatal heart attacks, mental
illness
7. Can lead to violent social and political change
such as high criminal rate.
INFLATION
General rise in the price level
Inflation reduces the purchasing power of
money
Consumer Price Index (CPI)

Price of the Most Recent Market

Basket in the Particular Year
CPI = Price estimate of the Market
x 100
Basket in 1982-1984

207.3 - 201.6
INF = x 100 = 2.8%
201.6
How to Calculate CPI (Unweighted)
Items Base Current Price Index Price Index
Year Year in 2000 in 2013
(RM) (RM)
2000 2013
Food 2 4 100 200
Clothing 2 4 100 200
Books 4 8 100 50
Transportation 5 12 100 240
Overall CPI 100 172.5

PriceCurrent 4
Food = 100 100 200
Price Base 2
How to Calculate CPI (Weighted)
Items Base Current Price Price Weight Weighted Weighted
Year Year Index, Index, Price Price
(RM) (RM) 2000 2013 Index, Index,
2000 2013 2000 2013
Food 2 4 100 200 4 400 800
Clothing 2 4 100 200 3 300 600
Books 4 8 100 50 2 200 100
Transportation 5 12 100 240 1 100 240
Overall CPI 100 172.5 10 100 174

PriceCurrent 4
Weighted - Food = 100 W 100 4 800
Price Base 2

800 600 100 240

Overall CPI = 174
10
Malaysia Inflation Rate (1970-2013)
20

18

16

14
Inflation rate (%)

12

10

0
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
Year

Source: International Financial Statistics (IFS)

Type of Inflation
Demand-Pull inflation
Excess spending relative to output
Central bank issues too much money

Cost-Push inflation
Due to a rise in per-unit input costs
Supply shocks
Demand-Pull Inflation

Suppose policymakers set an unemployment target

(4%) that is below the natural rate of unemployment
(5%), resulting in expansionary fiscal policy or an
autonomous easing of monetary policy that shifts the
AD curve upward, then:
Policymakers would initially achieve the 4%
unemployment rate target so that output is at its
target YT

However, wages would subsequently increase,

shifting the short-run AS curve up and to the left,
resulting in a steadily rising inflation rate
Demand-Pull Inflation
 Cost-Push Inflation
Suppose a temporary negative supply (cost push) shock
occurs, so that the short-run AS curve shifts up and the
left, then:
Initially output will to a level below its potential, inflation
will rise and unemployment will rise
In response to an increase in the unemployment rate,
activist policymakers with a high employment target
would implement expansionary policies to shift the AD
curve to the right
However, unemployment will rise again because the
short-run AS curve will shift up and to the left as workers
seek higher wages to keep their real wages from falling
(due to higher inflation)
This process continues and continuing inflation occurs
Cost-Push Inflation
 Complexity
Practically, it is hard to
differential between
demand-pull inflation
or cost-push inflation,
why?

Is the right hand side

picture show
demand-pull or cost
push inflation?

The difficulty in
determining type of
inflation cause the
delay or choosing
wrong policy to
mitigate the problem.
How is Hurt by Inflation?
Fixed-income receivers
Real incomes fall
Savers
Value of accumulated savings deteriorates
Creditors
Lenders get paid back in cheaper dollars
Cost of Inflation
Menu Cost
Cost to change menu due to inflation

Shoe-Leather Cost
Time and effort to bank to get cash for
spending of holding cash in hand that always
depreciate in value.
How is Unaffected by Inflation?

Flexible-income receivers
COLAs (Cost-of-Living Adjustments)
Social Security recipients
Union members

Debtors
Pay back the loan with cheaper dollars
Anticipated Inflation

Real interest rate

Rates adjusted for inflation

Nominal interest rate

Rates not adjusted for inflation
Does Inflation Affect Output?

Cost-Push inflation
As price rise, the demand for goods and
services drops. So firm reduces output &
unemployment goes up.

Demand-Pull inflation
One view is that zero inflation is best
Another view is that mild inflation is best
Why mild inflation is best?
Does Inflation Affect Output?
Demand-Pull inflation
One view is that zero inflation is best
Another view is that mild inflation is best
Why mild inflation is best? To enjoy growth
one should sacrifice by accepting the price
increase (inflation). This can be link to the
concept of sacrifice ratio. how much of
output loss when inflation goes down by 1%.

In our case, how much we can gain by

accepting additional 1 percentage point of
inflation.
Hyperinflation

Extraordinarily rapid inflation

Devastates an economy
Businesses dont know what to charge
Consumers dont know what to pay
Money becomes worthless
Zimbabwes 14.9 billion percent inflation in
2008
Stagflation
Inflation happen before full employment. In other
words, stagflation is a situation in which inflation and
unemployment problems happen together.
Sometime it call as inflation is the recession period.

It is usually cause by supply shock and improper

macroeconomic policies.
Thank You