The Business Cycle
Read this chapter for an overview of the concepts that are associated with the business cycle. The business cycle provides information on the causes and characteristics of the economic problems associated with unemployment and inflation. Be sure to complete the assessment in this subunit that accompanies this reading.
In this article, we study the nature, causes, and characteristics of the two major economic problems: periods of severe unemployment and periods of inflation.
Business cycles are recurring periods of recession and prosperity which are widespread throughout a nation and feed upon themselves. They differ from seasonal variations (such as a lack of coat sales in the summer) and long-run secular trends (such as a population trend like a baby boom). The phases of a business cycle are peak, contraction, recession, trough, recovery, and expansion.
We observe the business cycle most clearly by the number of people who are laid off work and have a difficult time finding new employment. This is less likely during peak periods of economic activity and common during periods of recession.
A recession is a widespread decline in economic activity. The decline usually causes significant unemployment. Causes for recession include excess inventories, decrease in consumption (often attributable to fears about the future), lack of innovations and new capital formation, and random shocks. A serious recession is a depression.
The United States experienced its worst recession during the 1930s. Close to one in four people (25 percent) were unemployed.
Consumer purchases of durable goods can affect the business cycle for several years, since buyers can postpone buying new durable goods when they employ additional maintenance and repair. Postponable items include the purchase of durable goods and new capital.
Individuals and businesses that are insecure about the economy or their continued employment will delay their purchase of durable goods, such as a new car or new factory equipment. They are cautious because they know that missing a payment when they encounter financial difficulty could result in the repossession of the durable good by the respective lender.
Unemployment occurs when members of the labor force are seeking employment, but unable to find it. Economists measure the cost of unemployment by deficiencies in a nation's potential output, such as foregone production, income, and consumption of needed goods and services. A loss in social and cultural value, such as from those unable to play an active role in society, represents a less tangible, but more significant cost to the economy and society at large.
The unemployed workforce includes people who were just laid off and new entrants to the labor force, such as young graduates seeking their first jobs.
Frictional unemployment describes instances where workers switch jobs to obtain a more productive or higher-paying position. This type of labor mobility is desirable since it assures the economy uses the labor force more efficiently and income is enhanced.
Workers in the United States often seek employment from different companies, when they are not satisfied with their working conditions or salary. This type of employment switching is desirable since employees find ways to make better use of their skills.
Structural unemployment describes fluctuations in various sectors of the economy experience. These fluctuations different industries experience may be due to changes in consumer preferences, technology, or innovation. Communities can reduce structural unemployment through worker retraining. Communities are strengthened by these changes since they reflect a desire to improve products and services.
The decrease in the price of oil in the 1980s meant many oil-related businesses in the United States were no longer profitable (especially in Texas). Companies cut oil drilling, exploration, and laid off many employees. These reductions were considered part of structural unemployment in the United States.
Cyclical unemployment is solely attributable to deficiencies in economic activity. This form of unemployment is the most undesirable because it is avoidable and costly.
Unemployment during the U.S. Great Depression in the 1930s was cyclical. Employees held onto their jobs and avoided frictional unemployment. Structural unemployment was far less noticeable than unemployment caused by people who were afraid to spend and firms that were forced to cut back on their output.
Rate of Unemployment
The United States government obtains the unemployment rate from a telephone survey of households to determine the proportion of the labor force actively seeking and unable to find employment. In many countries, unemployment statistics are based on the number of registrants at the unemployment office. Unemployment rates are distorted by underemployment (those working in jobs they are overqualified to perform), discouraged workers (those who have stopped looking for work), and the underground economy (those working in jobs not officially reported).
Some countries measure the unemployment rate by the number of individuals who file for unemployment benefits. Some economists believe the survey method the U.S. government uses is more accurate because people may file for unemployment benefits while working for an employer "off the books".
The presence of discouraged workers, who have given up looking for work, understates accurate unemployment figures. This understatement is especially problematic during a recession because a large number of discouraged workers leave the labor force.
Due to a disconnect among skills, abilities, and work that is available, some individuals have a difficult time finding full-time employment no matter how hard they try. Some eventually give up looking. Economists classify these individuals as discouraged workers.
Natural Rate of Unemployment
The natural unemployment rate describes a combination of frictional and structural unemployment: it cannot be avoided even during periods of high economic activity. The natural rate of unemployment has historically hovered around four percent in the United States, but has risen slightly in recent years due to changes in the labor force which includes more women and young people (who often take more time to find jobs).
Changes in consumer tastes and production methods are major causes of structural changes in our economy. Some structural unemployment is unavoidable. Some frictional unemployment is desirable. It is clear that a number of individuals will always be seeking employment.
Costs of Unemployment
There are economic and non-economic costs to unemployment. The GNP gap measures the main economic cost: lost income and output. Economists use Okun's law to determine the GNP gap: a 2.5 percent GNP gap exists for every one percent that the actual unemployment rate exceeds the natural unemployment rate. The cost of unemployment is not distributed equally: blue-collar workers and minorities often experience higher rates of unemployment during recessions.
Noneconomic Costs of Unemployment
Noneconomic costs tend to be high during cyclical unemployment. Unemployment can lead to family disintegration, loss of job skills, loss of self-confidence, social unrest, mental illness, increased crime, and a decline in morale. Throughout history, severe unemployment has often led to violent social and political changes.
Inflation describes a widespread pattern of price increases. The inflation rate equals the rate of change in the price index, such as the consumer price index (CPI). Historically, inflation in the United States is considered serious when it approaches or exceeds 10 percent per year.
Consumers experience inflation when they go to the store and find the same item costs more. Some countries are accustomed to high inflation rates: prices double within one year when inflation exceeds 100 percent.
Deflation describes a widespread pattern of price decreases. While deflation is historically less common than inflation, governments fear it more because when prices plummet on a widespread basis businesses experience a significant loss in revenue, which leads to decreased economic activity and widespread bankruptcies. Deflation occurred in the United States in the 1930s.
Periods of deflation are rare. During the great depression of the 1930s, many companies and farmers in the United States were devastated and went out of business due to a lack of revenue as prices plummeted.
Inflation can result when consumers demand products businesses are unable to supply fast enough. These companies cannot expand their output beyond their productive capacity. Economists refer to this situation as demand-pull inflation.
During the late 1960s, the United States experienced a period of high economic activity brought about by overall economic growth and the Vietnam war. Producers could not increase their production levels, while customers were eager to buy more with their high income. The result was a period of demand-pull inflation.
Increases in costs also cause price increases. For example, steep increases in the price of oil in the 1970s in the United States caused commodity prices to increase. Similarly, wage-push inflation occurs when unionized workers demand higher wages.
The oil crisis in the 1970s caused oil prices in the United States to jump drastically. In this historical example of cost-push inflation, American consumers experienced significantly higher gas and energy costs.
Economists measure inflation with the consumer price index (CPI), which reports the cost or price level for a basket of 300 specific consumer goods and services. The CPI is a ratio of prices in a given year, divided by the price for the same basket of goods and services in a base year. The base year index is set at 100.
Economists calculate the rate of inflation for any given year with the formula:
Current Year Index minus Previous Year Index / Previous Year Index
Rule of 70
Economists use the rule of 70 to determine how long it will take for prices to double at the current rate of inflation. Economists determine the number of years it will take for prices to double, by dividing 70 by the annual rate of inflation. We can also use the rule of 70 to determine how long it will take for savings or GNP to double.
Inflation Redistribution Effect
Unanticipated inflation will redistribute wealth and income. People who have saved a lot of money and those who live on a fixed income suffer because their savings are worth less (their purchasing power decreases). Meanwhile, those who have incurred a lot of debt and those who live on a variable income benefit. The purchasing power or value of a fixed monetary amount decreases and borrowers can repay their lenders with cheaper dollars.
A borrower who pays an interest rate that is lower than the inflation rate is paying their lender less in purchasing power than what they had borrowed. The borrower gains and the lender loses, as long as the interest rate remains the same and the lender does not adjust the interest rate to match or exceed the rate of inflation.
Real income is nominal income, adjusted for the rate of inflation. Real interest equals nominal interest, adjusted to the rate of inflation.
Purchasing power describes the amount of goods and services a person's income can buy. When prices increase, but income remains unchanged, employees are able to buy fewer and fewer goods and services.
When lenders and buyers are able to anticipate inflation, the redistribution effect of inflation is nonexistent. Employers give their employees wage increases (cost of living adjustments) to offset any loss of purchasing power an employee would have experienced due to inflation. Similarly, banks and lenders index the nominal interest rate they charge borrowers according to inflation so they do not lose money. In other words, they increase the nominal interest by the rate of inflation.
A drawback of using these automatic schemes that anticipate inflation is that inflation becomes a self-fulfilling prophecy. Because lenders, sellers, and wages automatically increase their interest rates, prices, and wages, prices increase, which causes inflation to persist.
In the 1980s, variable interest rates for mortgages became increasingly popular. The lenders (banks) benefit and borrowers (home buyers) can also benefit if they are able to adjust accordingly. When the interest rate is tied (indexed) to inflation, homebuyers see their payments reduced as inflation slows down. However, homebuyers see their payments increase when inflation speeds up: this protects banks from any losses and encourages buyers to pay off their loans early if they can.
Inflation Output Effect
Inflation may have a mild stimulative effect (called forced saving) or a serious recessionary effect (especially during hyperinflation). Most commonly, consumers are not entirely sure about the real value of products due to continuous price changes. This uncertainty can discourage them from making large purchases.
Historically, periods of inflation are associated with peaks of economic activity. During the inflationary years of 1970-80 in the United States, the high price of products, and uncertainty about the real value of products, caused a slowdown in purchases. However, many countries manage to adjust to high rates of inflation.
Inflation Output Effect
During periods of mild inflation (four to six percent per year), the additional revenues most businesses receive, as compared to costs, encourages them to make new investments that are expansionary. Economists call this forced saving.
Hyperinflation is the most severe and destructive form of inflation. When money decreases in value so fast that it ceases to be a medium of exchange, the economy returns to a barter system and economic activity may come to a halt. The danger of hyperinflation may be present even during periods of moderate inflation: expectations of inflation may cause costs to spiral out of control via cost-push and demand-pull inflation, leading to hyperinflation. However, some countries manage quite well despite high inflation.
The German Weimar Republic experienced a classical example of hyperinflation during the 1920s. Paper money was losing so much value that the weight of the paper money people needed to buy products exceeded the weight of the products they were purchasing! Many people avoided using German money in their transactions, bought gold or foreign currencies when they could, and resorted to a traditional barter system.
Source: John Petroff, https://www.peoi.org/Courses/Coursesen/mac/fram6.html
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