Economic Instability

Chapter 13

Is the economy getting better or worse?

Business Cycle• . The term business cycle refers to the recurrent ups

and downs in the level of economic activity, which

extend over several years.

• √ Individual business cycles may vary greatly

in duration and intensity.

• √ All display a set of phases.

THE BUSINESS CYCLEPhases of the Business CyclePhases of the Business Cycle

PEAK

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RECESSION TROUGH RECOVERY

SECULARSECULAR

TREND

PEAK

Time

GROWTHGROWTH

TREND

√ √ Peak or prosperity phase: Real output in the economy is at a high level Unemployment is low Domestic output may be at its capacity Inflation may be high.

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√ Contraction/recession phase ((> 2 quarters of declining GDP): Real output is decreasing Unemployment rate is rising. As contraction continues, inflation pressure fades. If the recession is prolonged, price may decline (deflation) The government determinant for a recession is two

consecutive quarters of declining output.

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RECESSIONSECULAR

TRENDTREND

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TROUGH

SECULASECULAR TREND

TREND

√ √ Trough or depression phase: Lowest point of real GDP Output and unemployment “bottom out” This phase may be short-lived or prolonged There is no precise decline in output at which a

serious recession becomes a depression.

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RECOVERY

SECSECULARLAR

TRENDTREND

√ √ Expansionary (> 2 quarters of ↑ rGDP):

Real output in the economy is increasing

Unemployment rate is declining

The upswing part of the cycle.

Causes of the Business Cycle • External shocks- such as increases in oil

prices and international conflicts, can cause business cycles.

• Changes in investment spending-when the economy is expanding, businesses expect future sales to be high, so companies build new plants or buy new equipment to replace old equipment..

• Changes in monetary policy- tight money policy of the Federal Reserve System slows down the economy

Causes of the Business Cycle(cont)

• Fiscal-policy- change in either taxation or spending can affect decisions in the economy.

• Speculation and “bubbles”-expectations about the future

Business Cycles in the United States

• Black Tuesday,” October 29th, 1929, marked the beginning of the Great Depression.

– Between 1929 and 1933, real GDP declined nearly 50%.

– Unemployment rose nearly 800%.

– Average wage plunged from 55 cents/hour to 5 cents

– one-quarter of all banks failed.

• Depression scrip used because official paper currency was in short supply

Causes of the Great Depression

– Enormous gap in the distribution of income

– Easy credit

– Global economic conditions

– International trade

Recovery and Legislative Reform

• Laws passed and government agencies were established to prevent another depression.

– Social Security Act of 1935

– Minimum Wage

– Unemployment programs

• Securities and Exchange Commission • Federal Deposit Insurance Corporation• After World War II, business cycles had

shorter recessions and longer periods of expansion.

Forecasting Business Cycles• Economists use statistics and models to

predict business cycles. • The Statistical series Is known as the

Leading economic indicator (LEI) monthly statistical series that uses a combination of ten individual indicators to forecast changes in real GDP

• Others use a tool called econometric modeling - a mathematical model that uses algebraic equations to describe how the economy behaves.

How is Inflation Tracked?

• By comparing prices from one year to the next

• These numbers are then reported through the CPI

• CPI = Consumer Price Index

Consumer Price Index (CPI)• The Labor Department surveyed the

purchasing patterns of consumers to determine a group of about 400 items that buyers typically use.

• These 400 items makes up a “Market Basket”

• Each month surveyors check on the prices of these items in cities across America.

• Results are used to compute what the market basket costs compared to what it cost in a base period.

CAUSES OF INFLATION• Demand-pull:

– All sectors of the economy try to buy more than the economy can produce

– Causes shortages – Excess demand for goods and services

causes businesses to raise prices; this can result when there is an increase in the money supply also

• Wage-price spiral-does not blame any particular group or event for rising prices

CAUSES OF INFLATION(cont)

• Cost-push -labor negotiations as well as an increase in the cost of inputs causes businesses to raise prices

• Excessive monetary growth-occurs when the money supply grows faster than real GDP

Consequences of Inflation (cont.)

– Reduced purchasing power

– Distorted spending patterns

• Encourages speculation

• Distorted distribution of income

• Creditors are hurt more than debtors

generally.

Measuring Unemployment

• The Census Bureau surveys 50,000 homes each month.

• Each household must answer a series of questions.– Broken down into:

• Non-institutional Population• Not in Labor Force• Labor Force• Employed• Unemployed

What is an Unemployed Person?

• People available for work who:–Made a specific effort to find a job

during the past month–Worked less than 1 hour for pay or

profit–Worked in a family business

without pay for less than 15 hours a week

Unemployment Rate

• The number of unemployed individuals divided by the total number of persons in the civilian labor force( sum of all persons aged 16 and above who are either employed or

actively seeking employment)• Unemployment rate rises during

recessions and comes down slowly afterwards

• Affected by downturns in real GDP – cost of a recession.

People NOT Counted

• People who have stopped looking for work. “Dropouts”

• People who have no interest in finding a job.– Retired persons– Housewives– Students– Disabled persons

Kinds of Unemployment

• Frictional • Structural

• Cyclical

• Seasonal

• Technological

Frictional • Workers who are between jobs

• Will always be present. • Examples:

1.People who get “fired” or “quit” to look for a better one.

• 2. “Graduates” from high school or college who are looking for a job.

Structural

• Occurs when a fundamental change in the operations of the economy reduces a demand for workers & their skills

• Consumer tastes change and therefore causes certain goods to no longer be demanded.

Cyclical

• Related to swings in the business cycle

• Recession: people don’t buy as many durable goods (cars, homes)– May result in lay-offs

– People usually get their jobs back when the economy improves

• These jobs do come back.”

Seasonal• Results from changes in seasons and demand for

certain products• Ex: construction• Difference between seasonal and cyclical:

– Cyclical follows the business cycle. Can last 3-5 years.

– Seasonal can take place every year despite the health of the economy

Technological

• Workers are replaced because machines can do the work more efficiently

Costs of Instability

• Recession, inflation, and unemployment hinder economic growth and have human costs.

– Opportunity cost like the GDP gap

– Misery index or discomfort index (unofficial statistic that is the sum of monthly inflation and the unemployment rate.

– Uncertainty leads to fewer consumer purchases

– Political instability

– Community and domestic matters- crime, poverty and family instability

“Should I make a big purchase?”

• Only if you know that you won’t lose your job in a contraction. So, buy your house during an expansion.

HOWEVER,• When the economy starts to slow down

(contraction), interest rates will decrease. Wait to buy a house until the rates drop to a low point, if you are sure you won’t lose your job.

“Don’t quit that job!”

• If the economy is going into a contraction, jobs will become more scarce. If you quit, you may not find another job!

• But, if the economy is in a period of expansion, jobs are readily available. It may be a good time to switch careers.