We want to try to understand how the economic fluctuates and changes over time, as it contracts and expands, going through the business cycle.

FLUCTUATIONS IN THE ECONOMY - BUSINESS CYCLES
Real growth in GDP has averaged 3% per year over this century.  Some periods it was 6% and other periods it was negative. The fluctuations in real GDP growth is what we call the business cycle.  We are now in the expansionary phase of the ninth business cycle since WWII.  Alternate periods of econ expansion and contraction make up the business cycle. See Exhibits 1 and 2 on pages 181-182.

Expansion - Low unemployment, strong retail sales, rising stock market, strong and positive growth in real output, strong car and housing markets, etc.

Contraction/recession - High unemployment, weak retail sales, declining stock market, low or neg. growth in real output, falling car/housing sales.

Recession - Usually defined as two or more consecutive quarters of negative real GDP growth.

Depression - prolonged and severe recession lasting years. UN was 20-25% for most of the  1930s.

The term business cycle does NOT mean that there is anything regular about the bus cycle. Fluctuations are random and unpredictable. Periods of expansion and contraction vary quite a bit. Expansions have lasted from two years to eight years, recessions from 6-18 months.  Economists have studied the business cycle for centuries, and will continue to conduct research on business cycles for centuries. 

Business cycle dates are determined by the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), www.nber.org.  Last recession officially started in March 2001.   Last expansion was from March 1991-March 2001, longest in U.S. history. 
 

ECONOMIC FLUCTUATIONS AND THE LABOR MARKET

Swings in the business cycle influence the demand for labor and the un rate. Some definitions:

Labor Force = Those over 16 who are either employed or actively looking for a job (unemployed).

RATE OF LABOR FORCE PARTICIPATION = Labor Force / Total population. See page 183.

Not in the labor force = Full time household workers, full time students, retirees, and disabled.

In 2001, the rate of labor-force participation was 66.92%. 141.8m / 211.9m.  Men - 74.4% Women - 60.1% (see page 184 for an analysis of how the labor-force participation of men and women varies over time.)

The LFP (labor force participation) for women has been increasing (more than 50% of married women now work compared to 20% in 1940s) and for men LFP has been decreasing. Shows how the workforce and labor market have been changing based on changes in culture and household/lifestyle (smaller families, higher opportunity cost for women with more education to stay home?). 

LFP is higher in Canada (77%) vs. US (67%) - in Italy it is 60% and Mexico 56%.  Why??

UN RATE = (Number of persons unemployed / Labor force) x 100.  In 2001, Un Rate was 4.8% ( 6.7m / 141.8) x 100), see p. 183.  Un rate is the percentage of persons in the labor force who are either:

1) Available for work and are actively looking for a job, or
2) Waiting to start a new job, or return (due to layoff) to an old job within 30 days.

Avg. un rate over the last 25 years has been 6.7% vs. 6% right now in U.S.

BLS at the Department of Labor calculates the Un Rate monthly by a survey of 50,000 households, representing about 90,000 adults around the country. See Applications, page 185 for a discussion about how the un rate is derived.  Also, see formulas in Thumbnail Sketch, p. 185. 
 

REASONS FOR UNEMPLOYMENT

In a dynamic economy, there will periods of labor mobility as workers move:
1) from contracting industries into expanding industries, and
2) into and out of the labor force during a lifetime (education, child raising, etc.).

Firms and entire industries are constantly changing.  Some are expanding and hiring people and others are contracting and laying people off.  There are new industries that didn't even exist 20 years ago - computer technology, VCRs, CDs, cellular phones, cable TV, fuel injection, fiber optics, web page design, etc. that have provided millions of new jobs.  Other industries have contracted or gone out of business - carburetors, vinyl records, typewriters, copper wire, etc.

Thousands of new products are introduced every year, many fail. Thousands of new companies start every year and many fail. An economy is a very dynamic system characterized by constant change.  As the economy changes, new opportunities are constantly emerging, and others are disappearing. Market is a net job creator, but it is also a job destroyer. "Creative destruction."

Point: in a dynamic economy, un is natural and in some ways even very healthy. Change makes us uncomfortable, but in most cases makes us better off in the long run.

See page 186 for a breakdown of the main five reasons that people are temporarily unemployed (BLS reasons).

1. 6.7% - New entrants. Graduates from high school, college, vo-tech school, grad school, etc. People looking for a job for the first time.

2. 30% - Re-entrants.  People going back to school for further education/grad school, etc.

About 37% of unemployed (reasons #1 and #2) are people entering or re-entering the labor market after getting education and training, investing in human capital.

3. 12% - People left jobs voluntarily to find something better, better match, better hours, or move to a new city or state, etc.

4. 35% - People who got dismissed because company went bankrupt, workers fired for cause, downsizing, budget cuts, outsourcing, factory moved to another state or country, etc.

5. 16% - People who got laid off, with the expectation of going back to work.  Layoffs due to seasonal factors (slow down in construction work during winter), temporary slow down, factory renovation, etc.

Demographics, age, sex, race, etc. affect unemployment significantly. See page 187 or Bureau of Labor Statistic's web page ( http://www.bls.gov).  Note: Un rate is higher for young people compared to older people, as they try to figure out what career is best suited to their talents and abilities.

Unemployment has a pos side - people are trying to find a better job, or a more pleasant work environment, or move to a better area, or find a job that better suits them. Job moves generally enhance worker productivity and earnings.  People can expect 4 or 5 careers now in their lifetime.
 

THREE TYPES OF UNEMPLOYMENT - Economists classify un into three theoretical categories:

1) Frictional un - A result of the "frictions" in the economy created by incomplete, imperfect information. Workers may not be aware of all of the jobs available and employers may not be aware of all of the qualified employees.  Information is costly and imperfect.  Because workers and employers don't have access to perfect information, there is some un due to the lack of complete information.

For example, employers don't always hire the first candidate, they may engage in a lengthy search process.  It is costly to hire and train an employee and it is sometimes difficult or costly to terminate an employee, so employers may be cautious.   And employees don't always take the first job offer that comes along, they are also cautious as they try to find the best match, best compensation package, etc.

There are ways to reduce frictional un, and the lack of information. Headhunters, employment agencies specialize in trying to match up employers and employees. Trade magazines and journals advertise. Colleges have career service offices, etc. Internet may reduce the cost of obtaining information, could reduce frictional unemployment. Frictional un is natural, doesn't necessarily represent inefficiency, see Myths of Economics, page 188.

2) Structural un - With frictional un, the workers are fully qualified, but the search process may be time consuming, leading to temporary periods of un.  With structural un, workers are unemployed a result of the dynamic changes in the economy that make someone's labor skills obsolete. They are faced with possible retraining and a career change if their skills have become obsolete.  Workers are structurally unemployed when they are no longer fully qualified in the new economy.  The "structure" of the economy has changed, leading to temporary un for workers who are now unqualified.

Causes of structural un:

a. Technological change - new products, new industries, new opportunities for some, reduced opportunities for others. Restructuring, downsizing, and outsourcing have created new opportunities, new jobs, but eliminated other jobs. Economy is changing as we move into the Information Age and as international competition intensifies. Increasing premium for education and high skilled jobs.

b. Shifts in public sector priorities. Examples: end of Cold War, reduction on defense spending, base closings. Regulation or Deregulation may create structural unemployment - airline and trucking industries were deregulated in early 80s, industries changed, resulting in some structural unemployment.

What would the appropriate public policy be for structural un?  What about for frictional un?

3. Cyclical un - temporary un due to recession from reduced demand for labor during an econ downturn. Stabilization policies could help minimize cyclical un. Historically, un rate is linked to the bus cycle and the real growth rate of the economy. During an expansion, output growth is high and un is low. During a recession, output growth is low / neg. and un is high. See page 190.
 

EMPLOYMENT FLUCTUATIONS - HISTORICAL RECORD

FULL EMPLOYMENT - Doesn't mean zero unemployment. We could achieve zero un with forced labor, or a chain gang approach. We really don't want zero unemployment, it could be a sign of a stagnant econ. Some un is natural, expected and healthy. People are trying to make their lives better, resulting in natural turnover in the labor market.

Full employment/Full output - efficient use of labor and resources in the econ, allowing for frictional and structural un. In US, it is estimated to be 94-95%. Means that 5-6% un rate is natural.  See page 190.

Natural rate of un = Frictional + Structural un. Long run, sustainable condition due to imperfect information and dynamic changes. Maximum, sustainable rate of output.

 Note: Full employment = Natural Rate of Un

Note: Nat Rate NOT a FIXED number that is calculated like the Un Rate, it is an estimate. Can be influenced by demographics and public policy, and fluctuates over time, see Exhibit 7, p. 190.   

Examples: Un is higher for young people, so as the baby boom generation entered the work force, a higher percentage of the labor force was young, which pushed up the natural rate of un by 1% in the 60s and 70s.

Page 190 shows the actual un rate vs. the estimated natural rate. Un rate fluctuates with the business cycle. Actual un was below the natural rate during the expansion of the late 80s and was again below the natural rate in the expansion of the late 1990s. Much of the study in the field of Macroeconomics is looking at why actual un differs from the natural rate, and why the natural rate changes over time.

Public Policy affects the natural rate.  When public policy makes it more expensive to employ workers or fire workers, natural rate increases.  When public policy makes it more attractive to remain unemployed, natural rate increases.  The more static/less dynamic the labor market due to policy, the higher the natural rate. 

Examples: Most European countries have very high un rates (7.5%-20%) compared to U.S., see Exhibit 8 on p. 192.  Reason: Public policy in Europe makes is relatively more expensive to hire workers, and also makes it relatively more attractive to remain unemployed vs. U.S.    

Final point: Full production vs. full employment. Full employment is not a desirable goal if it involves employment at unproductive jobs. Example: Cuba may have full employment in the sense that everyone has a "job," but it is not operating at full output or full production.
 

MEASUREMENT PROBLEMS FOR UN RATE (from 9th Edition)-

1. Discouraged workers, who have given up looking for a job, are NOT counted in the labor force, so are NOT counted in un rate. ONLY those people who are actively job searching are counted in un rate.

The current un rate of 4.1% un rate doesn't count discouraged workers, so actual rate (counting discourage workers) is higher. In the 1991 recession, the Dept. of Labor estimate that there were 1m discouraged workers, about .8% of the workforce.

2. Part-time workers are NOT classified as unemployed, even though they may desire full-time employment. Someone working only one hour a week is still considered to be EMPLOYED, even though they may be looking for a full time job. There could be significant UNDEREMPLOYMENT that is not calculated in un rate.  Dept. of Labor doesn't distinguish between part-time and full-time, everybody working at all is counted as employed.

3. Some unemployed people claim to be actively looking for a job, and are counted as unemployed, when they may not be seriously seeking employment at all. People receiving assistance in the form of un insurance, welfare programs, general assistance, AFDC, food stamps, etc. may be classified as unemployed (looking for work), even though they are not seriously job hunting.  For example, if you qualify for 18 weeks of unemployment benefits, how long would most people remain unemployed??
Increasing un benefits could actually increase un rate, e.g. Europe.

4. Underground economy - some people counted as unemployed may actually be working in the underground economy, or off the books.

Despite these measurement problems, the UN RATE (along with GDP) is one of the most closely watched economic variables, reported monthly for the nation, and for each state, county, city.  Michigan labor market data (including Flint and Genesee County) is available on the web at:  http://www.michlmi.org/lmiindex.htm
 

EFFECTS OF INFLATION -

Inflation = an increase in the general price level, calculated as the percentage change in a price index.  Note: unless otherwise specified, "inflation" generally refers to consumer inflation, calculated from the Consumer Price Index (CPI).  Inflation erodes the purchasing power of the dollar, since positive rate of inflation indicates that prices ON AVERAGE are increasing.  3% inflation means that prices rose by 3%, on average. Some goods increased by more than 3%, some less than 3%. Inflation is the percentage change in a price index (PI).

Example: Price index (PI) goes from 200 to 220, Inflation rate is 10% (220 - 200 / 200)  x 100.

See Exhibit 10, page 194 for an historical view of U.S. inflation. See Exhibit 8, page 195 for an international comparison of inflation. We can see that inflation in low inflation countries tends to be more stable (1- 4%) and high inflation tends to be more volatile (Brazil, 3% - 2050%).  One of the problems with high inflation is that is tends to be erratic and unpredictable leading to a high level of uncertainty about the future.  We want LOW, STABLE inflation, since it creates certainty and stability in the economy.  One of the most significant factors in the record-setting 1991-2001 economic expansion was the underlying price level stability (low and stable inflation) of that decade.

Anticipated vs. Unanticipated Inflation / Expected vs. Surprise Inflation
Unanticipated, or surprise inflation is inflation that was not expected by most people. People are caught off guard. When inflation is high and volatile, people never know what to expect, makes business planning difficult. Anticipated inflation is a change in the price level that is expected by most decision makers.

For example, we could expect inflation next year to be 3%. If it turns out to be 3%, it was expected. If it turns out to be 12%, there would be 9% that was unexpected.
 

COSTS OF INFLATION-

High and variable rates of inflation make the economy operate less efficiently for several reasons:

1. Inflation distorts long term projects and contracts. Examples: long term labor contracts, long term contracts between companies and suppliers, mortgages, long term debt, life insurance policies, capital investments, business investments, etc.

Example: German man who bought a life insurance for his wife and daughter, say 1m marks, when it was cashed it would only buy a loaf of bread.

If inflation is high and uncertain, people may not enter into potentially profitable long-term relationships and projects, leading to a reduction in trade and investments, reducing economic progress. Or people spend more time and energy on contracts, or make shorter contracts, or more complicated contracts.

Example: In all of Central and South America, only Panama has 30 year fixed-rate mortgages.  How would a bank in Brazil, Ecuador or Venezuela know what nominal interest rate to charge on a 30 year loan/mortgage, given the uncertainty about future inflation?  Panama uses the U.S. dollar, so it has about the same inflation rate as the U.S.  

It would also be very risky to invest in Brazil or Bulgaria, given the high and variable rates of inflation there.  Investment would flow to more stable economies like U.S., Europe, Japan with low inflation.  
 

2. Resources get used up trying to avoid the negative effects of inflation. Time, attention and energy get diverted away from productive activities to trying to protect against the effects of inflation. Investment gets distorted away from productive uses toward inflation hedges and speculation.  Production possibilities are reduced.

Example: Menu costs - costs of changing price tags during high inflation. Think of the economic costs imposed on the economy when prices change daily.  "Shoe Leather Costs"

3. Inflation reduces the "information content" of prices.  Market prices transmit information about relative scarcity, supply and demand conditions, etc.  Inflation distorts the important economic information delivered by prices. Relative prices are distorted and prices can't co-ordinate econ activity as well.  Econ efficiency is reduced. People lose faith in the econ system.

Example: producer sees that prices for its products are rising, e.g. gasoline.  If prices are rising just because of inflation, producer would then want to raise prices.  If prices are rising because an increase in real demand, then producer would want to increase output.  During periods of high inflation, it makes it harder to distinguish between the two effects, leading to confusion and a less efficient economy.

STAGFLATION -

Inflation (easy money) can act initially as an econ stimulant and temporarily lead to econ growth, but it is artificial and temporary and leads to malinvestment. Economy will eventually experience an econ hangover, as the negative effects of inflation slowly distort the econ and lead to a stagnant economy.

Stagflation describes the condition of high inflation and high unemployment, or high inflation and sluggish output growth. High misery index ( INF + UN RATE = MISERY INDEX).

Example: In the mid and late 70s U.S. inflation was high and variable (averaged about 12%) and un rate averaged about 10%, stock market was flat for a decade, and there were two serious recessions (74-75 and 79-80).  From 1983-2000 inflation was low and stable and the economy was in recession for only 8 months.  

One of the challenges of modern macroeconomics is to develop policies that contribute to low and stable rates of inflation, and sustained growth rates of real output.  One alternative for monetary policy: Inflation Targeting like in Canada, UK and Europe. 

 WHAT CAUSES INFLATION?
Milton Friedman quotes: "Too much money chasing too few goods."  "Inflation is always and everywhere a monetary phenomenon." We will consider inflation in detail later, but the main factor causing inflation is excessive growth in the money supply. Monetary Expansion = Inflation. 

Problems: 3, 10, 13, 15, 16