The business cycle: An overview
Contents
- 1 Introduction
- 2 Business cycle
- 3 Recession
- 4 Postponable durables
- 5 Unemployment
- 6 Frictional unemployment
- 7 Structural unemployment
- 8 Cyclical unemployment
- 9 Rate of unemployment
- 10 Discouraged workers
- 11 Natural rate of unemployment
- 12 Economic costs of unemployment
- 13 Noneconomic costs of unemployment
- 14 Inflation
- 15 Deflation
- 16 Demand-pull inflation
- 17 Cost-push inflation
- 18 Measuring inflation
- 19 Rule of 70
- 20 Inflation redistribution effect
- 21 Real income
- 22 Anticipated inflation
- 23 Inflation output effect
- 24 Hyperinflation
Introduction
The purpose of this topic is to study the nature, causes and characteristics of the two major economic problems: periods of severe unemployment and periods of inflation.
Business cycle
Business cycles are recurring periods of recession and prosperity which are widespread throughout a nation and which feed upon themselves. They must be distinguished from seasonal variations (lack of sales of coats in the summer) and long run secular trends (especially related to population, e.g. baby boom). The phases of a business cycle are peak, contraction, recession, trough, recovery, and expansion.
Recession
A recession is a widespread decrease in economic activity. Such decrease usually causes many employees to be unemployed. A very serious recession is referred to as a depression. Causes for recession have been tied to excess inventories, decrease in consumption (attributable to fears about the future, for instance), lack of innovations and new capital formation, and random shocks.
Postponable durables
Business cycles are significantly affected by changes in sales of items which last several years because their purchase can be postponed through additional maintenance and repair. Such postponable items are essentially the durable goods and new capital.
Unemployment
Unemployment is the labor force seeking employment and unable to find it. The cost of unemployment can be measured by the deficiency in the potential output of a nation: both foregone production, income and consumption of needed goods. A less tangible, but more significant cost is present in the loss of social and cultural value of those unable to play an active role in society.
Frictional unemployment
Frictional unemployment represents the employees switching jobs for more productive and higher paying positions. Such labor mobility is desirable since it assures that the labor force is more efficiently utilized and income is enhanced.
Structural unemployment
Structural unemployment is due to changes is various sectors of the economy. These continuous changing conditions in different industries are due to changes in tastes of consumers and are part of any changing society. While structural unemployment can be reduced by retraining, for most part it is desirable since it is a reflection of a society seeking improvements in its products.
Cyclical unemployment
Cyclical unemployment is attributable solely to a deficiency in the level of economic activity. This form of unemployment is the most undesirable because it is avoidable.
Rate of unemployment
The rate of unemployment in the United States is obtained from a telephone survey of households in which the proportion of the labor force actively seeking and unable to find employment is determined. (In other countries, statistics are based on those registered with the unemployment office; thus international comparison may be inaccurate). Unemployment rates may be distorted by underemployment (part time work), discouraged workers and underground economy.
Discouraged workers
The presence of discouraged workers causes the official rate of unemployment to be understating the real extent of unemployment. This is especially a serious problem during recessions because a larger number of discouraged workers will be leaving the labor force.
Natural rate of unemployment
The natural rate of unemployment corresponds to the combination of frictional and structural unemployment which cannot be avoided even in a very high level of economic activity. This natural rate of unemployment has historically been around 4%, but it has risen slightly in recent years because of changes in labor force which now includes more women and young people (who take often more time to find jobs).
Economic costs of unemployment
There are both economic and noneconomic costs to unemployment. The main economic cost is lost income and output which is measured in terms of the GNP gap. Okun's law is used to determine the GNP gap by using the following formula: for every 1% that the actual unemployment rate exceeds the natural rate of unemployment, there will be a 2.5% GNP gap. Another economic cost of unemployment is that its harm is not distributed equally: blue-collar workers and minorities experience higher rates of unemployment than the rest of society 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, increase in crime, and a decline in morale. History is full of examples where severe unemployment has brought about violent social and political changes.
Inflation
Inflation is a widespread pattern of price increases. The rate of inflation is equal to the rate of change in a price index such as the consumer price index (CPI). Historically, inflation has been considered serious when it has approached or exceeded 10% per year.
Deflation
Deflation is a widespread pattern of price decreases. Historically, deflation is less common that inflation, but it is also more feared because the loss of revenues of a large number of firms may result in widespread bankruptcies and decrease in economic activity (as it happened, for instance, during the great depression of the 1930's).
Demand-pull inflation
One of the possible explanations of inflation is that it is caused by excessive demand on the part of consumers while firms are unable to expand output beyond their productive capacity. This is referred to as demand pull inflation.
Cost-push inflation
A common cause of increases in prices are increases in costs. For instance, demands by unions for higher wages have been labeled as wage push inflation. At other times, increases in commodity prices were attributable for inflation, for instance, in the case of the oil crisis of the 1970's.
Measuring inflation
Inflation is commonly measured with the consumer price index. The consumer price index reports the general level of prices of a basket of 300 consumer goods and services. It is stated as a ratio of prices in a given year divided by the prices of the same basket of goods and services in a base year. The base year index is set at 100. The rate of inflation is calculated for any given year with the formula:
(current year index - previous year index)/previous year index
Rule of 70
The rule of 70 is used to determine how long it will take for prices to double at the current rate of inflation. The number of year for prices to double is determined by dividing 70 by the annual rate of inflation. (The rule of 70 can also be used to determine how long it will take for savings or GNP to double).
Inflation redistribution effect
The effect of inflation (if it is not anticipated) is to redistribute wealth and income from savers and those on fixed income to debtors and those on variable income. This happens because the purchasing power of a fixed money amount decreases, and because borrowers repay lenders their debt in cheaper dollars.
Real income
Real income is nominal income adjusted for the rate of inflation. For instance, real interest is equal to nominal interest less rate of inflation.
Anticipated inflation
If inflation is fully anticipated, the redistribution effect of inflation is nonexistent. This can be accomplished with cost of living adjustments for income to offset the loss of purchasing power, and by indexing nominal interest rates (i.e. increasing the nominal interest by the rate of inflation). The drawback of using various schemes of anticipated inflation is that it perpetuates inflation.
Inflation output effect
Depending on its severity, inflation may have a mild stimulative effect (called forced saving) or a serious recessionary effect (especially in hyperinflation). Most commonly, continuous price changes make consumers not sure of what the real value of products is, and the uncertainty reduces the volume of purchases.
In the case of a mild inflation (4-6% per year), the additional revenues over costs for most firms allows them to undertake new investment which is expansionary. (This is called forced saving).
Hyperinflation
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 barter and the economic activity may come to a halt. Such danger may be present even in a moderate inflation because inflation expectations may produce spirals of cost push and demand pull inflation leading to hyperinflation. However, some countries manage with very high inflation.