Chapter 9: Business Cycles, Unemployment, and Inflation

ECO 112 Principles of Macroeconomics

Today’s Roadmap

Key Concepts

• The business cycle: peak, recession, trough, expansion, oscillating around the long-run growth trend
• Why durable goods industries feel a downturn more than nondurable goods and services
• The labor force, the unemployment rate, and the labor force participation rate
• The four types of unemployment, and why “full employment” is not zero percent unemployment
• The Consumer Price Index and how the inflation rate is calculated
• The Fisher relationship: real interest rate = nominal interest rate minus inflation
• Who wins and who loses from unanticipated inflation
• The real costs of inflation, from menu costs to hyperinflation

The Business Cycle

From Chapter 8 to Chapter 9

Chapter 8 studied economic growth: the long-run upward trend in an economy’s potential output. But the economy never grows in a smooth straight line.

• Some years output grows quickly, other years it shrinks.
• This chapter studies the bumps around the trend: the business cycle, unemployment, and inflation.

These three ideas are connected. When the economy slows, people lose jobs. When it overheats, prices tend to rise faster.

What Is a Business Cycle?

A business cycle is the recurring, but irregular, up-and-down movement of overall economic activity around the economy’s long-run growth trend.

• Recurring: expansions and contractions happen again and again.
• Irregular: no two cycles have the same length or severity.
• Around a trend: the economy does not cycle around zero growth, it cycles around the rising trend line from Chapter 8.

The Four Phases of the Business Cycle

Economists divide the business cycle into four phases, always in the same order:

1. Peak: economic activity is at a high point, output and employment are strong.
2. Recession (or contraction): output, income, and employment fall.
3. Trough: economic activity hits its low point.
4. Expansion (or recovery): output, income, and employment rise again toward the next peak.

Plotting the Business Cycle

The dashed gray line is the long-run growth trend from Chapter 8. The solid blue line is actual output, weaving above and below it.

• Above trend: the economy is running hot.
• Below trend: the economy is underperforming its potential.

The cycle oscillates around growth, it does not replace it.

Cycles Are Irregular, Not Predictable

Real business cycles do not look like a neat, repeating wave.

• Some expansions last a decade, others only a couple of years.
• Some recessions are short and mild, others are deep and long, like the Great Depression or the 2007 to 2009 financial crisis.
• Economists cannot reliably predict exactly when the next turning point will arrive.

This is why the phrase “irregular” belongs in the definition, not just “recurring.”

Example: Reading a Business Cycle

The chart below plots an economy’s real output over 32 quarters. Four points are marked A, B, C, and D.

1. Which point is a peak?
2. Which point is a trough?
3. Between which two points is the economy in recession?
4. Between which two points is the economy in expansion?

Solution: Reading a Business Cycle

1. A and C are peaks.
2. B and D are troughs.
3. Recession runs from A to B (and again from C to D).
4. Expansion runs from B to C.

Durable Goods Feel a Downturn First

Not every industry feels a recession equally. Durable goods (cars, appliances, furniture, business equipment, new construction) and capital goods are hit much harder than nondurable goods and services (food, utilities, haircuts, health care).

Why? → Durable purchases can be postponed.

• If your income falls or your job feels shaky, you can keep driving your current car another year instead of buying a new one.
• You still need groceries, electricity, and a haircut regardless of the business cycle.

Example: Which Business Feels a Recession More?

Consider two local businesses as a recession begins:

• Business A: a furniture and appliance store.
• Business B: a neighborhood grocery store.

• Business A (furniture and appliances) is likely to see the bigger sales drop. A worn but working couch or refrigerator can be kept another year or two; the purchase is postponable.
• Business B (groceries) keeps selling at close to its normal pace, because food is a nondurable necessity that households cannot easily cut back on for long.

Unemployment

Connecting Back: Why Recessions Cost Jobs

Chapter 6 introduced sticky prices: in the short run, wages and many prices do not adjust quickly to a drop in demand.

• When demand for a firm’s product falls in a recession, a flexible price would simply fall to clear the market.
• But wages are especially sticky. Instead of cutting pay, firms often cut workers.

This is exactly why a recession shows up as rising unemployment rather than just falling prices. It is the bridge from the business cycle to the rest of this section.

Who Counts as Unemployed?

Government statistics divide the working-age population into three groups:

• Employed: currently working.
• Unemployed: not working, but actively looking for work.
• Not in the labor force: not working and not looking, including retirees, full-time students, and discouraged workers who have given up looking for a job.

The labor force is employed plus unemployed. Someone who has stopped looking for work is not counted as unemployed at all.

The Unemployment Rate

\[ \text{Unemployment rate} = \frac{\text{Unemployed}}{\text{Labor force}} \times 100 \]

A related measure, the labor force participation rate, shows how much of the working-age population is in the labor force at all:

\[ \text{Labor force participation rate} = \frac{\text{Labor force}}{\text{Working-age population}} \times 100 \]

Example: Computing the Unemployment Rate

A country’s working-age population is 250,000. Of these, 152,000 are employed and 8,000 are unemployed (actively looking for work). The rest are not in the labor force.

1. What is the size of the labor force?
2. What is the unemployment rate?
3. What is the labor force participation rate?

Solution: Computing the Unemployment Rate

• Labor force: \(152{,}000 + 8{,}000 = 160{,}000\)

• Unemployment rate: \(8{,}000 / 160{,}000 \times 100 = 5\%\)
• Labor force participation rate: \(160{,}000 / 250{,}000 \times 100 = 64\%\)

The 90,000 people not in the labor force are never counted in the unemployment rate at all.

Four Types of Unemployment

• Frictional unemployment: short-term, from people between jobs or newly entering the labor force. Generally considered healthy, it reflects normal job search and matching.
• Structural unemployment: a mismatch between workers’ skills or location and available jobs, often caused by technological change or a shrinking industry.
• Cyclical unemployment: caused by a recession, when a fall in aggregate demand leads firms to lay off workers.
• Seasonal unemployment: predictable, recurring patterns tied to the time of year, such as agriculture or holiday retail hiring.

Full Employment and the Natural Rate

Full employment does not mean a zero percent unemployment rate. There is always some frictional and structural unemployment even in a healthy economy.

\[ \text{Natural rate of unemployment} = \text{Frictional} + \text{Structural} \]

At full employment, cyclical unemployment is zero, the actual unemployment rate equals the natural rate. When the economy enters a recession, cyclical unemployment pushes the actual rate above the natural rate.

Example: Identify the Type of Unemployment

For each worker below, identify whether the unemployment is frictional, structural, cyclical, or seasonal. Be ready to explain your reasoning.

1. A recent college graduate is searching for her first job.
2. A coal miner loses his job as power plants switch to natural gas and solar, and his skills do not transfer to other local jobs.
3. A ski instructor is laid off every spring when the mountain closes for the season.
4. A factory worker is laid off because consumer spending collapsed during a nationwide downturn.

1. Frictional: normal job search after finishing school.

2. Structural: a lasting mismatch between his skills and the industries that are hiring.

3. Seasonal: a predictable, recurring pattern tied to the time of year.

4. Cyclical: caused directly by a fall in aggregate demand during a recession.

Real Data: The Unemployment Rate

Series UNRATE

1. During which periods does the unemployment rate spike sharply upward?

Answer: around recessions, such as 2008 to 2009 and the sharp 2020 spike, when cyclical unemployment rises.

2. Does the rate ever fall all the way to zero?

Answer: no, it never reaches zero, because frictional and structural unemployment persist even in strong years.

3. What would you expect this line to do in the year right after a recession ends?

Answer: it typically keeps rising for a while even after a recession officially ends, then gradually falls as the recovery strengthens.

Real Data: Labor Force Participation

Series CIVPART

1. If this rate falls, does that necessarily mean the unemployment rate rises?

Answer: not necessarily, a falling participation rate can mean people left the labor force entirely (discouraged workers), which can even make the unemployment rate look better than the job market really is.

2. What long-run trends might explain gradual shifts in this rate over decades?

Answer: factors such as more women entering the workforce over past decades, and more recently an aging population moving into retirement.

3. Why does an economist want to look at both UNRATE and CIVPART together?

Answer: the unemployment rate alone can miss changes in who is even counted as in the labor force, so participation fills in that part of the picture.

The Consumer Price Index and Inflation

The Market Basket and the CPI

The Consumer Price Index (CPI) tracks the cost of a fixed, representative “market basket” of goods and services that a typical household buys, relative to the cost of that same basket in a base period.

• The basket includes things like food, housing, transportation, medical care, and recreation.
• Because the basket is fixed, changes in the CPI over time reflect price changes, not changes in what people buy.
• The inflation rate is the percent change in the CPI from one period to the next.

The CPI is not the GDP price index from Chapter 7. They are both price indexes, but they measure different things:

• The CPI covers only what households buy, using a fixed basket.
• The GDP price index (deflator) covers everything produced domestically, including capital goods and government purchases, and its basket shifts with the economy’s actual output each year.

The Inflation Rate Formula

\[ \text{Inflation rate} = \frac{\text{CPI}_{\text{this period}} - \text{CPI}_{\text{last period}}}{\text{CPI}_{\text{last period}}} \times 100 \]

• A rising CPI means the overall price level is going up: inflation.
• The reverse case, a falling CPI and a declining overall price level, is called deflation.

Deflation is much less common than inflation in modern economies, but it can happen, and it brings its own problems, such as delayed spending as buyers wait for even lower prices.

Example: Computing the Inflation Rate

The table below gives illustrative CPI values for two consecutive years (base period index = 100 in some earlier year, not shown).

Year	CPI (illustrative)
Year 1	240.0
Year 2	252.0

1. Compute the inflation rate from Year 1 to Year 2.
2. If the CPI had instead fallen from 240.0 to 232.8, what would you call that, and what would the rate be?

Solution: Computing the Inflation Rate

• Inflation rate: \((252.0 - 240.0)/240.0 \times 100 = 5\%\)

• Deflation case: \((232.8 - 240.0)/240.0 \times 100 = -3\%\), a deflation of 3 percent, since the price level fell.

The Fisher Relationship: Real vs. Nominal Interest Rates

Inflation erodes the purchasing power of interest earned or owed. The real interest rate adjusts the nominal interest rate for inflation:

\[ \text{Real interest rate} = \text{Nominal interest rate} - \text{Inflation rate} \]

The nominal rate is the rate actually stated on a loan or savings account. The real rate tells you how much purchasing power you actually gain (or lose).

Irving Fisher, an American economist known for the Fisher equation relating nominal and real interest rates

Example: Finding the Real Interest Rate

A savings account pays a nominal interest rate of 6 percent this year. Inflation over the same year is 4 percent.

1. What is the real interest rate?
2. Now suppose inflation had instead been 7 percent. What would the real interest rate be, and what does a negative real interest rate mean for the saver?

1. Real interest rate: \(6\% - 4\% = 2\%\). The saver’s purchasing power grows by about 2 percent.

2. With 7 percent inflation: \(6\% - 7\% = -1\%\). A negative real interest rate means that even though the account balance grows in dollar terms, it buys less than it did a year ago.

Real Data: The Consumer Price Index

Series CPIAUCSL

1. Does this line ever slope downward for a sustained period?

Answer: rarely, and only briefly, most of the time the line slopes upward, showing ongoing inflation rather than deflation.

2. How would you use this series to calculate the inflation rate between two specific months?

Answer: take the percent change in the index value between those two months, exactly as in the worked example.

3. Why is 1982 to 1984 set as the base period, with an index value near 100?

Answer: a base period just fixes a reference point for comparison, any period could have been chosen; what matters is the percent change over time, not the absolute index number.

Who Wins and Loses from Inflation

Nominal Income vs. Real Income

• Nominal income is income measured in current dollars, the number on your paycheck.
• Real income is nominal income adjusted for changes in purchasing power.

\[ \text{Real income} = \text{Nominal income} \times \frac{\text{CPI in base period}}{\text{CPI in current period}} \]

If prices rise faster than your paycheck, your nominal income can rise while your real income falls.

Example: Nominal Income Rises, Real Income Falls

Last year, your salary was $50,000 and the CPI was 200.0. This year, your salary rose to $52,000 (a 4 percent raise), but the CPI rose to 212.0.

1. What was the inflation rate this year?
2. What is this year’s salary worth in last year’s dollars (real income)?
3. Did your real income rise or fall, and by about how much?

Solution: Nominal Income Rises, Real Income Falls

• Inflation rate: \((212.0 - 200.0)/200.0 \times 100 = 6\%\)
• Real income: \(52{,}000 \times (200.0/212.0) \approx \$49{,}057\)

• Nominal income rose 4 percent, but real income fell by about \((50{,}000 - 49{,}057)/50{,}000 \approx 1.9\%\).
• Inflation outpaced the raise, so purchasing power dropped even though the paycheck grew.

Losers from Unanticipated Inflation

When inflation is higher than expected, some groups are hurt:

• People living on fixed nominal incomes
  • Fixed pension payment that does not adjust for prices
• Savers, whose savings buy less in the future than expected.
• Lenders and creditors who lend at a fixed interest rate: they are repaid in dollars that are worth less than the dollars they lent.

Winners from Unanticipated Inflation

• Borrowers and debtors who owe a fixed-rate debt, such as a fixed-rate mortgage or student loan, benefit: they repay their loan with dollars that are worth less than the dollars they originally borrowed.

Unanticipated inflation redistributes purchasing power from lenders to borrowers, it does not, by itself, destroy purchasing power in the economy as a whole.

Core Inflation

Some prices swing sharply from month to month for reasons that have little to do with the broader economy:

• Food prices
  • Subject to seasonal and weather-related fluctuations
• Energy prices
  • Subject to seasonal and geopolitical fluctuations

Core inflation measures CPI inflation excluding food and energy prices, to give policymakers a clearer read on the underlying inflation trend, rather than short-term noise.

The Output Costs of Inflation

Costs of Inflation, Even When Anticipated

Even moderate, fully anticipated inflation imposes real costs on an economy:

• Menu costs: the resources businesses spend updating prices, price tags, menus, catalogs, and computer systems, every time prices change.
• Shoe-leather costs: the time and effort people spend trying to avoid holding cash that is losing value, making more frequent trips to the bank or shifting funds into interest-bearing accounts.

Hyperinflation

Hyperinflation is a very high and typically accelerating rate of inflation. It is far more damaging than ordinary inflation.

• Money loses value so quickly that people rush to spend it immediately, before prices rise again.
• Normal buying, selling, and production break down as money stops functioning as a reliable store of value.
• Total output can fall sharply as the economy struggles to function.

Germany, 1923: banknotes had become so worthless that people papered walls with them. Bundesarchiv, Bild 102-00104 / Pahl, Georg / CC-BY-SA 3.0

Real Data: Zimbabwe’s Hyperinflation

Zimbabwe’s 2007-2009 hyperinflation is one of the most extreme episodes in modern history, easily clearing the technical threshold economists use for hyperinflation (prices rising more than 50 percent per month).

• At its peak, in November 2008, the monthly inflation rate reached an estimated 79.6 billion percent, according to economist Steve Hanke.
• Zimbabwe’s central bank responded by printing ever-larger denominations, eventually issuing a 100 trillion dollar note.
• The currency ultimately collapsed. Zimbabwe abandoned its own dollar in 2009 and relied on foreign currencies instead.

Zimbabwe, 2009: a 100 trillion dollar banknote, issued near the end of the hyperinflation. Reserve Bank of Zimbabwe, public domain (demonetized banknote)

Discussion: Why Does the Fed Manage Even Low Inflation?

Suppose inflation is low and stable, say around 2 percent a year. It is positive, not a crisis, and not hyperinflation.

1. Given the menu costs and shoe-leather costs above, why might even this level of inflation be worth actively managing rather than ignoring?
2. What could go wrong if policymakers let inflation drift upward year after year without acting?

This previews Chapter 15, where we build the tools policymakers actually use to manage inflation. For now, the key point is only that business cycles, unemployment, and inflation are connected, and that connection is why inflation gets active attention even when it looks mild.

Possible Answers

1. Even at 2 percent, menu costs and shoe-leather costs are ongoing, every year, forever, not a one-time event. They add up over time, and they compound with other distortions, like making it harder for workers to tell whether a raise is a real raise or just catching up with prices.
2. Inflation is easiest to control when it is low and expectations are anchored. If policymakers let it drift upward unchecked:
   • Expectations can become unanchored, workers and firms start building higher expected inflation into contracts and prices, which can become self-fulfilling.
   • Reversing course later requires a much more painful policy response (higher interest rates, slower growth, higher unemployment) than acting early would have.
   • Low, stable inflation lets households and firms plan confidently. Rising, unstable inflation undermines that confidence even before it becomes a crisis.

Wrap Up

• The business cycle (peak, recession, trough, expansion) is the economy’s irregular movement around its long-run growth trend. Durable goods industries feel downturns more than nondurable goods and services.
• The unemployment rate is unemployed divided by the labor force. The four types are frictional, structural, cyclical, and seasonal; full employment means cyclical unemployment is zero, not that the rate is zero.
• The CPI tracks a fixed market basket’s cost; the inflation rate is its percent change. The real interest rate equals the nominal rate minus inflation.
• Unanticipated inflation hurts savers, lenders, and people on fixed incomes, and helps borrowers repaying fixed-rate debt.
• Even anticipated inflation has real costs (menu costs, shoe-leather costs), and hyperinflation can devastate an economy’s output.

Looking ahead: later chapters build the full model of what causes recessions, aggregate demand and aggregate supply, and how monetary and fiscal policy respond.