Chapter 3

Business Cycle, Unemployment,

and Inflation

The Business Cycle

The business cycle may be defined as the
periodic ups and downs of the economy. It
generally affects national output, income and
employment, and normally lasts between two
to ten years. The depression after the great
stock market crash in the US in October 1929
lasted arguably for seven years (up to 1936)

The Business Cycle

The Business Cycle

Peaks and depressions are the

turning points od the cycle, while
recessions and recoveries are the
major phases.

Recessions generally characterized by

a weakness in aggregate demand in
relation to aggregate supply resulting
to a general build-up of unwanted
inventory that results to widespread
unemployment. The economy is said
to be in recession when the real GNP
declines for at least two consecutive
quarters in a given year.

The peak in the business cycle is the

most ideal stage. It is characterized
by full employment of resources, high
employment, high income and high
output. At this stage, crime rate is
becoming negligible as people
become generally contented with
their lives as their level of income
generally support their needs and
wants.

Since the general appreciation and

acceptance of the macroeconomics
theory and the widespread utilization
of fiscal and monetary policy
worldwide, recessions had been
shallow and no economy in the free
world had since experienced a
depression.

The Business Cycle

Depression is the lowest point of the business cycle. It is
characterized by relatively very low level of aggregate
demand that results to very low level of business activity,
low income, alarmingly widespread unemployment and
rapidly increasing crime rate.

Recovery is the phase in the business cycle characterized by

the increasing level of business activity resulting from the
pick-up of aggregate demand, which is further resulting
from increasing national income. At this stage, unwanted
inventory is slowly and consistently being wiped out due to
a general increase in demand

The Business Cycle

Business cycle is a description of the fluctuations in the general level of economic

activity in an economy as measured by changes in variables such as real GDP,
employment, and unemployment

1.

Business Peak. When most businesses in the economy are operating at capacity,
real GDP is growing rapidly and unemployment has fallen. It is not sustainable
over along period of time and thus leads to contraction.

2.

Contraction. Aggregate business condition slow, real GDP growth falls and may
even turn negative, and unemployment begins to rise.

3.

Recessionary Through. Economic slowdown reaches at its lowest. From this

point onward, aggregate economic activity tends to rise.

4.

Expansion. This is when aggregate activity completely recovers from the

previous slowdown. Real GDP growth rises, firms begin to increase their capacity
utilization, and unemployment begins.

Table 3.1
Relationship of Cycle and Economic
Sectors
Economic
Slowdown

Slowdown
Recovery

Economic
Expansion

Expansion Peak

Economy

Slowing

Slow

Growing

Decelerating

Monetary Policy

Neutral

Easy

Neutral

Tight

Interest Rates

Falling

Falling

Rising

Rising

Profits

Slowing

Falling

Rising

Decelerating

Sector Group
Expected to do Well

Finance
Health care

Consumer
Cyclical

Basic capital goods

Technology and
energy

Utilities

Stock
Characteristics

Non-cyclical
Blue chip
High yield

Economic sensitive
visible earning
growth oriented

Cyclical leverage
high growth

Non-cyclical visible
earning high-yield

Output and Employment

The use of index leading to economic

indicators is a composite index of 11
key variables that generally turn
down prior to a recession and turn up
prior to recovery. The changes in the
index are used to forecast future
changes in the state of economy, but
there is a significant variability in the
lead-time of the index; and hence,
the index is not always an accurate
indicator of the economys future.

1.

Length of average work week in

hours
2. First partial weekly claims for
unemployment compensation
3. New orders
4. Percentage of companies receiving
slower deliveries from suppliers of
manufactured goods
5. Arrival of new contracts and order
of new plant and equipment
6. Permits for a new structure chart
7. Change of unfilled orders for
durable goods
8. Change of material prices
9. Changes in S and P index
10. Change in money supply
11. Index of consumer expectations

Key Labor Market Indicators

1.

Civilian Labor Force. Number of persons, 16

years of age or greater, who are either
employed or are actively seeking for work
2.
Unemployed. A person who is not currently
employed who is either a) actively looking for
a job or b) waiting to begin or to return to a
job.
3.
Labor Force Participation Rate. Number of
persons in the civilian labor force, who are 15
years old or older and are either employed or
actively seeking for work, as a percentage of
total civilian population 15 years of age or
older.
4.
Unemployment Rate. Percentage of persons
in the labor force who are currently
unemployed.
Problems in Measuring Unemployment
a.
It doesnt count discouraged workers as
unemployed because they have given up
looking for a job;
b.
It doesnt adjust for underemployed workers
those working part-time who would prefer be
working full time; and

c.

It doesnt count non-market

employment such as stay-at-home
fathers/mothers as employed, even
though they would be considered
employed if working as maids, cooks, or
nannies.

5.

Full Employment. Level of employment

that result from the efficient use of
labor force after making allowances for
the normal rate of unemployment
consistent with information costs,
dynamic changes and structural
characteristics of the economy
Natural Rate of Unemployment. Longrun average level of unemployment due
to frictional and structural conditions in
the economys labor markets. This level
is not set in stone but rather is affected
by dynamic economic change and public
policy over time.

6.

Key Labor Market Indicators

Inflation. The sustained rise in the general

level of prices of goods and services in the
economy. Annual inflation rate is calculated
as the percent change in a chosen price index
(PI).

PIt - PIt - 1
Inflation Ratet =
x100
PIt - 1

a.

Harmful Consequences of Inflation

Anticipated Inflation. An increase in the
general level of prices that was expected
by most decision-makers on the economy.

b.

Unanticipated Inflation. An increase in the

general level of prices that was not
expected by most decision-makers on the
economy
Unanticipated inflation alters the outcome
of the long-term projects, increases the risks
of long-term investment activities, and o
reduces the amount of long-term investment
undertaken. Less investment today is likely t
lead to lower levels and growth of output in
the future.
Inflation distorts the information contained
n prices. This distorts the signals of scarcity
or plenty contained in prices, reducing the
effectiveness of markets and harming
economic activity.
High and variable rates of inflation lead
people to try to protect themselves from
inflation risk. This is likely to harm current
production as resources are devoted to
inflation protection.

Fiscal Policy
To explain the process which fiscal policy affects aggregate demand and
aggregate supply, it can be simply said that:

Fiscal policy affects Da directly through government spending and

indirectly though effects of taxes on consumption and investment. Taxes
may affect Sa by changing incentives for workers and firms. Fiscal policy
can be restrictive (lowers Da) or expansionary (raises Da)

It will also explain the importance of the timing of changes in fiscal

policies and the difficulties in achieving proper timing.

Recognition lags, implementation lags, before policy passes;

effectiveness lags before policy works. If timed correctly, it can stabilize
economy; if not, policy will bring more instability (usually in opposite
direction).

Fiscal Policy
Discuss the impact of expansionary and restrictive fiscal policy based on
the basic Keynesian model, the crowding-out model, the new classical
model and the supply-side mode;
1.

2.

3.
4.

Keynesian Model. Assumes SRAS is upward-sloping when the economy

is in recession (below LRAS), expansionary fiscal policy shifts out AD,
moves economy back to LRAS
Crowding-Out Model. Similar but notes expansionary fiscal policy raises
government deficit, which changes interest rates and exchange rates.
These changes lower investment and net exports, partly offsetting
expansionary fiscal policy
New Classical Model. Believes fiscal policy has no effect because any
change in deficit (from spending or tax changes) is offset by changes in
private saving behavior.
Supply-Side Model. Believes tax changes affect productivity and so can
increase equilibrium output in the long run.

Fiscal Policy
National Income Identity:
Y= C + I + G + NX
Rearrange yields

Y C G = I + NX or
(Y C T) + (T G) = I + NX
Where:
Y C T = Private Savings = S
T G = budget balance
Note: if S and I re fixed, then increased in Budget Deficit, {(T G)
more negative}, implies that NX s more negative, i.e. larger Current
Account Deficit

Fiscal Policy
Automatic Stabilizers:
are fiscal policies that automatically promote
budget deficits during recessions and surpluses
during blooms.
Examples are unemployment compensation,
corporate profit tax, and progressive income tax.
These policies affect AD in ways then offset
economic fluctuations.

Fiscal Policy
Supply-Side Effect of Fiscal Policy
Changes in tax rates, particularly marginal tax
rates, affects aggregate supply thorough their
impact on the relative attractiveness of productive
activity In comparison to leisure time and tax
avoidance. Supply-side tax cuts are a long-term
growth-oriented strategy that will eventually
increase both SRAS and LRAS.

Fiscal Policy
Budget Deficits, Inflation, and Real Interest
Rates
In theory, higher government budget deficits
should lead to higher real interest rates b loanable
funds market analysis. In practice, effect is not as
strong as expected.
Higher government budget deficits may lead to
higher inflation rates and higher nominal interest
rates, if government finances deficit by printing
money

Unemployment
Unemployment may be defined as a condition in the
economy where a significant number in the labor
force are out-of-work. It is a situation in the economy
whereby for one reason or another, available
resources are not fully used for productive purposes.

The rate of unemployment may be measured by

the ratio of the actual number of people who are
out-of-wok by the total who are in the labor
force:
Unemployment Rate=

Number without Work

Number in the Labor Force

Unemployment
However, not everyone who are alive and kicking are members of
the labor force. There are those who are not. These are:
1.
2.
3.
4.

Retirees who are 65 and above.

Retardates (physical and mental)
Below 15 years old
Students who are currently enrolled

Therefore, only those who do not fall in any of the above

characteristics who are out of work should be included in counting
the number of people who are unemployed because any person
who belongs to any of the above categories is considered as not
belonging to the labor force.

Unemployment
Example.

Question;

Given an economy with a labor force of

5,000,000 out of total population of
15,000,000. If 2,000,000 are out-of-work,
and the breakdown of those who are not
working are:

What is the economys unemployment

rate?

500,000 retirees
130,000 retardates
200,000 below 15 years old
300,000 students presently enrolled
And the remaining does not belong to
any of the four categories.

Solution:

= 2,000,000 1,130,000
= 870,000
These are the actual number of
people who are counted as unemployed
Answer:
= 870,000 / 5,000,000
= 17% This is the economys
unemployment rate

Types of Unemployment

Frictional Unemployment. The

people who fall under this
classification are those who are
temporarily out-of-work but are sure
to have work very shortly. These are
those who have just resigned from a
previous job but who are just
completing the requirements to start
in another job; those OFWs who just
finished their contracts but about to
sign another contact and will leave
for abroad shortly; those who work in
contractual basis in malls, and other
stores. E.g., SM, Jollibee, McDonalds,
who had end-of-contract but will
soon be rehired after a month or
two.

Structural unemployment. The

people who belong to this
classification are those who become
unemployed due to changes in the
operating and market environments.
These are those who lost their jobs
because their skills became irrelevant
due to changing technology and
consumer demand. For example, a
skilled typist who, for one reason or
another, cannot adopt to learn how
to use a computer will find himself
irrelevant and unemployed later on.
Another example is a worker whose
only skill is to make hula-hoops. Since
nobody buys this thing anymore, he
will become unemployed later on if
he refuses or fails to learn another
skill that could make him relevant
again.

Types of Unemployment
Cyclical Unemployment. The
people who fall under this
category are those who lost their
job because of the downturn
(recession) in the economy. For
example, at the lowest point of
the Asian financial crisis, the real
estate industry suffered the most,
so that those who were working
in this industry got unemployed
because of the severe lack of
demand for housing and office
space. They are the victims of
cyclical unemployment. As of this
writing real, estate industry has
not yet recovered fully after five
years starting 1997.

Seasonal Unemployment. Those

who experience this kind of
unemployment are the people
who are engaged in the
production of goods and services
whose demand are affected by
the changes in the season. For
example, those who make a living
in producing Christmas tree,
Christmas cards, fireworks and
others that are only in demand
during the Christmas and New
Year months (November to
December); those who make
raincoats and umbrellas whose
products are principally in
demand only during rainy months
(June to October).

General Theories of Unemployment

1.

Classical Theory. States that unemployment is a unction of wage arte

such that a lower wage level, unemployment is reduced and higher wage
level, unemployment increases.
Since a theory is supposed to be premised on the set of observable facts
leading to its formulation, we can say that this theory actually holds at that
time. Remember that the classical thoughts held from the time of Adam Smith
in the 18th century up to the time of Alfred Marshall at the beginning of the
20th century, until its final demise in 1936.
During these times, the prevalent economic activities were agriculture and
handicrafts, and industry was just in its infancy stage. At this time, landlords
were also farmers by skills and shop owners are also craftsmen themselves.
Hence, when wage increases; these owners can easily turn themselves from
owner-manager to owner-farmer or owner-craftsman. In other words, they
can do away with extra hands if they think that the marginal output of their
extra hands will not justify their marginal costs attached to their employment
in their fields or shops.

General Theories of Unemployment

This graph shows the
relationship of wage
and quantity of labor
employed at different
wage levels as viewed
by the classical
economists

General Theories of Unemployment

2. Keynesian Theory.

In his General Theory of Employment, Interest and Money, J.M.

Keynes argued that in the modern industrial set-up, wage is
not the primary determinant of employment but other factors.
He suggested that for as long as the firm believes that
additional labor will give it positive marginal income, it will
continue to hire labor regardless of the age rate is pays.

In a vibrant economy, a high wage rate gives the consumer

high purchasing power which can sustain demands for goods
and services produced by the firm which will motivate the firm
to employ more resources and hire more labor to cope with
the high demand. Hence, promoting more employment
despite high wages instead of instigating unemployment.

Inflation
Inflation may be defined as a phenomenon
whereby a sustained increase in the general
price level is happening, lead by the market
increases in the prices of basic commodities.
In the Philippines, inflation rate is indicated
by the upward movement of the price of the
basket of commodities that are included in the
calculation of the national price index.

Inflation
1.

2.

Demand-Pull Inflation. This kind of inflation

happens when the increase in aggregate demand
grows faster than the increase in the aggregate
supply which creates a shortage of supply in the
economy it happens when the level of money
supply exceeds the ideal level, so that additional
purchasing power is put in the hands of the
consumers without the corresponding additional
output created in the economy so that there is
too much money chasing too few goofs.
Cost-Push Inflation. This type of inflation occurs
when external forces affect the price equilibrium
in an economy.
For example, the real cause of the increase in the
domestic price of gasoline comes from outside of
our shore. Wherever OPEC (Organization of
Petroleum Exporting Countries) increases prices the
price of its crude oil, inflation is brought to our
shores. Since OPEC is not part of our country, (they
are mostly composed of middle Eastern countries),
our government is not able to do anything about it.

3.

As it name implies, cost-push inflation always

starts from the arbitrary decision of those
resource owners with market power to increase
the price of their products to gain higher
returns.
Structural Inflation. This type of inflation
happens when some sectors of the economy
us unable to adjust to changes in the level
and composition of aggregate demand. For
example, when supply is unable to respond to
an abrupt increase in demand, like when an
earthquake hit Baguio in 1990, prices of basic
commodities skyrocketed in that area
because supply cannot pass through the
destroyed roads leading to that place. It can
also happen to a particular industry that
experience acute shortage of skilled labors
that is unable to produce enough supply to
cope with existing demand.

Measurement of Inflation
Inflation rate can be
calculated by dividing
the change in the price
index by the price index
of the base year:
Inflation Rate=

(CPI2-CPI1)
(CPI1 )

Where: CPI =
Consumer Price Index

Example:
Given:
CPI1 = 120
CPI2 = 130
Find:
Inflation Rate =
Inflation Rate=

130-120
=8.33%
120

Inflation
Who are Affected?
Inflations affects everyone, both individuals and
firms; households and government; rich and poor
alike; employed and unemployed. Inflation is
always a public issue; hence, governments always
consider the inflationary effect of most of their
spending and tax collection policies.