Business Cycles and Fluctuations

Business Cycles in the United States

• The business cycle consists of two phases: expansion and recession.

• Recession begins with a peak and ends with a trough.

• Expansion is the recovery from a recession.

• If a recession becomes very severe, it can turn into a depression.

• The worst depression in U.S. history was the Great Depression, which began in 1929.

• The Great Depression was caused by various factors, including excessive borrowing in the 1920s and global economic conditions.

• Since the Great Depression, the United States has experienced several recessions, but each was short compared with the recovery that followed.

Business Cycles in the United States

Business Cycles in the United States

Causes of the Business Cycle

• Businesses reduce their capital expenditures once they decide they have expanded enough.

• Businesses cut back their inventories at the first sign of an economic slowdown.

• Businesses cut back on investment after an innovation takes hold

• Tight money policies of the Federal Reserve System slow the economy.

• External shocks, such as increases in oil prices and international conflicts, can cause business cycles.

Predicting Business Cycles

• Econometric models are macroeconomic model that use algebraic equations to describe how the economy behaves.

• The index of leading indicators is a monthly statistical series that helps economists predict the direction of future economic activity.

UNEMPLOYMENT

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

• 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

Who Can Skew?

•People who hold part-time jobs

•Person who has lost his high-paying job, but is working part-time at a minimum wage job.

American Labor Force

•136.5 million people in the labor force

•0.1 % rise in the unemployment rate means that 136,500 people have lost their jobs.

Kinds of Unemployment

• Frictional • Structural

• Cyclical

• Seasonal

• Technological

Frictional

•Workers who are between jobs

•Will always be present. WHY?

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

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

Full Employment

• Lowest possible unemployment rate with the economy growing and all factors of production being used as efficiently as possible

• Acceptable unemployment rate = below 5%– (full employment is reached)

INFLATION

INFLATION

•A rise in the general price level of goods/services - reported in terms of annual rates of change

•Decrease in the value of money

INFLATION RATE

2nd year price level minus 1st yr price level X 100

1st year price level

Example: (115-111) X 100 = 3.6% 111

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

CAUSES OF INFLATION

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

CAUSES OF INFLATION

• Wage-price spiral: higher prices force workers to ask for higher wages; forces producers to recover with higher prices; workers have more money to spend and create higher demand; self-perpetuating

Effects of Inflation: Effect #1

• The purchasing power of the dollar falls - after inflation, a dollar buys less than it did before

• Real vs. Nominal Income: real income is expressed in terms of purchasing power;

• Nominal income is expressed as an actual dollar amount (ex: $50,000)

Question: Can someone's nominal income increase but their

purchasing power decrease?

•YES!!! If there is inflation, an increase in nominal income may not make a difference since the dollar is worth less.

Who is hurt the most by inflation?

• People on fixed incomes are especially hurt because their money buys less each month, unless they receive a cost of living adjustment (COLA) to keep up with inflation

Effects of Inflation: Effect #2

• Spending habits change • Interest rates go up in times of

inflation• This causes people to borrow

less, spend less, and some businesses may have to lay off workers

Effects of Inflation: Effect #3

•Speculative investing increases to take advantage of higher price level & diverts spending from "normal" purchases, which could lead to some structural unemployment

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.

Poverty and Distribution of Income

The Distribution of Income

• The Lorenz curve shows how the actual distribution of income differs from an equal distribution.

• Since 1980 the distribution of income in the United States has become more unequal.

Reasons of Income Inequality

• Level of education affects people’s ability to get high-paying jobs.

• Differences in wealth lead to difference in income.

• Discrimination reduces the incomes of women and minorities.

• Differences in abilities allow some people to earn more than others.

• Monopoly power allows some groups, such as doctors, to maintain high incomes.

Poverty

• Poverty is defined as having an income below a certain level (poverty guidelines).

• Poverty in America is extensive: more than 13 percent of the population lives in poverty.

• Poverty has increased – growing gap in the

distribution of income – structural changes from a

goods production to a service production economy,

– the widening gap between well-educated and poorly educated workers,

– declining unionism– the changing structure of

the American family.

Antipoverty Programs

• Income assistance provides cash to people in need.

• General assistance provides noncash assistance, such as food stamps, to people in need.

• Social service programs provide assistance with family planning, job training, child abuse prevention, and other problems affecting lower-income people.

• The earned income tax credit provides federal tax credits and/or cash to low-income workers.

• Enterprise zones provide jobs in poor neighborhoods.

• Workfare programs require welfare recipients to work in order to receive benefits.

• A negative income tax would replace welfare programs by providing cash to people living below the poverty line.

Antipoverty Programs

Federal Reserve System

Organization of the FED

• Board of Governors– 7 governors- appointed by the

Pres. and approved by the Senate

– 14 year terms/4 year term for the chairman

– Chairman – Ben Bernanke

• Open Market Committee– 7 governors and 5

presidents of district banks

Organization of the FED

• Federal Advisory Council – offers advice– 12 Commercial bankers – 1 from each district

• District Banks– 1 regional bank in each of 12 geographic districts

What are the FED’s responsibilities?

• Provide banking services for financial institutions

• Hold deposit accounts for member banks• Control and supply currency• Process checks• Make loans to member banks• Transfer funds• Approve bank mergers• Set margin requirements

Responsibilities Cont.

• Serve as the federal government’s bank

• Supervise and regulate the nation’s banking system

• Control monetary policy

Monetary Policy

• Actions by the FED to regulate the money supply and to stabilize the economy.

Fractional Reserve System

• System requiring financial institutions to set aside a fraction of their deposits in the form of reserves

Excess Reserves

• Financial institution’s cash, currency, and reserves not needed to back existing loans

• Potential source of new loans

Easy Money/Expansionary Policy

• The FED expands the money supply when spending is too low (recession)

Tight Money/Contractionary Policy

• The FED decreases the money supply when spending is too high and prices are rising (inflation)

Tools of Monetary Policy

• Reserve Requirement

• Open Market Operations

• Discount Rate

• Moral Suasion

Reserve Requirement

• The % of deposits banks must keep on reserve and not loan out.

• This creates required reserves and excess reserves.

• Only excess reserves can be loaned out

• Every time a deposit, and then a loan, is made, the money supply is increased.

Open Market Operations

• The FED buys and sells govt. securities from member banks.

• By buying securities (writing a check to a bank) the money supply is increased.

• By selling securities (a bank writes a check to the Fed) the money supply is decreased.

Discount Rate

• Interest rate the Fed charges banks for loans.

• This affects the prime rate.

• Prime rate – interest rate banks charge customers

Moral Suasion

• The Fed tries to direct the economy by making announcements, speeches, testifying before Congress, etc.

• Unofficial tool

Tool (used by the FED unofficial)

Stimulate Economy (Recession)

Cool Off Economy (Inflation)

Reserve Requirement

decrease increase

Open MarketOperations

Buy Sell

Discount Rate Lower Raise

How is money defined?

• M1 – transactional components of the money supply, or the components of the money supply that most closely match money’s role as a medium of exchange. Ex: coins, currency, traveler’s checks

• M2 – a measure of money that includes those components most closely conforming to money’s role as a store of value. Ex: time deposits, savings deposits, money market funds, includes M1

How is money defined?

Weaknesses of Monetary Policy

• Tight money policy works better than a loose money policy

• By enacting a loose money policy, the Fed encourages spending, but can’t guarantee it

• Businesses don’t always depend on credit

Strengths of Monetary Policy

• Changes take effect quickly

• Members of the Fed are not elected, so they feel freer to make changes, even though they may be unpopular