Business Cycle, Unemployment, and Inflation Midterm Exam PDF

ADV. MACRO PROF. FLORDELIZA GERARDO | MIDTERM EXAM CHAPTER 12: – Business cycle is a characteristic of industrialized BUSINESS CYCLE, UNEMPLOYMENT, AND and developing capitalistic economies; economic INFLATION....

ADV. MACRO PROF. FLORDELIZA GERARDO | MIDTERM EXAM CHAPTER 12: – Business cycle is a characteristic of industrialized BUSINESS CYCLE, UNEMPLOYMENT, AND and developing capitalistic economies; economic INFLATION. fluctuations occurred long before modern economies. Every nation had gone through the ups and downs in economy. Even the richest country in the – Fluctuations in economic activities are too world like the United States of America has suffered complex and too different to be incorporated into a depression. single universal theory applicable to every country. The biggest economic problems of a business cycle are Even if the same explanation for business cycle unemployment holds in highly industrialized countries (i.e., U.S.A.) and inflation. and in developing countries (i.e., Philippines), it is not easy to determine the causes of a business BUSINESS CYCLE cycle. – The country's economy can be described by a PHASES OF A BUSINESS CYCLE chain of modest economic growth proceeded by an abrupt downturn in economic activities. 1. Peak/Prosperity. – This series of events in the economy is apparent – This is a phase where business activities are in in the last half of the 21st century that results to their temporary maximum. The economy at this mediocre growth for most of the period. Although the phase is at full employment and the level of real economy has recorded growth above 4% in the last output is at its full capacity, and there is the tendency six years, its structural problems forestall any for the price level to rise. chances to break from a cycle of boom-bust that 2. Recession. afflicts it for the last two decades and prevents it from moving to a higher and sustained growth. – A phase in business cycle that is characterized by a decline in total output, income, trade, and – What seems to be typical of the Philippine ultimately, employment. Therefore, during this economy from other countries is that it has short phase, unemployment is induced. periods of average levels of economic growth while having an extended period of severe contractions 3. Trough/Depression. and slower pace of recovery. This pattern of fluctuations in economic activities is referred to as – It is the turning point of recession, or when the business cycle economic activity is at its lowest. In this phase of the business cycle, unemployment is so severe. – Business cycle is defined as the diffusion of fluctuations in aggregate economic activities all over 4. Expansion. the economy and not just on a single industry. – In this phase, there is a recovery in the economy – The economy of any given country is a system of wherein income, output, trade, interest rate, wage, closely interrelated parts, and to understand and employment are rising, meaning, business cycle is to know the workings of an unemployment is low. economic system organized largely in a network of free enterprise searching for profits. …. ASHNIA SULTA | 1  by a notable economic growth at the beginning of 1997. – The second cycle is around third quarter of 1997, and the other from 2000 to 2007. Figure 12. Phases of a Business Cycle – Notice the third cycle has the deepest and longest BUSINESS CYCLE IN THE PHILIPPINES recession in the economy compared to the first cycle, while the second cycle has shorter length but During the early times, the business cycle with a deep impact as well on the economy. was already operating. Primitive communities had periods of good and bad harvests, and their hunting Several factors with various natures can be and farming were greatly affected by the weather. A attributed to the formation of the cycles; the first good amount of rain and sunshine improved their cycle was mainly caused by insufficient power farming and hunting outputs, while vagaries of supply in the country at the beginning of the 1990s weather depressed their output. causing widespread blackouts that crippled different industries and the entire economy. At the end of the In today's advancement of the Philippine Aquino administration, newly elected President Fidel economy, it does not follow a steady course of good V. Ramos entered into different contracts with business condition. different private electric power companies with the objective of ending the power crisis in the country. – Its performance is highly correlated with the performance of other economies due to its openness The second cycle was instigated by the Asian to international trade. financial crisis causing currencies in the region to depreciate significantly. The Philippine peso in – The major export earnings of the country are tied particular was adversely affected. Before the crisis, up with the U.S., Taiwan, South Korea, Japan, and the peso-US. Dollar rate was 25 pesos to 1 dollar, some European countries. When these countries as a result of the financial crisis, the exchange rate enjoy prosperity, it trickles down to the Philippine against the US dollar depreciated to 45. This caused economy through more hefty export revenues. But if prices of goods and services in the country to go up the demand for these goods and services is reduced significantly. to poor economic performances of the trading partners, the country’s economy will be affected with The third cycle was due to the lingering political lower export receipts. instability in the country from the turn of the century when President Joseph Estrada was ousted from Malacañang because of corruption. He was replaced by then Vice President Gloria Macapagal Arroyo who assumed office. After the assumption of President Arroyo to power, corruption issues didn’t die down in her administration causing spurts of coup d’etat that adversely affected the economy. Figure 12.1 shows the business cycles in the Philippines for the period 1990-2009. Interestingly, …..,.,., the observed graph comprises three business cycles of different lengths and depths; – The first cycle covers the period 1990 to 1997 ……………. characterized by a deep recession in 1993 followed 2 SELECTED CLASSICAL THEORIES EXPLAININ 3. Self-generating theory. BUSINESS CYCLES – According to Wesley Mitchell, one phase of the There are various explanations of the business cycle grows out of the preceding phase. business cycle in the economic literature. For example, the period of prosperity grows to a Particularly, there are two opposing theories that crisis. provide rationalization in the business cycle theories – This crisis develops into depression and this such as the endogenous (internal) and condition will lead to recovery and eventually to exogenous (external) prosperity. – These different phases of the business cycle are ENDOGENOUS THEORIES – These theories series of cumulative changes by which one condition explain the causes of business cycles within rather is a product of another. than outside the economy. 4. Underconsumption theory. The following are specific explanations of the causes of business cycle: – This theory comprises the older explanations of the business cycle. 1. Real structural hypothesis (RSH). – Economists subscribing to the underconsumption view attribute the deficiency in purchasing power. – This hypothesis is based on the explanation that This is due to the fact that purchasing power typifies aggressive investment plans, together with import all business contractions, and if in some fashion, dependence, attain a normal frontier in the weak society could sustain the demand for goods, then (structural) ability to bring in foreign exchange. prosperity could endure. – This results to a period of low growth as investment – The underconsumptionists have brooded is suppressed and large price adjustments affect the excessively over the role of savings. economy. – A downward turn of production could conceivably – Investment is stimulated as foreign credit is result if the accumulated savings of the society were reestablished, and a new cycle begins. not invested, or if, through savings, the demand for consumer goods were forced below a level of 2. Innovation theory. profitable production. – This theory was based on the ideas put forward by 5. Monetary theory. Joseph Schumpeter. This theory holds that innovation is a fundamental cause of business cycle. – If inflation is threatening the economy, the Central – Innovation is defined as enhancement of an Bank (CB) should slow the rate of growth of money existing production system that leads to new and supply. But this action of the CB will adversely affect better products. economic growth as recession will ensue. If inflation – This innovation will bring higher profits for is no longer a threat, the CB can now accelerate producers as prices are reduced because of a more money growth to promote economic recovery. efficient production. – High profitability attracts more producers in the EXOGENOUS THEORIES – These theories explain industry. Too many players will reduce individual the causes of business cycle as disturbances profit, making others withdraw especially those who outside the economy. are unable to meet with efficiency, making the industry profitable again. It has been said that when the economy of United States catches cold, the Philippine economy contracts pneumonia. The reason behind this is that the country’s economy is so dependent 3 on the demand of the United States for our Unemployed – is officially defined as all those who products. are 15 years old as their last birthday and during the reference period and are reported as: – In fact, the United States remains as our top trading partner, so any decline in their economic 1. Without work, i.e., had no job or business activities will definitely generate fluctuations in the during the basic survey reference periods; economy. 2. Currently available for work, i.e., were available an willing to take up work in paid – Another exogenous factor that will create employment or self-employment during the fluctuations in the economy would be conflicts in basic survey reference period, and/or would other nations or regions such as the Middle East. be available and willing to take up work in paid employment or self-employment within – Since the Philippines relies heavily in this region two weeks after the interview date; and for our oil supply, any political unrest will create 3. Seeking work, i.e., had taken specific steps higher prices of crude oil in the world market which to look for a job or establish a business eventually leads to higher prices of gasoline and during the basic survey reference period; or diesel in the local market. These higher prices will not seeking work due to the following generate economic woes for the households and reasons; industries. a. tired/believe no work is available, i.e., the discouraged workers who looked for UNEMPLOYMENT work within the last six months prior to – Why do Filipinos want to go abroad instead of the interview date. staying here in the country and work? b. Awaiting result s of previous job – Why do Filipinos have to take the life-threatening application. risk in the Middle East countries like Kingdom of c. Temporary illness/disability Saudi Arabia, United Arab Emirates, Iraq, and d. Bad weather Kuwait to work? e. Waiting for rehire/job recall – Or why do they choose to be away from their families for a long time just to leave the country? Unemployment Rate – is the proportion in – Hava you ever asked these questions? percent of the total number of unemployed persons to the total persons in the labor force. The answer is simple: unemployment, but its solution is difficult to achieve. – Unemployment rate in the Philippines for the past three years (2008-2010) is shown in Figure During the trying times of high inflation in the 12.2. 1970s, the late Senator Blas Ople who was then the Minister of Labor opened the labor market to the Labor Force – includes all persons 15 years old countries in the Middle East as a temporary solution and over as of their last birthday who contribute to to the ballooning unemployment in the Philippines. the production of goods and services in the country But more than three decades after, this country is whether employed or unemployed. still relying on other countries for help. Mathematically: – Unemployment represents sheer waste – the Philippine society loses the goods and services Labor Force = Employed + Unemployed which might have been produced by those out of work. The loss of this country is the gain of other countries as they progress with the help of the Filipinos who work for them. 4  However, not all persons who are 15 years because of temporary disturbance (weather, old and over can be considered part of the labor temporary shutdown for renovation of the plant or force. building). There are persons who are considered outside b. Structural unemployment. the labor force: – It occurs when the location and qualifications do not match the available jobs. For example, when – if they are neither employed nor unemployed, i.e., California Manufacturing Corporation moved its persons who are not working and are not available factories from Sucat to Laguna, hundreds or even a during the reference week, and persons who are not thousand workers were displaced because some available and are not looking for work because of the were unwilling to be relocated to its new location. reasons other than those previously mentioned – Changes in technology cause this type of (e.g., temporary illness/ disability, bad weather, unemployment. During the early 90s, the "in" thing etc.). Examples are was the pager. With the advent of the cellular phone, – housewives, a lot of pager operators were displaced caused by – full- time students, the advancement in technology in the – permanently disabled, telecommunication industry. – retired persons, – The skills may be also lacking in the labor force. In – seasonal workers, among others. the Philippines, the jobs that are available are in the agricultural sector, so the country needs more The Labor Force Participation Rate – The agriculturists and other skills related to this sector. percentage of the total number of persons in the Colleges and universities, however, produce more labor force to the total population of 15 years old and business graduates, nurses, and the like that are not over is called the labor force participation rate. related to agriculture. This results to structural unemployment. Mathematically: Labor Force c. Cyclical unemployment. Participation Rate = Total Number of persons in the Labor force x 100 – Unemployment caused by the recession phase of Total population of 15 yrs old and over the business cycle. It is caused by inadequate total spending. – As the overall demand for goods and services TYPES OF UNEMPLOYMENT decreases, unemployment rises. There are two types of unemployment, and 2. AVOIDABLE UNEMPLOYMENT. these are: – This refers to unemployment usually associated with insufficient demand for workers caused by 1. AVOIDABLE UNEMPLOYMENT many factors such as poor performance of the – There are three types of unavoidable economy. unemployment: a. Frictional unemployment. HOW MUCH IS FULL EMPLOYMENT? – It is a temporary unemployment associated with the changes in the economy. – Full employment does not mean that the – It happens for a number of reasons. unemployment rate is 0%. – Some new entrants into the labor force take time – Full employment is unavoidable unemployment or to find jobs, such as a new B.S. Economics graduate if cyclical unemployment is zero. taking a one-month vacation before hunting for a job. – The full employment rate of unemployment is – Some workers quit their current jobs to look for referred to as the natural rate of unemployment. something better. Still, some others are unemployed 5  UNDEREMPLOYMENT – When prices rise, producers are given the incentive to produce more, but buyers suffer, and There are persons who are already they will need more money (in nominal terms) to employed but they express the desire to have cope with higher prices. additional hours of work in their present job on in an – Even though there is inflation, it does not additional job, or to have a new job longer with necessarily mean that all commodities have higher longer working hours. Those persons are called prices; in some instances, the prices of some underemployed. commodities fall even if there is inflation. – What is difficult about inflation is that prices rise There are two classifications of underemployed unevenly. Some commodities rise, others decline persons: while others do not change at all. 1. Invisibly underemployed. Mathematically, it is expressed as follows: – A person is considered invisibly underemployed if the person already worked 40 hours during the reference week but still want additional hours of Inflation Rate = CPI current – CPI previous x 100 work, and CPI previous 2. Visibly underemployed. – A person is considered visibly underemployed if The above formula gives the percentage of the person worked less than 40 hours during the change in the CPI or consumer price index. reference week and wanted additional hours of work. It is used as an indicator of the change in the average price of a fixed standard basket of goods Okun’s Law and services commonly purchased by households This was developed by Arthur Okun who relative to a base year. This standard basket was a macroeconomist and served in the economic contains hundreds of consumption items whose council of President Lyndon Johnson. He developed price movements are monitored to determine the the relationship between GDP and unemployment. change in the CPI or the level of inflation. As a result of his findings, he concluded that for every 2-3% movement in GDP, unemployment The kind of inflation rate that the Bangko changes by 1% in both opposite directions. Central ng Pilipinas monitors under its inflation targeting approach is called the headline inflation INFLATION and not the core inflation: 1. Headline Inflation – is calculated as the To be the president of the Philippines, a change in the weighted overall average political should only promise on thing: to reduce the prices of all goods and services in the CPI price of rice. For politician to stay in the power, he basket. should keep the price of rice low. 2. Core Inflation – is an alternative measure of The standard of living and inflation has a high inflation that is calculated as the rate of correlation: when the prices of basic commodities change in the CPI that excludes the items are low, there is a higher standard and vice versa. that have transitory effects on the CPI. – While it is true that unemployment poses a greater problem than inflation because as we have mentioned earlier, unemployment represents sheer waste, in inflation, there are winners and losers, not taking away the fact that so much resentment is also tagged to it. 6 These items or commodity groups and their EFFECT OF INFLATION corresponding CPI weights are listed as follows: Inflation has an effect on the real income of – rice (9.4 percent) individuals in the economy. It may reduce the real – corn (0.9 percent) income (purchasing power) of an individual or – fruit and vegetables (5.3 percent) individuals but does not necessarily follow that it – LPG (1.3 percent) reduces the real income of the whole economy. – kerosene (0.3 percent) – oil, gasoline, and diesel (1.3 percent). Inflation results to redistributive effects, meaning, the effects of inflation are redistributed to The excluded items account for 18.4 percent of the different individuals, and as such, there will be CPI. The excluded items are subject to volatile price gainers and losers. The primary assumption of this movement and are also affected by supply-side redistributive effect is that inflation is unanticipated. factors and the price changes are not within the control of monetary policy. Loser and winner in inflation Therefore, core inflation is used to capture Losers during inflation are individuals who the permanent component if the inflationary process are hurt when prices are increasing. that can be influenced by monetary policy. The following are considered losers during CAUSES OF INFLATION unanticipated inflation: 1. Demand Pull Inflation - This inflation is 1. Fixed income earners (including pensioners). characterized by “too much spending chasing too few goods”. Pressures on – Laborers and office workers who are getting a fixed inflation are caused by relatively higher amount of money monthly cannot keep up with the demand compared to the available supply of high prices because their nominal income does not goods and services. Excess demand pulls rise with prices. Therefore, the real income of these the general price level. workers diminishes, and they feel the impact of 2. Supply Shocks to Inflation - These are inflation. pressures on inflation resulting from 2. Savers. shortages in supply and increases in the cost of production without a corresponding – The interest rate of savings deposits may not cover expansion in output. Example of these are the cost of inflation. If the amount of money that was bad weather, natural calamities and saved will be withdrawn during the time when the disasters, wage increases not matched by prices are high, that money will lose purchasing higher productivity of labor, hikes in power. international oil prices, increases in prices of imported raw materials, and hikes in rental 3. Creditors. rates. These tend to limit or decrease supply and, assuming no decline in demand for – Same with the situation being faced by savers, goods and services, push prices up. creditors are hurt because by the time they will Conversely, an oversupply of commodities receive the payment, the amount of goods and tends to induce the opposite effect on prices. services that can be bought by the sum of money 3. Profit-Push Inflation - These are pressures has less purchasing power during inflationary times. on inflation resulting to higher markups by They are somehow receiving "cheap" pesos. It businesses. happens whenever interest payments may be less than the inflation rate. Markup is the difference between the original price and the selling price. 7 4. Holders of securities. HYPERINFLATION Hyperinflation refers to a period of extremely – People who have investment in bonds and or high inflation reaching 100,000 and above. stocks lose during the time of inflation because the An example of this is the case of Germany value of their money invested in securities after World War I where the Deutschmark (currency depreciates in terms of purchasing power. of Germany) lost its value due to the increase in its circulation from 50 billion to 500 billion in just four Gainers during inflation are the groups of years. Because money was so plentiful, people individuals that are helped by unanticipated rushed to spend it because it was practically inflation: worthless. Inflation reached 116,000% in Bolivia in the early 80s, where a sack of money could only 1. Debtors. purchase a bag of grocery, or a bar of chocolate cost – They are paying back "cheap" pesos to their 50,000 Bolivian pesos. creditors that have less purchasing power. The cause of this hyperinflation is the planeload of printed money that arrived in that 2. Fixed Asset Owners. country from Germany and Britain every month. – Landowners gain during inflation as the value of PHILIPS CURVE land and other fixed assets appreciate To show the concept of Phillips curve, let us look at Figure 12.5 where the short-run 3. Producers. aggregate supply (AS) is constant, while aggregate demand (AD) is increasing from AD1 to – The income of producers increases when inflation AD3 The shift in AD from AD1 to AD2 increases takes place. As the price of commodities increases, national output from Q1 to Q2 but the short-run price business firms gain higher returns. level also increases from P1 to P2; this increase in output resulted to an increase in employment. We IS DEFLATION BETTER THAN INFLATION? can generalize this simple illustration, with AS constant, a high rate of inflation is accompanied by Deflation is a sustained decease in the a high rate of employment (or low unemployment) average price level. This is in sharp contrast to because output expands. inflation. – Is deflation good for the economy? No. If there is deflation in the economy, producers will lose and eventually will shut down their businesses, because a substantial decrease in price will adversely affect their incomes. – The obvious reaction they will take when losing profits is to cut down their labor cost. The effect will be higher unemployment, lower output, taxes, national output. – An inflation rate of 2-3% is good for both consumers and producers. It will give incentives for producers to produce, and at the same time a 2-3% increase in inflation is not burdensome to consumers ….. because it is very minimal. 8  TRADE-OFFS Inflation and unemployment have an existing short-run trade-offs, and there is policy implication on this. According to this concept, full employment cannot be attained without the existence of inflation. – As seen in figure 12.6, there is an inverse relationship between inflation and unemployment. – A low level of unemployment rate will accompany a high level of inflation rate; the inverse relationship connotes trade-offs between the two. – Policy makers are faced with dilemma in deciding which will be favored, because if they support policies reducing unemployment, they will be confronted with the problem of rising prices. – Or if policies will be geared towards the elimination of inflation, unemployment will suffer. In dealing with inflation and unemployment, aggregate demand is influenced, and the tools being used are fiscal policy and monetary policy. STAGFLATION can occur due to various factors, including: SUPPLY SHOCKS For example, a sudden increase in oil prices can raise production costs, leading to higher prices (inflation) while also slowing economic growth. POOR ECONOMIC POLICIES Inappropriate fiscal or monetary policies can contribute to inflation without stimulating economic growth. DECREASED PRODUCTIVITY When productivity declines, it can lead to higher costs for businesses, resulting in both inflation and stagnation. 9