Fundamentals of Economics 6th Edition Boyes Solutions Manual

CHAPTER 11
Unemployment, Inflation, and Business Cycles
FUNDAMENTAL QUESTIONS
1. What is a business cycle?
2. How is the unemployment rate defined and measured?
3. What is the cost of unemployed resources?
4. What is inflation?
5. Why is inflation a problem?
TEACHING OBJECTIVES
The primary purpose of this chapter is to present the three major macroeconomic problems countries
encounter: business cycles, unemployment, and inflation.
The unique features of this chapter include the discussion of the GDP gap and an introduction to the
basic justification for macroeconomic policy.
One area that needs special attention is the discussion of the effects of inflation. It is especially
important to emphasize that only unanticipated price changes have macroeconomic impacts on output
and that anticipated general price changes have far fewer effects. Anticipated versus unanticipated
inflation will come into play in the aggregate supply and demand model. It is also important to
distinguish between real and nominal values.
KEY TERMS
business cycle
recession
depression
leading indicator
coincident indicator
lagging indicator
unemployment rate
discouraged workers
underemployment
potential real GDP
natural rate of unemployment
inflation
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publicly accessible website, in whole or in part.
Chapter 11: Unemployment, Inflation, and Business Cycles 81
nominal interest rate

real interest rate
demand-pull inflation
cost-push inflation
hyperinflation
LECTURE OUTLINE AND TEACHING STRATEGIES
1. What is a business cycle?

1. Definitions: A business cycle is the recurrent pattern of rising real GDP followed by falling real
GDP.
2. Historical record: There have been 12 recessions since 1929.
Teaching Strategy: Students are often interested in why business cycles occur. This is a good
opportunity to show that economists are not always in agreement about important issues. Contrast
the Keynesian view that business cycles are caused by variations in aggregate demand with the
view of Schumpeter that business cycles are natural and necessary for “creative destruction”
within the economic system.
3. Indicators: Those variables that move over the business cycle include leading indicators, which
are useful for forecasting; coincident indicators, which are more immediately available than the
GDP; and lagging indicators, which can help identify peaks and troughs in the cycle.
Teaching Strategy: Have your students look up the index of leading indicators and plot the data
for last year. Then help them to interpret the data and make a forecast for the U.S. economy.
Have students ask their employers how they anticipate changes in their markets. What are their
leading indicators?
2. How is the unemployment rate defined and measured?

1. Definition and measurement: The unemployment rate is the percentage of the labor force that is
not working.
Teaching Strategy: Place special emphasis on who is not counted in the labor force.
2. Interpreting the unemployment rate: The existence of underemployment and discouraged workers
tends to make the unemployment rate an underestimation of true unemployment.
Teaching Strategy: Ask if anyone knows the unemployment rate in France, Germany, or Italy.
If you have a European student, ask if they know anything about unemployment benefits in most
European countries (much more generous than the United States and lasting for a year or more.)
Could this explain why there is a higher rate in European countries?
3. The four basic types of unemployment are seasonal, frictional, structural, and cyclical.
3. What is the cost of unemployed resources?

4. The costs of unemployment are measured by economists as the lost output of unemployment in
terms of the GDP gap.
82 Chapter 11: Unemployment, Inflation, and Business Cycles
Teaching Strategy: To emphasize the costs of unemployment ask the students if they have a
family member, friend or neighbor who has experienced a spell of unemployment. Ask if they
know what it was like for them or their family.
5. The record of unemployment: Teenagers and nonwhites tend to have higher unemployment rates;
Europe has a high unemployment rate, while Japan’s is low.
4. What is inflation?
Inflation is a sustained rise in the average level of prices.
Teaching Strategy: Note that for price increases to be inflationary, they must persist over time.
1. Absolute versus relative price changes
Teaching Strategy: Pay special attention to the material on relative versus absolute price
changes. If students understand that incentives change only when relative prices change, they will
find the concept of the long-run Phillips curve and the long-run aggregate supply curve easier to
understand.
5. Why is inflation a problem?

2. Effects of inflation (expected versus unexpected inflation)
Teaching Strategy: Show what the equivalent of $3,000 a month today would be 40 years from
now (when the students retire) if the average annual rate of inflation over the next 40 years is 3
percent. Then show what it would be if the average rate of annual rate of inflation is 4 percent.
Teaching Strategy: Be sure to emphasize the distinction between nominal and real interest rates,
using an example in class.
3. Types of inflation: Economists often classify inflation in terms of demand-pull and cost-push.
4. The inflationary record: Inflation is a relatively new problem for the United States.
Teaching Strategy: Emphasize redistributional effects of inflation.
OPPORTUNITIES FOR DISCUSSION

1. Why do economists and policymakers care about the business cycle?
2. Why and how do economists and policymakers use cyclical indicators?
3. What would our economy be like if unemployment were zero?
4. What would our economy be like if inflation were reduced to a zero rate?
5. What are the social costs of unemployment?
6. Present a graph that shows both inflation and unemployment over the past 30 years. Ask the
students to point out the various events that caused these two series to fluctuate over time.
ANSWERS TO EXERCISES
1. The labor force is the sum of all adults (persons older than 16 years of age) who are employed or
unemployed but are currently seeking work minus those who are in institutions.
The second part of this question can be answered in two mutually exclusive ways. First, the
definition of the labor force is a good one because it allows only those individuals who are
actually working or are willing to work to be counted in the labor force. Second, the definition of
the labor force does not fully reflect the available labor resources because people who are
discouraged workers are not counted in the labor force. Furthermore, when workers would like to
work full-time but are working part-time instead, they are in the labor force, but the labor
resources they represent are undercounted.
2.
a. You are not officially unemployed because you are not willing to work.
b. You are not discouraged because you know you could find a job if you looked for one. In
official terms, you are not in the labor force.
3. No. The personal and social costs of unemployment are not measured by the GDP gap.
4. Teenagers have the highest unemployment rate because they typically have the fewest marketable
skills.
5. The real interest rate is the nominal interest rate (the rate that is quoted by the bank) less the rate
of inflation that is expected over the term of the loan. When the inflation rate is unexpectedly
high, lenders will make loans with nominal interest rates that are too low to compensate them for
inflation and provide them with the real return that they expect. Debtors pay a lower than expected
real interest rate on the money that they borrow. In this way unexpectedly high inflation
redistributes income away from creditors and toward debtors.
6. The standard fixed-interest-rate mortgage commits a mortgage company to a fixed interest rate for
30 years. If the inflation rate turns out to be unexpectedly high, the mortgage company will end up
with a lower real interest rate on the mortgage than expected when the loan was made. By
allowing the interest rate to vary annually, the interest rate can be adjusted to changing economic
conditions so that unexpected inflation will result in an increased interest rate.
7. Although the actual pattern of the business cycle is not as regular as is shown in Figure 11.2, the
economy is subject to recurrent periods of expansion and contraction.
8.
a. 460
b. 2.2 percent
9.
a. 100 percent
b. Relative prices were unchanged.
10.
a.
S2
S1
P2
Price
P1
D1
Quantity
b.
P2
Price
P1
D2
D1
Quantity
11. Nominal interest rates cannot be negative because it would mean people would be paying for others
to take their money.
ACTIVE LEARNING EXERCISE

This exercise will explore the definition and measurement of the unemployment rate through the use of
role-playing. Beyond testing the actual calculation of the unemployment rate, students will explore the
composition of the labor force and define those persons who are statistically unemployed. Be sure to
incorporate the interpretation of the unemployment rate by discussing discouraged and underemployed
individuals. The exercise can also be used to discuss the types of unemployment.
Divide the class into groups of four. Each group is a separate economy. In each group students count
off from one to four and play roles in the following scenarios. Each group should determine the
unemployment rate for each four-person economy in each scenario. (Hint: First determine the size of
the labor force and then determine the unemployment rate.)
Scenario A
1. Full-time worker
2. Full-time student
3. Laid-off worker searching for a new job
4. Full-time worker whose job picking fruit will end in one month
Answer: 33 percent
Scenario B
5. Housewife or househusband
6. Recent graduate looking for a job
7. Someone neither working nor looking for work (stays home and watches TV)
8. Full-time worker
Answer: 50 percent
Scenario C
9. Retired worker
10. Full-time worker

11. Prisoner
12. Full-time worker
Answer: 0 percent
Note: Students may argue that some of these should be counted in the labor force because they are
actively seeking work. Where their arguments are convincing, you may alter the solutions. Use this
discrepancy to point out that the definition of those not actively seeking work is difficult to identify and
accurately measure.

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CHAPTER 11

Unemployment, Inflation, and Business Cycles

nominal interest rate

LECTURE OUTLINE AND TEACHING STRATEGIES

1. What is a business cycle?

2. How is the unemployment rate defined and measured?

3. What is the cost of unemployed resources?

5. Why is inflation a problem?

OPPORTUNITIES FOR DISCUSSION

ACTIVE LEARNING EXERCISE

10. Full-time worker

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