Chapter 9

Business Cycles, Unemployment, and Inflation

LEARNING OBJECTIVES

L09.1 - Describe the phases of the business cycle.

L09.2 - Measure unemployment and explain the different types of unemployment.

L09.3 - Measure inflation and distinguish between cost-push inflation and demand-pull inflation.

L09.4 - Explain how unanticipated inflation can redistribute real income.

L09.5 - Describe how inflation may affect the economy's level of real output.

The Canadian economy has experienced remarkable economic growth over time. But this growth has not been smooth, steady, and predictable year to year. At various times Canada has experienced recessions, high unemployment, and high inflation. For example, during the Great Recession, unemployment in Canada rose over 400,000 workers from the third quarter of 2008 to the third quarter of 2009, and the unemployment rate increased from 6.1 percent to 8.7 percent.

In January 2020, the unemployment rate was down to 5.5 percent, the lowest rate in a generation. But only months later the onset of COVID-19 saw the unemployment rate skyrocket to a post-World War Il high of 13.7 percent. In May 2020, 2.6 million people were out of work, as against just over 1.1 million in January of the same year.

Other nations have also suffered high unemployment rates at times. For example, the Greek unemployment rate exceeded 25 percent in 2015, and Venezuela's inflation rate soared to 1.4 million percent in 2018!

In this chapter we examine the concepts, terminology, and facts relating to macroeconomic instability. Specifically, we discuss the business cycle, unemployment, and inflation.

The Business Cycle

L09.1 - Describe the phases of the business cycle.

In Canada, real GDP grows by about 3 percent per year, on average. So, the long-run trend is up, as shown by the upsloping line labelled "Growth Trend" in & Figure 9-1. There is, however, a lot of variation around the average growth trend. That's because the Canadian economy demonstrates a pattern of alternating rises and declines in the rate of economic activity.

Economists refer to this cyclical pattern as the business cycle. Individual cycles (one "up" followed by one "down") vary substantially in duration and intensity. So while each cycle has similar stages, no two are identical.

Phases of the Business Cycle

Figure 9-1 shows the four phases of a generalized business cycle.

• At a peak, such as the middle peak shown in L Figure 9-1, business activity has reached a temporary maximum. Here the economy is near or at full employment and the level of real output is at or very close to the economy's capacity. The price level is likely to rise during this phase.

• A recession is a period of decline in total output, income, and employment that lasts at least six months. Recessions generate widespread contraction of business activity in many sectors of the economy. Along with declines in real GDP, unemployment increases significantly.

• In the trough of the recession or depression, output and employment bottom out at their lowest levels. The trough Page 202 phase may be either short-lived or quite long.

• A recession is usually followed by a recovery and expansion, a period in which real GDP, income, and employment rise. At some point the economy again approaches full employment. If spending then expands more rapidly than does production capacity, prices of nearly all goods and services will rise, thereby generating inflation.

Although business cycles all pass through the same phases, they vary greatly in duration and intensity. That is why many economists prefer to talk of business fluctuations rather than cycles, because cycles imply regularity but fluctuations do not.

The Great Depression of the 1930s resulted in a 27.5 percent decline in real GDP over a three-year period in Canada and seriously impaired business activity for a decade. The deep recession caused by COVID-19 in 2020 resulted in a steep decline in GDP and a sudden rise in the unemployment level. By comparison, other recessions in the post-World War Il period, detailed in L Table 9-1, have been less severe in both intensity and duration.

Recessions occur in other countries, too. Nearly all industrial nations and many developing nations have suffered recessions in the past decade.

Causation: A First Glance

A key question in macroeconomics is why the economy experiences business cycle fluctuations rather than slow, smooth growth. In terms of Figure 9-1, why does output move up and down rather than just staying on the smooth trend line?

The most prominent theory is that business cycle fluctuations are the result of sticky prices interacting with economic shocks. As discussed in Chapter 6, economic shocks are events that unexpectedly shift demand or supply. If prices were fully flexible, markets could always adjust very quickly to unexpected shifts in demand or supply because market prices would rapidly adjust to equalize the quantities demanded and quantities supplied of every product in the economy. But the prices of many goods and services are, in fact, sticky (barely able to adjust) or stuck (completely unable to adjust) in the weeks and months after a shock occurs. As a result, the economy is forced to respond to shocks primarily through changes in output and employment rather than through changes in prices.

With these factors in mind, economists cite several sources for the demand and supply shocks that cause business cycles.

• Irregular Innovation Significant new products or production methods, such as those associated with the railroad, automobile, computer, and Internet, can rapidly spread through the economy, sparking sizable increases in investment, consumption, output, and employment.
  After the economy has largely absorbed the new innovation, the economy may for a time slow down or possibly decline. Because such innovations occur irregularly and unexpectedly, they may contribute to the variability of economic activity.

• Productivity Changes When productivity-output per unit of input-unexpectedly increases, the economy booms; when productivity unexpectedly decreases, the economy recedes. These changes in productivity can result from unexpected changes in resource availability (of, say, oil or agricultural commodities) or from unexpected changes in the general rate of technological advance.

• Monetary Factors Some economists see business cycles as purely monetary phenomena. When a nation's central bank shocks the economy by creating more money than people were expecting, an inflationary boom in output occurs. By contrast, printing less money than people were expecting triggers an output decline and, eventually, a decrease in the price level.

• Political Events Unexpected political events such as peace treaties, new wars, or terrorist attacks can create economic opportunities or strains. In adjusting to these shocks, the economy may experience upswings or downswings.

• Financial Instability Unexpected financial bubbles (rapid asset price increases) or bursts (abrupt asset price decreases) can spill over to the general economy and create economic booms and busts.

• Pandemics Not since 1918 had the world seen a severe health crisis such as that created by COVID-19 in 2020. The spread of the virus brought the world economy almost to a standstill, causing a severe recession in most economies around the globe.

The COVID-19 pandemic of 2020 caused the deepest recession in Canada since World War II. Parts of the world economy were less affected than others, but the impact on the GDP in most economies was large. The first wave of the pandemic began in March 2020, and subsided by the summer when most economies experienced a rise in GDP. But in the fall a second wave swept across Europe and South and North America, once again slowing their economies.

As for the recession of 2008-2009, it was precipitated by a combination of excessive money and a financial frenzy in the United States that led to overvalued real estate there and unsustainable mortgage debt. Institutions bundled this debt into new securities (derivatives), which were sold to financial investors all over the world. Some of the investors, in turn, bought insurance against losses that might arise from the securities. As real estate prices plummeted and mortgage defaults unexpectedly skyrocketed, the securitization and insurance structure buckled and nearly collapsed. Credit markets froze, pessimism prevailed, and spending by businesses and households declined. Canadian exports to the U.S. fell precipitously, which led to a severe slowdown in Canada.

Whatever the source of economic shocks, most economists agree that unexpected changes in the level of total spending cause the majority of cyclical fluctuations. If total spending unexpectedly sinks and firms cannot lower prices, firms sell fewer units of output (because with prices fixed, lower spending implies fewer items purchased). Slower sales cause firms to cut back on production. As they do, GDP falls.

And because fewer workers are needed to produce less output, employment also falls. The economy contracts and enters a recession.

By contrast, if the level of spending unexpectedly rises, then output, employment, and incomes rise. With prices sticky, the increased spending means that consumers buy more goods and services (because, with prices fixed, more spending means more items purchased).

Firms respond by increasing output, and thus GDP will also rise. And because firms will need to hire more workers to produce the larger volume of output, employment will also increase. The economy booms and enjoys an expansion. Eventually, as time passes and prices become more flexible, prices also rise due to increased spending.

Cyclical Impact: Durables and Nondurables

Although the business cycle is felt everywhere in the economy, it affects different segments in different ways and to different degrees.

Firms and industries producing capital goods (for example, housing, commercial buildings, heavy equipment, and farm implements) and consumer durables (for example, automobiles and refrigerators) are affected most by the business cycle. Within limits, firms can postpone the purchase of capital goods. When a recession strikes, firms patch up their old equipment and make do rather than replace the old equipment. As a result, investment in capital goods declines sharply. The pattern is much the same for consumer durables such as cars and refrigerators. When recession occurs and households must trim their budgets, they often defer their purchases of these goods. Families repair their old cars and appliances rather than buy new ones, and the firms producing these products suffer. (However, producers of capital goods and consumer durables also benefit most from expansions.)

In contrast, service industries and industries that produce nondurable consumer goods are somewhat insulated from the most severe effects of recession. People find it difficult to cut back on needed medical and legal services, for example. And a recession actually helps some service firms, such as pawnbrokers and law firms that specialize in bankruptcies. Nor are the purchases of many nondurable goods such as food and clothing easy to postpone. The quantity and quality of purchases of nondurables will decline, but not by as much as the quantity and quality of the capital goods and consumer durables that are purchased.

Quick Review 9.1

• The typical business cycle goes through four phases: peak, recession, trough, and expansion.

• Fluctuations in output and employment are caused by economic shocks combined with sticky prices.

• Sources of shocks that cause recessions include irregular innovation, productivity changes, monetary factors, political events, financial instability, and pandemics.

• During recessions, industries that produce capital goods and consumer durables normally suffer greater output and employment declines than industries that produce services and nondurable consumer goods.

Unemployment

L09.2 - Measure unemployment and explain the different types of unemployment.

Two problems arise over the course of the business cycle: unemployment and inflation. Let's look at unemployment first.

Measurement of Unemployment

Statistics Canada conducts a nationwide random survey of some 56,000 households each month to determine who is employed and who is not. It asks which members of the household are working, unemployed and looking for work, not looking for work, and so on. From the answers, it determines the nation's unemployment rate.

To measure the unemployment rate we must first determine who is eligible and available to work. I Figure 9-2 provides a helpful starting point. It divides the total Canadian population into three groups.

• Under 15 and/or institutionalized is composed of people under 15 years of age as well as people who are institutionalized, for example, in psychological hospitals or correctional institutions. These people are assumed to be unemployable either because of child labour laws or due to the circumstances that accompany institutionalization.

• Not in labour force is composed of noninstitutionalized people 15 years of age or older who are neither employed nor seeking work. They include stay-at-home parents, full-time students, and retirees.

• Employed consists of noninstitutionalized people age 15 and older who have jobs. These are people who both want to work and have a job.

• Unemployed consists of every noninstitutionalized person age 15 or older who is not employed but who wants to work and is actively seeking employment. (Please note that to be classified as unemployed, a person has to not only want a job but also be actively seeking employment. A person who claims to want a job but who isn't bothering to look for work is classified as "not in labour force.")

The labour force consists of the latter two groups-the employed plus the unemployed. The labour force includes anyone who has a job plus anyone lacking a job who is actively seeking employment.

The unemployment rate is the percentage of the labour force that is unemployed:

Unemployment rate = unemployed/labour force *100%

The statistics included in Figure 9-2 show that in January 2021 the unemployment rate averaged 1.9 million/22.1 million = 8.6 percent.

Despite the use of scientific sampling and interviewing techniques by Statistics Canada, the data collected are subject to the following criticism:

• Part-Time Employment Statistics Statistics Canada fails to distinguish between fully and partially employed workers. In January 2021, about 3.1 million people worked part-time. By counting them as fully employed, say critics, Statistics Canada understates the unemployment rate.

• Discouraged Workers An individual must be actively seeking employment to be counted as unemployed. An unemployed person who is not actively seeking work is classified as "not in the labour force." The problem is that many people, after unsuccessfully seeking employment for a time, become discouraged and drop out of the labour force. The number of such discouraged workers is larger during recession than during prosperity.

Types of Unemployment

There are four types of unemployment: frictional, structural, cyclical, and seasonal.

FRICTIONAL UNEMPLOYMENT

At any given time some workers are "between jobs." Some are moving voluntarily from one job to another. Others have been fired and are seeking re-employment. Still others have been laid off temporarily because of seasonal demand. In addition to those between jobs, many young workers are searching for their first job.

As these unemployed people find jobs or are called back from temporary layoffs, other job seekers and laid-off workers will replace them in the "unemployment pool." While the pool itself persists because there are always newly unemployed workers flowing into it, most workers do not stay in the pool for very long. Indeed, when the economy is strong, most unemployed workers find new jobs within a couple of months. We should be careful not to confuse the permanence of the pool itself with the false idea that the pool's membership is permanent, too. Nevertheless, there are workers who do remain unemployed and in the unemployment pool for many months or even several years.

Economists use the term frictional unemployment or search unemployment for workers who are unemployed as they actively search for a job.

The word frictional implies that the labour market does not operate perfectly and instantaneously (without friction) in matching workers and jobs.

Frictional unemployment is inevitable and, at least in part, desirable. Many workers who are voluntarily between jobs are moving from low-paying, low-productivity jobs to higher-paying, higher-productivity positions. Their new jobs mean greater income for the workers, a better allocation of labour resources, and a larger real GDP for the economy.

STRUCTURAL UNEMPLOYMENT

Frictional unemployment blurs into structural unemployment. Changes over time in consumer demand and in technology alter the "structure" of the total demand for labour, both occupationally and geographically.

Occupationally, the demand for certain skills (for example, sewing clothes or working on farms) may decline or even vanish. The demand for other skills (for example, designing software or maintaining computer systems) will intensify. Structural unemployment occurs because the composition of the labour force does not respond immediately or completely to the new structure of job opportunities. Workers whose skills and experience have become obsolete thus find that they have no marketable talents. They are structurally unemployed until they adapt or develop skills that employers want.

Geographically, the demand for labour also changes over time. For example, industry and thus employment opportunities have migrated from the Maritimes to central Canada over the past few decades. Another example is the offshoring of jobs that occurs when the demand for a particular type of labour shifts from domestic firms to foreign firms. As job opportunities shift from one place to another, some workers become structurally unemployed.

The distinction between frictional and structural unemployment is hazy. The key difference is that frictionally unemployed workers have marketable skills and either live in areas where jobs exist or are able to move to areas that have job opportunities. Structurally unemployed workers find it hard to find new jobs without retraining, gaining additional education, or relocating. Frictional unemployment is short-term; structural unemployment is more likely to be long-term and consequently more serious.

CYCLICAL UNEMPLOYMENT

Unemployment caused by a decline in total spending is called gyclical unemployment. It typically begins in the recession phase of the business cycle. As the demand for goods and services decreases, employment falls and unemployment rises. Cyclical unemployment results from insufficient demand for goods and services, and is exacerbated by the downward stickiness of wages in the economy, as discussed in the L Consider This box on downwardly sticky wages. The 20 percent unemployment rate in the depth of the Great Depression in 1933 reflected mainly cyclical unemployment. On the other hand, the COVID-19-induced deep recession of 2020 was caused by the lockdown of the economy to avoid hospitals being overwhelmed with patients suffering from the virus.

We will say more about the high costs of cyclical unemployment later; but first we need to define full employment.

SEASONAL UNEMPLOYMENT

Most parts of Canada have severe winters during which some sectors (for example, building construction and farming) can come to a virtual stop. These sectors experience seasonal unemployment, as many workers are temporarily laid off due to seasonal factors. Another example of seasonal unemployment is ski resort workers laid off during summer months.

Definition of Full Employment

Because frictional and structural unemployment are largely unavoidable in a dynamic economy, full employment is something less than 100 percent employment of the labour force. Economists say that the economy is "fully employed" when it is experiencing only frictional, structural, and seasonal unemployment. That is, full employment occurs when there is no cyclical unemployment.

Economists describe the unemployment rate that is consistent with full employment as the full-employment rate of unemployment, or the nat ural rate of unemployment (NRU). At the NRU, the economy is said to be producing its potential output, the real GDP that occurs when the labour force and other inputs are "fully employed."

Note that a fully employed economy does not mean zero unemployment. Even when the economy is fully employed, the NRU is some positive percentage because it takes time for frictionally unemployed job seekers to find jobs. Also, it takes time for the structurally unemployed to achieve the skills needed for reemployment.

"Natural" does not mean that the economy will always operate at the NRU and thus realize its potential output. When cyclical unemployment occurs, the economy has much more unemployment than that which would occur at the NRU. Moreover, the economy can operate for a while at an unemployment rate below the NRU. At times, the demand for labour may be so great that firms take a stronger initiative to hire and train the structurally unemployed. Also, some parents, teenagers, college and university students, and retirees who were casually looking for just the right part-time or full-time jobs may quickly find them. Thus the unemployment rate temporarily falls below the natural rate.

Also note that the NRU can vary over time as demographic factors, job-search methods, and public policies change. In the 1980s, the NRU was 7 to 8 percent. Today, it is estimated at 5 to 6 percent.

Economic Costs of Unemployment

High unemployment involves heavy economic and social costs.

GDP GAP

The basic economic cost of unemployment is forgone output. When the economy fails to create enough jobs for all who are able and willing to work, potential production of goods and services is irretrievably lost. Unemployment above the natural rate means that society is operating at some point inside its production possibilities curve. Economists call this sacrifice of output a GDP gap-the difference between actual and potential GDP. That is,

GDP gap = actual GDP - potential GDP

The GDP gap can be either negative or positive:

• When unemployment is above the natural rate of unemployment, the GDP gap will be negative (actual GDP < potential GDP) because only a smaller amount of output can be produced when employing a smaller amount of labour.

• By contrast, when unemployment is below the natural rate, the GDP gap will be positive (actual GDP > potential GDP) because the large quantity of labour being utilized allows the economy to produce more than the full-employment level of output.

To calculate potential GDP at any point in time, we need to estimate what the economy's output would be at the instant if the actual unemployment rate equalled the natural rate of unemployment. Figure 9-3 shows the GDP gap for recent years in Canada. Please note the close correlation between the actual unemployment rate (Figure 9-3b) and the GDP gap (Figure 9-3a). The higher the unemployment rate, the larger the GDP gap.

OKUN'S LAW

Arthur Okun was the first macroeconomist to quantify the inverse relationship between the unemployment rate and the GDP gap. He noticed that, on average,

GDP gap = -2.0 (actual unemployment rate - natural unemployment rate)

This relationship came to be known as Okun's law. With respect to recessions, it implies that for every 1 percentage point by which the actual unemployment rate exceeds the natural rate, a GDP gap of about negative 2.0 percent will occur.

By applying Okun's law, we can calculate the absolute loss of output associated with any above-natural unemployment rate. For example, in 2009 the average annual unemployment rate was 8.3 percent, or 1.8 percentage points above the 6.5 percent natural rate of unemployment.

Multiplying this 1.8 percent by Okun's 2 percent indicates that 2009's GDP gap was 3.6 percent of potential GDP (in real terms). By applying this 3.6 percent loss to 2009 potential GDP of $1360 billion, we find that the economy sacrificed $49 billion of real output.

As Figure 9-3 shows, sometimes the economy's actual output will exceed its potential GDP, or full-employment output. An unusually strong economic expansion in from 1997 to 2000, for example, caused actual GDP to exceed potential GDP, thereby generating a positive GDP gap. Note, though, that while actual GDP might exceed potential GDP for a time, positive GDP gaps create strong demand-pull inflationary pressures and cannot be sustained indefinitely.

UNEQUAL BURDENS

An increase in the unemployment rate, say from 6 to 9 or 10 percent, might be more tolerable to society if every worker's hours of work and wage income were reduced proportionately. But this is not the case. The burden of unemployment is unequally distributed. Some workers retain their hours and income, while others become unemployed and earn nothing.

Table 9-3 examines unemployment rates for various labour market groups for the unusual year of 2020, during which the COVID-19 pandemic caused the Canadian economy to go from full employment to recession in the space of a few months. In January 2020, the Canadian economy was at full employment, with an unemployment rate of 5.5 percent. In May of the same year, the unemployment rate skyrocketed to 13.7 percent, an unprecedented rise in such a short time period, and plunging the Canadian economy into a deep recession.

By observing the large variations in unemployment rates for the different groups within each year and comparing the rates between the two years, we can generalize as follows.

• Occupation Workers in lower-skilled occupations (for example, labourers) have higher unemployment rates than workers in higher-skilled occupations (for example, professionals). Lower-skilled workers have more and longer spells of structural unemployment than higher-skilled workers. They also are less likely to be self-employed than are higher-skilled workers. Manufacturing, construction, and mining workers tend to be particularly hard hit, but businesses usually retain most of their higher-skilled workers, in whom they have invested the expense of training.

• Age Teenagers have much higher unemployment rates than adults. Teenagers have lower skill levels, quit their jobs more frequently, are more frequently fired, and have less geographic mobility than adults. Many unemployed teenagers are new in the labour market, searching for their first job. Male Aboriginal teenagers, in particular, have very high unemployment rates. The unemployment for all teenagers rises during recessions.

• Gender The unemployment rates for women in the past few decades has been a little lower than for men. But in the the recession brought about by the COVID-19 pandemic, women's unemployment rate exceeded that for men.

• Education Less-educated workers, on average, have higher unemployment rates than workers with more education. Less education is usually associated with lower-skilled, less permanent jobs, more time between jobs, and jobs that are more vulnerable to cyclical layoff.

• Duration The number of persons unemployed for long periods-15 weeks or more-as a percentage of the labour force is much lower than the overall unemployment rate. But that percentage rises significantly during recessions. For example, the COVID-19 recession caused the long-term unemployment rate increase substantially in the fall of 2020. About a quarter of the unemployed had been out of work for more than 27 weeks

Noneconomic Costs of Unemployment

Policymakers are deeply concerned with unemployment rates and how to minimize the length and depth of business cycle downturns as a way of moderating the harm caused by unemployment. Their attention is warranted, because severe cyclical unemployment is more than an economic malady; it is a social catastrophe.

• At the individual level, research links high unemployment to increases in suicide, homicide, heart attacks, strokes, and mental illness. The unemployed lose skills and self-respect. Morale plummets and families disintegrate. Widespread joblessness increases poverty, reduces hope for material advancement, and heightens ethnic tensions.

• At the social level, severe unemployment can lead to rapid and sometimes violent political upheaval. Witness Adolf Hitler's ascent to power against a background of unemployment in Germany.

Regional Variations

The national unemployment rate in Canada does not reveal the significant diversity in regional unemployment. L Table 9-4 gives both the national unemployment rate and a provincial breakdown. In early 2021, the national rate was 9.4 percent, but rates went as high as 12.8 percent in Newfoundland and Labrador and as low as 7.2 percent in Saskatchewan.

Quick Review 9.2

• Unemployment is of four general types: frictional, structural, cyclical, and seasonal.

• The natural unemployment rate (frictional plus structural) is currently about 5 to 6 percent.

• Society loses real GDP when cyclical unemployment occurs: according to Okun's law, for each one percentage point of unemployment above the natural rate, the Canadian economy suffers a 2 percent shortfall in real GDP below its potential GDP.

• Lower-skilled workers, teenagers, and less-educated workers bear a disproportionate burden of unemployment

Inflation

LO9.3 - Measure inflation and distinguish between cost-push inflation and demand-pull inflation.

Inflation is a rise in the general level of prices. When inflation occurs, each dollar of income will buy fewer goods and services than before.

Inflation reduces the "purchasing power" of money. But inflation does not mean that all prices are rising. Even during periods of rapid inflation, some prices may be relatively constant and others may even fall. For example, although Canada experienced high rates of inflation in the 1970s and early 1980s, the prices of video recorders, digital watches, and personal computers declined.

Measurement of Inflation

The Consumer Price Index (CPI) is the main measure of inflation in Canada. The government uses this index to report inflation rates each month and each year. It also uses the CPI to adjust social security benefits and income tax brackets for inflation. The CPI reports the price of a "market basket" of about 700 consumer goods and services in 175 commodity classes that are purchased by a typical Canadian urban consumer.

The composition of the CPI market basket is based on spending patterns of Canadian consumers in a specific period, currently 2002.

Statistics Canada sets the CPI for 2002 equal to 100. So the CPI for any particular year is found as follows:

CPI =

Price of the 2002 basket in the particular year / Price of the same basket in the base year (2002) * 100%

The rate of inflation for a certain year (say 2019) is found by comparing, in percentage terms, that year's index with the index in the previous year. For example, the CPI was 137.2 in June 2020, up from 136.3 in June 2019. So the rate of inflation for the year between June 2019 and June 2020 is calculated as follows:

Rate of inflation = CPI of bigger year - CPI of lower year / CPI of lower year * 100%

EX: 137.2 (2020 CPI) - 136.3 (2019 CPI) / 136.3 (2019 CPI) * 100% = 0.7%

In rare cases, the CPI declines from one year to the next. For example, the CPI fell from 115.8 in July of 2008 to 114.7 in July of 2009. The rate of inflation for the period therefore was -0.9 percent. Such price level declines are called deflation.

In Chapter 8 we discussed the Rule of 70, which tells us that we can find the number of years it will take for some measure to double, assuming that it grows at a constant annual percentage rate. To do so, we divide the number 70 by the annual percentage growth rate.

Inflation is the growth rate of the price level. So, with a 3 percent annual rate of inflation, the price level will double in about 23 (= 70 ÷ 3) years. Inflation of 8 percent per year will double the price level in about 9 (= 70 ÷ 8) years.

Facts of Inflation

Figure 9-4 shows the December-to-December rates of annual inflation in Canada between 1960 and 2020. Observe that inflation reached double-digit rates in the 1970s and early 1980s, but has since declined and recently has been relatively mild.

Types of Inflation

Nearly all prices in an economy are set by supply and demand. So if the overall price level is rising, we need to look for an explanation in terms of supply and demand.

DEMAND-PULL INFLATION

Usually, increases in the price level are caused by an excess of total spending beyond the economy's capacity to produce. Where inflation is rapid and sustained, the cause is invariably an over-issuance of money by the central bank (the Bank of Canada). When resources are already fully employed, the business sector cannot respond to this excess demand by expanding output. The excess demand bids up the prices of the limited real output, producing demand-pull inflation. This type of inflation is "too much spending chasing too few goods."

COST-PUSH INFLATION

Inflation may also arise on the supply, or cost, side of the economy. During some periods in Canadian economic history, including the mid-1970s, the price level increased even though total spending was not excessive. In these periods, output and employment were both declining (evidence that total spending was not excessive) while the general price level was rising.

The theory of cost-push inflation explains rising prices in terms of factors that raise the per-unit production cost at each level of spending. Rising per-unit production cost squeezes profits and reduce the amount of output firms are willing to supply at the existing price level. As a result, the economy's supply of goods and services declines, and the price level rises.

Per-unit production cost = total input cost / units of output

In this scenario, costs are pushing the price level upward, whereas in demand-pull inflation demand is pulling it upward.

The major sources of cost-push inflation have been so-called supply shocks. Specifically, abrupt increases in the costs of raw materials or energy inputs have on occasion driven up per-unit production costs and thus product prices. The rocketing prices of imported oil in 1973-1974 and again in 1979-1980 are good illustrations. As energy prices surged upward during these periods, the costs of producing and transporting virtually every product in the economy rose. Cost-push inflation ensued.

Core Inflation

The inflation statistics calculated by Statistics Canada are supposed to reflect the general trend in overall prices. That general trend can be obscured, though, by the rapid up-and-down price movements typical of energy and food products like wheat, gasoline, corn, and natural gas.

To avoid anyone being misled by these rapid but temporary price changes, Statistics Canada calculates a measure of inflation called core inf lation that excludes food and energy items.

If core inflation is low and stable, policymakers may be satisfied with current policy even though changes in the overall CPI index may be suggesting a rising inflation rate. But they get greatly concerned when core inflation is high and rising, and take deliberate measures to try to halt it.

We discuss these policy actions in detail in later chapters, but at this point it is important to add that the Bank of Canada (Canada's central bank) has set a 2.0 percent inflation target since 1991, with the promise that it will adjust monetary policy as necessary to keep the Canadian inflation rate at or near 2.0 percent per year.

Quick Review 9.3

• Inflation is a rising general level of prices and is measured as the percentage change in a price index such as the Consumer Price Index (CPI).

• Demand-pull inflation occurs when total spending exceeds the economy's ability to provide goods and services at the existing price level; total spending pulls the price level upward.

• Cost-push inflation occurs when factors such as rapid increases in the prices of raw materials drive up per-unit production costs; higher costs push the price level upward.

• Core inflation is the underlying inflation rate after volatile food and energy prices have been removed

Redistribution Effects of Inflation

L09.4 - Explain how unanticipated inflation can redistribute real income.

Inflation redistributes real income, which helps some people, hurts others, and leaves yet others largely unaffected. Who gets hurt? Who benefits? Who is unaffected? Before we can answer, we need to discuss some terminology.

Nominal Income and Real Income

There is a difference between money (or nominal) income and real income. Nominal income is the number of dollars received as wages, rent, interest, or profits. Real income is a measure of the amount of goods and services nominal income can buy; it is the purchasing power of nominal income, or income adjusted for inflation, and it is calculated as follows:

Real Income = nominal income / price index * 100%

Inflation need not alter an economy's overall real income. It is evident from the above equation that real income will remain the same when nominal income rises at the same rate as the price index.

But when inflation occurs, not everyone's nominal income rises at the same pace as the price level. Therein lies the potential for redistribution of real income from some to others. If the change in the price level differs from the change in a person's nominal income,

their real income will be affected. The following approximation (shown by the = sign) tells us roughly how much real income will change:

Percentage change in real income =

Percentage change in nominal income - Percentage change in price

For example, suppose that the price level rises by 6 percent. If Bob's nominal income also rises by 6 percent, his real income will remain unchanged. But if his nominal income instead rises by 10 percent, his real income will increase by about 4 percent. If Bob's nominal income rises by only 2 percent, his real income will decline by about 4 percent.

EXPECTATIONS

The redistribution effects of inflation depend upon whether or not it is expected:

• We will first discuss situations involving unanticipated inflation, which causes real income and wealth to be redistributed, harming some and benefiting others.

• We will then discuss situations involving anticipated inflation, in which people see inflation coming. With the ability to plan ahead, people are able to avoid or lessen the redistribution effects of inflation.

Who Is Hurt by Inflation?

Unanticipated inflation hurts people with fixed incomes, savers, and creditors. It redistributes real income away from them and toward others.

Those with Fixed Incomes

People whose incomes are fixed see their real incomes fall when inflation occurs. The classic case is the elderly couple living on a private pension or annuity that provides a fixed amount of nominal income each month. They may have retired in, say, 1998 on what appeared to be an adequate pension. However, by 2020, they would have discovered that inflation had cut the annual purchasing power of that pension-their real income-by one-third.

Similarly, landlords who receive lease payments of fixed dollar amounts are hurt by inflation, as they receive dollars of declining value over time. Likewise, public-sector workers whose incomes are based on fixed pay schedules may see a decrease in their purchasing power. The fixed "steps" (the upward yearly increases) in their pay schedules may not keep up with inflation. Minimum-wage workers and families living on fixed welfare incomes are also hurt by inflation.

Savers

Unanticipated inflation hurts savers. As prices rise, the real value (purchasing power) of accumulated savings deteriorates. Paper assets such as savings accounts, insurance policies, and annuities that were once adequate to meet rainy-day contingencies or provide for a comfortable retirement decline in real value. The simplest case is the person who hoards cash. A $1000 cash balance lost one-third of its real value between 1995 and 2015. Of course, most forms of savings earn interest. But the value of savings will still decline if the inflation rate exceeds the interest rate.

Creditors

Unanticipated inflation harms creditors (lenders). Suppose the Manitoba Bank lends Bob $1000, to be repaid in two years. If in that time the price level doubles, the $1000 that Bob repays will possess only half the purchasing power of the $1000 he borrowed. As prices go up, the purchasing power of the dollar goes down. So the borrower pays back less-valuable dollars than those received from the lender. The owners of Manitoba Bank suffer a loss of real income.

Who Is Unaffected or Helped by Inflation?

Not everyone is hurt by unanticipated inflation.

Those with Flexible Incomes

People who have flexible incomes may escape inflation's harm or even benefit from it. For example, individuals who derive their incomes solely from social security are largely unaffected by inflation because payments are indexed to the CPI. Nominal benefits automatically increase when the CPI increases, thus preventing inflation from eroding their purchasing power. Some union workers also get automatic cos t-of-living adjustments (COLAs) in their pay when the CPI rises, although such increases rarely equal the full percentage rise in inflation.

In addition, some people with flexible income are helped by unanticipated inflation. The strong product demand and labour shortages implied by rapid demand-pull inflation may cause some nominal incomes to spurt ahead of the price level, thereby enhancing real incomes.

For some, the 3 percent increase in nominal income that occurs when inflation is 2 percent may become a 7 percent increase when inflation is 5 percent. As an example, property owners faced with an inflation-induced real estate boom may be able to boost rents by more than the inflation rate. Also, some business owners may benefit from inflation. If product prices rise faster than resource prices, business revenues will increase more rapidly than costs.

Debtors

Unanticipated inflation benefits debtors (borrowers). In our previous example, Manitoba Bank's loss of real income from inflation is Bob's gain of real income. Debtor Bob borrows "dear" dollars but, because of inflation, pays back the principal and interest with "cheap" dollars of which purchasing power has been eroded by inflation. Real income is redistributed away from the owners of Manitoba Bank toward borrowers such as Bob.

The federal government, which had amassed about $900 billion of public debt through 2020, has also benefited from inflation. Historically, the federal government regularly paid off its loans by taking out new ones. Inflation permitted the Treasury to pay off its loans with dollars of less purchasing power than the dollars originally borrowed. Nominal national income and therefore tax collections rise with inflation; the amount of public debt owed does not. Thus, inflation reduces the real burden of the public debt.

Anticipated Inflation

The redistribution effects of inflation are less severe or are eliminated altogether if people anticipate inflation and can adjust their nominal incomes to reflect the expected price-level rises. The prolonged inflation that began in the late 1960s prompted many labour unions in the 1970s to insist on labour contracts that provided cost-of-living adjustments.

Similarly, if inflation is anticipated, the redistribution of income from lender to borrower may be altered. Suppose a lender (perhaps a chartered bank or a credit union) and a borrower (a household) both agree that 5 percent is a fair rate of interest on a one-year loan provided the price level is constant. But assume that inflation has been occurring and is expected to be 6 percent over the next year. If the bank lends the household $100 at 5 percent interest, the borrower will pay the bank $105 at the end of the year. But if 6 percent inflation occurs during that year, the purchasing power of the $105 will have been reduced to about $99. The lender will in effect have paid the borrower $1 for the use of the lender's money for a year.

The lender can avoid this subsidy by charging an inflation premium-that is, by raising the interest rate by 6 percent, the amount of the anticipated inflation. By charging 11 percent, the lender will receive back $111 at the end of the year. Adjusted for the 6 percent inflation, that amount will have the same as $105 worth of today's money. The result will then be a mutually agreeable transfer of purchasing power from borrower to lender of $5, or 5 percent, for the use of $100 for one year.

Our example reveals the difference between the real rate of interest and the nominal rate of interest. The real interest rate is the percentage increase in purchasing power that the borrower pays the lender. In our example the real interest rate is 5 percent. The nominal interest rate is the percentage increase in money that the borrower pays the lender, including that resulting from the built-in expectation of inflation, if any. In equation form:

Nominal interest rate = real interest rate + inflation premium (expected rate of inflation)

Other Redistribution Issues

We end our discussion of the redistribution effects of inflation by making three final points.

• Deflation The effects of unanticipated deflation-declines in the price level-are the reverse of those of inflation. People with fixed nominal incomes will find their real incomes enhanced. Creditors will benefit at the expense of debtors. And savers will discover that the purchasing power of their savings has grown because of the falling prices.

• Mixed Effects A person who is simultaneously an income earner, a holder of financial assets, and a debtor will probably find that the redistribution impact of inflation is cushioned. If the person owns fixed-value monetary assets (savings accounts, bonds, and insurance policies), inflation will lessen their real value. But that same inflation may produce an increase in the person's nominal wage. Also, if the person holds a fixed-interest-rate mortgage, the real burden of that debt will decline. In short, many individuals are simultaneously hurt and benefited by inflation. All these effects must be considered before we can conclude that any particular person's net position is better or worse because of inflation.

• Arbitrariness The redistribution effects of inflation occur regardless of society's goals and values. Inflation lacks a social conscience and takes from some and gives to others, whether they are rich, poor, young, old, healthy, or infirm.

QUICK REVIEW 9.4

• Inflation harms those who receive relatively fixed nominal incomes and either leaves unaffected or helps those who receive flexible nominal incomes.

• Unanticipated inflation hurts savers and creditors while benefiting debtors.

• The nominal interest rate equals the real interest rate plus the inflation premium (the expected rate of inflation).

Does Inflation Affect Output?

L09.5 - Describe how inflation may affect the economy's level of real output.

Thus far, our discussion has focused on how inflation redistributes a given level of total real income. But inflation also may affect an economy's level of real output (and thus its level of real income).

Cost-Push Inflation and Real Output

Recall that abrupt and unexpected rises in key resource prices can drive up overall production costs sufficiently to cause cost-push inflation.

As prices rise, the quantity of goods and services demanded falls. Firms respond by producing less output, and unemployment goes up.

Economic events of the 1970s provide an example of how inflation can reduce real output. In late 1973 the Organization of Petroleum Exporting Countries (OPEC) managed to quadruple the price of oil by unexpectedly restricting supply. The resulting cost-push inflation generated rapid price-level increases in the 1973-1975 period. At the same time, the unemployment rate in Canada rose from slightly less than 6 percent in 1973 to 8.5 percent in 1977. Similar outcomes occurred in 1979-1982 in response to a second OPEC oil supply shock.

Like other forms of unexpected inflation, cost-push inflation redistributes income and output. But cost-push inflation is unique in that it reduces the overall quantity of real output that gets divided. Prices rose for everybody during the 1973-1975 period, but OPEC members experienced higher incomes while unemployed workers in oil-importing countries like Canada lost their incomes entirely.

Demand-Pull Inflation and Real Output

Economists do not fully agree on the effects of mild inflation (less than 3 percent) on real output.

The Case for Zero Inflation

Some economists believe that even low levels of inflation reduce real output, because inflation diverts time and effort toward activities designed to hedge against inflation. For example:

• Businesses must incur the cost of changing thousands of prices on their shelves and in their computers simply to reflect inflation.

• Households and businesses must spend time and effort obtaining the information they need to distinguish between real and nominal prices, wages, and interest rates.

These economists argue that without inflation, more time and effort would spent producing more valuable goods and services. Proponents of zero inflation bolster their case by pointing to cross-country studies indicating an association between lower rates of inflation and higher rates of economic growth. Even mild inflation, say these economists, is detrimental to economic growth

The Case for Mild Inflation

Other economists note that full employment and economic growth depend on strong levels of total spending.

• They argue that strong spending creates high profits, strong demand for labour, and a powerful incentive for firms to expand their plants and equipment. In this view, the mild inflation is a small price to pay for full employment and continued economic growth.

• A low but steady rate of inflation also makes it easier for firms to adjust real wages downward when the level of total spending declines.
  That is helpful to the overall economy because if real wages can be cut during a recession, firms can afford to hire more workers. To see why having some inflation matters, note that with mild inflation, firms can reduce real wages by holding nominal wages steady. That is a good strategy for firms because workers tend to focus on what happens to nominal, rather than real, wages. Their real wages will in fact be falling because of the inflation, but they will continue to work just as hard because their nominal wages remain unchanged. By contrast, if inflation were zero, the only way to reduce real wages would be by cutting nominal wages and thereby angering employees, who would likely retaliate by putting in less effort and agitating for higher pay.

The defenders of mild inflation argue that it is much better for an economy to err on the side of strong spending, full employment, economic growth, and mild inflation than on the side of weak spending, unemployment, recession, and deflation.

Hyperinflation

A hyperinflation occurs when a country's inflation rate exceeds 50 percent per month. Compounded over a year, that is equivalent to an annual rate of about 13,000 percent.

Adverse Effects

Unlike mild inflation, which has its fans, hyperinflation is roundly condemned by all economists because it has devastating impacts on real output and employment.

• As prices shoot up sharply during hyperinflation, normal economic relationships are disrupted. Business owners do not know what to charge for their products. Consumers do not know what to pay.

• Production declines because businesses, anticipating further price increases, find that it makes more financial sense to hoard (rather than use) materials, and to stockpile (rather than sell) finished products. Why sell today when the same product will fetch more money tomorrow?

• Investment also declines as savers refuse to extend loans to businesses, knowing that the loans will be repaid with rapidly depreciating money.

• Many people give up on money altogether and revert to barter, causing production and exchange to drop further as people spend literally hours every day trading and bartering instead of working and producing.

• The net result is economic collapse and, often, political chaos.

Examples

Examples of hyperinflation are Germany after World War I and Japan after World War II. In Germany, "prices increased so rapidly that waiters changed the prices on the menu several times during the course of a lunch. Sometimes customers had to pay double the price listed on the menu when they ordered."' In postwar Japan in 1947, "fisherman and farmers... used scales to weigh currency and change, rather than bothering to count it."?

Causation

Hyperinflations are always caused by governments, through their central banks, instituting highly imprudent expansions of the money supply. The rocketing money supply produces frenzied total spending and severe demand-pull inflation. Zimbabwe's 14.9 billion percent inflation rate in 2008 is just the worst recent example. Venezuela in 2018 and several dozen other countries over the past century have caused inflation rates of 1 million percent per year or more.

Motivation

Because hyperinflation causes so much harm, you might be asking why governments are sometimes willing to engage in the reckless money printing that invariably generates hyperinflation. The answer is that governments sometimes find themselves in a situation in which they cannot obtain enough revenue through either taxation or borrowing to cover the government's desired level of spending.

This is often the case during or immediately after a war, when government expenses skyrocket but tax revenues stagnate or even decline due to a depressed wartime or postwar economy. Unwilling or unable to slash spending down to a level that could be paid for by taxes plus borrowing, the government resorts to the printing press and prints up whatever amount of money is needed to cover its funding gap. The by-product is hyperinflation. The government maintains its rate of spending, but crashes the economy as a side effect.

Termination

Hyperinflations end when governments cut their spending down to or below the amount of revenue that they can obtain through taxes and borrowing. Because the collateral damage is so great, most bouts of hyperinflation last 12 months or less. On the other hand, Greece in the 1940s and Nicaragua in the late 1980s each experienced over four years of continuous hyperinflation.

QUICK REVIEW 9.5

• Cost-push inflation reduces real output and employment.

• Economists argue about the effects of demand-pull inflation. Some argue that even mild demand-pull inflation (1 to 3 percent) reduces the economy's real output. Other say that mild inflation may be a necessary by-product of the high and growing spending that produces high levels of output, full employment, and economic growth.

• Hyperinflation, caused by highly imprudent expansions of the money supply, may undermine the monetary system and cause severe declines in real output.

Chapter Summary

L09.1 Describe the phases of the business cycle.

• Canada and other industrial economies have gone through periods of fluctuations in real GDP, employment, and price level.
  Although they have certain phases in common-peak, recession, trough, expansion-business cycles vary greatly in duration and intensity.

• Although economists explain the business cycle in terms of underlying causal factors such as major innovations, productivity shocks, money creation, financial crises, and pandemics, they generally agree that the level of total spending is the immediate determinant of real output and employment.

• The business cycle affects all sectors of the economy, though in varying ways and degrees. The cycle has greater effects on output and employment in the capital goods and durable consumer goods industries than in the services and nondurable goods industries.

L09.2 Measure unemployment and explain the different types of unemployment.

• Economists distinguish among frictional, structural, cyclical, and seasonal unemployment. The full-employment or natural rate of unemployment, which is made up of frictional and structural unemployment, is currently 5 to 6 percent. The presence of part-time and discouraged workers makes it difficult to measure unemployment accurately.

• The GDP gap, which can be either a positive or a negative value, is found by subtracting potential GDP from actual GDP. The economic cost of unemployment, as measured by the GDP gap, consists of the goods and services forgone by society when its resources are involuntarily idle. Okun's law suggests that every increase in unemployment by 1 percent above the natural rate causes an additional 2 percent negative GDP gap.

L09.3 Measure inflation and distinguish between cost-push inflation and demand-pull inflation.

• Inflation is a rise in the general price level and is measured in Canada by the Consumer Price Index (CPI). When inflation occurs, each dollar of income will buy fewer goods and services than before. That is, inflation reduces the purchasing power of money. Deflation is a decline in the general price level.

• Economists identify both demand-pull and cost-push (supply-side) inflation. Demand-pull inflation results from an excess of total spending relative to the economy's capacity to produce. The main source of cost-push inflation is abrupt and rapid increases in the prices of key resources. These supply shocks push up per-unit production costs and ultimately the prices of consumer goods.

L09.4 Explain how unanticipated inflation can redistribute real income.

• Unanticipated inflation arbitrarily redistributes real income at the expense of people with a fixed income, creditors, and savers. If inflation is anticipated, individuals and businesses may be able to take steps to lessen or eliminate adverse redistribution effects.

• When inflation is anticipated, lenders add an inflation premium to the interest rate charged on loans. The nominal interest rate thus reflects the real interest rate plus the inflation premium (the expected rate of inflation).

L09.5 Describe how inflation may affect the economy's level of real output.

• Cost-push inflation reduces real output and employment. Proponents of zero inflation argue that even mild demand-pull inflation (1 to 3 percent) reduces the economy's real output. Other economists say that mild inflation may be a necessary byproduct of the high and growing spending that produces high levels of output, full employment, and economic growth. A mild inflation also makes it easier for firms to adjust real wages downward when the the level of total spending declines.
  They can do so by keeping nominal wages fixed while inflation reduces the purchasing power of every dollar received by employees.

• Hyperinflation, caused by highly imprudent expansions of the money supply, may undermine the monetary system and cause severe declines in real output.