Business Cycles, Unemployment, and Inflation

Over the long run economies grow, but they do not grow smoothly. Periods of expansion give way to downturns in a recurring pattern, and these fluctuations bring two of the most closely watched problems in economics: unemployment and inflation. This chapter examines the business cycle and then takes each problem in turn.

The Business Cycle

The business cycle is the recurring pattern of expansion and contraction in economic activity around its long-run growth trend. A typical cycle has four phases:

1. Peak — Economic activity is at its highest; the economy is operating at or above capacity.
2. Recession (contraction) — Output and employment fall. A common rule of thumb defines a recession as two consecutive quarters of declining real GDP.
3. Trough — The low point of the cycle, after which recovery begins.
4. Expansion (recovery) — Output and employment rise again toward and past the previous peak.

Cycles are irregular in length and depth; no two are alike. Most economists attribute them primarily to changes in total spending. When spending falls unexpectedly, firms cut production and lay off workers; when it surges, production and prices rise. Industries producing durable goods and capital equipment tend to swing the most, while services and nondurables are more stable.

Unemployment

The unemployment rate is the percentage of the labor force that is not working but is actively seeking work. The labor force includes everyone who is either employed or actively looking; it excludes full-time students, retirees, and others not seeking work. A related measure, the labor force participation rate, tracks the share of the working-age population in the labor force.

Types of Unemployment

• Frictional unemployment is the short-term joblessness of people between jobs or entering the workforce. It is normal and even healthy, reflecting workers and employers searching for good matches.
• Structural unemployment arises when workers' skills or locations no longer match available jobs, often due to technological change or shifts in the industries an economy supports. It tends to last longer and may require retraining.
• Cyclical unemployment is caused by downturns in the business cycle — the unemployment that rises in recessions when spending and production fall.

Full Employment and Its Costs

Because some frictional and structural unemployment always exists, "full employment" does not mean zero unemployment. It means the absence of cyclical unemployment — the economy operating at its natural rate of unemployment. The cost of unemployment above this level is real: lost output that can never be recovered (sometimes summarized by Okun's law, which links the unemployment gap to lost GDP), along with the personal and social hardship that joblessness brings.

Inflation

Inflation is a sustained rise in the general price level. The most familiar gauge is the Consumer Price Index (CPI), which tracks the cost of a fixed market basket of goods and services bought by a typical urban household. The inflation rate is the percentage change in the CPI from one period to the next.

Causes of Inflation

• Demand-pull inflation occurs when total spending outruns the economy's capacity to produce — "too much money chasing too few goods." Prices are pulled up by excess demand.
• Cost-push inflation occurs when the costs of production rise — for example, a spike in oil prices — pushing firms to raise prices even without an increase in demand.

Why Inflation Matters

Inflation redistributes purchasing power in arbitrary ways. It hurts people on fixed incomes and lenders who are repaid in cheaper dollars, while it can benefit borrowers. Unanticipated inflation is especially damaging because it adds uncertainty that discourages saving, lending, and long-term planning. The flip side, deflation — a falling price level — can be even more dangerous, since expectations of further price declines lead people to delay spending, deepening downturns. For these reasons, most central banks aim for low and stable inflation rather than zero.

---

Next chapter: to explain why total spending fluctuates, we build up the behavioral relationships that govern consumption, saving, and investment.

Further Listening & Reading

• 🎥 Intro to Business Fluctuations (MRU) — the AD-AS view of the business cycle.
• 🎥 Frictional Unemployment and 🎥 Cyclical Unemployment (MRU) — two of the key unemployment types.
• 🎥 Measuring Inflation (MRU) — the CPI in practice.
• 🎧 Planet Money #664: The Great Inflation (NPR) — Paul Volcker's fight against inflation as a real-world case study.