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 problems of macroeconomics: the business cycle, 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. The chapter also discusses the major problems of a capitalist macroeconomy: inflation and unemployment.

One area that needs special attention is the discussion of the effects of inflation. It is especially important to emphasize that only relative price changes have macroeconomic impacts on output and that anticipated general price changes do not. Anticipated versus unanticipated inflation will come into play as the aggregate supply and demand model, so make certain to clearly define these concepts. It is also important to distinguish between real and nominal values.

Much of the analysis in macroeconomics is concerned with the problems outlined in this chapter. Hence, this material is key for understanding the theory and policy that are discussed later.

Key Term Review

business cycle
recession
depression
leading indicator
coincident indicator
lagging indicator
unemployment rate
discouraged workers
underemployment
potential real GDP
natural rate of unemployment
inflation
nominal interest rate
real interest rate
hyperinflation

Lecture Outline and Teaching Strategies

1. Business Cycles

1.a. Definitions: A business cycle is the recurrent pattern of rising real GDP followed by falling real GDP.

1.b. Historical record: There have been twelve 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.

1.c. 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.

2. Unemployment

2.a. 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.b. Interpreting the unemployment rate: The existence of underemployment and discouraged workers tends to make the unemployment rate an underestimation of true unemployment.

2.c. Types of unemployment: The four basic types are seasonal, frictional, structural, and cyclical.

2.d. Costs of unemployment: Economists measure the lost output of unemployment in terms of the GDP gap.

2.e. The record of unemployment: Women, teenagers, and nonwhites tend to have higher unemployment rates; Europe has a high unemployment rate, while Japan's is low.

3. 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.

3.a. 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.

3.b. 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.

3.c. Types of inflation: Economists often classify inflation in terms of demand pull and cost push.

3.d. The inflationary record: Inflation is a relatively new problem for the United States.

Teaching Strategy: Emphasize that the costs of inflation are in its re-distributional effects.