econos

1. Chapter- 2 part II
BUSINESS CYCLE
 One of the major concerns of macroeconomics is the upswing
and downswings in the level of real output.
 Such upswings and downswings are conceptualized using the
business cycle whose discussion is of great importance to know
the position of an economy in the business cycle and forward
the appropriate policy packages.
 The business cycle can be defined as a more or less regular
pattern of path fluctuating with the level of economic activity
of an economy around the trend path.
 It shows alternating periods of economic growth and
contraction, which can be measured by the changes in real
Gross Domestic Product (RGDP).

2. • Business cycles are recurring periods of
recession and prosperity which are
widespread throughout a nation and which
feed upon themselves.
• The trend path is given by straight-line that
shows the movement of the economy if it is
in full employment.

3. Phases of the Business Cycle
• The business cycle has four different phases. These phases are stages
through which an economy passes to complete one full cycle. Namely,
these phases of the business cycle are Peak (Boom), Contraction
(Recession), Trough (Bottom) and Expansion (Recovery). Once
completed, these phases repeat themselves.
• That means, the sequence of changes in the business cycle is recurrent
but not periodic and varies in duration.
• The duration depends on factors like good or bad economic policies and
favourable or unfavourable natural conditions.
• However, the different phases come one after another in the same
sequence in all cycles.

5. 1. Recession or contraction is a period of reduced economic
activity in which levels of buying, selling, production, and
employment typically diminish.
• This is the most unwelcome stage of the business cycle for
business owners and consumers alike.
• During recession prices also decline as unemployment
starts to increase.
• In this period, prices tend to decrease.
• A particularly severe recession is known as a depression.

6. 2.Trough is where the output and employment
‘bottom out’ at their lowest level.
• During this time, there is an excess amount of
unemployment and idle productive capacity,
businesses are more likely to fail because of low
demand for their product, unemployment is high
and output is low.
•

7. 3. Expansion or recovery follows the opposite
factors like good economic policies or favourable
natural factors.
• Expansion or recovery is the period when the
economy’s level of output and employment
expand towards full employment.
• In this period, the employment of factors of
production increases and that is the source of
increased production.

8. 4. peak, economic activities reach their maximum
after rising during a recovery.
• Peak is the highest point between the end of an
economic expansion and the start of a contraction in
a business cycle.
• During Peak period, Real GDP and Spending is at
its highest level, higher investment in the economy,
Very high employment of resources and Inflation is
usually present.

9. • Trend path is the level corresponding to full
employment of the factors of production. Actual
output fluctuates around the trend level.
• During expansion the employment of factors of
production increases, and that is a source of increased
production.
• Conversely, during recession, unemployment
increases and the output produced is below its
capacity. Deviation of output from trend is known as
output gap.
• The output gap measures the gap between the output
the economy could produce at full employment (trend
line) given the existing resources and actual output
(cyclical line).

10. UNEMPLOYMENT
• Unemployment is the labor force seeking
employment and unable to find it.
• The cost of unemployment can be measured by
the deficiency in the potential output of a nation:
both foregone production, income and
consumption of needed goods.
• Unemployment: refers to idle resources not
utilized in the production process.

11. • Mostly, economists emphasize on the
unemployment of labor than other resources
due to:
Most individuals earn income from employment
in any nation and hence highly related with
living standard.
 Labor is a combining factor in the production
process and its unemployment implies the
unemployment of other resources.
• Unemployment is said to exist when there are
people who are part of the labor force, willing
and able to work but couldn't find one at the
current market wage rate.

12. • Unemployment rate is defined as the percentage or the proportion of the
labour force that is unemployed.
• Labour force (L) is the sum of both employed (E) and unemployed people of
working age and working or ready to work (U). This can be given by the following
equation:
𝐿 = 𝐸 + 𝑈 −−−−−−−−−−−−−−−−−−−− − (1)
• Labour force participation is the percentage of adult or working age
population who are in the labour force.
• These two concepts are summarized by the following equations:
• 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝐿𝑎𝑏𝑜𝑢𝑟 𝐹𝑜𝑟𝑐𝑒
𝑥 100
• 𝐿𝑎𝑏𝑜𝑢𝑟 𝐹𝑜𝑟𝑐𝑒 𝑃𝑎𝑟𝑐𝑖𝑝𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 =
𝐿𝑎𝑏𝑜𝑢𝑟 𝐹𝑜𝑟𝑐𝑒
𝐴𝑑𝑢𝑙𝑡 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
𝑥 100

13. Types of Unemployment
• Depending on the causes or sources of the
unemployment and the duration of the unemployment,
we can divide unemployment into different categories.
• In this respect, economists divide unemployment into
three or four major categories. These are:
• Frictional unemployment
• Structural unemployment
• Cyclical unemployment and/or

14. 1. FRICTIONAL UNEMPLOYMENT
• Frictional unemployment represents the
employees switching jobs for more productive
and higher paying positions.
• Such labor mobility is desirable since it assures
that the labor force is more efficiently utilized
and income is enhanced.
• it is the unemployment caused by the time it
takes workers to search for a new job or
switching between jobs.
• People who are in transitions „between jobs‟

15.  Frictional unemployment occurs due to two reasons:
• The first reason is when employers are not aware of the
available workers and their job qualifications.
• The second reason is when workers are not fully aware of the
jobs being offered.
Thus, basic cause of frictional employment is thus lack of
information flow among workers and employers called imperfect
information.
 So for workers this is the period of unemployment until they
get a job and the duration of unemployment is equal to the time
it takes workers to search for a job.
 New graduating students from colleges and universities or
training institutions are usually frictionally unemployed.
 This is the period when such people look for vacancies and
apply to different offices getting interviewed and so on.

16. The main characteristics of frictional
unemployment are that:
• It affects large number and wide range of
people.
• It tends to be of short period.
• Certain amount of frictional unemployment is
unavoidable.

17. • One of the policy options to solve such unemployment is
improving labour market information (e.g. establishment of
information office about workers and vacancies).
• Note that in trying to reduce frictional unemployment, some
policies inadvertently increase the amount of frictional
unemployment.
• One example of such policy is unemployment insurance. In this
case, people will be reluctant in looking for job as soon as
possible since they can collect some money because of their
unemployment and prefer to stay for certain period after
unemployment.

18. 2. STRUCTURAL UNEMPLOYMENT
• Structural unemployment is due to changes is
various sectors of the economy.
• These continuous changing conditions in different
industries are due to changes in tastes of
consumers and are part of any changing society.
• Structural unemployment occurs due to the
structural changes in the economy.
• These changes eliminate some jobs while they
create some new jobs for people with new skill
level.
• The skill sets take time to develop and hence
some people lose their job simply because they
do not have the new required skill(s).

19. • While structural unemployment can be reduced by
retraining, for most part it is desirable since it is a
reflection of a society seeking improvements in its
products.
• This problem arises from a mismatch between demand
in the labor market and the skills and locations of the
workers seeking employment.
• This problem arises from mismatch between the types
of jobs that are available and type of job seekers. Such
mismatch may be related to skill, experience, education
level, geographical area, age, etc.
• For instance, some skills may no longer be demanded.
For instance, typing machines are replaced by
computers. In this case type writers who do not have
computer skill would lose their job and potentially
become unemployed.

20. Some of the characteristics of this type of
unemployment are that:
• It tends to be concentrated among certain
group of people who are adversely affected by
technological change.
• It tends to be long lasting (e.g. it takes time to
the victims until they train themselves under
new situation or new technology).
• In this respect one of the policy options used to
reduce such unemployment is training workers
and improving labour mobility.

21. 3. CYCLICAL UNEMPLOYMENT
• Cyclical unemployment: occurs due to general
downturn in the business activities including
production and demand for the products and
services.
• Cyclical unemployment is attributable solely to
a deficiency in the level of economic activity.
• This form of unemployment is the most
undesirable because it is avoidable.

22. • Cyclical unemployment is also known as
demand deficient unemployment.
• Cyclical unemployment is the result of
insufficient aggregate demand in the
economy to generate enough jobs for those
seeking them. It occurs during cyclical
contraction of an economy (recession).
• The policy instrument to solve this problem is
fiscal policy (for instance increasing
government expenditure and reducing tax
rates) and/or monetary policy (such as
reducing interest rate and increasing money
supply).

23. 4. NATURAL RATE OF UNEMPLOYMENT
• The natural rate of unemployment
corresponds to the combination of frictional
and structural unemployment which cannot
be avoided even in a very high level of
economic activity.

24. INFLATION
• Inflation is a widespread pattern of price
increases.
• Inflation is a rise in the general level of prices of
goods and services in an economy over a period
of time.
• The rate of inflation is equal to the rate of
change in a price index such as the consumer
price index (CPI).
• Historically, inflation has been considered
serious when it has approached or exceeded
10% per year.

25. DEFLATION
• Deflation is a widespread pattern of price
decreases.
• Historically, deflation is less common that
inflation, but it is also more feared because the
loss of revenues of a large number of firms
may result in widespread bankruptcies and
decrease in economic activity

26. • During inflationary periods, the purchasing power of
money decreases. Deflation is the opposite of
inflation.
• One can measure inflation using either the consumer
price index (CPI) or GDP deflator.
• CPI is constructed by using the prices of consumer
goods.
• GDP deflator = Nominal GDP X 100
Real GDP
• In Ethiopia, the inflation rate is calculated by using
the consumer price index.
πt = CPt-CPt-1 X 100
CPt-1

27. Where πt is the inflation rate in period t.
• Both inflation and deflation are bad for the
economy because of the uncertainty they
create and that negatively affect investment
and hence production.
• Most empirical studies show a higher rate of
inflation is highly correlated with lower or
negative economic growth.
• Some levels of inflation could be good for the
economy since it could serve as an incentive
for investors, but it must be predictable.

28. Some definitions
• Deflation: a fall in general price level
• Stagflation: a combination of inflation and poor
economic growth.
• Disinflation: the reduction of the rate of inflation.
Creeping inflation: small and gradual rises in
prices overtime.
Hyperinflation: large and accelerating prices
rises (>50% )...a very high inflation rate
Types of inflation
• Based on its cause, iflation can be of three types

29. DEMAND-PULL INFLATION
• it is type of inflation which caused by the
existence of high demand for goods and service
compared to its supply.
• One of the possible explanations of inflation is
that it is caused by excessive demand on the
part of consumers while firms are unable to
expand output beyond their productive
capacity. This is referred to as demand pull
inflation

30. 2. COST-PUSH INFLATION
• Cost pulls inflation; is inflation caused by supply
shock and it is sometimes called supply shock
inflation.
• Such type of inflation is caused by increase in the
prices of important raw materials. Ex. Oil
• A common cause of increases in prices are
increases in costs.
• For instance, demands by unions for higher
wages have been labeled as wage push inflation.
• At other times, increases in commodity prices
were attributable for inflation,

31. 3. Built‐in Inflation: results from past events and
persists in the present.
It is related to inflationary expectation and
price‐wage spiral.
Expectation-induced-inflation…if prices or costs of
production are expected to rise…. May cause demand
and supply to rise in advance.
 example, _if the consumers expecting goods to be
more expensive in the future , may buy more now
rather than delay their spending.

32.  if workers expect prices to rise, they
demand higher wage to retain the real
value of their wages.
_if the firms expect inflation then they
are likely to respond by building in
inflationary expectations in to their
price planning and
_government may anticipate higher cost
of running public services and raises
taxes in advance.

33. Effects of Inflation
• Negative effects of inflation includes
• an increase in the opportunity cost of holding money,
• uncertainty over future inflation which may discourage
investment and savings, and
• Shortages of goods as consumers begin hoarding out of
concern that prices will increase in the future.
• Positive effects include
• ensuring that central banks can adjust real interest
rates (intended to mitigate recessions), and
• encouraging investment in non-monetary capital
projects
• Today, most economists favor a low and
steady rate of inflation.

34. Phillips Curve
• The Phillips Curve is a downward sloping curve that
shows an inverse relationship between the inflation rate
and the unemployment rate.
• The explanation for this inverse relationship is simple;
when unemployment rate is very low (employment is
high), then workers have the market power to push up
wages.
• Higher wage rate again implies that the cost of
production is high and that sellers charge high prices.
• When unemployment rate is very high, then workers do
not have much bargaining power; rather they would be
ready to accept lower wage to get job.
• Due to this, the pressure on prices also remains low. This
relation can be described by the following figure, Phillips
curve.

36. MEASURING INFLATION
• A chief measure of price inflation is the inflation rate,
the annualized percentage change in a general price
index (normally the consumer price index) over time.
• The consumer price index reports the general level of
prices of a basket of consumer goods and services.
• It is stated as a ratio of prices in a given year divided
by the prices of the same basket of goods and services
in a base year.
• The base year index is set at 100.
• The rate of inflation is calculated for any given year
with the formula: (current year index - previous year
index)/previous year index

37. Measures to control inflation
• Economists agree that inflation beyond a
certain level is bad and causes different
type of disastrous to the economy.
Therefore, it should be controlled by using
appropriate mix of fiscal and monetary
policies.
• In addition to monetary and fiscal policies,
there are other policy intervention
measures that are used to control inflation.

38. • Therefore, the following policy measures are
used in combination to control inflation.
i. Monetary measures
 classical macroeconomist argue that inflation is
any time a monetary phenomenon. That is
inflation originate from increase in money
supply in excess of its optimal level.
 Therefore, they hold the view that control of
money supply through appropriate monetary
policy (Bank rate, reserve requirement ratio,
open market operation) greatly effective in
controlling inflation.

39. ii. Fiscal measures
 Keynesians or fiscalists argue that demand pull,
inflation originates in the real (product) sector
due to an increase in aggregate demand in
excess of aggregate supply.
 The excess demand may result from the
increase in expenditure by households, firms
and government.
 They emphasize that the excess demand arises
mainly due to excessive government expenditure.
 Therefore, fiscal policy or the budgetary measure
are a more powerful and effective weapon to
control demand pull inflation.

40. iii. Price and wage control measures
 Monetary and Fiscal policies are ineffective in
controlling cost push inflation.
 Thus if the inflationary condition is the result
of cost push, it is advisable to introduce price
and wage control measures rather than using
monetary and fiscal policy.
iv. Population control
 population growth reduces the per head
distribution of income, which results in intensive
competition on the existing level of output.
 Well- managed population growths can one a
solution for inflation control in the long run.