On Inflation

Parties to a contract want to take inflation into account. A problem arises when the expected inflation does not match the actual inflation. If, for example, a contract was negotiated anticipating 2.5% inflation and it came in at 1.5%,  the workers end up benefiting at the expense of the company.

To illustrate the advantage the workers gain at the expense of the company, assume that there were no pay raises in the contract other than that for the expected rate of inflation. This would mean that a worker making $10000 the first year would make $10250 in the second year and then $10506.25 in the third year of the contract. His real wage would be the same based on the assumption, having the same buying power as in the first year.

If inflation instead comes in at 1.5% instead of 2.5%, the company should be paying $10000 in the first year, $10150 in the second year, and $10302.25 in the third year to maintain the same buying power as the worker had in the first year. However, the contract was negotiated at 2.5%, so the employees benefit at the expense of the employer. In the example, the price of labor is the same in the first year. There is, however, a difference of $100 in the second year and then $204 in the third year. These amounts compound as even a difference of 1% adds up over time to make a material difference in a firm’s bottom line. Perhaps the next time they negotiate, the firm may look more carefully about its inflation assumptions.

The Business Cycle

Below is a basic diagram of the business cycle (Figure 1).

Figure 1 adapted from Krugman & Wells, 2013, P. 171

In the diagram, four separate elements of the business cycle can be seen. The first element is the expansion, where growth is positive. The cycle then reaches a peak where the growth turns from positive to negative. The business cycle then enters a period of contraction, which is illustrated in this diagram by the purple bars. During contraction the size of the economy is shrinking. These times of shrinkage are called recessions, which are two or more quarters of consecutive shrinkage. It is possible to have a shorter contraction that is not a recession, but that is not illustrated in the graph. The shrinkage then stops, and then growth begins again. This local minimum on the diagram is known as a business cycle trough. Overall, despite the cyclical nature of the ups and downs in the business cycle, the upward trend is illustrated with the orange line, a mean with which to revert to.

There are certain economic phenomena related with each segment. For periods of growth in the expansionary phase, the biggest worry is that people might have too much money to spend. Though counter-intuitive, when there is too much money in the economy, the risk of inflation rises as there is too much money chasing too few goods, and the price level rose. Conversely, during times of contraction and especially those that are long enough to be called during recessions, the risk of unemployment is present, as companies lay off workers in reaction to less consumption.

Though there are recessions shown on the diagram, there is one final rare business cycle phenomenon that is not shown on the chart. That would be the potential for depression, which is an extended slump such as happened globally in the 1930s. Through the use of both fiscal and monetary policy, governments were able to make sure that the most recent fiscal downturn was just a deep recession instead of another replay of the Great Depression (Krugman & Wells, 2013, p. 168).  

References

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers

 

On Unemployment

To be unemployed has a strict technical meaning of people who do not have a job but are actively looking for a job. In the United States, the BLS tracks the number of people who are in the labor force but do not have a job, in a report issued every month (Krugman & Wells, 2013, p. 215).

There are multiple ways to get to that point. Even in a growing economy, people are leaving jobs all the time. There is a transition period between the time a worker leaves a job and the time they enter a new job. For example, if a worker wants job in another state, and they quit one position but the new position is not immediately forthcoming, the time the worker is in transition from the old job to the new job is a time they are technically unemployed. This is called frictional unemployment (Krugman & Wells, 2013, p. 221). Frictional unemployment is always present in the economy and not necessary and bad thing. It can mean that people are finding positions that are better fits for their skill sets.

There is more pernicious way for a worker to be unemployed. The economy works through cycles, where there are periods of growth and periods of contraction. The number of jobs available at times of growth increase and the number of jobs available as the economy shrinks decreases. Workers caught up in this “cyclical unemployment” are why the unemployment rate increase is recessions. They are jobless through the workings of firm-level responses to the business cycle. Fortunately, for the effected workers, a safety net exists to soften the blow of the job loss for those affected. For example, federal unemployment insurance was increased to 99 weeks of benefits in some states during the peak of joblessness during the most recent recession. They were able to re-enter the workforce when as the economy once again found itself on a growth track.

The worst form of unemployment is when there is a surplus of workers even during the peaks in the business cycle. This surplus is called “structural unemployment,” and can have multiple causes. The main factor is that the wage rate for whatever reason is above the equilibrium rate so that the quantity demanded of jobs is less than the quantity supplied of jobs, and there is a gap where people who would be willing workers are locked out of work. Examples of this include a minimum wage, where businesses would hire more workers at a lower rate but the statutory minimum means those potential workers find themselves without. Another example is labor unions, where in the same mechanism the negotiated rate is higher than the clearing rate, and the price floor protects the incumbents who hold the jobs at the expense of the surplus workers who would work the positions in the simple supply and demand framework (Krugman & Wells, 2013, p. 168).  

References

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers