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ECN 204 Lecture Notes - Frictional Unemployment, Nominal Interest Rate, Real Interest Rate

Course Code
ECN 204
Thomas Barbiero

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Chapter 7 Review
7.1 The business cycle
Canada and other industrial economies have gone through periods of
fluctuations in real GDP, employment, and price level.
o Although they have certain phases in common:
o Business cycles vary 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
o 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.
o 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.
7.2 Unemployment
Economists distinguish among four types of employment:
o The full-employment or natural rate of unemployment, which is made
up of frictional and structural unemployment, is currently 6-7 percent.
o 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.
o 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.
o Okun’s law suggests that every increase in unemployment by 1
percent about the natural rate causes an additional 2 percent negative
GDP gap.
Unemployment rates vary widely globally.
Unemployment rates differ because nations have different natural rates of
unemployment and often are in different phases of their business cycles.
7.3 Inflation
Inflation is a rise in the general price level and is measured in Canada by the
Consumer Price Index (CPI)
o When inflation occurs, each dollar of income will buy fewer goods and
services than before.
o That is, inflation reduces the purchasing power of money.
Economists distinguish between demand-pull and cost-push (supply-side)
o Demand-pull inflation - results from an excess of total spending
relative to the economy’s capacity to produce.
o Cost-push inflation results from abrupt and rapid increases in the
prices of key resources.
o These supply shocks push up per-unit production costs and ultimately
the prices of consumer goods.
7.4 Redistribution effects of inflation
Unanticipated inflation arbitrarily redistributes real income at the expense of
people with a fixed income, creditors, and savers.
o If inflation is anticipated, individuals and businesses may be able to
take steps to lessen or eliminate adverse redistribution effects.
When inflation is anticipated, leaders add an inflation premium to the
interest rate charged on loans
o The nominal interest rate thus reflects the real interest rate plus the
inflation premium (the expected rate of inflation).
7.5 Effects of inflation on output
Cost-push inflation reduces real output and employment.
Proponents of zero inflation argue that even mild demand-pull inflation (1-3
percent) reduces the economy’s real output.
Other economists say that mild inflation may bye 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
Key Terms:
Economic theory deriving economic principles from relevant economic
facts; and economic principle.
Business cycle recurring increases and decreases in the level of economic
activity over period of years.
Peak a phase in the business cycle during which the economy is at full
employment and the level of real output is at or very close to the economy’s
Recession a period of decline in total output, income, and employment.
Trough the point during a recession or depression when output and
employment reach their lowest levels.