20.4 Review and Practice


In this chapter we examined growth in real GDP and business cycles, price-level changes, and unemployment. We saw how these phenomena are defined and looked at their consequences.

Examining real GDP, rather than nominal GDP, over time tells us whether the economy is expanding or contracting. Real GDP in the United States shows a long upward trend, but with the economy going through phases of expansion and recession around that trend. These phases make up the business cycle. An expansion reaches a peak, and the economy falls into a recession. The recession reaches a trough and begins an expansion again.

Inflation is an increase in the price level and deflation is a decrease in the price level. The rate of inflation or deflation is the percentage rate of change in a price index. We looked at the calculation of the consumer price index (CPI) and the implicit price deflator. The CPI is widely used in the calculation of price-level changes. There are, however, biases in its calculation: the substitution bias, the new-product bias, the quality-change bias, and the outlet bias.

Inflation and deflation affect economic activity in several ways. They change the value of money and of claims on money. Unexpected inflation benefits borrowers and hurts lenders. Unexpected deflation benefits lenders and hurts borrowers. Both inflation and deflation create uncertainty and make it difficult for individuals and firms to enter into long-term financial commitments.

The unemployment rate is measured as the percentage of the labor force not working but seeking work. Frictional unemployment occurs because information about the labor market is costly; it takes time for firms seeking workers and workers seeking firms to find each other. Structural unemployment occurs when there is a mismatch between the skills offered by potential workers and the skills sought by firms. Both frictional and structural unemployment occur even if employment and the unemployment rate are at their natural levels. Cyclical unemployment is unemployment that is in excess of that associated with the natural level of employment.

Concept Problems

  1. Describe the phases of a business cycle.
  2. On the basis of recent news reports, what phase of the business cycle do you think the economy is in now? What is the inflation or deflation rate? The unemployment rate?
  3. Suppose you compare your income this year and last year and find that your nominal income fell but your real income rose. How could this have happened?
  4. Suppose you calculate a grocery price inflation rate. Using the arguments presented in the chapter, explain possible sources of upward bias in the rate you calculate, relative to the actual trend of food prices.
  5. Name three items you have purchased during the past year that have increased in quality during the year. What kind of adjustment would you make in assessing their prices for the CPI?
  6. Why do some people gain and other people lose from inflation and deflation?
  7. Suppose unemployed people leave a state to obtain jobs in other states. What do you predict will happen to the unemployment rate in the state experiencing the out-migration? What might happen to the unemployment rates in the states experiencing in-migration?
  8. Minority teenagers have the highest unemployment rates of any group. One reason for this phenomenon is high transportation costs for many minority teens. What form of unemployment (cyclical, frictional, or structural) do high transportation costs suggest?
  9. Welfare reforms enacted in 1996 put more pressure on welfare recipients to look for work. The new law mandated cutting off benefits after a certain length of time. How do you think this provision might affect the unemployment rate?
  10. American workers work more hours than their European counterparts. Should Congress legislate a shorter workweek?

Numerical Problems

  1. Plot the quarterly data for real GDP for the last two years. (You can find the data in the Survey of Current Business or in Current Economic Indicators in the current periodicals section of your library. Alternatively, go to the White House, Economic Statistics Briefing Room at http://www.whitehouse.gov/fsbr/esbr.html. Relate recent changes in real GDP to the concept of the phases of the business cycle.)
  2. Suppose that in 2009, the items in the market basket for our movie price index cost $53.40. Use the information in the chapter to compute the price index for that year. How does the rate of movie price inflation from 2008 to 2009 compare with the rate from 2007 to 2008?
  3. Recompute the movie price indexes for 2007 and 2008 using 2008 as the base year. Now compute the rate of inflation for the 2007–2008 period. Compare your result to the inflation rate calculated for that same period using 2007 as the base year.
  4. Here are some statistics for August 2006. Compute the unemployment rate for that month (all figures are in thousands).

    Population (Civilian, noninstitutional) 229,167
    Civilian Labor Force 151,698
    Participation Rate 66.2%
    Not in Labor Force   77,469
    Employed 144,579
    Unemployed     7,119
  5. Suppose an economy has 10,000 people who are not working but looking and available for work and 90,000 people who are working. What is its unemployment rate? Now suppose 4,000 of the people looking for work get discouraged and give up their searches. What happens to the unemployment rate? Would you interpret this as good news for the economy or bad news? Explain.
  6. The average price of going to a baseball game in 2008, based on the observations in the Case in Point, was $191.92. Using this average as the equivalent of a base year, compute fan price indexes for:

    1. The New York Yankees.
    2. The Chicago Cubs.
    3. The Boston Red Sox.
    4. The Tampa Bay Rays.
    5. The team of your choice.
  7. Suppose you are given the following data for a small economy:

    Number of unemployed workers: 1,000,000.

    Labor force: 10,000,000.

    Based on this data, answer following:

    1. What is the unemployment rate?
    2. Can you determine whether the economy is operating at its full employment level?
    3. Now suppose people who had been seeking jobs become discouraged, and give up their job searches. The labor force shrinks to 900,500 workers, and unemployment falls to 500,000 workers. What is the unemployment rate now? Has the economy improved?
  8. Nominal GDP for an economy is $10 trillion. Real GDP is $9 trillion. What is the value of the implicit price deflator?
  9. Suppose you are given the following data for an economy:

    Month Real GDP Employment
    1 $10.0 trillion 100 million
    2 $10.4 trillion 104 million
    3 $10.5 trillion 105 million
    4 $10.3 trillion 103 million
    5 $10.2 trillion 102 million
    6 $10.3 trillion 103 million
    7 $10.6 trillion 106 million
    8 $10.7 trillion 107 million
    9 $10.6 trillion 106 million
    1. Plot the data for real GDP, with the time period on the horizontal axis and real GDP on the vertical axis.
    2. There are two peaks. When do they occur?
    3. When does the trough occur?
  10. The Consumer Price Index in Period 1 is 107.5. It is 103.8 in Period 2. Is this a situation of inflation for deflation? What is the rate?


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