Chapter 27:

Business Cycles, Unemployment,

and Inflation

Part A: Business Cycles

Dr. Shamlan Waleed Albahar
ECON 140
Department of Economics, College of Business Administration
Kuwait University
Spring 2024
 Uncertainty, Expectations, and Shocks
• No one knows what the future holds.
• Shocks occur when unexpected changes happen.
Ø Demand shocks are unexpected changes in the demand for goods and S(people)
services.
Ø Supply shocks involve unexpected changes in the supply of goods and W =---- .

services.
-

• Prices are either flexible or sticky (inflexible).

! D(firms)
Ca
Ø Flexible prices: Product prices that freely and immediately move upward or i
downward when product demand or supply changes. Q

Ø Sticky prices (inflexible prices): Product prices that are slow to change even
when supply or demand has changed.
• An example of sticky prices: wages (labor market).
Ø Wages do not quickly respond to shocks. If there is a demand shock (demand
unexpectedly low), firms cannot change workers wages right away. This needs
time and maybe it is hard to do so (due to contracts, laws and unions
pressure).
Ø Firms do not flexibly change prices (wages), and instead, they will dismiss
some workers to lower costs. 27-2

Negative Shock in Sticky Price Market

§ Assume there is a negative demand shock: demand curve shifts to the left.
• Leftward shift in the goods market because consumers are demanding less of the
product.
• Leftward shift in the labor market because firms are demanding less labor.
• Recall that the labor market is a resource market where firms demand labor and
people supply labor.

Dr. Shamlan Albahar ECON 140 27-3

 Negative Shock in Sticky Price Market

X
QD Rs AB as
surplus surplus

• When prices are sticky: product price remains the same (P0) in the goods market
and labor wage remains the same (W0) in the labor resource market.
• Because the good’s price and labor wage do not respond immediately to the
demand shock and remain at P0 and W0 for a while, the quantity supplied in the
goods market and labor market (Q0) is higher than the quantities demanded in
these markets (Q1).

Dr. Shamlan Albahar ECON 140 27-4

Negative Shock in Sticky Price Market

• There will be a surplus (excess supply) of the good and a surplus of labor (more
than needed labor).
Ø Surplus of goods = leads to recession
Ø Surplus of labor = leads to unemployment
• Eventually, the firm will produce Q1 of the good (recession) and employ Q1 workers
given the sticky price P0 and sticky wage W0.
• Sticky wages and sticky prices, combined with a negative demand shock, lead to
unemployment and recession. 27-5
Negative Shock in Flexible Price Market

W* P*

Q* Q*

• What would happen if prices were flexible instead?

Ø The market price would adjust to unexpected changes in demand such that the
market reaches equilibrium where quantity demanded equals quantity supplied.
Ø The price of the good would be P* (lower than P0) and labor wage would be W*
(lower than W0). why ?
Ø There would be less unemployment and less severe recession from the negative
demand shock because Q* (flexible prices case) is higher than Q1 (sticky prices
- case) in both the goods and labor markets. 27-6

Measuring Stickiness

• The degree of price stickiness can be measured

by looking at the length of time between the
change in the market (e.g. change in demand
or supply) and the the change in the price of
the good/service of interest.
• Most of the final goods and services that
people consume are sticky, with an average of
4.3 months between price changes.
• But not all prices are sticky or slow to change.
Many commodities such as corn, oil, and
natural gas have very flexible prices and can
change in seconds to changes in supply and
demand.

Dr. Shamlan Albahar ECON 140 27-7

 Why Sticky?

• In reality, a large portion of the goods and services we consume are sticky in the
short run.
• Why is that?
1) Consumers prefer stable prices. They are unhappy with frequent price
changes and may shift to alternative substitutes with stable prices.
2) Firms face menu costs when they change their prices.
Ø Changing prices is also costly for firms (e.g. research on what new price to
charge, changing product labels, communicating with costumers about
price changes).
Ø These costs of changing prices are called menu costs named after the cost
associated with printing new menus at restaurants.
3) Firms want to avoid price wars (especially in oligopolies).
• All prices are flexible in the long run and price stickiness will moderate.
Ø Even if a firm must make short run adjustments to adapt to shocks, in the long
run it does not have to stick with that policy.

Dr. Shamlan Albahar ECON 140 27-8

Sticky Prices and Market Equilibrium

• It is often assumed when doing demand and supply analysis that prices move
quickly to equilibrium bringing quantity supplied and quantity demanded into
balance (market clears where demand and supply curves intersect). However, we
are assuming flexible prices in this case.
• We learned that prices of most goods and services in reality may be sticky and
adjust slowly in the short run.
• This means that with sticky prices, the market may not be in equilibrium, where
the supply and demand curves intersect (in the short run).
• But after all, prices are not stuck forever. They will adjust to changes in supply
and demand in the long run.
Ø Remember that whatever is fixed or given in the short run is flexible in the
long run.
• Therefore, studying sticky prices is important when we want to study the short-run
behavior of the economy.

Dr. Shamlan Albahar ECON 140 27-9

 The Business Cycle
-
• Business cycles are alternating increases and
decreases in economic activity over time.
• Each business cycle consists of four phases:
↳ Ø Recession (contraction): a phase of the business
cycle lasting six months or more in which output
(real GDP), income, and employment decline.
2 Ø Expansion (recovery): a phase of the business
cycle in which output (real GDP), income, and
employment rise.
3 Ø Trough: a temporary minimum of the recession
·
it is the
period with output and employment at their
ending
of lowest levels. It is the point at which a recession
the recession has ended, and an expansion will begin.
I Ø Peak: a temporary maximum of the expansion
period with full employment and near-capacity
output. It is the point at which an expansion has
ended, and a recession will begin.

Dr. Shamlan Albahar ECON 140 27-10

The Business Cycle

what is the
difference between
trend?
Growth and

• The duration and strength of a business cycle and each of its four phases vary.
• Note that all classified recessions in the table above last for at least 6 months
and are associated with negative real GDP growths.
• The long run trend in the figure above is economic growth.
Dr. Shamlan Albahar ECON 140 27-11
 Recession VS. Depression
- 5 *

§ Recession VS. Depression:

• Depression is a prolonged period of economic recession marked by a significant
decline in output, income and employment.
15
dis
,
Ø So a depression is a very severe recession and lasts longer than a regular
y

recession (e.g. may last for years).

• Recessions happen in every business cycle. On the other hand, depressions do
NOT happen in every business cycle. They rarely happen.
GDP

§ Overall, there is a decrease in output, income and employment in both

recessions and depressions.
Ø Difference: depression = more severe + lasts longer
• Classic example of depressions: The Great Depression (1929-1939)

Dr. Shamlan Albahar ECON 140 27-12

The Great Depression

• Classic example of depressions: The Great Depression (1929-1939)

Ø Unemployment rate peaked at about 25%.
Ø Real GDP declined by about 27%.

Dr. Shamlan Albahar ECON 140 27-13

 Why Ups and Downs?
-8
§ Why the economy sees business cycle fluctuations (associated with fluctuations .
in output and employment) rather than slow, smooth economic growth?
• These fluctuations are caused by economic shocks combined with short run sticky
prices.
1) Sticky prices ↳ ↓ D
Ø Sticky prices in the short run result in slower sales (e.g. with a negative
demand shock) which will cause firms to cut back on production; this causes
↳
↳GDP to fall.
Ø Then↳employment will fall because of the reduced demand for output and a
recession will happen.
Ø Sticky prices prevent the economy from quickly adjusting to economic shocks.
S
E
Ø The economy is forced to respond to shocks in the short run through changes
in output and employment rather than through changes in prices.

Stick
/ Respond in shortrun
Dr. Shamlan Albahar ECON 140
Theatr ontest
27-14

duction )
changes/pr
(employment)

Why Ups and Downs?

2) Economic shocks
§ Different causes of economic shocks:
a. Unexpected innovations
Ø Major inventions (e.g. railroads, computer and internet) have a large
impact on investment and consumption spending, and therefore when
they happen unexpectedly, then output, employment, and the price level
fluctuate.
b. Unexpected changes in productivity Prot expansio prote I recession
Ø When productivity unexpectedly increases, the economy booms
(expansion); when productivity unexpectedly falls, the economy goes into
a recession.
c. Unexpected changes in the money supply
Ø When the central bank shocks the economy by printing more money than
people were expecting, inflation happens. --
-

- -

Ø When the central bank shocks the economy by printing less money than

-
people were expecting, a decline in output and employment occur.
-
Dr. Shamlan Albahar ECON 140 27-15
 Why Ups and Downs?

2) Economic shocks
§ Different causes of economic shocks:
d. Unexpected financial bubbles j'ene ; 55
Ø Spills over the economy through optimism or pessimism that affect the
production of goods and services. expansick rocession

Ø Rapid asset price increases or decreases can spill over to the general*, asset or z I
economy and cause expansions and recessions.
Ø The financial crisis (recession in 2008 and 2009) started from excessive
money, overvalued real estate and unsustainable mortgage debt. Then,
the heavily deregulated financial market with weak government
intervention caused the crisis.
e. Unexpected disasters
Ø Unexpected political events like wars or terrorist attacks.
Ø Unexpected health events like the COVID-19 pandemic.
Ø Unexpected natural disasters like earthquakes and floods.

Dr. Shamlan Albahar ECON 140 27-16

Why Ups and Downs?

• Economists generally agree that changes in the level of total spending are the
immediate causes of fluctuating real output and employment.
Ø If the level of spending unexpectedly decreases, then the economic shock with
sticky prices will cause output, employment, and incomes to decrease.
Ø If the level of spending unexpectedly increases, then the economic shock with
sticky prices will cause output, employment, and incomes to increase.
• Recall from chapter 25:
Ø Durable goods: good with an expected life of 3 or more years. EX: cars, TV and
phones.
Ø Nondurable goods: good with an expected life of less than 3 years. EX: food,
cosmetics and gasoline.
Ø Services like lawyers, doctors and barbers.
1 =

• Spending on durable goods output is more volatile (fluctuates more) than

/

nondurables and services because spending on nondurables or services often

cannot be delayed. Also, durable goods are generally more expensive.

Dr. Shamlan Albahar ECON 140 27-17