The Business Cycle Effects
The Effect of the Business Cycle on the Inflation Rate
The price level measures the average prices of goods and services in the economy, and the inflation rate is the percentage increase in the price level from one year to the next.
An important fact about the business cycle Opens in new window is that during economic expansions the inflation rate usually increases, particularly near the end of the expansion, and during contractions the inflation rate usually decreases.
The exception to this is if the expansion is due to rising productivity levels and an expansion of potential GDP Opens in new window, or if the contraction is caused by high prices Opens in new window for production inputs, such as very high oil prices, or if real wages rise at a rate that is faster than the rate at which labor productivity increases.
Figure I illustrates the fact that the inflation rate fell significantly during Australia’s recessions of 1982 – 1983 and 1990 – 1991 Opens in new window.
- Prior to the 1982 – 1983 recession the inflation rate was over 11 percent, which then fell to just over 4 percent during the recession.
- Prior to the 1990 – 1991 recession the inflation rate was over 8 percent, as it had been for many years.
The recession of 1990 – 1991 caused the inflation rate to fall back to 1 percent by 1992. This result is not surprising.
During a business cycle expansion spending by businesses and households is strong and producers of goods and services find it easier to raise prices.
As spending declines during a recession firms have a more difficult time selling their goods and services and are likely to increase prices Opens in new window less than they otherwise might have.
A substantial fall in the inflation rate can also be seen in 1996 and 1997, when Australia entered a short economic contraction as a result of the Asian financial crisis Opens in new window of that time.
The inflation rate also dipped for a short time during the economic contraction resulting from the GFC of 2007 – 2008 Opens in new window, after which time it remained low for many years due to below-average economic growth Opens in new window.
The Business Cycle Effect on the Unemployment Rate
Contractions and recessions Opens in new window cause the unemployment rate to increase while expansions and booms cause the unemployment rate to decrease.
During a contraction firms see their sales decline and they begin to reduce production and lay off workers.
From Figure II, we can clearly see the impact of the 1982 – 1983 recession and the 1990 recession on the unemployment rate.
For example, as the 1990 – 1991 recession began, the economic growth rate Opens in new window fell below 0 percent from June 1990, and the unemployment rate started to rise, and more than doubled by 1992.
The rate of unemployment continued to rise even after the end of the recession in December 1991. This pattern is typical and is due to two factors.
- First, during the business cycle discouraged workers (unemployed people who have given up hope of finding a job and stopped looking for one) drop out of and then return to the labor force.
When discouraged workers drop out of the labor force during a recession, they keep the measured unemployment rate from increasing by as much as it otherwise would because they are no longer looking for jobs and therefore are not counted as unemployed.
When discouraged workers return to the labor force as the recession ends, they increase the measured unemployment rate because they are now counted as being unemployed.
- Second, firms continue to operate well below their capacity even after a recession has ended and production has begun to increase.
As a result, at first firms may not re-hire all of the workers they have laid off and may even continue for a while to lay off more workers.
The period of continual economic growth from 1991 to 2007 was associated with a significant and almost continual decline in the rate of unemployment from around 11 percent in 1992 to 4 percent by early 2008.
The economic contraction of 2008 associated with the GFC Opens in new window led to an increase in the unemployment rate from around 4 percent to close to 6 percent.
This rise in unemployment was not as significant as it might have been had it not been for the flexible work practices of both employers and employees.
Many employers preferred not to sack workers and lose their investment in their skills, and were also fresh from experiencing labor shortages.
Instead, many employees worked fewer hours or days per week, while keeping their jobs during the contraction.