CHAPTER TWENTY-SIX BUSINESS CYCLES, UNEMPLOYMENT, AND INFLATION

chapter Twenty-Six
Business Cycles, Unemployment, and Inflation CHAPTER OVERVIEW
This chapter discusses the business cycle, unemployment, and inflation. It sets the stage for the analytical presentation in later chapters.
The business cycle is introduced in historical perspective and is presented in stylized form (Figure 26.1). While hinting at various business cycle theories, the authors stress the general belief that changes in aggregate spending, especially durable goods and investment spending, are the immediate cause of economic instability. Non-cyclical fluctuations are also treated briefly before the analysis of unemployment and inflation.
In the section on unemployment, the various types of unemployment—frictional, structural, and cyclical—are described. Then the problems involved in measuring unemployment and in defining the full‑employment unemployment rate are considered. The economic and non-economic costs of unemployment are presented, and finally, Global Perspective 7.2 gives an international comparison of unemployment rates.
Inflation is accorded a rather detailed treatment from both a cause and an effect perspective. International comparisons of inflation rates in the post-1992 period are given in Global Perspective 7.2. Demand‑pull and cost‑push inflation are described. Considerable emphasis is placed on the fact that the redistributive effects of inflation will differ, depending on whether inflation is anticipated or unanticipated. The chapter ends with historical cases of hyperinflation to remind students that inflationary fears have some basis in fact.
*Concept Illustration … Types of Unemployment*

Imagine a fictitious country named Miniature that has a stable population of 120 people, of which 100 are in the labor force. Of these 100 people, 95 are employed and 5 are unemployed. That means Miniature’s unemployment rate is 5 percent (= 5/100).

Suppose we could take a group photo of the unemployed workers each month so as to obtain a continuing record of their monthly numbers and reveal whom they are. By comparing the monthly photos over long periods, we could sort out the types of unemployment occurring in Miniature.

Suppose that in a typical month there are 5 people in the photo. Also, suppose that 4 of these people are never the same individuals who were in the photo the previous month and the other person never shows up in the photo for more than two or three consecutive months.
We can reasonably conclude that Miniature is experiencing *frictional unemployment *and *structural unemployment*. The frictionally unemployed workers are quickly finding jobs, and after retraining or relocation, the structurally unemployed workers are obtaining new jobs within a few months. Taking the places of these formerly unemployed persons are newly unemployed people who are looking for new jobs, waiting for future jobs, retraining, or relocating. Five percent of the labor force is unemployed each month, but nobody is unemployed for any substantial length of time. Miniature is not suffering an “unemployment problem.”

In contrast, suppose that over a six-month period we observe that the number of people in the unemployment photo increases from 5 to 10, with no change in the size of the labor force. Thereafter, the 10 percent unemployment rate continues for a full year. A comparison of the monthly photos reveals that it is mainly the same people who are employed month after month.

We can reasonably conclude that Miniature is now experiencing *cyclical unemployment*. Total spending must have declined, reducing production and employment. The increase in the unemployment rate from 5 percent to 10 percent has accompanied this recession. Miniature now has a serious “unemployment problem.” Cyclical unemployment is involuntary, relatively long lasting, and creates serious financial hardship for those people unemployed. It also results in an irretrievable loss of output to society. (Note that there could also be a more serious form of structural unemployment contributing to the increased rate and duration).

1. Table 26.2 can be used to discuss the definition of unemployment and its limitations. Current data to update the table can be found in the *Monthly Labor Review, Employment and Earnings*, *Economic Indicators, or see web-based question 1.* Make it clear that a portion of each unemployment statistic is due to frictional and structural unemployment, which are found even in a “full employment” economy. Frictional unemployment indicates a healthy economy with labor mobility. Structural unemployment is viewed as serious, but not responsive to economic policies alone.
2. Have students consider the losses from unemployment. Perhaps they could write a feature article on losses due to GDP gap, higher inflation, or the social and personal losses incurred by those unemployed.
3. Try web-based question 2 for current inflation data. While we have been concerned with inflation since World War II, it is interesting to note that past (and now current) economists have been as concerned about deflation. A good topic is to ask students how deflation can be a problem, as it has been in Japan and has threatened to be in the U.S. within the past decade.
4. For a deeper understanding of the costs of inflation, you may wish to share the following “Concept Illustration” with your students: Concept Illustration … Costs of Inflation

On pages 138-139 costs of inflation are explained. The following metaphors highlight some of the more subtle, but very present, costs imposed by rising prices.

*Menu costs * Inflation requires firms to change the prices they charge from one period to another. This new pricing of products and the communication of the new prices to customers requires time and effort that could otherwise be used for more productive purposes. These inflation costs are sometimes called *menu costs*, because they are similar to the costs incurred by restaurants that need to print new menus when prices rise. Menu costs include all costs associated with the inflation-caused need to change prices.

*Yardstick costs* Inflation interferes with money functioning as a measure of value and thus requires more time and effort to determine what something is worth (in real terms). Dollar price tags lose some of their meaning when inflation occurs, because the dollar’s value has declined relative to before. It is as if a yardstick that formerly measured 36 inches now measures 34, 33, or even fewer inches. All inflation-caused costs associated with determining real versus nominal values can be thought of as *yardstick costs*.

*Shoe-leather costs* We have noted that people try to protect their financial assets against erosion from inflation by limiting the amounts of money they hold in their billfolds and in their non-interest-bearing checking accounts, putting those funds instead into interest-bearing saving accounts or stock and bond funds. But people actually need more money to buy the higher priced goods and services. So, they figuratively walk to and from financial institutions much more often in order to move money from these latter accounts to checking accounts or to get cash when it is needed. In the process they wear out their shoes—they incur so-called *shoe-leather costs*. These costs include all time and resource costs associated with the inflation-induced need to make more financial transactions.

5. *The Wall Street Journal* is a good source of information on the most current economic situation. They have a “Newspaper‑in‑Education” program that provides various teaching aids, in addition to favorable subscription rates for students. Call 1-800-JOURNAL contact their website for more information. Among their aids is a stylized *Wall Street Journal Education* edition, which gives information on dates on which important economic statistics are announced each month or each quarter. Your local newspaper and periodicals may have similar education programs. *The Economist* includes up-to-date macroeconomic information and presents stories of U.S. macroeconomic policies and conditions that are detailed but accessible.
6. Unemployment and inflation have a human face. A dramatic reading of quotes from a book such as Studs Terkel’s *Hard Times *can be used to bring statistics to life. You or your students may be acquainted with individuals who lived through the depression years or who have suffered from periods of unemployment. Inviting them to discuss the impact of these experiences also helps to make this material more interesting for students. NOTES
*I. Unemployment (One Result of Economic Downturns)*
A. Measuring unemployment (see Figure 26.2 for 2007):
1. The population is divided into three groups: those under age 16 or institutionalized, those “not in labor force,” and the labor force that includes those age 16 and over who are willing and able to work, and actively seeking work (demonstrated job search activity within the last four weeks).
2. The unemployment rate is defined as the percentage of the labor force that is not employed. (Note: Emphasize *not* the percentage of the *population*.)
3. The unemployment rate is calculated by random survey of 60,000 households nationwide. (Note: Households are in survey for four months, out for eight, back in for four, and then out for good; interviewers use the phone or home visits using laptops.) Two factors cause the official unemployment rate to understate actual unemployment.
a. Part‑time workers are counted as “employed.”
b. “Discouraged workers” who want a job, but are not actively seeking one, are not counted as being in the labor force, so they are not part of unemployment statistic.
B. Types of unemployment:
1. Frictional unemployment consists of those searching for jobs or waiting to take jobs soon; it is regarded as somewhat desirable, because it indicates that there is mobility as people change or seek jobs.
2. Structural unemployment: due to changes in the structure of demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs changes.
a. Glass blowers were replaced by bottle-making machines.
b. Oil-field workers were displaced when oil demand fell in 1980s.
c. Airline mergers displaced many airline workers in 1980s.
d. Foreign competition has led to downsizing in U.S. industry and loss of jobs.
e. Military cutbacks have led to displacement of workers in military-related industries.
3. Cyclical unemployment is caused by the recession phase of the business cycle.
a. As firms respond to insufficient demand for their goods and services, output and employment are reduced.
b. Extreme unemployment during the Great Depression (25 percent in 1933) was cyclical unemployment.
4. It is sometimes not clear which type describes a person’s unemployment circumstances.
C. Definition of “Full Employment”
1. Full employment does not mean zero unemployment.
2. The full‑employment unemployment rate is equal to the total frictional and structural unemployment.
3. The full‑employment rate of unemployment is also referred to as the natural rate of unemployment.
4. The natural rate is achieved when labor markets are in balance; the number of job seekers equals the number of job vacancies.
5. The natural rate of unemployment is not fixed but depends on the demographic makeup of the labor force and the laws and customs of the nations.
6. Recently the natural rate has dropped from 6% to 4 to 5%. This is attributed to:
a. The aging of the work force as the baby boomers approach retirement.
b. Improved job information through the internet and temporary-help agencies.
c. New work requirements passed with the most recent welfare reform.
d. The doubling of the U.S. prison population since 1985.
D. Economic cost of unemployment:
1. GDP gap and Okun’s Law: GDP gap is the difference between potential and actual GDP. (See Figure 26.3) Economist Arthur Okun quantified the relationship between unemployment and GDP as follows: For every 1 percent of unemployment above the natural rate, a negative GDP gap of about 2 percent occurs. This is known as “Okun’s law.”
2. Unequal burdens of unemployment exist. (See Table 26.2)
a. Rates are lower for white‑collar workers.
b. Teenagers have the highest rates.
c. African-Americans have higher rates than whites.
d. Rates for males and females are comparable, though females had a lower rate in 2002.
e. Less educated workers, on average, have higher unemployment rates than workers with more education.
f. “Long‑term” (15 weeks or more) unemployment rate is much lower than the overall rate, although it has nearly doubled from 1.1% in 1999 to 2% in 2002.
E. Noneconomic costs include loss of self‑respect and social and political unrest.
F. International comparisons. (See Global Perspective 26.1)
*II. Inflation: Defined and Measured*
A. Definition: Inflation is a rising general level of prices (not all prices rise at the same rate, and some may fall).
B. The main index used to measure inflation is the Consumer Price Index (CPI). To measure inflation, subtract last year’s price index from this year’s price index and divide by last year’s index; then multiply by 100 to express as a percentage.
C. “Rule of 70” permits quick calculation of the time it takes the price level to double: Divide 70 by the percentage rate of inflation and the result is the approximate number of years for the price level to double. If the inflation rate is 7 percent, then it will take about ten years for prices to double. (Note: You can also use this rule to calculate how long it takes savings to double at a given compounded interest rate.)
D. Facts of inflation:
1. In the past, deflation has been as much a problem as inflation. For example, the 1930s depression was a period of declining prices and wages. The prospect of deflation was a concern of economic policymakers earlier this decade.
2. All industrial nations have experienced the problem (see Global Perspective 26.2).
3. Some nations experience astronomical rates of inflation (Zimbabwe’s was 585 percent in 2005).
4. The inside covers of the text contain historical rates for the U.S.
E. Causes and theories of inflation:
1. Demand‑pull inflation: Spending increases faster than production. It is often described as “too much spending chasing too few goods.”
2. *CONSIDER THIS … Clipping Coins*
a. Princes would clip coins, paying peasants with the clipped coins and using the clippings to mint new coins.
b. Clipping was essentially a tax on the population as the increased money supply caused inflation and reduced the purchasing power of each coin.
3. Cost‑push or supply‑side inflation: Prices rise because of rise in per-unit production costs (Unit cost = total input cost/units of output).
a. Output and employment *decline* while the price level is rising.
b. Supply shocks have been the major source of cost-push inflation. These typically occur with dramatic increases in the price of raw materials or energy.
4. Complexities: It is difficult to distinguish between demand‑pull and cost‑push causes of inflation, although cost‑push will die out in a recession if spending does not also rise.
*III. **Redistributive effects of inflation:*
A. The price index is used to deflate nominal income into real income. Inflation may reduce the real income of individuals in the economy, but won’t necessarily reduce real income for the economy as a whole (someone receives the higher prices that people are paying).
B. Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects.
C. Fixed‑income groups will be hurt because their real income suffers. Their nominal income does not rise with prices.
D. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power.
E. Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender.
F. If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders.
1. “Inflation premium” is amount that interest rate is raised to cover effects of anticipated inflation.
2. “Real interest rate” is defined as nominal rate minus inflation premium. (See Figure 26.5)
G. Final points
1. Unexpected deflation, a decline in price level, will have the opposite effect of unexpected inflation.
2. Many families are simultaneously helped and hurt by inflation because they are both borrowers *and* earners and savers.
3. Effects of inflation are arbitrary, regardless of society’s goals.
*III. Output Effects of Inflation*
A. Cost‑push inflation, where resource prices rise unexpectedly, could cause both output and employment to decline. Real income falls.
B. Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous economy, or it may have an undesirable impact on real income. C. Danger of creeping inflation turning into hyperinflation, which can cause speculation, reckless spending, and more inflation (see examples in text of Japan following World War II, and Germany following World War I). *IV. LAST WORD: The Stock Market and The Economy: How, if at all, do changes in stock prices relate to macroeconomic stability?* A. Do changes in stock prices and stock market wealth cause instability? The answer is yes, but usually the effect is weak. 1. There is a wealth effect: Consumer spending rises as asset values rise and vice versa if stock prices decline substantially. 2. Also, there is an investment effect: Rising share prices lead to more capital goods investment and the reverse in true for falling share prices. B. Stock market “bubbles” can hurt the economy by encouraging reckless speculation with borrowed funds or savings needed for other purposes. A “crash” can cause unwarranted pessimism about the underlying economy. C. A related question concerns forecasting value of stock market averages. Stock price averages are included as one of ten “Leading Indicators” used to forecast the future direction of the economy. (See Last Word, Chapter 11). However, by themselves, stock values are not a reliable predictor of economic conditions. ANSWERS TO END-OF-CHAPTER QUESTIONS 26‑1 (*Key Question*) What are the four phases of the business cycle? How long do business cycles last? How do seasonal variations and long-term trends complicate measurement of the business cycle? Why does the business cycle affect output and employment in capital goods and consumer durable goods industries more severely than in industries producing nondurables? The four phases of a typical business cycle, starting at the bottom, are trough, recovery, peak, and recession. As seen in Table 26.1, the length of a complete cycle varies from about 2 to 3 years to as long as 15 years. There is a pre-Christmas spurt in production and sales and a January slackening. This normal seasonal variation does not signal boom or recession. From decade to decade, the long-term trend (the secular trend) of the U.S. economy has been upward. A period of no GDP growth thus does not mean all is normal, but that the economy is operating below its trend growth of output. Because capital goods and durable goods last, purchases can be postponed. This may happen when a recession is forecast. Capital and durable goods industries therefore suffer large output declines during recessions. In contrast, consumers cannot long postpone the buying of nondurables such as food; therefore recessions only slightly reduce non-durable output. Also, capital and durable goods expenditures tend to be “lumpy.” Usually, a large expenditure is needed to purchase them, and this shrinks to zero after purchase is made. 26‑2 What factors make it difficult to determine the unemployment rate? Why is it difficult to distinguish between frictional, structural, and cyclical unemployment? Why is unemployment an economic problem? What are the consequences of a negative GDP gap? What are the noneconomic effects of unemployment? Measuring the unemployment rate means first determining who is eligible and available to work. The total U.S. population is divided into three groups. One group is made up of people under 16 years of age and people who are institutionalized. The second group, labeled “not in the labor force” are adults who are potential workers but for some reason—age, in school, or homemakers are not seeking work. The third group is the labor force, those who are employed and those who are unemployed but actively seeking work. It is not easy to distinguish between these three types and since the unavoidable minimum of frictional and structural unemployment is itself changing, it is difficult to determine the full‑employment unemployment rate. For example, a person who quits a job in search of a better one would normally be considered frictionally unemployed. But suppose the former job then disappears completely because the firm is in a declining industry and can no longer make money. Our still jobless worker could now be considered structurally unemployed. And then suppose the economy slips into a severe recession so that our worker cannot find any job and has become cyclically unemployed. The unavoidable minimums of frictional and structural unemployment fluctuate as the labor force structure changes. In other words, there is no automatic label on the type of unemployment when someone is counted as unemployed. Unemployment is an economic problem because of the concept of opportunity cost. Quite apart from any idea of consideration for others, unemployment is economic waste: A unit of labor resource that could be engaged in production is sitting idle. The “GDP gap” is the difference between what the economy could produce its potential GDP and what it is producing its actual GDP. The consequence of a negative GDP gap is that what is not produced – the amount represented by the gap—is lost forever. Moreover, to the extent that this lost production represents capital goods, the potential production for the future is impaired. Future economic growth will be less. The noneconomic effects of unemployment include the sense of failure created in parents and in their children, the feeling of being useless to society, of no longer belonging. 26-3 (*Key Question*) Use the following data to calculate (a) the size of the labor force and (b) the official unemployment rate: total population, 500; population under 16 years of age or institutionalized, 120; not in labor force, 150; unemployed, 23; part-time workers looking for full-time jobs, 10. Labor force = 230 [=500 – (120 + 150)]; official unemployment rate = 10% [=(23/230)x100]. 26‑4 Since the U.S. has an unemployment compensation program which provides income for those out of work, why should we worry about unemployment? The unemployment compensation program merely gives the unemployed enough funds for basic needs. Furthermore, many of the unemployed do not qualify for unemployment benefits. The programs apply only to those workers who were covered by the insurance, and this may be as few as one-third of those without jobs. Most of the unemployed get no sense of self‑worth or accomplishment out of drawing this compensation. Moreover, from the economic point of view, unemployment is a waste of resources; when the unemployed go back to work, nothing is forgone except undesired leisure. Finally, unemployment could be inflationary and costly to taxpayers: The unemployed are producing nothing—their supply is zero – but the compensation helps keep demand in the economy high. 26‑5 (*Key Question*) Assume that in a particular year the natural rate of unemployment is 5 percent and the actual rate of unemployment is 9 percent. Use Okun’s law to determine the size of the GDP gap in percentage-point terms. If the nominal GDP is $500 billion in that year, how much output is being foregone because of cyclical unemployment? GDP gap = 8 percent [=(9-5)] x 2; forgone output estimated at $40 billion (=8% of $500 billion). 26‑6 Explain how an *increase *in your nominal income and a *decrease *in your real income might occur simultaneously. Who loses from inflation? Who loses from unemployment? If you had to choose between (a) full employment with a 6 percent annual rate of inflation or (b) price stability with an 8 percent unemployment rate, which would you choose? Why? If a person’s nominal income increases by 10 percent while the cost of living increases by 15 percent, then her real income has decreased from 100 to 95.65 (= 110/1.15). Alternatively expressed, her real income has decreased by 4.35 percent (= 100 ‑ 95.65). Generally, whenever the cost of living increases faster than my nominal income, real income decreases. The losers from inflation are those on incomes fixed in nominal terms or, at least, those with incomes that do not increase as fast as the rate of inflation. Creditors and savers also lose. In the worst recession since the Great Depression (1981-82), those who lost the most from unemployment were, in descending order, African-Americans (who also suffer the most in good times), teenagers, and blue‑collar workers generally. In addition to the specific groups who lose the most, the economy as a whole loses in terms of the living standards of its members because of the lost production. The choice between (a) and (b) illustrates why economists are unpopular. Option (a) spreads the pain by not having a small percentage of the population bear the burden of employment. There is the risk, however, that inflationary expectations will give rise to creeping inflation and ultimately hyperinflation; or that the central bank will raise interest rates to reduce inflation, stalling economic growth. If one chooses (b) the central bank will have no cause to raise interest rates and cut off the economic expansion needed to get unemployment down from the unforgivable 8 percent. However, the weakness in spending resulting from an 8% unemployment rate might push the economy into deflation, which would ultimately exacerbate the weak economic conditions. 26-7 What is the Consumer Price Index (CPI) and how is it determined each month? How does the Bureau of Labor Statistics (BLS) calculate the rate of inflation from one year to the next? What effect does inflation have on the purchasing power of a dollar? How does it explain differences between nominal and real interest rates? How does deflation differ from inflation? The CPI is constructed from a “market basket” sampling of goods that consumers typically purchase. Prices for goods in the market basket are collected each month, weighted by the importance of the good in the basket (cars are more expensive than bread, but we buy a lot more bread), and averaged to form the price level. To calculate the rate of inflation for year 5, the BLS subtracts the CPI of year 4 from the CPI of year 5, and then divides by the CPI of year 4 (percentage change in the price level). Inflation reduces the purchasing power of the dollar. Facing higher prices with a given number of dollars means that each dollar buys less than it did before. The rate of inflation in the CPI approximates the difference between the nominal and real interest rates. A nominal interest rate of 10% with a 6% inflation rate will mean that real interest rates are approximately 4%. Deflation means that the price level is falling, whereas with inflation overall prices are rising. Deflation is undesirable because the falling prices mean that incomes are also falling, which reduces spending, output, employment, and, in turn, the price level (a downward spiral). Inflation in modest amounts (<3%) is tolerable, although there is not universal agreement on this point. 26‑8 (*Key Question*) If the CPI was 110 last year and is 121 this year, what is this year’s rate of inflation? What is the “rule of 70”? How long would it take for the price level to double if inflation persisted at (a) 2, (b) 5, and (c) 10 percent per year? This year’s rate of inflation is 10% or [(121 – 110)/110] x 100. Dividing 70 by the annual percentage rate of increase of any variable (for instance, the rate of inflation or population growth) will give the approximate number of years for doubling of the variable.26-9 Distinguish between demand-pull inflation and cost-push inflation. Which of the two types is most likely to be associated with a (negative) GDP gap? Which with a positive GDP gap, in which actual GDP exceeds potential GDP? Demand-pull inflation occurs when prices rise because of an increase in aggregate spending not fully matched by an increase in aggregate output. It is sometimes expressed as “too much spending (or money) chasing too few goods.” Cost-push inflation describes prices rising because of increases in per unit costs of production. Cost-push inflation is most likely to be associated with a negative GDP gap, as the rising production costs reduce spending and output. Demand-pull inflation is more likely to occur with a positive GDP gap, because actual GDP will exceed its potential only when aggregate spending is strong and rising. As the economy produces above its potential, bottlenecks and more severe resource scarcity occur, driving up prices. 26‑10 Explain how “hyperinflation” might lead to a severe decline in total output. With inflation running into the double, triple, quadruple, or even greater number of digits per year, it makes little sense to save. The only sensible thing to do with money is to spend it before its value is cut in half within a month, a week, or a day. This very fact of everyone trying to spend as fast as possible will speed the inflationary spiral and cause people to spend more and more time trying to figure out what goods are most likely to go up fastest in price. More and more people will turn away from productive activity, because wages and salaries are not keeping up with inflation. Instead, they will spend their time speculating, transferring goods already in existence and producing nothing. Eventually, money may become worthless. No one will work for money. Barter and living by one’s wits become the only means of survival. Production falls for this reason and also because investment in productive capital practically ceases. Unemployment soars. A massive depression is at hand. 26‑11 Evaluate as accurately as you can how each of the following individuals would be affected by unanticipated inflation of 10 percent per year: a. A pensioned railroad worker. b. A department‑store clerk. c. A unionized automobile assembly‑line worker. d. A heavily indebted farmer. e. A retired business executive whose current income comes entirely from interest on government bonds. f. The owner of an independent small‑town department store. (a) Assuming the pensioned railway worker has no other income and that the pension is not indexed against inflation, the retired worker’s real income would decrease every year by approximately 10 percent of its former value. (b) Assuming the clerk was unionized and the contract had over a year to run, the clerk’s real income would decrease in the same manner as the pensioner. However, the clerk could expect to recoup at least part of the loss at contract renewal time. In the more likely event of the clerk not being unionized, the clerk’s real income would decrease, possibly by as much as the pensioned railroad worker. Although with prices increasing, the store hiring the clerk may be able to pay the clerk better (and need to in order to retain his or her services). (c) Since the UAW worker is unionized, the loss in the first year would be the same as in (b) but it is likely—barring a deep recession—that the loss will be made up at contract renewal time plus the usual real increase that may or may not be related to increased productivity. If the contract had a cost-of-living allowance clause in it, the wage would automatically be raised at the end of the year to cover the loss in purchasing power. Next year’s wage would rise by 10 percent. (d) If the inflation is also in the price the farmer gets for his products, he could gain. But more likely the price increases are mostly in what he buys, since farm machinery, fertilizer, etc., tend to be sold by less competitive sellers with more power to raise their prices. The farmer faces a lot of competition and has to rely on the market price to go up—the farmer has little control over prices on an individual basis. Moreover, if interest rates on the farmer’s new debts have gone up with the prices, the farmer could be even worse off. The other side of the coin is that if no new borrowing is necessary, the inflation will reduce the real burden of the farmer’s debt, because the purchasing power declines on the fixed payments he contracted to make before inflation. (e) The retired executive is in the same boat as the pensioned railroad worker, except that the executive’s income from the bonds or other interest bearing assets is probably greater than that of the worker from the pension. The increase in inflation has most probably been accompanied by rising interest rates, with a proportional drop in the price of bonds. Therefore, the retired executive would suffer a capital loss if he or she decided to cash in some of the bonds at this time and the fixed interest received on these existing bonds is worth less in terms of purchasing power. In other words, the executive, although wealthier than the retired worker, may be affected just as much or more from inflation. (f) Assuming the store owner’s prices and revenues have been keeping pace with inflation, his or her real income will not change unless the costs have risen more than the product prices. 26-12 (*Last Word*) Suppose that stock prices were to fall by 10 percent in the stock market. All else equal, would the lower stock prices be likely to *cause *a decrease in real GDP? How might they predict a decline in real GDP? GDP could be reduced if stock owners feel significantly poorer and reduce their spending on goods and services, including investment in real capital goods. However, research indicates that downturns in the stock market have not had major impacts on GDP. A fall in stock prices might signal a change in expectations. Evidence does suggest that there is a link between falling stock prices and future recessions. However, this is only one factor related to predicting recessions and, by itself, a fall in stock prices is not a reliable predictor of recession.