Inflation, Unemployment and Business Cycles
What the exam tests
This domain covers inflation measurement and causes, unemployment types and measurement, the Phillips curve and business-cycle fluctuations.
Core rules
- Inflation is a sustained rise in the general price level. Demand-pull inflation comes from aggregate demand exceeding potential output; cost-push from rising input costs or supply shocks.
- CPI measures a fixed basket of consumer goods; the GDP deflator covers domestic output; RPI is an older measure with different weighting. Core inflation excludes volatile food and energy.
- Unemployment rate = unemployed / labour force × 100. Types: frictional (search), structural (skills mismatch), cyclical (demand deficiency), seasonal.
- The short-run Phillips curve shows an inflation-unemployment trade-off; the long-run curve is vertical at the natural rate, so there is no permanent trade-off.
- Okun's law links output gaps and unemployment: growth above trend tends to lower unemployment.
- Business cycles have expansion, peak, contraction and trough phases; the output gap is actual minus potential output.
Worked example
Labour force is 50 million and employment is 45 million, so unemployment is 5 million and the rate is 5/50 = 10%. If the working-age population is 60 million, participation is 50/60 = 83.3%. A CPI basket costing 200 in the base year and 220 now implies 10% inflation. If nominal wages rise 6% over the same period, real wages fall by about 3.6% because 1.06/1.10 - 1 = -0.036.
Traps
- Counting discouraged workers as unemployed; they leave the labour force and can lower the measured rate.
- Treating part-time workers as unemployed when they are employed.
- Using the CPI as a deflator for GDP; coverage differs.
- Assuming the Phillips trade-off persists in the long run.
- Confusing the level of output with its growth rate when assessing the cycle.