IFT Notes for Level I CFA® Program

R15 Understanding Business Cycles

Part 3


4.  Unemployment and Inflation

Most governments try to limit unemployment and contain inflation because these conditions can lead to social and political unrest. The graph below shows the relationship between these variables and the business cycle:

econ r17 4 1

Interpretation of the graph:

  • Unemployment is at its lowest at the peak of the business cycle. This is also indicative of a tight labor market. This situation may also trigger a downturn in the economy, because the bargaining power of labor increases. Workers demand high wages as inflation is at its peak now and they expect prices of goods to further go up. Labor costs account for a significant part of a firm’s costs. When wages are up, the SRAS shifts to the left, causing a decrease in real GDP.
  • If central banks act to tame inflation, it may result in recession.
  • Unemployment is at its highest level at the trough of the economic cycle. Unemployment numbers lag the cycle as we will see shortly, but they are closely related to the cycle.
  • Inflation numbers move along with the business cycle. So, it is said to be pro-cyclical.

4.1. Unemployment

The table below lists some important terms related to unemployment:

Terms related to unemployment
Employed Number of people with a job. Excludes informal workers such as illegal workers.
Working age Those between 16 and 64 years of age.
Labor force Includes unemployed and employed i.e. working age population who are either working or looking for work. Discouraged workers are not included here.
Unemployed People who are actively seeking employment, but currently without a job. To be considered unemployed, one must have been looking for work in the past 4 weeks.
Long-term unemployed People who have not been working for a long-time (3-4 months).
Frictionally unemployed People who are between jobs. They are not working at the time of filling the survey. But, they are not 100 percent unemployed. They have another job waiting and are yet to start.
Structurally unemployed Unemployment that arises because the demand for certain skills has reduced while employers are looking for a different set of skills. Ex: need for typists decreased because of computers/public telephone operators decreased in developing countries because of mobile phones. It can also be due to changes in business, technology, etc.
Activity (participation) ratio
Underemployed A person who has a job that pays significantly less for the qualifications they possess. Ex: a person out of work with a CFA charter working in a grocery store.
Discouraged worker A person who has stopped looking for a job probably because of a weak economy. They are not included in the unemployment rate. If they stop looking for work, then unemployment rate may decrease in a recession.
Voluntarily unemployed Person voluntarily outside the labor force. Ex: early retirees, a 22-year old who is pursuing a Master’s degree and hence not looking for work.
Unemployment rate

Unemployment Rate

Unemployment rate = \frac{Unemployed}{Labor \ Force}

  • Most quoted measure of employment.
  • Measured differently in different countries, which makes international comparisons difficult. Some countries may include even people of working age who are not willing to work, or underemployed.
  • Unemployment rate is inaccurate in predicting the direction of an economy. It lags the economic cycle because it is the economic environment that forces people to look actively for jobs or drop out of it. The following two reasons elaborate on why it is an inaccurate indicator:
    • Businesses are reluctant to lay off people as it is more expensive to hire and train new workers.
    • In difficult economic times, discouraged workers stop looking for jobs (hence not counted as unemployed). So the unemployed number becomes low. But, when the economy recovers, these people start looking for jobs again pushing the unemployed number up undermining recovery.

Overall payroll employment and productivity indicators:

  • To get a sense of the employment cycle and address the issue of discouraged workers, analysts often look at payroll growth. Most companies publish their payroll data. If payroll numbers are increasing, then unemployment is decreasing.
  • Two other measures used to understand the employment situation: overtime hours and the number of temporary workers. During a recovery, the first step taken by firms is to increase overtime hours instead of hiring new workers. Then, they increase the number of temporary workers. The opposite happens at the peak of a business cycle. Instead of laying off workers immediately, firms first reduce overtime hours, and then reduce temporary workers.
  • Productivity is output/(hours worked). A drop in productivity (idling workers) precedes decrease in full-time payrolls. There is a decrease in full-time payrolls once the economy moves fully into recession.
  • Conversely, an increase in productivity precedes an increase in full-time payrolls.


Economics Understanding Business Cycles Part 3