Economic Growth and Economic Growth and InstabilityInstability

Economic GrowthEconomic GrowthHow to increase the economy’s productive How to increase the economy’s productive

capacity over timecapacity over time Two definitions of economic growth:Two definitions of economic growth:

• The increase in real GDP, which occurs The increase in real GDP, which occurs over a period of time.over a period of time.

• The increase in real GDP per capita, The increase in real GDP per capita, which occurs over timewhich occurs over time

This is superior if comparison of living This is superior if comparison of living standards is desiredstandards is desired

Growth in real GDP does not Growth in real GDP does not guarantee growth in real GDP per guarantee growth in real GDP per capitacapita• If growth in population exceeds the If growth in population exceeds the

growth in real GDP, real GDP per capita growth in real GDP, real GDP per capita will fall.will fall.

Growth is an important economic Growth is an important economic goal because it means more material goal because it means more material abundance and ability to meet the abundance and ability to meet the economizing problemeconomizing problem• Growth lessens the burden of scarcity.Growth lessens the burden of scarcity.

Using the “Rule of 70,” a growth rate Using the “Rule of 70,” a growth rate of 2% annually would take 35 years of 2% annually would take 35 years for GDP to double, but a growth rate for GDP to double, but a growth rate of 4% annually would only take about of 4% annually would only take about 18 years for GDP to double.18 years for GDP to double.

Rule of 70: Uses the absolute value Rule of 70: Uses the absolute value of a rate change, divides it into 70, of a rate change, divides it into 70, and the result is the number of years and the result is the number of years it takes the underlying quantity to it takes the underlying quantity to doubledouble

Main sources of growth:Main sources of growth:• Increasing inputs Increasing inputs OROR• increasing productivity of existing inputsincreasing productivity of existing inputs

About 1/3 of U.S. growth comes from About 1/3 of U.S. growth comes from more inputsmore inputs

About 2/3 comes from increased About 2/3 comes from increased productivity.productivity.

Growth doesn’t measure quality Growth doesn’t measure quality improvementsimprovements

Growth doesn’t measure increased leisure Growth doesn’t measure increased leisure timetime

Growth doesn’t take into account adverse Growth doesn’t take into account adverse effects on environment or human securityeffects on environment or human security

International comparisons are useful in International comparisons are useful in evaluating U.S. performanceevaluating U.S. performance

Overview of the Business CycleOverview of the Business Cycle Historical RecordHistorical Record

• The U.S. impressive long-run economic The U.S. impressive long-run economic growth has been interrupted by periods growth has been interrupted by periods of instability.of instability.

Uneven growth has been the patternUneven growth has been the pattern• with inflation often accompanying rapid with inflation often accompanying rapid

growthgrowth• and declines in employment and output and declines in employment and output

during periods of recession and during periods of recession and depressiondepression

Overview of Business CycleOverview of Business Cycle Four phases of the business cycle are Four phases of the business cycle are

identified over a several-year period:identified over a several-year period:• PeakPeak – When business activity reaches a – When business activity reaches a

temporary maximum with full employment and temporary maximum with full employment and near-capacity output.near-capacity output.

• RecessionRecession – A decline in total output, income, – A decline in total output, income, employment, and trade lasting six months or employment, and trade lasting six months or moremore

• TroughTrough – The bottom of the recession period. – The bottom of the recession period.• RecoveryRecovery – When output and employment are – When output and employment are

expanding toward the full-employment levelexpanding toward the full-employment level

Several Theories About CausationSeveral Theories About Causation

Major innovations may trigger new Major innovations may trigger new investment and/or consumption investment and/or consumption spendingspending

Changes in productivity may be a Changes in productivity may be a related cause.related cause.

Most agree that the level of Most agree that the level of aggregate spending is important, aggregate spending is important, especially changes on capital goods especially changes on capital goods and consumer durables.and consumer durables.

Cyclical Fluctuations:Cyclical Fluctuations: Durable goods output is more volatile Durable goods output is more volatile

than non-durables and servicesthan non-durables and services This is because spending on services This is because spending on services

usually cannot be postponed. usually cannot be postponed.

UnemploymentUnemploymentOne Result of Economic DownturnOne Result of Economic Downturn

Population is divided into three Population is divided into three groups:groups:• Those under age 16 or institutionalizedThose under age 16 or institutionalized• Those not in the workforce. Those not in the workforce. • The labor force that includes those age The labor force that includes those age

16 and over who are willing and able to 16 and over who are willing and able to work, and actively seeking work work, and actively seeking work (demonstrated job search activity within (demonstrated job search activity within the last four weeks)the last four weeks)

Unemployment RateUnemployment Rate Defined as the percentage of the labor Defined as the percentage of the labor

force that is not employedforce that is not employed• Note: NOT the percentage of populationNote: NOT the percentage of population

The unemployment rate is calculated by The unemployment rate is calculated by random survey of 60,000 households random survey of 60,000 households nationwide.nationwide.• Households are in survey for four months, out Households are in survey for four months, out

for eight, back in for four, and then our for for eight, back in for four, and then our for goodgood

• Interviewers use the phone or home visits Interviewers use the phone or home visits using laptops.using laptops.

Unemployment RateUnemployment Rate Two factors cause the official Two factors cause the official

unemployment rate to understate unemployment rate to understate actual unemploymentactual unemployment• Part-time workers are counted as Part-time workers are counted as

“employed”“employed”• ““Discouraged workers” who want a job, Discouraged workers” who want a job,

but are not actively seeking one, are not but are not actively seeking one, are not counted as being in the labor force, so counted as being in the labor force, so they are not part of unemployment they are not part of unemployment statistic.statistic.

Types of UnemploymentTypes of Unemployment FrictionalFrictional StructuralStructural CyclicalCyclical

Full EmploymentFull Employment Full employment does not mean zero Full employment does not mean zero

unemploymentunemployment The full-employment unemployment The full-employment unemployment

rate is equal to the total of frictional rate is equal to the total of frictional and structural unemploymentand structural unemployment

The full-employment rate of The full-employment rate of unemployment is also referred to as unemployment is also referred to as the “natural” rate of unemploymentthe “natural” rate of unemployment

Natural Rate of UnemploymentNatural Rate of Unemployment Achieved when labor markets are in Achieved when labor markets are in

balance; The number of job seekers balance; The number of job seekers equals the number of job vacanciesequals the number of job vacancies

At the end of the last century the At the end of the last century the economy’s potential output was economy’s potential output was being achieved.being achieved.

Natural Rate of UnemploymentNatural Rate of Unemployment

The recent drop in the natural rate from The recent drop in the natural rate from 6% to 4 or 5% has occurred mainly 6% to 4 or 5% has occurred mainly because because • the aging of the work forcethe aging of the work force• Improved information flows in job Improved information flows in job

marketsmarkets• Work requirements enacted with welfare Work requirements enacted with welfare

reformreform• Doubling of the U.S. prison population Doubling of the U.S. prison population

since 1985.since 1985.

Natural rate of unemployment not Natural rate of unemployment not fixed but depends on the fixed but depends on the demographic makeup of the labor demographic makeup of the labor force and the laws and customs of force and the laws and customs of the nations.the nations.

Economic Cost of UnemploymentEconomic Cost of Unemployment

GDP gap and Okun’s Law:GDP gap and Okun’s Law: The GDP gap is the difference The GDP gap is the difference

between potential and actual GDP.between potential and actual GDP. Economist Arthur Okun quantified Economist Arthur Okun quantified

the relationship between the relationship between unemployment and GDP as follows:unemployment and GDP as follows:• For every 1% of unemployment above For every 1% of unemployment above

the natural rate, a negative GDP gap of the natural rate, a negative GDP gap of 2% occurs.2% occurs.

• This is known as “Okun’s Law.”This is known as “Okun’s Law.”

Unequal Burdens of UnemploymentUnequal Burdens of Unemployment

Rates are lower for white-collar workersRates are lower for white-collar workers Teenagers have the highest ratesTeenagers have the highest rates Blacks have higher rates than whitesBlacks have higher rates than whites Rates for males and females are Rates for males and females are

comparable, though females had a lower comparable, though females had a lower rate in 2002rate in 2002

Less-educated workers, on average, have Less-educated workers, on average, have higher unemployment rates than workers higher unemployment rates than workers with more education.with more education.

Non-Economic CostsNon-Economic Costs Loss of self-respect and social Loss of self-respect and social

political unrestpolitical unrest International comparisonsInternational comparisons

Inflation – Defined and MeasuredInflation – Defined and Measured

Inflation – a rising general level of Inflation – a rising general level of prices (not all prices rise at the same prices (not all prices rise at the same rate, and some may fall).rate, and some may fall).

Main Index used to measure Main Index used to measure inflation: Consumer Price Index (CPI).inflation: Consumer Price Index (CPI).

The “Rule of 70” permits quick The “Rule of 70” permits quick calculation of the time it takes the calculation of the time it takes the price level to doubleprice level to double

Facts of InflationFacts of Inflation In the past, deflation has been as much a In the past, deflation has been as much a

problem as inflation.problem as inflation. 1930s, the depression was a period of 1930s, the depression was a period of

declining prices and wagesdeclining prices and wages Prospect of deflation is a recent concern of Prospect of deflation is a recent concern of

economic policymakerseconomic policymakers All industrial nations have experienced the All industrial nations have experienced the

problemproblem Some nations experience astronomical Some nations experience astronomical

rates of inflation (Angola’s was 4,145% in rates of inflation (Angola’s was 4,145% in 1996)1996)

Causes and Theories of InflationCauses and Theories of Inflation

Demand-pull inflation:Demand-pull inflation:• Spending increases faster than Spending increases faster than

production. production. • It is often described as “too much It is often described as “too much

spending chasing too few goods.”spending chasing too few goods.”

Causes and Theories of InflationCauses and Theories of Inflation

Cost-push Inflation (or supply-side Cost-push Inflation (or supply-side inflation):inflation):• Prices rise because of a rise in per-unit Prices rise because of a rise in per-unit

production costs (Unit cost = total input production costs (Unit cost = total input cost/units of output).cost/units of output).

• Output and employment Output and employment declinedecline while the while the price level is rising.price level is rising.

• Supply shocks have been the major source of Supply shocks have been the major source of cost-push inflation.cost-push inflation.

• These typically occur with dramatic increases These typically occur with dramatic increases in the price of raw materials or energy.in the price of raw materials or energy.

ComplexitiesComplexities Difficult to distinguish between Difficult to distinguish between

demand-pull and cost-push causes of demand-pull and cost-push causes of inflationinflation• although cost-push will die out in a although cost-push will die out in a

recession if spending does not also rise.recession if spending does not also rise.

Redistribution Effects of InflationRedistribution Effects of Inflation Price index is used to deflate nominal Price index is used to deflate nominal

income into real incomeincome into real income Inflation may reduce the real income Inflation may reduce the real income

of individuals in the economy, but of individuals in the economy, but won’t necessarily reduce real income won’t necessarily reduce real income for the economy as a whole for the economy as a whole (someone receives the higher prices (someone receives the higher prices that people are paying). that people are paying).

Redistribution Effects of InflationRedistribution Effects of Inflation Unanticipated inflation has stronger Unanticipated inflation has stronger

impacts: those expecting inflation impacts: those expecting inflation may be able to adjust their work or may be able to adjust their work or spending activities to avoid or lessen spending activities to avoid or lessen the effects.the effects.

Redistribution Effects of InflationRedistribution Effects of Inflation Fixed income groups will be hurt Fixed income groups will be hurt

because their real income suffers. because their real income suffers. Their nominal income does not Their nominal income does not rise with prices.rise with prices.

Savers will be hurt by unanticipated Savers will be hurt by unanticipated inflation, because interest rate inflation, because interest rate returns may not cover the cost of returns may not cover the cost of inflation.inflation.• Their savings will lost purchasing power.Their savings will lost purchasing power.

Redistribution Effects of InflationRedistribution Effects of Inflation Debtors (borrowers) can be helped Debtors (borrowers) can be helped

and lenders can be hurt by and lenders can be hurt by unanticipated inflation.unanticipated inflation.• Interest payments may be less than the Interest payments may be less than the

inflation rate, so borrowers receive inflation rate, so borrowers receive “dear” money and are paying back “dear” money and are paying back “cheap” dollars that have less “cheap” dollars that have less purchasing power for the lender.purchasing power for the lender.

Redistribution Effects of InflationRedistribution Effects of Inflation If inflation is anticipated, the effects If inflation is anticipated, the effects

of inflation may be less severe, since of inflation may be less severe, since wage and pension contracts may wage and pension contracts may have inflation clauses built in, and have inflation clauses built in, and interest rates will be high enough to interest rates will be high enough to cover the cost of inflation to savers cover the cost of inflation to savers and lenders.and lenders.

Redistribution Effects of InflationRedistribution Effects of Inflation Inflation Premium: The amount that Inflation Premium: The amount that

the interest rate is raised to cover the interest rate is raised to cover effects of anticipated inflation.effects of anticipated inflation.

Real interest rate – nominal rate Real interest rate – nominal rate minus inflation premiumminus inflation premium

Final PointsFinal Points Unexpected deflation is a decline in Unexpected deflation is a decline in

price level and will have the opposite price level and will have the opposite effect of unexpected inflation.effect of unexpected inflation.

Many families are simultaneously Many families are simultaneously helped and hurt by inflation because helped and hurt by inflation because they are both borrowers and earners they are both borrowers and earners and savers.and savers.

Effects of inflation are arbitrary, Effects of inflation are arbitrary, regardless of society’s goals.regardless of society’s goals.

Output Effects of InflationOutput Effects of Inflation Cost-push inflation, where resource Cost-push inflation, where resource

prices rise unexpectedly, could cause prices rise unexpectedly, could cause both output and employment to both output and employment to decline. Real income falls.decline. Real income falls.

Mild inflation (<3%) has uncertain Mild inflation (<3%) has uncertain effects.effects.• It may be a health by-product of a It may be a health by-product of a

prosperous economy, or it may have an prosperous economy, or it may have an undesirable impact on real income.undesirable impact on real income.

Output Effects of InflationOutput Effects of Inflation Danger of creeping inflation turning Danger of creeping inflation turning

into hyperinflation can cause:into hyperinflation can cause:• SpeculationSpeculation• Reckless spendingReckless spending• More inflationMore inflation

The Stock Market and the The Stock Market and the EconomyEconomy

Do changes in stock prices and stock Do changes in stock prices and stock market wealth cause instability?market wealth cause instability?• Yes. But usually the effect is weak.Yes. But usually the effect is weak.

There is the wealth effect: There is the wealth effect: • Consumer spending rises as asset Consumer spending rises as asset

values rise and vice versa if stock prices values rise and vice versa if stock prices decline substantially.decline substantially.

The Stock Market and The The Stock Market and The EconomyEconomy

Investment EffectInvestment Effect• Rising share prices lead to more capital goods Rising share prices lead to more capital goods

investment and the reverse is true for falling investment and the reverse is true for falling share pricesshare prices

Stock Market Bubbles – Can hurt the Stock Market Bubbles – Can hurt the economy by encouraging reckless economy by encouraging reckless speculation with borrowed funds or speculation with borrowed funds or savings needed for other purposes (a savings needed for other purposes (a crash can cause unwarranted pessimism crash can cause unwarranted pessimism about the underlying economy)about the underlying economy)

The Stock Market and The The Stock Market and The EconomyEconomy

Stock price averages are included as Stock price averages are included as a “Leading Indicator” used to a “Leading Indicator” used to forecast the future direction of the forecast the future direction of the economyeconomy

By themselves, stock values are not By themselves, stock values are not a reliable predictor of economic a reliable predictor of economic conditions.conditions.